The Big Bank Regulatory Reform Isn’t What You Think

The pendulum swings.

It swung in the direction of super-tight regulation of the nation’s banks during, and immediately after, the financial crisis of 2008. And now it is swinging in the opposite direction. President Trump and congressional Republicans, along with a handful of Democrats, have pushed through legislation that will ease the regulatory burdens imposed on some banks by the so-called Volcker Rule.

There is deregulation of all sorts, some an over-reaction to bigger government, some a legitimate loosening of ties that bind businesses too tightly. So the details of last week’s roll-back of financial regulation in America matter. The Volcker rule was designed to prevent banks from making risky bets using their depositors’ money. If the bets paid off, shareholders benefited, if the bets were lost, depositors were protected by a taxpayer funded insurance program, and the shareholders were none the poorer. And if bad bets threatened to bring down the banking system, well, there was always the taxpayer to post bail to prevent a collapse of the financial system.

The Volcker Rule brought that asymmetric gambling system to an end, but at the expense of high compliance costs. Big banks had no trouble covering those costs, but smaller banks found them so high as to impair their ability to lend. “Too big to fail had become too small to succeed,” said senator Heidi Heitkamp, Democrat from North Dakota. The rule was written to apply to all banks with over $50 billion in assets; the new law raises that threshold to $250 billion, which restricts its application to perhaps ten banks out of the nation’s approximately 5,000.

Support for this first significant regulatory roll-back in the financial sector was based on a variety of facts. First, the ten banks that remain subject to the Volcker Rule control about 60 percent of all the assets of the entire system. They are the institutions that truly are too big to fail-that could bring down the financial system if they went under. They remain under such watchful eye as regulators possess. Second, failure of any of the other banks is unlikely to spread to the entire system. Third, bad bets are less likely by smaller banks, many of which can still rely on that old safeguard: “know your customer.” Finally, since the rule was enacted, small banks have been losing market share to their bigger competitors and the losers believe it is because regulation has played into the hands of the regulated, who can afford its costs.

Most important, the world has changed since the collapse of Lehman Brothers had the global financial system heading for disaster. Banks are healthier. The industry’s earnings are at an all-time high. Net income in the first quarter of this year rose 27 percent from the same period last year, to a record $56 billion. That includes almost $7 billion from the Trump tax cuts, but even excluding this benefit, earnings would have been a record $49 billion. JP Morgan Chase, the largest American bank, recorded the highest quarterly profit by any U.S. bank, ever. Morgan Stanley and Bank of America broke their quarterly-earnings records. Goldman Sachs reported “solid performances across our business” and raised its dividend.

Perhaps best of all, the banks’ capital positions are stronger than ever, although the Wall Street Journal,no regulation-lover, worries that the new legislation allows an unnecessary weakening of capital positions in response to whining by big banks. Larger banks must still pass the Federal Reserve Board’s stringent “stress tests” that require them to hold what the Fed describes as “a capital buffer sufficient to withstand a several-year period of severe economic and financial stress.” The largest banks must have orderly plans for their dissolution should they become insolvent. Their rules for risk management must pass regulatory scrutiny.

There’s more, but you get the idea. Neither regulators nor politicians have forgotten the lessons of the last crisis, when bankers permitted dicey mortgages to be bundled into even dicier securities, and then sold them to investors who believed the AAA ratings lavished on these securities by rating agencies whose fees depended on the deals going through. Thanks in part to the infusion of billions of taxpayer “bail out” dollars, in part to the new regulations, and in part to Fed policy that prevented the Great Recession from morphing into another Great Depression, the major banks did not follow Lehman Brothers, Bear Stearns, and others into the graveyard of mismanaged financial institutions.

We learned a lot about financial markets after 2008, but not so much that we can be certain there will never be another crisis. After all, policy is based first on models no better than the historic data on which they rely, and on numerous assumptions by the model-builder. Then, models in hand, policy is made by fallible humans, often operating under great stress, real, imagined, and political. Richard Bookstaber, who spent 30 years on Wall Street-part of the time as risk manager for Morgan Stanley-says, “People . . . find another way to be stupid. . . . I think there are going to be other crises.”

Just as the only way to avoid traffic accidents is to outlaw automobiles, the only way to avoid another financial crisis is to end the use of money and credit, reverting to barter. So we have to devise regulatory tools that balance our need to minimize crises with our need for adequate credit to finance economic growth. Everyone agrees on two things: the big banks are not to be left to the unregulated direction of their CEOs, and small banks cannot be burdened with regulatory costs so high that they are unable to lend to job-creating smaller businesses.

So far, the pendulum has not swung as far back as the wildest deregulators would have it. So far. But beware bankers seeking to push the pendulum to its pre-2008 position.