By Priya Saraff
Banks are starting to unwind, literally. Ten years after the financial crisis, the U.S. government, much to the delight of the Wall Street banks, has initiated a process of financial deregulation. While Wall Street continues to cheer, some economists aren’t as confident.
The 2008 financial crisis
The 2008 financial crisis was a result of rampant risky lending and trading by banks. Mortgages essentially became investments. They were sold to investment banks which created Collateralised Debt Obligations (funds pooled together to create investments of different risk levels). These were bought by hedge funds, pension funds and many others. These institutions borrowed money to invest and investment banks borrowed money to buy mortgages and sell them as investments. Banks kept giving out mortgages, even to people with low creditworthiness (called subprime mortgages). Everyone in the chain was profiting. Since house prices were on the rise, banks had faith that a default could be recovered.
But then, house prices began falling and defaults started. Banks couldn’t recover their loans through foreclosure. They stopped lending to each other as well as to the businesses. The credit market froze and some of the most important companies in the world started to fail. In September 2008, the Lehman Brothers went bankrupt. There was a subsequent run on the money market. A $700 billion bail-out scheme was rolled out. Over the year, there were a series of them. JP Morgan Chase bought Bear Stearns. Fannie Mae and Freddie Mac, government-owned companies that offer mortgage-backed securities, and insurance giant AIG were bailed out. In February 2009, a $787 billion Economic Stimulus Package was approved. It gave tax cuts, unemployment benefits, and jobs. Other programmes were initiated to help homeowners pay off their loans. Finally, in March 2010, the Dodd-Frank Wall Street Reform Act was passed.
Too big to fail and the Dodd-Frank Wall Street Reform Act
A company that is ‘too big to fail’ is a company whose failure could lead to worldwide disaster. These companies must be bailed out. In India, the RBI has identified HDFC Bank, State Bank of India and ICICI Bank as ‘too big to fail’. To prevent such a situation (and overall financial crisis) from arising again, the Dodd-Frank Wall Street Act was made a law in July 2010. It established the Financial Stability Oversight Council that keeps a check on the risks affecting the financial industry. It also prohibits banks from using depositor money to trade for themselves (through the Volcker Rule), regulates derivatives, hedge fund trading and credit rating agencies (which played a role in causing the crisis by rating risky investments as ‘safe’. It is alleged that they were paid by investment banks to do so). The Act supervises credit and debit card agencies, loans and mortgages, insurance companies, and gives more power to the Government Accountability Office, besides reforming the Fed.
Trumping it (or Wall Streeting it)
Through legislation like the Financial Choice Act, 2017 and Financial Services & General Government Appropriations Act, 2018, Dodd-Frank is being undone. Bank stress tests are being eased. Living wills (a bank’s plan out of bankruptcy), which so far were to be submitted annually, are now biennial. The leverage ratio and Volcker Rule are being revised. A similar thing had happened to the Glass-Steagall Act passed after the Great Depression. A compact law, it was repealed under the Gramm-Leach-Bliley Act of 1999.
Former Treasury official Michael Barr warns against deregulation. Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation (FDIC) agrees. He highlights the fact that even with regulations, banks have grown more profitable. He worries that an “arrogant” financial industry may get ahead of itself, forgetting that all booms come to an end. But voices like his, actively opposing deregulation, are few. Many heads of institutions under the Trump administration have a past in the financial industry. Steven Mnuchin, Secretary of the Treasury, was a partner in Goldman Sachs. Joseph Otting, head of the Office of the Comptroller of the Currency, was once CEO of OneWest and profited from the financial crisis. Jerome Powell, Chairman of the Federal Reserve, supports deregulation as does the Fed vice chairman for bank supervision, Randal Quarles. Janet Yellen, former Chair, cautions against it. Mick Mulvaney, running the Consumer Financial Protection Bureau, doesn’t believe in the institution, once having called it a “joke“. Jay Clayton of the Securities & Exchange Commission was a lawyer for many Wall Street companies during the crisis. As the head of the SEC, he has reduced oversight and SEC penalties have fallen by 15.5 percent during his tenure.
A middle ground?
But it would be inaccurate to say Dodd-Frank has no faults, whatsoever. An August 2017 article on fortune.com takes expert opinion to analyse several aspects of the Act. For example, the Act mandates certain minimum capital requirements through a minimum risk-based capital ratio and leverage ratio. These might seem too rigid, but the need for a sound capital base is undeniable. The Volcker Rule also receives opposition for being very convoluted and going too far. The Orderly Liquidation Authority provides a midway between a bank bailout and bankruptcy. It allows the government to wind down the company slowly. Repealing this, Alan Blinder (former VC of Board of Governors of the Federal Reserve System, and currently an economics professor in Princeton) believes this is a bad idea.
The last concept the article touches upon is that of the regulation of small banks. Dodd-Frank may have laid its regulations too heavily on these smaller entities, though the Act alone cannot be blamed for the slowing growth of small banks. Perhaps the middle ground lies in Blinder’s suggestion: Not of introducing a new act (Financial Choice Act) entirely but fixing up the Dodd-Frank to what the US financial industry needs today.
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