On February 3rd we saw the unveiling of President Trump’s much vaunted Executive Order into reviewing United States financial regulations. In what could signal a major change in the post-crisis regulatory landscape, the President declared that ‘we expect to be cutting a lot out of Dodd-Frank’ and set out his administration’s new ‘core principles’ for regulating the financial system – the consequences of which will be felt not only in the US, but also across the globe.
While the announcement itself contained plenty of tough rhetoric on rolling back Dodd-Frank and other Obama-era banking legislation, it is difficult at this stage to know precisely what Trump’s reforms will mean in practice. Clearly there will be an attempt to remove aspects of financial regulations that are deemed too onerous on US banks and to encourage a greater level of risk-taking to stimulate economic growth. The wording of the Executive Order itself is reasonably high-level, focusing on core principles that foster economic growth, prevent future taxpayer bailouts, ensure the competitiveness of American firms and advance American interests in international financial regulatory negotiations.
President Trump has ordered the review to be completed within 120 days of the Order on identifying laws, treaties and regulations that conflict with his new core principles. Whilst we await the specifics or any recommendations, we can note a number of practical challenges in any plans to water down Dodd-Frank, not least the likely resistance that will come from Congress. The process of unpicking a 2,300-page Act will be long and complicated and will be met with fierce opposition from Democrats.
That said, we can determine the likely areas of focus from statements given by Trump and his key advisers, notably Gary Cohn (Director of the National Economic Council) and Steven Mnuchin (the nominee for Treasury Secretary). We explore, below, the key areas of focus and the likely levers that the President and his administration can use in pursuing their agenda.
While many US banks will welcome the new President’s focus on easing regulatory burdens and increasing competitiveness, there will be many others around the world that will be concerned about the wider impacts on financial stability and coordinated global standards for capital, liquidity and compliance. Given the central role that the United States plays in international rule-making bodies, the changes could be profound.
It should be noted that Trump’s Executive Order has been made at a time when divisions are emerging between jurisdictions in terms of the application of international regulatory standards, most notably on the Basel Committee on Banking Supervision. Indeed, Trump’s plan to roll back the post-crisis regulatory reforms and pursue an ‘America First’ strategy on banking could signal a new era in fragmenting global regulatory standards.
Designation of SIFIs and increasing competitiveness
One of the areas that is most likely to receive attention is the classification of Systemically Important Financial Institutions (SIFIs). These are designated by the Financial Stability Oversight Council (FSOC), who determine which institutions are large enough to carry an implicit taxpayer guarantee and must comply with stricter regulations. These stricter regulations include the requirements to submit resolution plans to the Federal Reserve and the Federal Deposit Insurance Corporation – the so called ‘living wills’.
Trump’s adviser, Gary Cohn has publicly commented on the administration’s intention to review FSOC and the designation and regulation of SIFIs. He has already questioned the value of these living wills as an effective resolution mechanism and has indicated that he wants FSOC to stop designating non-bank institutions as SIFIs. There have also been suggestions that the threshold for SIFIs be increased from $50 to $250 billion in assets, meaning that fewer banks and financial institutions would be designated and thereby reducing the regulatory burden on all but the largest banks. Such a move would be designed to increase competitiveness within the US banking system and allow mid-sized and regional banks to grow and compete with larger lenders and provide greater levels of lending.
It is possible that President Trump can achieve these reforms without the need for legislative change, by ensuring that his appointees are on the key regulatory agencies to direct FSOC’s approach. Major changes will, of course, be controversial and encounter opposition (particularly by those who think this will exacerbate the problem of Too Big to Fail) but the political barriers are not likely to be insurmountable.
It should also be noted that reclassification of SIFIs may have wider ramifications, including an impact on global standards and the rules governing Global Systemically Important Financial Institutions (GSIFIs or GSIBs) including issues such as capital surcharges currently agreed at international level (by the FSB and the Basel Committee) but applied by the Federal Reserve Board. A dramatic policy change to the regulation of SIFIs could mean that global rules surrounding GSIFIs and their implementation are cast into doubt.
Governance and supervision
The Trump administration could ease regulations on banks without changes in legislation through ‘neutralising’ regulatory institutions by placing their own appointees on them. A clear example of this is the Consumer Financial Protection Bureau, which many Republicans believe has overstepped its remit under its current Director, Richard Cordray. There has already been much speculation over whether the Trump administration would replace him with a less interventionist head, in order to ease the level of consumer and conduct regulation on US banks. Similarly, the new head of the Securities and Exchange Commission (SEC), Jay Clayton, is widely expected to ease capital-raising rules in financial markets rather than focus on enforcement.
A key source of tension is likely to emerge between the administration and the Federal Reserve. The Trump administration are likely want their own appointment in charge, once the term of current Chair, Janet Yellen, ends. The Fed’s stress testing regime, the Comprehensive Capital Analysis and Review (CCAR), is regarded as one of the toughest and most stringent stress tests in banking. Its scope covers governance, data collection, senior management capability and linking living wills to management action plans. It is very possible for Trump to weaken the CCAR regime as he dismantles the powers of FSOC – which in turn would have severe consequences for the wider global regulatory regime and even financial stability. Already this week the Fed announced that it would not subject all but the very large banks to the strenuous qualitative supervisory review of CCAR.
Another critical policy under Dodd-Frank is the Fiduciary rule, a major pillar of Conduct regulation. Implemented by the Department of Labor (but not yet fully legislated), the Fiduciary rule mitigates against conflict of interest, where advisors have to demonstrate they are providing the best advice to benefit their customers. While this rule counters moral hazard issues rampant in the crisis and more recently in the Wells Fargo Scandal, Republicans oppose it since it reduces the availability and diversity of products sold to customers. Trump has already announced that this fiduciary rule will be repealed.
Future of the Volcker Rule and trading
One part of Dodd-Frank that will gain considerable attention is the Volcker Rule, which currently restricts US banks from engaging in proprietary trading or from making hedge fund and private equity investments. There has been speculation that the Trump administration would scrap or amend this rule – and should it be repealed or sufficiently amended, it would add immediate profitability to some major investment banks. Trump’s nominee for Treasury Secretary, Steve Mnuchin, has stated that he would like to amend the rule, although he has also said he does not want to scrap it in its entirety. Critics of the Volcker Rule have said that it is overly restrictive and has reduced market liquidity, through failing to define the difference between proprietary trading and market making.
Major changes to the Rule, however, would be politically controversial. The Volcker Rule is a core component of Dodd-Frank and high risk trading was seen as one of key factors that lead the global financial crisis. It could be argued, however, that these concerns are misplaced and that a bigger contributor to the financial crisis was the use of structured products and securitisation. During the crisis, in my capacity as the Director of Risk Specialists at the FSA in 2009, we examined the origination of losses in all London-based GSIFI banks and the data are very clear that over 80% of the losses were all in structured products and hedges (such as credit derivatives) versus less than 5% in proprietary trading.
Alongside the debate about the Volcker Rule, there is also talk of a return of Glass-Steagall – a rule that imposes a strict firewall between retail and investment banking that was repealed in the 1990s. A 21st century version of this rule may be adopted and some investment banks would welcome this. In the UK, the Vickers structural reform programme ring-fences these types of investment banking activities. However, ring-fence rules together with the creation of IHCs puts pressure on policing operations and technology between the entities – this is extremely cumbersome, exponentially increasing operational risks and Board conflict of interest. It may then be preferable to revert back to having separate entities – a revised 21st century Glass-Steagall.
Future of cross-border cooperation and global regulatory standards
The potential reforms I have outlined will be a major source of encouragement for the US banking industry (indeed, US banking shares have rallied strongly since Trump’s Executive Order). Many have welcomed the new administration’s focus on ensuring competitiveness and rebalancing a regulatory environment, which they regard as having overreached. Away from Wall Street, however, there will be many who will be concerned by the attempt to roll back the post-crisis regulatory landscape and its impact on long-term financial stability. Perhaps of bigger concern for those outside the US is the potential impact that an aggressive ‘America First’ approach will have on global regulatory rule-making and harmonisation.
The United States plays a central role in international rule-making bodies, such as the FSB and the Basel Committee on Banking Supervision, and in underpinning global standards. The protectionist rhetoric from Trump and his advisers has led some to speculate that the US commitment to these coordinated global standards is waning and could even lead to withdrawal from some key initiatives. For example, any major changes and deviation to the designation, regulation and stress testing of SIFIs by US authorities is likely to have a knock‑on effect on global rules for GSIFIs. Any wider reforms and softening of prudential and conduct rules could also stymie global agreements on rules governing capital, reporting and disclosure. This comes at a time when there are already disagreements and divisions emerging on reforms to capital rules on the Basel Committee between European and US regulators.
The prospect of a new era of regulatory divergence and fragmentation is real. This raises several challenges for banks and regulators – not least that the easing of regulatory standards in US could create asymmetry in the global regulatory landscape and undermine the regulatory reforms taking place in other jurisdictions. Following the financial crisis, many of the reforms in Dodd-Frank were mirrored in other jurisdictions to enhance financial stability and regulate conduct, for example, through EU Directives such as CRD IV and MIFID II. If the US is seen to significantly undercut these regulations, then there is a real risk of regulatory arbitrage – with business moving away from Europe and London and towards the US and New York. It could also undermine the system of equivalency in which regulators allow international banks to operate in their jurisdiction under their home country’s regular by broadly harmonised standards.
This change poses a significant dilemma for policy‑makers and regulators around the world. Do they uphold current commitments to prudential and conduct regulations, or do they aim to compete with the US market through a programme of deregulation (in what some would call a race to the bottom)? This process could pose a problem for the UK as it determines its future post-Brexit. Many in the City of London will be focused is on ensuring the best possible access to European markets by maintaining a system of regulatory equivalence with EU authorities. There is a competing need to align the UK’s regime closer to the United States and be more competitive. There will, of course, be significant risks to both approaches – policy‑makers will soon be facing key dilemmas about where UK’s future lies.
Sir Jon Cunliffe, Head of Financial Stability of the Bank of England, this week articulated the need to safeguard the new regulatory architecture or risk a new financial crisis. He believes that any weakening of the global regime will undermine all the progress made to date. Naturally the Bank are concerned about the UK becoming an offshore centre competing more aggressively for global business. Sir Jon commented that ‘One doesn’t become successful as an international centre by having lax standards and by being open to crises and regulatory arbitrage.’ That said, a weakened US regulatory regime could see a flight of firms to the USA if indeed the costs of capital, liquidity (and entrapment of the latter two) are significantly lower.