I'm Negative on the Dodd-Frank Bill: Here's What Dodd Has to Say

Includes: KBE, XLF
by: Tom Brown

Well, here’s the quote of the day: “No one will know until this is actually in place how it works.”

That’s Chris Dodd (a “teary-eyed” Chris Dodd, according to the Washington Post), talking about the financial services reform bill that House and Senate conferees finally agreed to last week. How encouraging!

You already know I’m no fan of Dodd’s bill. It’s not that I think the new regulations will pose some new undue burden on the banks and permanently dent industry returns. If there’s anything banks are good at, it’s operating within a byzantine regulatory environment. For all I know, the new rules will serve as a helpful new barrier to entry to the business that will make it easier for banks to compete against heretofore unregulated players. Who can say? Rather the problem with the bill is that, with its CFPA, and its Volcker Rule, and its lack of preemption of state regs, and the rest, it will have the effect of restricting the availability of credit generally and make it more expensive.

This worry was underscored to me this week when I read a couple of reports by one of the most insightful followers of banks on Wall Street, Dick Bove. While I’m no fan of the new legislation, Dick sees its implications even more darkly:

Congress is about to pass a law that may put in place rules that would restrict bank access to new funds (eliminating trust preferreds) and reduce bank profitability (Volcker Rule, etc.).

Thus, more capital is being demanded as methods to gain that capital are being reduced. In response to the demands being placed upon them, banks stopped lending incrementally. Money supply growth is tumbling and M-3 (in the green below), no longer calculated by the Fed, is declining meaningfully. Presumably, if the banking bill is passed, this decline will accelerate.

To me this is a repeat of 1937 and 1981. The hyper focus on interest rates is misplaced. If money supply continues to decline it matters little what interest rates are. It is very difficult to imagine an economy avoiding recession if the policy makers keep taking actions which reduce this vital part of the economy. Check this view with your local economist.

Therefore, it is quite possible that voting for this banking bill and the associated regulations is voting for recession. [Emph. added]

Meanwhile, Dick adds, the problems that the legislation is supposed to fix are unavoidable occurrences that have been happening regularly since the banking system first developed back in the 1200s. Trying to regulate them away is like trying to regulate away gravity. (Or, more properly, like trying to regulate away risk.)

So the effect of the legislation could be bad, or it could be really bad. Both of Dick’s notes are definitely worth your time.