Will Bank Regulation Cause The Next Financial Crisis? Part III: No, It Won't

| About: Bank of (BAC)

Summary

Kurt Dew has contended that bank regulation will cause the next financial crisis. I disagree.

Dodd-Frank has strengthened bank regulation in ways that are likely to prevent, rather than cause, a financial crisis.

Stress tests in particular are useful and effective. They have made bank balance sheets forward-looking rather than merely historical.

Living wills and better consumer protection also tend to prevent financial crises.

The Dodd-Frank innovations even are likely to deter the kind of extreme booms that lead to the big busts that cause financial crises. Bank investing therefore will be safer.

This is the third article of a three-part series that discusses whether bank regulation will cause the next financial crisis. In his own series of articles, Kurt Dew has contended that it will. I contend that it will not. I encourage you to read Part I and Part II of my rebuttal.

Before examining Dodd-Frank and its likely results, let me remind readers that financial crises follow recessions that cause or result in a significant fall (after a significant rise) in the price of an asset that is backed by loans (or, in the modern world, instruments backed by or dependent on the price of loans) held in large quantities by financial institutions.

Almost always, this has been real estate or natural resources to be found in real estate, though on occasion, it has included financial instruments. We therefore know what to look for. That may not make us more likely to be able to prevent the price increases that set the table, but it should make us more likely to be able to minimize the impact of the losses on the financial system on the downside.

Summary of Kurt Dew's Position

I would summarize Dew's position as being that bank regulation adopted as part of the Dodd-Frank law is weakening the large banks and preventing them from engaging in profitable business. The profitable business will go into non-regulated sectors, and the big banks each will end up taking similar risks. Therefore, when the next significant recession comes about, the non-banks that have taken the big risks will fail, and they will drag down the economy. Alternatively, bank regulation under D-F is making all the big banks too similar, and with similar risks, they will be prone to failing at the same time. If I am misstating his position, I am sure Dew will let us know, as he should.

As part of Dew's discussion, he calls on the redoubtable Karen Shaw Petrou, a Washington banking consultant for more than 40 years. See Petrou's cited talk here. I will mention some of the points she made (I confess that Ms. Petrou and I have disagreed on many things since before she added the Petrou to the Shaw).

Two Answers

I suggest that there are two answers to Dew's forecast. First, JPMorgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC) and Goldman Sachs (NYSE:GS) are strong companies that are learning to flourish under the new rules. Citigroup (NYSE:C) and Bank of America Merrill Lynch (NYSE:BAC), I grant, are still groping for their proper métiers.

BofA was not natively a dealer bank, and neither was Merrill Lynch, on whose platform BofA has sought to build. Merrill was (to some extent still is) a retail broker with an investment banking business semi-bolted on. Maybe BofA will not be a dealer bank long term.

Citi still is in the woods, trying to maximize its strengths and reduce its exposure to weaknesses. Shrinking will be good for Citi, and perhaps it will find its way.

Morgan Stanley (NYSE:MS) has for the last 25 years been uncertain what it should be. Maybe it is just a wealth manager. I do not know. But whatever happens to these banks, I do not think they will be clones of each other, as were the Texas banks that lent on oil and gas and real estate in the red-hot days of the early 1980s. Today's big banks already are distinguishing themselves from each other.

Second, the large non-banks are not really large at all. Take BlackRock (NYSE:BLK), the biggest money manager. Although it manages trillions, it is not systemically dangerous. Its money is not on the line with its clients' money. And its clients' money is in so many different entities that the failure of any one need not affect any other.

But even more to the point, the entities are mutual funds or mutual-fund-like structures. They trade, to the extent that they trade, at net asset value or close to it. True, there are some liquidity issues concerning open-end bond funds (and those issues are being dealt with by the SEC). But closed end funds have no such issues, and the EFT structure avoids the liquidity issues almost completely. See my article here.

Could BlackRock have a big impact on market prices by electing to change investment strategies? Yes, that could happen, even though so much of the money under management is not subject to such changes. But markets are supposed to reflect what investors think. That means losses as well as gains. Dew, like me, is fundamentally pro-market. I doubt that we disagree here.

The money management industry has been subjected to both national and international scrutiny over the last few years, looking to see whether it was systemically dangerous. The reports do not substantiate the innuendo.

Karen Petrou and some others worry about what will happen when the online lenders, such as LendingClub (NYSE:LC) fall on hard times (You might take a look at the U.S. Treasury Department's study released May 10, 2016, or my article here that describes it). The online lenders' business models are untested. Yes, they are untested. Yes, some may fail. So who cares? They are pipsqueaks masquerading as important financial players. There will be no lines at their doors, they will cause no liquidity shortages. If they fail (which I am not predicting), the economy will hardly know they had passed by.

The same can be said for hedge funds. They failed in numbers in the Great Recession, many have failed since, they are performing badly for their investors at the moment, more failures can be expected. So what? No lines, no liquidity crisis, no credit crunch, no threat to the payments system.

What Dodd-Frank Did Accomplish

So let's look at what D-F actually did: (1) stress tests, (2) more capital, (3) living wills, and (4) established the Consumer Financial Protection Bureau.

Stress Tests

Even Kurt Dew and Karen Petrou actually agree with me that stress tests are a good idea. Petrou says:

The FRB hails [stress testing] as a hallmark of the post-crisis framework and deservedly so. That tough tests make a meaningful difference is demonstrated by the strength U.S. banks regained after the strict 2009 exercise and macroeconomic growth thereafter.

Kurt Dew's problem is that the Fed determines some of the scenarios against which the banks are measured (which tends to make them take similar risk management steps). I demur. The Fed has to do that because history has taught us that banks cannot be trusted to define their own tests. I am not a fan of so-called Black Swans. But it is correct that there are incentives for bankers to miss the fat tails. And please see the discussion comparing bank capital in the 1920s with bank capital in the 2000s below.

The Regulatory Regime Changed In 2009

Amazingly, the system of bank regulation, which I would say had not been successful in adjusting to the post-Bretton-Woods world, changed for the better in 2009 with the stress tests administered by the Fed. The results were reported in May of that year, and they ended the vestiges of the U.S. financial crisis after only seven months. The stringent stress test technique set the stage for a new way to manage credit availability in the U.S. and, potentially, elsewhere as well.

The 2009 stress tests involved two radical departures from previous regulation:

  1. The tests were forward-looking rather than based on historical accounting, and
  2. the regulators trumpeted the results rather than keeping them secret, as had been the policy with regulatory findings about individual banks for the last 75 years. Those departures have changed the nature and effectiveness of bank regulation.

Dodd-Frank institutionalized the stress test for major banks (CCAR), established the possibility that other institutions could be subject to such tests, and called for something that I, at first, thought was rather silly-living wills. Dodd-Frank contained a lot of waste - but it also contained the seeds of a forward-looking instead a backward-looking way to see bank balance sheets.

Historically based loan loss reserves have made it impossible to rely on bank financial statements regarding solvency or insolvency. In good times, they looked high, in bad times they always were too low. Therefore when severe economic conditions occurred, no one knew which banks were safe and which were not - and perversely, regulatory secrecy prevented either the regulators or the bankers from saying anything about what the regulators found in their examinations.

In that situation, which banks survived and which failed was hit or miss and largely a question of reputation, except that deposit insurance plus Fed liquidity support made failure or survival more a question of the regulators' judgment about solvency because mere runs need not doom a bank that gets Fed support.

The change that came from stress-tested capital that was given publicity by the regulators was enormous. All of a sudden, the bank's balance sheet was not opaque and backward-looking; it was, instead, fairly transparent (still difficulties with derivatives) and forward-looking. Yes, a stress test is not perfect, but with a fairly robust capital regime, perfect is not necessary. As the stress test regime has developed over the last six years, it has improved, and, more importantly, some of the best banks have embraced the concept and utilize it more explicitly internally. See, e.g., Jamie Dimon's chairman's letter in JPM's most recent annual report.

Stress tests are not static. They have the capacity to change as bank risk profiles change. And the Fed changes its tests every year, which is designed to prevent a completely uniform approach to risk management.

Will Stress Testing Prevent All Failures?

Will stress testing mean that big banks cannot fail all at the same time due to having made the same bets? No, there is no guarantee, but the chances are better than they were without stress tests. In addition, there now will be credible evidence regarding the impact of a severe recession on each major bank. That information change will be crucial in making runs less likely.

Even more important, the Fed will be able to use the data from the last stress test to tell everyone that a bank is solvent and will be eligible to be supported. That is likely to be an even more important deterrent to runs.

Stress Tests Change Management Conduct

Perhaps the best benefit of stress tests is that they tell banks what their real risks are in a severe downturn. The process tells them what parts of their portfolios are most likely to incur the largest losses when the severe recession hits. No longer can such a downturn be assumed to be such an outlier that it safely can be discounted. That stress test feature tends to make banks more risk averse where the dangers are greatest, which in turn tends to make them less likely to advance credit in a manner that feeds into a building bubble.

Stress Testing Shows That Much Regulation Is Not Needed

There is another important benefit: With stress testing, much of the remainder of the safety and soundness regulatory apparatus readily can be seen as unnecessary. It therefore can be eliminated, with great savings to the banks and great consternation among the bank examination fraternity.

I would put the general ledgers of the major parts of each bank online to the Fed and forget about onsite examination, jawboning about specific types of credit, and many other costly and now-redundant regulatory features. Let the Fed talk with each board of directors once a year after the stress test results have been announced, with the option to go back if anything fishy turns up from reviews of the general ledgers.

Historical Comparisons Show Strong Capital Regulation Is Needed

A recent paper published in the May 2016 American Economic Review entitled "Bank Leverage and Regulatory Regimes", by Christoffer Koch, Gary Richardson and Patrick Van Horn, provides insight into why modern capital requirements are so important. The paper compares the capital accumulation or lack thereof by large banks during the run-up to the Great Depression and during the run-up to the Great Recession.

The bank regulatory and support systems were very different in the two periods. In the 1920s, bank stockholders were subject to being required to pay double the amount of capital they had contributed if the bank failed. Bank directors were required to own stock, and most senior executives held significant amounts of stock. There was no deposit insurance, which made runs on weaker banks more likely. And regulators in New York, for example, were pretty quick on the trigger to take over failing banks. By the 2000s, none of this applied, and the bankers had less incentive to prevent failure.

With this contrast in incentives, the big New York City banks increased their capital to asset ratios in the boom time of the 1920s and none of them failed. In the 2000s' boom, the big banks did not increase their capital ratios, adhering to ratios close to the minimum permitted by regulatory authorities. Here are the contrasting graphs:

The lesson I draw from these data is that the existence of the regulatory support for big banks, regardless of TBTF, has made it critical that high regulatory capital be imposed and tested stringently because the bankers of today, unlike those who were at risk in the 1920s, will not act counter-cyclically by building their capital ratios in the good times, as they should. They will, instead, try to maximize their stock prices by maintaining high leverage, if they are permitted to do so. Squirrels know to store nuts in the summer and early fall. They have no safety net. The safety net changes incentives.

Living Wills

The peculiar living will stuff in Dodd-Frank also is creating unexpected (at least by me) benefits. The process is causing banks to simplify their corporate structures and to remove runnable liabilities from the top holding company, replacing them with longer-term liabilities that qualify as T-LAC (Total Loss Absorbing Capital, as if we needed another bank regulatory acronym).

Although the living will structures are untested - and probably will be untested until there is a crisis - they are worthwhile even if they do not work when put to the test because they make being put to the test less likely.

The Dodd-Frank Innovations Would Have Reduced The Run-Up Of House Prices In The 2000s

Stress tests and their publication, plus living wills, are counter-cyclical measures that would have decreased the severity of the GFC and might well have reduced the amplitude of the 2004-2006 boom as well. Goldie (GS), Bear, Lehman, Merrill and Morgan Stanley all would have been under the Fed's stress test regime (as would WAMU) and all would have had to maintain capital as SIFIs. Those forms of regulation would have made their businesses and the way that they priced risk very different. They also would have had living wills which, whether they would have worked or not, at least would have made their resolution much easier.

Would non-banks have made the same credits that drove the real estate market into boom territory if the above-listed investment banks had been deterred?

A substantial percentage of the loans were made by mortgage banks that would not have been under the stress test or living will regimes. They were originators but not holders to maturity or securitizers. As such, they sold their product to Bear, Lehman, Goldie, JPM, Citi, Barclays (NYSE:BCS) and, later on, to Merrill, RBS (NYSE:RBS) and Nomura (NYSE:NMR). Bear and Lehman both also owned mortgage banks that would have been under their stress test and living will regimes.

Most of the mortgage banks would have made loans of whatever type they could for as long as they could. Most of them had no internal discipline - the only discipline was what they could sell. The mortgage brokers that supplied the mortgage bankers also had no discipline other than what they could sell. Therefore the discipline in the mortgage pipeline depended entirely on the buyers - that is the investment banking houses that did the securitizations (assisted by the credit rating agencies) and those who bought from them.

If the investment bankers would not buy the mortgages, they would not get made. There was no other outlet for the riskier types of product in such volume.

It is meaningful to ask whether D-F likely would have prevented the investment banks from buying the poorly underwritten loans since that is what would have prevented the bubble from inflating after about 2003. I do not have an answer to that question, but I have some suggestions.

Dodd-Frank would have made the GFC less stressful. But whether it would have prevented the boom is, I think, entirely speculative. Nevertheless, here is what I would speculate: WAMU would not have taken the risks it took. The investment banks' quality assumptions about the loans they held (pending securitization) would have been contested by the Fed. Maybe that would have altered investment banker conduct - maybe not. And maybe the publicity given to that questioning would have caused the credit rating agencies to question those assumptions - maybe not. The end buyers - in Germany, Switzerland or wherever might have been deterred from their few-basis-point arbitrage by the Fed's questioning of the assumptions underlying the product - maybe not. But one should not dismiss the possibility that D-F might have made a great deal of difference in whether the poorly underwritten loans could have been sold.

Consumer Protection As A Macro-Prudential Tool

As part of this evaluation, one should not forget another important aspect of Dodd-Frank: The establishment of the Consumer Financial Protection Bureau (CFPB). The CFPB has established fairly strict rules regarding mortgage lending under which the poorly underwritten loans could not have been made. Those rules have been, of course, created with the hindsight of the loans made in the boom period. Therefore, the particular rules are not probative. The basic intent of the agency and its mission, however, are indicative of what kinds of rules might have been in place had the Bureau been part of G-L-B Act in 1999 instead of the D-F Act in 2010. The rules would have prevented many of the tricks that mortgage brokers used to disguise the actual terms of mortgages, and there might have been standard types of mortgages that could be offered with a safe harbor, with other types being offered at greater risk to the mortgagee and subsequent purchasers, including securitizers. One cannot be certain of the impact that such rules would have had, but I believe that they would have had a significant - and possibly a crucial - impact.

Would the aspects of D-F discussed in the last few paragraphs have prevented other credit grantors from doing essentially the same things that I suggest probably would have been prevented? What kinds of credit grantors might we have in mind that could have made the loans? Mutual funds, hedge funds, insurance companies, endowments, pension funds? All of those rely on the securitization market to make loans that they buy (except for large loans that hedge funds and insurance companies may make directly).

Credit can derive from any pool of capital anywhere in the world

Nevertheless, it is possible that credit of whatever kind it is that might spawn the next crisis could be made by any large pool of capital. For that reason, I would add to the existing Dodd-Frank requirements the coverage of all large pools of capital by the stress test regime (But I would not impose capital requirements or prudential supervision on non-banks). Insurance companies already are under such regimes in most of the U.S. The SEC is bearing down on mutual fund abuses of the liquidity requirements. Foreign banks with large U.S. presences are coming under the stress test regime. Regulation is moving in the right direction.

That regulation will not change the natural flow of capital. From all over the globe, capital flows to whatever investment the owners of the capital perceive to be the highest return on a risk-adjusted basis. In the 2000s, the money flowed into the U.S. housing market because, as the securities were structured and rated, the risk-return trade-off looked like the best to many pools of capital, including European banks that were attracted by a regulatory arbitrage of a few basis points. Anything that would have changed either the rates or the apparent risks would have tended to make the pools of capital go elsewhere in their search for yield. It is not inevitable that those funds had to flow into the U.S.

Can The Fed Keep Its Edge?

I conclude that bank regulation as now practiced is likely to prevent a financial crisis from visiting the U.S. for a long time. The Fed is a conflicted regulator, however. It protects the solvency of the banking system on the one hand, but it pumps up the money supply to encourage credit on the other. Such schizophrenia is dangerous.

Fundamentally, booms occur because people and governments like them. The myth is that the Fed takes away the punch bowl just when the party is getting started. Unfortunately, often it doesn't do that because everyone loves a party. I am sorry to be a scold, but it is that party animal in most of us that is the enemy. A tip of the hat to the late, great Walt Kelly ("We have met the enemy and he is us").

What Should I Invest In?

What about we investor types? What does it mean for us? If I am right, then the tail risk in the big banks is smaller than many people think. The equity market reflects the differences that I see between Wells, JPMorgan and Goldman, on the one hand, and Citi, BofA and Morgan Stanley on the other. They trade at the following multiples of book value:

  • Wells Fargo: 1.4
  • JPMorgan Chase: 1
  • Goldman Sachs: 0.9
  • Morgan Stanley: 0.75
  • Citigroup: 0.6
  • Bank of America: 0.6.

If I am right about the big picture, the downsides of all of them are not that they will go to zero. Therefore, the lower multiples of book should be more profitable over the long run if the three subject banks can get their you-know-what together. Will they do that? I wish I knew. Banking is a hard business, and it is hard to use capital efficiently when high levels are required unless one's business plan and its execution are sound.

My thanks to Kurt Dew for providing the foil for this exploration. He is a great asset to the Seeking Alpha community.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.