Are Banks Safer After Dodd-Frank?

by: John M. Mason

Summary

A new research study by Harvard economics professors Natasha Sarin and Larry Summers questions whether or not big commercial banks safer now than before the Great Recession.

Market measures of valuation presented by Sarin and Summers indicate that banks are not safer, despite the passage and application of the Dodd-Frank rules and regulations.

Furthermore, the Federal Reserve still acts very gently when it comes to reducing all the reserves pumped into the banking system over the past nine years.

A major paper has just been published in the Brookings Papers on Economic Activity by Natasha Sarin and former Secretary of the Treasury Larry Summers titled "Have Big Banks Gotten Safer?."

The general answer to the question they raise is "No."

The paper is a very sophisticated piece of economic research and the results cannot be presented here in very detailed form.

A summary of some of the results of the Sarin/Summers paper can be found in Bloomberg, written by noted economist Tyler Cowen and titled "Let's Think Again About Dodd-Frank."

Mr. Cowen begins his article: "Six years after the U. S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in response to the 2008 financial crisis, it is not obvious that it made the U. S. economy safer and sounder."

Mr. Cowen reviews some of the major empirical findings of the Sarin/Summers paper. The question about bank safety is addressed by means of statistical studies of market judgments on bank safety.

For example, the study examines the price of options for major banks and the spreads for credit-default swaps.

In terms of this latter measure Sarin and Summers found that credit-default swap spreads are "now about three times higher than before the financial crisis." What does this mean, Mr. Cowen asks?

And the ratio of the market value of equity in the "Big 6" U S banks has declined relative to book value indicating "falling values for true economic capital, even though banks have met the letter of law by increasing capital as the regulations specified."

Mr. Cowen adds that "Sarin and Summers note that measures of bank capital, as defined by regulators rather than the market, have little predictive power for bank failures."

"The core problem is this: The franchise value of banks fell after the crisis, which pushed banks closer to insolvency. As recovery proceeded, however, Dodd-Frank pushed down the value of banks once again."

Dodd-Frank may not be the end of the story. Maybe, Cowen suggests, "lower interest rates…have had the biggest role in reducing the value of banks."

And, "On top of all that, non-bank financial institutions like hedge funds, insurance companies and investment banks now have a much larger role in originating mortgages. They're not covered by Dodd-Frank at all."

Although Mr. Cowen believes that maybe we need to address rolling back some of the Dodd-Frank rules and regulations, Ms. Sarin and Mr. Summers do not. What they suggest, and this is the meat of their paper, that more market-based measures of bank value be used to determine the risk status of a bank.

These are, I believe very interesting results and I would recommend that people read both of these papers, but especially the Sarin/Summers paper. There are some very challenging results presented.

It is troubling, however, that Ms. Sarin and Mr. Summers come to the conclusion that banking system, especially the "Big Six" banks are not any more safer now than they were before the financial unwinding connected with the Great Recession took place.

Maybe this is also a sign that the whole banking system is not any safer now than just before the financial meltdown and that this is one reason the Federal Reserve has been so cautious over the past nine years in its policy efforts.

Throughout the current economic recovery, the Federal Reserve has constantly wanted to err on the side of too much monetary ease. This was one of the reasons for the three rounds of quantitative easing. One thing quantitative easing did was to provide sufficient liquidity to the banking system so that failing banks could be smoothly removed from the banking system, primarily through acquisitions, causing as little disruption to the whole system as possible.

Up until the year ending June 30, 2016, the commercial banking system lost well more than 200 institutions every twelve-month period. In the year ending June 30, 2016, only 100 banks, net, left the system. The reduction in bank numbers has been smooth and unobtrusive for the rest of the banking system and the economy.

But, "excess reserves" in the banking system as measured by Reserve Balances With Reserve Banks on the Federal Reserves H.4.1 statistical release measure more than $2,349 billion on September 14, 2016.

The peak level of "excess reserves" was hit on July 6, 2014 at $2,809 billion.

Just before the financial troubles, the "excess reserves" totaled only slightly more than $3 billion on September 12, 2007.

The Federal Reserve has been very reluctant to reduce these excess reserves and has only done so with the utmost care, always wanting to err on the side of too much ease in the system.

The concern here is that Fed officials do not want to cause a post-Recession collapse of the banking system the way it did in the recovery from the Great Depression in 1937-38.

So, there is still great concern within official circles about the solvency of the U. S. banking system. And, I don't see this ending anytime soon.

So, whether or not the banking system is safer now than before the passage of Dodd-Frank is not the question. The question has to do with the overall safety of the banking system at the current time.

There are three results that lead me to believe that we still should be concerned. First, the Federal Reserve is still extremely sensitive about reducing the "excess reserves" in the banking system, even at their current historically massive level.

Second, commercial banks are still dropping out of the banking system at a record pace for this time in the economic recovery. The decline in numbers is due to acquisitions, but still the declines are taking place. Expect a much, much smaller banking industry in the future.

Third, as Ms. Sarin and Mr. Summers show, market measures of bank value are very low and show a lack of investor confidence in the amount of book equity that are on bank balance sheets.

And, there is one last point, the growing presence of non-bank institutions that are not regulated by Dodd-Frank. These, in my mind, will continue to grow and continue to challenge "real" banks.

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.