Financial Choice Act: Positive For U.S. Bank Stockholders, Negative For Creditors

by: Long/Short Investments


The Financial Choice Act passed a vote in the U.S. House of Representatives Financial Services Committee and will be brought before the full House in the near future.

It will repeal and/or reduce the influence of several rules and regulations that came as part of the Dodd-Frank Act.

The passage of the Choice Act is expected to be broadly positive for shareholders and help justify the post-election surge in bank shares.

However, it is expected to be negative for creditors due to potentially enhanced risk within the banking system.

On May 4, The Republican-led U.S. House of Representatives Financial Services Committee voted 34-26 to approve the Financial Choice Act of 2017, which aims to offer relief to banks from various provisions of the Dodd-Frank Act, passed in July 2010. The bill will be passed to the full 435-member House for what will be a likely approval. (Full-text of the legislation can be found here).

The Choice Act proposes to roll back much of the regulation enacted as part of Dodd-Frank. This would be broadly beneficial for shareholders by freeing up capital to be put to use operationally or returned to shareholders. However, it would expect to be negative for creditors given Dodd-Frank helps better ensure conservative capital management practices and the ability for banks to remain healthy in the event of a subsequent financial crisis.

Low rates and a stringent regulatory environment were largely responsible for much of the stagnation in big banks' share prices from 2013 to the November 2016 U.S. elections. The prospect of Dodd-Frank's partial or full repeal - one of the Trump administration's campaign promises - was greeted by investors with a surge in demand for bank shares. "Long U.S. banks" was one of the most popular trades post-election. Many big banks have seen their shares appreciate at least 20% since early November.

However, any rollback in regulatory and supervisory requirements could expect to increase risk within the system and the prospect of a disorderly resolution of a systemically important bank. The undoing would at the very least increase the perception of asset risk within the banking system.

Reduced compliance expenses and new/renewed revenue opportunities would likely boost bank profitability and therefore benefit shareholders. At the same time, increased tail risks and augmented credit risk and consequent higher borrowing costs would be negative to creditors.

Impact on orderly liquidation of systemically important banks

The Choice Act proposes to repeal the orderly liquidation provision of Dodd-Frank, which entails the process of efficiently liquidating large, interconnected, systemically important banks should one be close to failing.

The intended aim of repealing the orderly liquidation provision is to end "too big to fail," or the idea that the failure of a large banking institution would have such a material effect on broader financial and economic conditions that they are entitled to special support from the federal government. Namely, if banks no longer have the safety net of a publicly funded bailout, this will inherently reduce risk in the banking system without the necessity of onerous rules, regulations, and supervisory regimes.

However, dismantling this aspect of the legislation could actually impose the opposite effect and increase the prospect of a federal government bailout of a systemically important bank if no form of orderly resolution replacement legislation is put in place. The loss to creditors, depositors, and counterparties in the event of a wind-down could also be more severe.

The orderly liquidation framework part of current Dodd-Frank legislation is designed to limit losses to all forms of creditors. If no operational resolution framework is supplied as part of the Choice Act, and this works to increase the probability of a systemically important bank being put through bankruptcy, it is expected that creditors would be the most adversely affected by the change.

On the same token, an argument could be made that if the Choice Act forces failing banks to go through bankruptcy, it could work to shore up internal risk-taking by letting management teams realize that their firms can no longer rely on being bailed out by the government in the event matters sour.

Impact on stress testing, CCAR, DFAST

Stress testing would be reduced back to a biennial basis rather than annually. Banks would also be subject to an exemption from enhanced Federal Reserve supervision (which includes stress testing) for banks that have a supplementary leverage ratio of 10% or greater, which would loosen up restrictions on capital and dividend payout allowances. Some Republicans are nonetheless likely want a higher ratio than this 10%.

The influence of capital supervision initiatives such as the Comprehensive Capital Analysis and Review ("CCAR") and Dodd-Frank Act Stress Test ("DFAST") would be reduced. CCAR and DFAST provide highly relevant publicly released data points for creditors and market participants to assess the strength of a bank's balance sheet and susceptibility to financial or economic stress.

These Dodd-Frank provisions have led to what could be considered an overall improvement in banks' risk management practices, including an increase in capital buffers and less aggressive capital management practices, which are positive for creditors. However, the means by which these policies have forced an internal tie-up of additional capital have effectively curbed shareholder distributions.

Impact on risk-taking

The proposed elimination of the Volcker Rule, which imposed restrictions on how banks could invest taxpayer-insured deposits - particularly as it pertained to proprietary trading - could have a material impact on internal risk-taking.

A repeal of the Volcker Rule would be welcomed by banks who largely argue that the regulation has led to a brain drain of top talent as they've moved on to pursue their trading activities in less regulated investment vehicles such as hedge funds. The decline in proprietary trading within has led to declines in risk measures such as value at risk ("VaR"), which may increase following a repeal, though its elimination would be expected to see a lift in trading inventories and profits.

Impact on the Consumer Financial Protection Bureau

The influence of the Consumer Financial Protection Bureau ("CFPB"), a supervisory watchdog, would also be scaled back through a restructuring and would support a more limited assortment of consumer protection laws. Specifically, the CFPB would no longer have power to detect fair-lending violations, in what's known as "UDAAP authority" (UDAAP: unfair, deceptive or abusive acts or practices). The CFPB has resulted in banks eliminating certain riskier lending products, such as short-term, high-interest payday loans.

Impact on the Securities and Exchange Commission

The proposed legislation would allow companies the right to greater confidentiality in their communications with the SEC. Any dealings and correspondence regarding prospective initial public offerings and other such matters would no longer be publicly available to investors. Activist investors would also lose out on a proposed new SEC rule that would allow greater control to reject candidates up for company board seats. Moreover, the SEC would be opened up to greater outside influence through the setting up of an advisory committee that would take reform recommendations.

Legislative prospects

The Choice Act is most likely to pass the House, but may face issues within the Senate, given Republicans' narrow 52-48 majority. The two most contentious issues are likely to entail the orderly liquidation process, given its high degree of relevance to the broader economy, and a rollback in the CFPB's powers, which may concern some moderate Republicans.

Another bone of contention is likely to pop up with respect to the Durbin Amendment, which took effect in October 2011 to limit the swipe fees that banks can collect from retailers. The Durbin Amendment's addition into Dodd-Frank reduces banks' aggregate income by billions of dollars per year due to these fee-cap restrictions. Its repeal would be warmly welcomed by banks but Democrats will push back saying it hurts retailers, which may try to pass off extra costs to consumers. Republicans are most in favor of letting swipe fees hit an equilibrium as dictated by the market.


The Financial Choice Act is expected to alter banks in a few main areas: repealing an orderly liquidation framework and forcing banks to go through bankruptcy, rolling back stress testing frequency and capital supervisory regimes such as CCAR and DFAST, eliminating the Volcker Rule, limiting the reach of the Consumer Financial Protection Bureau, and bringing a few smaller changes to SEC such as better protecting the confidentiality of banks' communications with the agency.

The capital free up and loosening of rules and regulations is expected to be positive for shareholders and is largely responsible for the recent rise in bank and financial shares observed since the November U.S. elections. However, the extra risk that could be added to the banking industry is largely expected to be negative for creditors.

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.