The Trump administration and Congress appear eager to press ahead with reform to roll back much of the Dodd-Frank Act. Unfortunately, many of the early reform proposals would provide relief applicable only to large banks, diverting focus away from the burden of community banks.
If successful, this approach would reverse recent gains to financial stability made by Dodd-Frank and further erode the competitiveness of community banks.
It is remarkable that reform proposals which would benefit Wall Street banks are even being discussed just eight years after the end of the financial crisis. It took more than 60 years to repeal the Glass-Steagall Act of 1933, and most of the other Great Depression banking reforms remain in place today. Either our collective memories are much shorter than they once were, or Dodd-Frank was misguided from the start. I believe the former is more accurate.
A review of the causes of the financial crisis should refresh our memories. Somewhere around the year 2000, Wall Street banks—the largest investment and commercial banks—began to significantly increase their interest in subprime mortgage lending because they discovered that they could apply the securitization process to this segment of the market. Low initial interest rates and rapidly rising home prices masked the default risk. As the housing bubble expanded, the creditworthiness of the home buyers declined while leverage increased. Everyone that noticed the surge in risk didn’t care, and everyone that cared didn’t notice.
Mortgage brokers, Wall Street banks and credit rating agencies surely noticed risk building up, but the enormous profits for not caring were too good to pass up. Honest brokers that accurately reported their clients’ financial conditions lost business to those that exaggerated or chose to believe their clients’ “alternative” income and employment history. Banks securitized the risky mortgages, (mis)represented them as high quality and sold them to investors, shedding the default risk in the same way that a used car dealer sells a lemon without a warranty. Credit rating agencies that refused to provide the AAA ratings the banks demanded lost business to the agencies that issued a rubber stamp.
Subprime mortgage bond investors and banking regulators certainly would have cared about the risk buildup, but they didn’t notice. Bond investors relied too heavily on the inflated ratings. Bank regulators trusted financial institutions, but did not verify. Regulators like the Federal Reserve Board, the now-defunct Office of Thrift Supervision and the Commodity Futures Trading Commission were legally equipped to deal with many of the abuses in the subprime mortgage lending industry, but there were major gaps in their oversight, raising question about whether bank regulators had the experience to handle investment banking issues in consolidated financial companies.
In 2007, the housing bubble began deflating, households began defaulting and mortgage valuations began falling. Hedge funds run by Bear Stearns and Lehman Brothers that were loaded with subprime assets collapsed in 2008, ultimately leading to their demise. By September 2008, financial markets were frozen with fear, and the largest banks required massive bailouts.
There was plenty of blame to go around. Wall Street banks, ratings agencies, unscrupulous mortgage broker, naive investors and banking regulators were all partly to blame. The federal government was overaggressive in encouraging homeownership, millions of households unwisely purchased homes they could not afford, and hundreds of community banks that had financed the construction boom failed.
But ultimately the financial crisis resulted from severely misaligned incentives, and getting the incentives right is more important than assigning blame.
Dodd-Frank made great strides in realigning the incentives of the key players. Banks’ incentives to originate, securitize and sell risky mortgages are now much weaker because banks must make a reasonable, good-faith determination that customers have the ability to repay their loans, and they must also retain an ownership stake in the bonds they securitize. That an ability-to-repay rule had to be implemented at all is astounding; yet the originate-to-distribute model made it necessary.
Because of the 2010 law, credit ratings agencies have diminished incentives to rubber-stamp ratings. They are subject to direct Securities and Exchange Commission oversight and stricter disclosure and governance requirements. However, the agencies are still paid by the banks for ratings, leaving the primary conflict of interest unchanged from the housing bubble years.
Regulators have enhanced tools to recognize systemic risk and promote financial stability, and important gaps in the supervisory framework have been closed. The Financial Stability Oversight Council and the Fed have explicit responsibility for stability of the entire financial system. Yes, several banks and some nonbanks are still too big to fail, but the likelihood of failure is far lower mostly because the Fed stress tests impose strict capital requirements, which has the side benefit of encouraging banks to shrink. Moreover, the Volcker Rule places tight restrictions on commercial banks’ ability to invest in and sponsor hedge funds and private equity funds.
Finally, the establishment of the Consumer Financial Protection Bureau reduced the likelihood that consumers will be harmed from inappropriate, deceptive or fraudulent transactions. It is telling that subprime lending is prevalent today in the automobile industry, an industry that was explicitly exempt from oversight by the CFPB.
Today, the Wall Street banks are safe and sound, lending is up and risky trading activity is down. Goldman Sachs and Morgan Stanley have introduced new lending programs to replace trading revenue. Dodd-Frank is working as intended. That is why potential rollbacks of the provisions that promote financial stability and discourage harmful lending are unwise and dangerous.
However, sensible modifications can be made that would alleviate the unintended regulatory burden placed on community banks.
The top priority should be tailoring the Dodd-Frank regulations to a bank’s size and complexity. Community banks are unable to afford teams of high-priced compliance officers. They cannot afford to pay attorneys and consultants to facilitate transactions on a $75,000 mortgage that used to be routine. Results from the 2016 Community Banking in the 21st Century national survey of state-chartered banks show that compliance costs absorbed an average of 21% of legal expenses and 43% of consulting and advisory expenses.
The same survey revealed that the integrated mortgage disclosure rules – combining requirements under the Real Estate Settlement Procedures Act and Truth in Lending Act – adopted in October 2015 were the most confusing and costliest regulations for state-chartered banks in 2016, accounting for 23% of all compliance costs.
Banks also remain confused about Qualified Mortgage rules, including the computation of points and fees. One concrete change that would alleviate compliance costs and simultaneously increase credit to homeowners is to grant safe harbor status to loans originated and held in portfolio because banks have inherently strong incentives to screen borrowers when they retain the risk.
Relaxing regulations on the largest banks less than a decade after the worst financial crisis since the Great Depression is a mistake. Instead, reform should reduce the regulatory burden on community banks. The number of community banks is already diminishing at a fast clip due to competitive forces. The additional regulatory burden imposed by Dodd-Frank only accelerates consolidation, which ultimately leads to fewer choices, less personal service and higher prices for consumers.