The Trump Administration has made banking industry deregulation a cornerstone of its growth stimulus plan and, on February 3, President Trump signed an executive action requiring a broad review of the 2010 Dodd-Frank law.

Given an industry-friendly Republican-controlled Congress and Cabinet, and an increasing number of Trump appointees in the U.S. Federal Reserve (Fed) and Securities and Exchange Commission, an overhaul of Dodd-Frank is likely. In combination with anticipated lower corporate tax rates and higher interest rates, we believe a scaling back of Dodd-Frank could benefit banks over the next two to three years.

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010 by President Obama in the aftermath of the 2008-2009 financial crisis. The law directed the creation of rules designed to reduce risk in the U.S. financial system through activities, such as monitoring the health of large financial institutions and strengthening capitalization, leverage and liquidity requirements; preventing predatory consumer lending practices; and eliminating proprietary trading and limiting speculative investing, to name a few.

Rating Dodd-Frank – and How It May Evolve

Proponents of Dodd-Frank believe that the rules have made the banking industry safer and that the basis for them remains sound. Detractors complain that the rules have gone too far and are continually expanding, hurting the banking industry and its customers, and even increasing market risk. Few are calling for a full-scale dismantling of Dodd-Frank – including the newly appointed industry veterans holding key positions in the Trump Administration. There is widespread support within the industry and Congress, however, for the review underway. We believe that the most likely outcome will be a loosening of some standards, a rollback of certain rules and a clarification of the more opaque rules. The following are some key Dodd-Frank provisions we anticipate will change.

  • Definition of a Systemically Important Financial Institution
    Dodd-Frank’s mandate is to prevent another financial crisis or government-funded bailout of a large financial institution. Banks, insurance companies and other financial institutions deemed “too big to fail” are required to undergo stress tests annually, hold more capital and maintain a “living will” supplying plans for their dismantling should they fail.

    In general, a bank holding $50 billion or more in assets qualifies today as a systemically important financial institution (SIFI), and is held to higher standards than smaller banks. But many feel that this threshold is too low, and that banks with $50 billion in assets pose little threat to the system. The burdens associated with being a SIFI are substantial, so many banks today intentionally stay small to avoid becoming one. Under the current regime, we believe that the SIFI threshold will rise – to as much as $250 billion in assets, reducing the regulatory burden and capital requirements for smaller banks.
  • Stress Test Guidelines
    Each year, the Fed administers stress tests on SIFIs that simulate a period of extreme hardship to ensure the institutions have adequate capital even under the most severe economic scenario. (Smaller banks holding between $10 billion and $50 billion in assets also undergo stress testing, but requirements are far less burdensome.) The stress tests include both quantitative and qualitative components, with a black-box design to simulate unanticipated crises. SIFIs have complained that the qualitative reviews are moving targets, and that they don’t receive clear guidance about test results, making it difficult to improve. Following the review of Dodd-Frank, we expect the stress tests to continue but believe they may become less opaque and that requirements to pass are unlikely to get any more difficult – a better outcome than expected prior to the election.
  • Capital Requirements
    The stress tests evaluate bank capitalization levels using a ratio of a bank’s capital to its risk-weighted assets. Post-crisis capital ratios have risen dramatically for SIFIs, with some of the largest banks holding over 12% common equity tier 1 capital (CET1), nearly double the levels held before the crisis. While this makes banks safer, it also prevents them from returning this capital to shareholders through share buybacks or dividends. Going forward, we anticipate that capital requirements will soften, freeing up those assets for distribution or reinvestment.
  • Liquidity Coverage Ratio (LCR)
    Banks today must hold a certain amount of high-quality liquid assets (e.g., cash or short-term government bonds) to meet short-term obligations. The thinking goes that, if customers worry about a bank’s health and withdraw their funds en masse, having these liquid assets on hand will prevent the bank’s failure. The requirement today is for at least 100% coverage of potential net asset outflows over a 30-day stress period. This prevents banks from deploying those high-quality liquid assets into more lucrative vehicles such as loans. The current regime may relax how the LCR is calculated and exempt some of the smaller banks from the requirement.
  • The Volcker Rule
    The Volcker Rule, named for the former Federal Reserve chair who originally proposed it, bans proprietary trading by banks and prevents them from investing in higher-risk assets like hedge funds and private equity. An unintended consequence of the Volcker Rule is that less trading makes for less liquid markets. When the market is under stress, illiquidity can compound the problem. Even if the rule is eliminated or continues but is less strictly enforced, ongoing capital requirements would likely prevent banks from returning to pre-crisis trading levels.
  • Consumer Financial Protection Bureau
    The Consumer Financial Protection Bureau (CFPB) was created under Dodd-Frank to protect consumers from predatory practices by financial institutions and has implemented rules concerning mortgages, credit cards and bank fees. The CFPB, for example, has prevented banks with more than $10 billion in assets from charging fees on debit card transactions. This potential loss in revenue discouraged small banks from growing or pursuing mergers and acquisitions. While some of the rules put in place by the CFPB will survive, the bureau itself may shrink and lose some authority. We also anticipate that restrictions on banking fees will slacken for all banks, which should help boost earnings.

Evaluating the Outlook for Banks

Since the financial crisis, banks have struggled under regulations that restricted their activities and required increases in compliance spending. Additionally, many industry watchers have argued that the atmosphere within regulatory agencies had become anti-enterprise, with banks complaining about unreturned phone calls and merger approvals being held up, in some cases for years. As regulations are rethought and the Trump Administration continues to populate cabinet and agency positions, the environment for banks appears likely to improve.

Overall, we anticipate increased merger and acquisition activity among smaller banks that should have fewer concerns about the implications of growing larger. All banks are likely to benefit from the President’s inflationary policies, which may drive interest rates higher. And lower regulatory costs and anticipated lower corporate tax rates could help boost banks’ bottom lines.

Follow @OppFunds for more news and commentary.