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Not pro-CHOICE

12 July 2016 By Rob Cox

For professed lovers of free markets, there’s something philosophically attractive about a grand plan to remake American banking. That may explain why Donald Trump has taken a shine to the Texas Republican who chairs the House Financial Services Committee, and whose views on the matter are heavily shaping the Grand Ole Party’s policy platform, which will come to full light at next week’s convention in Cleveland.

A month ago Jeb Hensarling unveiled a blueprint for trashing the financial-reform act passed into law six years ago this month bearing the names of its two Democratic legislator-sponsors, Chris Dodd and Barney Frank, whose chair Hensarling now occupies. Hokey title aside (he calls it the Financial CHOICE Act, an acronym derived from Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs) there is an appealing simplicity to the proposal.

The basic thrust of Hensarling’s proposal is to replace America’s current massive financial regulatory complex. The Financial Stability Oversight Council, a star chamber by Hensarling’s account, conspires with myriad agencies like the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to keep banks from lending. Instead, he offers banks a straightforward promise that if they reserve $1 of capital for every $10 extended to borrowers he will take a machete to red tape.

In addition, the new plan calls for greater penalties for fraud, of the kind his committee highlighted in a critical report released this week about HSBC’s 2012 settlement over money-laundering violations, and allows the Securities and Exchange Commission to seek higher monetary fines. The bill also offers regulatory relief for community banks; reins in the Consumer Financial Protection Bureau and renames it the Consumer Financial Opportunity Commission; and enhances oversight of regulators, among other changes.

The trouble is that Hensarling and Trump, who promises “close to a dismantling” of Dodd-Frank if elected president in November, may be embarking on a quixotic battle. The law isn’t perfect, but to argue as Trump does that it’s “a very negative force,” is a more difficult assertion to make against the realities of the business today.

Consider the results of the Federal Reserve’s latest comprehensive capital analysis and review of the 33 largest U.S. bank holding companies. The central bank evaluated whether the banks would have sufficient capital to keep operating even under severe distress. The Fed’s worst-case scenario assumed a global recession, negative yields on short-term U.S. Treasury securities, 10 percent unemployment, halving of stock prices and a 25 percent drop in house values would lead to $526 billion of losses over nine quarters.

That’s nastier than what followed the failure of Lehman Brothers. Yet by the Fed’s reckoning, the banks still would have aggregate common equity tier 1 capital ratios of around 8.4 percent, well above the 5.5 percent reported in the first quarter of 2009. This is a testament to the way the new regulatory apparatus, working to the spirit and letter of Dodd-Frank, has made banks safer. They have boosted their capital buffers by $700 billion, to some $1.2 trillion.

Much of this is coherent with Hensarling’s pitch. “If you put a whole lot more of private capital into the system, you will get a whole lot less federal control,” he told Breakingviews. The idea, as he sees it, would be to give banks a choice to substantially pump up the amount of capital they reserve for a rainy day in exchange for avoiding micromanagement. Hensarling blames Dodd-Frank for “the single weakest recovery in our public’s history.” Moreover, by heaping so many fiddly new strictures, Dodd-Frank “codified” that some banks are too big to be allowed to fail.

An acolyte of Phil Gramm, a senator who in the late 1990s spearheaded banking deregulation that many critics blame for the financial crisis a few years later, Hensarling may be right that when the next crisis strikes, politicians will give in and bail out faltering banks. It’s a counterfactual argument, of course. By at least one important and visible metric, however – the difference in the costs big and small banks pay for deposits – progress has been made on removing the too-big-to-fail advantage.

In its last quarterly banking profile, the FDIC calculated the effective cost of paying for deposits by banks with assets over $50 billion was about 23 percent lower than it was for all other banks. That gap is one way to quantify the benefits big banks receive – by dint of the perception they will never be allowed to go belly up – over smaller rivals. But it compares with a 38 percent advantage big banks enjoyed before Dodd-Frank passed. So something is working.

None of this is to say the law is perfect. Even so, banks are better capitalized, have avoided some of the bad practices that got them into trouble and are enjoying fewer benefits from being big. That’s why General Electric, for one, embarked on the biggest-ever fire-sale of financial assets.

Perhaps the biggest flaw of the CHOICE Act is its call to repeal the way Dodd-Frank would allow failing institutions to wind down, known as resolution authority, with a “new chapter of the bankruptcy code.” While theoretically attractive, most non-ideologically focused bankers and regulators struggle to see how swapping the judgment on thousands of experienced financial experts for the untested powers of bankruptcy judges would work in practice, especially given the need to act swiftly to stem a global crisis.

Then again, Trump has been through bankruptcy courts on four occasions. It’s a milieu he knows all too well. In that sense, Hensarling’s pitch may not be perfect, but perhaps it is perfectly suited for a role in the presumptive nominee’s inner circle.


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