Some US Banks Might Face Fewer Rules, and That’s Ok

(Editor's Note: MarketMinder does NOT recommend individual securities; companies referenced herein are merely cited as examples of a broader theme we wish to highlight.)

Ever since Dodd-Frank’s 2010 passage, politicians have fought over what size bank ought to be labeled a “systemically important financial institution” (SIFI) and therefore subject to stricter rules and oversight. Today the Senate approved a bill moving that threshold from $50 billion in assets to $250 billion, reducing the number of SIFIs from 38 to 12. Proponents argue this will free smaller banks from unnecessary, burdensome requirements inhibiting growth, lending and competition. Others are, in our view, more forcefully arguing less oversight will encourage excessive risk-taking among smaller but still “too big to fail” financial firms, potentially inviting another financial crisis. We believe these concerns are overwrought and misdiagnose the crisis’s causes.

The bill—which still must clear the House^[i]—contains a number of regulatory tweaks. It would exempt the 26 ex-SIFIs from having to submit annual “living wills”^[ii] and give them relief from the Liquidity Coverage Ratio, which requires banks to hold enough high-quality liquid assets to cover expected short-term cash obligations. Additionally, banks with less than $100 billion in assets would no longer face onerous annual “stress tests” intended to gauge their resilience to adverse scenarios. Failing a test can result in arbitrary capital surcharges and restrictions on buybacks and dividends.

Many banks in the $50 billion – $250 billion range received taxpayer funds under the Troubled Asset Relief Program (TARP) in 2008—to some, proof they were big enough to threaten the financial system and would have failed had the government not stepped in. But TARP recipients weren’t necessarily going to collapse without it. Rather, the Treasury foisted the funds on healthy banks of all sizes and types in an effort to destigmatize it. If TARP aid was restricted to the very worst off, officials worried, investors and depositors might see it as a sign of impending doom and panic—and the resulting deposit flight would compound banks’ issues. So the Treasury said only “healthy institutions” were eligible. No surprise, then, that plenty such institutions participated.

For example, Regions—an Alabama-based bank—bowed to Treasury pressure and took $3.5 billion in TARP funds. Or consider M&T Bank, which initially received $600 million despite skating through the crisis mostly unscathed—even acquiring some struggling banks along the way. (They weren’t the only one.) As M&T’s finance chief said in 2012: “We didn't want [TARP money], we didn't think we needed it. … But at the height of the crisis, there was a lot of pressure on banks to prove that they were strong enough to receive it.” The same logic applied to many banks, regardless of size.

Profits played a role for others. Banks got TARP funds by selling the Treasury preferred stock with a 5% dividend though 2013.^[iii] For many at the time, this was cheaper than other available financing. Even healthy banks had an incentive to take it. Meanwhile, midsized regional bank IndyMac wasn’t bailed out. Yet its highly publicized failure didn’t cause a chain reaction. The FDIC assumed control and eventually sold it to investors, protecting all insured deposits. This undercuts claims TARP money was necessary to prevent bank failures from rippling through the financial system.

Yet the bill’s opponents claim relaxing rules risks repeating history. Deregulation, they say, was a key factor allowing banks large and small to jack up leverage, loosen lending standards and securitize risky mortgages—creating “toxic assets” galore—in the run-up to 2008. True, bank leverage was higher—and loan standards looser—than now. Yet the scale and scope of this—and the loan losses banks actually registered—were far smaller than this narrative suggests. In our view, they weren’t what wrought 2008.

Those “toxic” mortgage-backed securities weren’t as poisonous as most thought—they were merely illiquid, with temporarily depressed prices thanks to housing sector troubles. A well-intended-but-ill-designed accounting rule (FAS 157, aka “mark-to-market accounting”) then exacerbated these issues. It required banks to value these assets using the last observable trade of a comparable asset, linking their market values to bank balance sheets. Since these assets are illiquid—some rarely trading—one sale sparked mass writedowns. This incentivized banks to sell them, creating a downward spiral that massively overstated banks’ exposure to loan losses. Former FDIC head William Isaac testified to Congress in March 2009 that the rule’s impact turned hundreds of billions in loan losses—not good but still manageable—into trillions of dollars’ worth of paper writedowns … and a full-fledged panic. This is also why the Fed—never subject to FAS 157—turned a profit on assets it lifted from banks’ balance sheets. Regulators suspended this accounting rule in 2009 and revised it thereafter. Thus, changes to SIFI rules and Dodd-Frank generally are irrelevant to the trigger that set 2008 in motion.

Moreover, as IndyMac’s experience shows, taxpayer bailouts needn’t follow bank failures. And if a bank just needs temporary liquidity, the Fed can—and, we believe, should—fulfill its role as lender of last resort while the bank gets back on its feet or finds a buyer. No Dodd-Frank interventions necessary.

As for banks overleveraging themselves if this bill passes, it isn’t as if arbitrary stress tests and regulations are the only thing standing between regional banks and razor-thin capital buffers. Before the crisis, when capital requirements were lower, midsize banks like M&T and Regions held more than the rules demanded.^[iv] Today, most banks (including regional) keep well above the minimum. FDIC data show banks in the $10 billion – $250 billion asset range hold more capital as a percentage of assets than banks with more than $250 billion in assets.^[v] Leverage simply isn’t the issue many believe today—nor does it explain what happened a decade ago. Rules to reduce it are therefore probably a solution seeking a problem—like much of Dodd-Frank, in our view. Subjecting fewer banks to some of its more stringent rules isn’t likely to trigger a new crisis.

[i] If House members tack on a bunch of amendments (as some suspect is likely), the Senate would have to reapprove it—and depending on what those amendments are, the revised version might not get enough Senate support to pass. So this isn’t a done deal by any means.

[ii] These detail plans for winding down operations and liquidating assets without endangering the rest of the financial system should the bank fail.

[iii] The rate rose to 9% thereafter—a step-up intended to wean banks off government support.

[iv] You can see their Q3 2007 balance sheet filings here and here, respectively. Search for “regulatory capital” to locate the relevant figures.

[v] Source: Federal Deposit Insurance Corporation’s Quarterly Banking Profile for Q4 2017. Not to throw more massive documents at you, but the data are on page nine here, in the “Condition Ratios (%)” section.