Let’s think again about Dodd-Frank

That is my latest Bloomberg column, here is one excerpt:

Looking at a broad swath of history, I see three major forces that can make financial systems safer: people being scared by recent events, solid economic growth and reduced debt in comparison to the value of equity. The financial crisis gave us the first on that list as perhaps its main “gift” (for now), but Dodd-Frank may have worsened economic growth problems.

On the plus side, we might like to think that Dodd-Frank improved the debt-equity balance by pushing banks to raise more capital. But that, too, now stands in doubt.

Last week Natasha Sarin and Lawrence H. Summers of Harvard University released a paper questioning whether Dodd-Frank has made big U.S. banks safer at all. The authors look at a variety of measures, including options prices, the ratio of market prices to book values, bank share volatility relative to overall market volatility, credit-default swap spreads and the value of preferred equity shares for banks. In every metric, it seems that the big banks are at least as risky as they were before the crisis, in part because they have lower capital values.

And this:

It’s a common economic prescription that regulation should insist that banks carry high levels of capital to withstand losses in bad times. But although Dodd-Frank raised statutory capital requirements, it may have drained banks of some of their true economic capital by regulating and sometimes prohibiting valuable banking activities. The ratio of market price to book value has declined for the biggest banks, and that is one sign of falling values for true economic capital, even though banks have met the letter of law by increasing capital as the regulations specified. Sarin and Summers note that measures of bank capital, as defined by regulators rather than the market, have little predictive power for bank failures.

Do read the whole thing.


If market price to book value has declined , perhaps that may indicate that shareholders, based on experience , are more cynical of big Banks' values?

No, the primary reason is because regular multi-billion dollar fines have become a perpetual cost of doing business. Banks are still paying out 11 figure settlements for their misdeeds from 2006-2008 roughly every 1-2 years. They likely will until perpetuity. Inventive US attorneys keep making up new abuses, because opening civil action against banks has become one of the most reliable way to advance your career at DOJ.

The US government has become a shadow claimant in the capital structure, lodged between HoldCo bondholders and stockholders. If you formally added the NPV cost of perpetual fines to the balance sheet, then market-book would be about the same as 2007.

And I guess as the recent fiasco at Wells Fargo shows Banks are currently so pure in their behaviour but for those pesky DOJ guys.

When all is said and done, I suspect Wells Fargo's most recent scandal will prove you both right. Certainly, banks continue to embroil themselves in misconduct, but at the same time, the government tendency to pile on--with random agencies and foreign enforcement officials taking "me too" settlements that are costless to leverage after the initial investigation--dramatically ramps up the cost of doing business.

What the Wells Fargo situation shows that regulation drains the industry of ethical players. The only ones who can remain are the ones willing to arbitrage regulations.

Wells Fargo is a demonstration of regulation working as designed.

In a rational market anyone pulling a stunt like they did would be out of business, but since trust and rational pricing of risk no longer are core values of a bank these things are to be expected.

Regulations are a ceiling, not a floor.

What the Wells Fargo situation shows that regulation drains the industry of ethical players. The only ones who can remain are the ones willing to arbitrage regulations.

I fail to see how this is the case. The Wells Fargo scandal had nothing to do with regulatory arbitrage, or even making money at all (WF almost certainly lost money on the fake accounts before they had even been discovered). It was the unsurprising result of an ill-conceived incentive structure among line employees, nothing more.

This sounds about right.

The Wells Fargo debacle was a result of very poor management, nothing more. Sometimes a cigar is just a cigar.

Poor management, or maybe that it is more profitable to pull stunts than actually serve customers.

As for blaming the employees, sure. The Ukrainians were to blame for not meeting agricultural quotas too.

Highly regulated industries end up working as designed. Sometimes regulations make an industry better when they are well designed. US banking has a history of extraordinarily perverse regulatory structures.

But it wasn't profitable. That's the point everyone is trying to get through.

This doesn't mean that WF should get off scot-free. But since WF didn't benefit, it's going to be very hard to show that it was done on purpose by management.

Wells Fargo will have to pay out nearly $200 million in fines for at most $5 million in erroneous fees. Keep in mind the abuses were never authorized by management, were actually extremely unprofitable for the company, and were the result of rogue employees trying to lie about their performance numbers. Wouldn't it be wonderful if every single one of the millions of people who work in the banking sector never did anything wrong. But is there any other industry where fines for employee misdeeds are anywhere near this punitive?

In comparison courts generally award at least a million in wrongful death. That means the scale of the entire Wells Fargo scandal is on the order of one or two medical malpractice cases. Imagine if every time a doctor committed malpractice, the hospital had to pay out $200 million? Imagine if the Vioxx lawsuit resulted in a $6 *trillion* settlement. There's simply no way an industry can continue to operate at these types of punitive ratios. We're in a very analagous period to the tobacco companies pre-MSA.

The fines are clearly not yet high enough to serve as effective disincentives. The fine is about $120 per fraudulent bank account opened in real people's names, not including the half million sham credit card applications. And it wasn't a few bad apples. Over 5,000 employees fired. Wells Fargo's stocks rose in value in response to this fine. So, basically, no.

It is wrong to measure the profitability of the undesirable activity without considering the other activity that the incentive structure encouraged. Surely, Wells Fargo knew that employees were gaming the system in ways that were harmful. Just as surely, Wells Fargo knew that its high pressure sales culture also produced significant benifits. The fraudulent accounts were merely a cost of the "good" sales activity.

Wells makes $3 billion in profit (not sales, net profit) every MONTH. They will be fine with the fine.

I think the media reporting on the Wells Fargo has been very bad.

5,000 people over several years in a group with hundreds if not thousands of branches?

And some of the behavior was things like merely telling customers you can't open a checking account unless you also open a savings account. Sure, that's deceptive, but its not opening a credit card and using it to buy beanie babies for yourself.

Also, they have 9,000 retail branches. 5,000 people over say 5 years is how many per branch?

Firing 5000 people for violating the policy makes it hard to say that the policy was unenforced.

It still points to a management problem, but Hanlon's razor applies.

"Wells Fargo will have to pay out nearly $200 million in fines for at most $5 million in erroneous fees."

Good point, but as reported by the Consumer Financial Protection Bureau (CFPB) the total amount to be reimbursed to customers is only $2.5 million: http://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-fines-wells-fargo-100-million-widespread-illegal-practice-secretly-opening-unauthorized-accounts/

So, the CFPB's actions result in $2.5 million being reimbursed to customers and Wells Fargo is fined $185 million (including required payments to other agencies). The head of the CFPB has hailed this as the biggest victory of his agency. However, that agency has an annual budget of about $636 billion!!

Someone needs to ask the question whether all the money being expended by these agencies is actually worth the cost (in addition to the enormous cost of compliance). Our elected officials seem incapable of doing even the simplest cost benefit analyses.

The main victims of the malfeasance of Wells Fargo employees are the shareholders. And, the main victims of the agency enforcement actions in the form of fines against the corporation are again the shareholders. This doesn't make any sense. Over 5000 Wells Fargo employees lost their jobs, but the proper remedy should have been for those employees (and management) to disgorge the improper bonuses the collected through this scheme. And, some of them should go to jail.

That should be $636 *million* (still a lot).

Don't forget that DOJ has figured out a way to transfer bank settlements to go to politically connected NGO's instead of to the taxpayers, too.

Its pretty much over if you ask me. When La Raza gets a cut of bank settlements, and the media just yawns...

Sarin and Summers don't find that major banks have lower asset values, they find that major banks have lower franchise values. They attribute the fall in franchise value to a variety of factors including the consequences of low interest rates, a flat yield curve for bank profitability, regulatory restrictions on bank activity (Dodd-Frank), increased competition from shadow banks, and uncertainty about future regulatory actions. As for the graph reproduced by Cowen showing a lower post crisis average ratio of market value to total assets as compared to the pre-crisis average, Sarin and Summers attribute it to financial markets underestimating risk prior to the crisis and significant distortions in measures of regulatory capital (i.e., bank assets were significantly overvalued pre-crisis). Cowen is presenting a distorted picture of the findings and conclusions of Sarin and Summers.

+1, seeing lots more spin on TC posts over the past 9 mos. Seems like incentives do work.

Looking at the results, I'd reach the opposite conclusion. Historical price volatility today is lower than before the crisis. Beta difference is most likely noise since it's hard to measure it exactly. Lower market value to asset ratio reflects loss of money making activities that create higher volatility. So, I'd say overall, nothing to see here.

If only we could have readily available credit with low risk. Let's create an innovative financial product for that.

Getting back to growth we had is hard because the prior state was unsustainable.

I don't understand the point of comparing a bank's equity before and after the crisis when we know pre-crisis banking valuations were inflated based on unsustainable practices and misunderstood risk.


RE: "I don’t understand the point of comparing a bank’s equity before and after the crisis when we know pre-crisis banking valuations were inflated based on unsustainable practices and misunderstood risk."

Did Dodd-Frank separate deposits-and-loans banking from the capital markets or separate the insurance business from banking or the securities business? Were deposit-and-loans banks debarred from operating hedge funds? Dimon? Dimon?

Did Dodd-Frank require that activities which heretofore had been separated by 'Chinese walls' within firms be conducted by separate firms without inter-locking directorates?

Did Dodd-Frank require American banks to divest themselves of foreign subsidiaries with deposits not insured by the U.S. Government?

Did Dodd-Frank debar deposits-and-loans banks from engaging in securities lending?

Did Dodd-Frank debar deposits-and-loans banks and/or insurance companies from taking positions in futures, options, swaps, or derivatives?

Did Dodd-Frank contrive an agency which might be able to rapidly roll up bust securities firms like Lehman?

Did Dodd-Frank repeal the Community Re-investment Act?

Did Dodd-Frank put limits on the leverage of hedge funds?

Did Dodd-Frank flush out the market in over the counter derivatives?

Did Dodd-Frank provide for rapid debt-for-equity swaps (CoCos &c) to recapitalize bust firms?

Did Dodd-Frank remove any regulatory perversities which promote secondary mortgage markets in lieu of portfolio lending?

Did Dodd-Frank remove de facto and de jure privileges held by Fannie Mae and Freddie Mac?

Did Dodd-Frank provide for liquidating federal lending services and conduits (e.g. Ginne Mae, the Farm Credit System, &c)?

Was there any point to Dodd-Frank other than providing more opportunities for graft for creatures like Dodd and Frank?

At least half of the things you listed had absolutely no discernible contribution to bank failures in 2008. Securities lending? Futures? Foreign branches? Asset management divisions? What are you even talking about? Some of your proposals actively contradict each other. So banks and insurers can't take positions in OTC derivatives, but they also can't take positions in derivatives like futures or listed swaps? That would leave no way to hedge rate exposure, making financial institutions much riskier because they'd be forced to hold massive duration. This list reads like a random grab-bag of "evil" financial practices based on mood affiliation.

Some of your proposals actively contradict each other. So banks and insurers can’t take positions in OTC derivatives, but they also can’t take positions in derivatives like futures or listed swaps?

That's not internally contradictory.

At least half of the things you listed had absolutely no discernible contribution to bank failures in 2008.

I wasn't limiting my discussion to that, nor did I suggest I was limiting my discussion to that?

What are you even talking about?

What I'm talking about is perfectly plain, and was discussed by journalists and economists observing the financial sector at the time. Do you have the institutional and regulatory architecture to handle what's afoot. See Megan McArdle on Sheila Bair's dilemmas re Citigroup: they did not have ready means to address Citigroup's problems, so had to improvise.

That would leave no way to hedge rate exposure, making financial institutions much riskier because they’d be forced to hold massive duration.

Somehow financial institutions managed between 1933 and 1995 without credit default swaps, and without some hideous crisis every 10 years. Hmmmm....

"Did Dodd-Frank provide for rapid debt-for-equity swaps (CoCos &c) to recapitalize bust firms?"

It prohibits that. There will be no TARP III.

Just to be clear, 2008 TARP was a rerun caused by a decade of financial deregulation to prevent a rerun of 1990 TARP.

Dodd-Frank gives the agency that does FDIC clear expanded power to seize and restructure institutions and protect the assets of protected classes (workers with insured saving, workers with savings, workers with assets) by screwing over the rent seekers. Think of it as a super bankruptcy court with more powerful unelected technocrats than Federal bankruptcy judges. Just like unelected technocrats redistribute wealth on orders issued by bankruptcy judges, under the FDIC are hordes of accountants who swoop in when bank oversight triggers them to seize and redistribute wealth in a matter of days.

Any recapitalization comes from the private sector. Or the institutions are liquidated.

I have no doubt that BofA could be seized and liquidated with a BofA DepositCo carved out quickly from the holding company along with ATMs run by a competitor. I'm sure FDIC has a separate team with a plan for the first week for each of the big banks so there would be no run, and no disruptions of payments by 25-50 million customers. The big banks are supposed to write it for FDIC, but it is FDIC alone that saves trust in banking.

And FDIC did save trust in banking in 2008 and 2009, including the money market funds which in the 60s we were promised would NEVER EVER do anything to cause a bank panic and a run on money market funds "deposits".

(I can't remember why, but in my teens in the 60s I was very interested in "theory of banking" so I followed with great skepticism all the debates on bank deregulation. Everything I believed in the 60s and 70s could go wrong from bank deregulation has gone wrong, worse than I imagined.)

Good points raised by Art Deco (if his own work, very good)...

My two cents: I'm not sure that in modern society in the USA that banks do anything anymore other than lend to consumers to buy houses. Maybe also meet short term payroll shortfalls for businesses. In other words, unlike Germany, banks are not that useful in the USA for business. Nowadays companies like Apple issue their own bonds, and don't need banks. I think it's true for most of the Fortune 1000 companies.

Residential real estate, commercial real estate, and consumer lending's the bulk of it. Commercial and industrial loans make up about 22% of commercial bank loan portfolios by value, and about 16% of total assets. A great deal of that is business banking. IIRC, JP Morgan reported their corporate lending portfolio as amounting to $53 bn, out of $2,100 bn in assets. I think if you're looking at savings banks and credit unions, there's hardly any C & I lending.

"...it may have drained banks of some of their true economic capital by regulating and sometimes prohibiting valuable banking activities."

Until you list such "valuable banking activities" this claim is totally bogus.

In my view, things banks do today that they did not do in 1965 are 99% rent seeking and thus economic welfare decreasing.

People like Tyler were writing all sorts of academic essays against "regulation Q" because it was fixing personal loans at 12% meaning most people could not get personal loans of significant because they had no "capital" to back it, and on the other hand, free checking paid no interest by mandate and savings paid no more than 4%.

The Tylers then promised deregulation would give us checking paying 6% interest, easy personal loans at 8% without needing income or assets.

So, reality check.

Checking costs money and pays no interest and what was free with lots of human manual effort, like checks, now costs a dollar with high automation and zero human effort in ATM or debit transactions.

And personal loans are easy but are high fee to retailers and carry interest rates of 35% while savers earn 0.1% for funding 35% debt.

Banking was a small part of a booming economy in the 60s. Today banking is a bloated high costs burden on a stagnant economy, one recovering from excessive financial derivatives of static physical assets churning constantly for no purpose except rents and arbitrage.

Tyler is looking at banking trying to return to the high profits from rents in churning loans on the same assets just to earn fees, making the loans larger as the physical assets age and depreciate, totally contrary to the functions of banking in the 60s when getting loans paid off was a top priority so the cash could be loaned to builders of new physical assets, or to finance buying new physical assets.

In the 60s, banks helped build new factories or expand production of businesses with new capital assets. To a large degree, banks ability to do so was constrained by the overall worker income of the community. Banks did not want wage cuts, job cuts, or anything that made the 90% in the community worse off. Bankers were part of the community promoting the general economic welfare, which meant most bankers wanted most people in the community to earn close to what he earned. That is the parable of "It's a Wonderful Life".

So, name one thing banks are prohibited from doing by regulation that would be good for the economic general welfare and also sustainable for the bank.

Given prior comments related to banks and securities firms, I have to put on my lawyer hat and discuss what Glass-Steagall did and did not prohibit. Then, put my economic historian hat back on and discuss which market practices did and did not exist under Glass Steagall.

Glass Steagall did not create strong walls between depository banking and securities markets. Key word there is markets. Legally, it prohibited a non-depository from accepting deposits (seems like a tautology when written that way but the importance will be shown below). That was pretty much the only limitation on non-depositories in Glass-Steagall, although the securities acts were contemporaneous. Legally, Glass-Steagall prohibited depositories from doing lots of things - but of immediate relevance was that they could not be part of a securities broker-dealer conglomerate and their managers could not serve both types of firms. It was a restriction on conglomerate firms and their managers, not a prohibition against securities markets participants funding commercial lending. Proponents of Glass-Steagall often get that wrong.

Under Glass-Steagall, could securities markets fund commercial loans? Yes. Need to say that again, yes. Securities markets could not have a depository as part of its conglomerate, but private label securitization of commercial debt (business loans, consumer loans, mortgages,...) was not prohibited by the Banking Act of 1933 (Glass-Steagall), nor was such a prohibition subsequently tacked on to the Banking Act of 1933. You can find NBER articles in the 1950s describing nondepository mortgage originators. Nondepositories could and did offer commercial lending services in direct competition (sometimes partnership with) banks. Not a big part of the market, but that was due to relative prices subject to change, not legal prohibitions. Then GSEs created later in the Glass-Steagall period, but again, as nondepositories, so what? The charters of Fannie Mae and Freddie Mac violated neither the letter nor the spirit of the Banking Act of 1933 because they are not depositories, and unlike broker-dealers, they don't even offer investment accounts with redemption rights.

Under Glass-Steagall, could securities markets offer transaction accounts? Oh, tougher question. It really depends on how the term deposit is defined. Those checkable money market accounts offered by a securities firm instead of a depository bank? They existed under Glass-Steagall. So, yes, under Glass-Steagall, securities markets could and did offer transaction accounts in direct competition with bank deposits. Arguably, a reinterpretation of the Banking Act of 1933's use of the term deposit could be used to shut down investment accounts with immediate redemption rights. Would be a good fight.

So, the way to think of Glass-Steagall is to think of passenger airline markets and bus transport markets. We can pass a law that prohibits an airline from owning a bus company, and vice versa. But that doesn't erect an iron wall between the two MARKETS. It won't mean that Southwest Airlines is not in direct competition with Greyhound for short haul passenger transport between Austin, Texas and Dallas, Texas. Nor will it prohibit passengers from combining the two by taking a plane from New Orleans to San Antonia and then connecting to a bus to New Braunfels.

I don't think corporate lending by investment banks was anyone's concern. London Whales and the FDIC stymied because it has never handled a bank with a complicated trading book would be concerns.

"The ratio of market price to book value has declined for the biggest banks, and that is one sign of falling values for true economic capital,"

This is an error that any junior credit analyst would get reprimanded for making. A firm's market equity value has very little to do with it's credit quality or probability of default. Consider a simple example:

Company A has $2 in assets that are completely invested in an options portfolio and has $1 in debt.

Company B has $1.50 in assets that consists completely of cash and $1 in debt.

Company A has a much higher "market price to book" than Company B and is also much more likely to fail.

A better interpretation of the data is that Dodd-Frank reduced bank's returns to equity by reducing their leverage and their risk. With less risk and lower returns, equity values are lower. But with a more stable asset base, default risk is reduced.

I'll add that any methodology that compares pre-crisis bank market prices (CDS spreads, VOL, equity market caps, etc) with post-crisis levels runs into the inevitable problem that pre-crisis market prices massively understated the risks of financial firms. In 2007 Citigroup was insolvent but nobody knew it. Everyone massively miss-priced C risk. If you owned C equity in 2007 and held it until today you're still down about 90-95% . . . that's how massively the market misjudged bank risk in 2007.

The only reason C equity investors didn't lose 100% is because the federal government bailed out the company and the rest of the banking sector.

Now what lessons can we take from the fact that bank equity values are lower and CDS spreads higher today versus their massively miss priced pre-crisis levels?

Is the right answer that bank risk is just as high or higher?

Is it that investors are far more circumspect regarding banking securities in 2016 than they were in 2007?

Is there any way to tell the difference?

But although Dodd-Frank raised statutory capital requirements, it may have drained banks of some of their true economic capital by regulating and sometimes prohibiting valuable banking activities

Equityholders have limited liability, after all, so some market-value enhancing activity, especially if very risky, may not be valuable in a broader sense.

This argument is akin to the conclusion that, because patients who receive a cure for a serious illness appear worse off than before they manifested obvious symptoms of their illness, the cure is ineffective.

Dodd Frank is just a domestic implementation of Basel III, and it was imposed because we were blamed for not fully implementing Basel II (hence the 2008 financial crisis). If we rethought Dodd Frank our bank regulation would be different from the rest of the world.

Was Fortis in compliance with Basel II? How about the Spanish banks which financed the bubblicious real estate market there? Deutsche Bank?

Banks were involved in put writing by holding massive amounts of MBS on the balance sheet and running a carry trade by repo-ing Treasuries. This game has been greatly regulated / reduced post bailout so yes the value of this type of game to the equity holders is less. Have banks been precluded from doing some activities that posssibly had value to them and "society". Maybe. It kind of reminds me of the cops vs blacks problem. Is it the fault of the cops that more innocent blacks get hassled or the fault of the higher crime rate in the black community that has to be policed. Same thing applies here.

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