Repealing Dodd-Frank: The Long-Term Impact of Financial Deregulation

President Donald Trump is setting his sights on eliminating the Dodd-Frank Act, a set of financial regulations aimed at preventing another credit crisis like the one that occurred in 2008. While bank investors have cheered a possible end to the burdensome regulations, deregulation of the financial sector may be setting the table for another economic crisis years down the road.

Trump has called Dodd-Frank “horrendous” and said that he intends to perform “a major streamlining and perhaps elimination” of the law. Bank stocks traded higher following Election Day after Trump repeatedly pledged to eliminate corporate regulations throughout the campaign season.

But what’s good for banks may not necessarily be what’s good for the country in the long haul.

Understanding Dodd-Frank. One of the major provisions in the 2,300-page Dodd-Frank Act sets strict guidelines for the amount of capital banks must hold at all times as a protective cushion in the event of unexpected loan losses. In addition, banks must limit a certain percentage of their investments to assets that can be easily liquidated, if needed.

Dodd-Frank requires any U.S. bank with at least $50 billion in assets to pass an annual Federal Reserve stress test to make sure the banks are fully prepared for a potential economic downturn. Dodd-Frank also requires each of these large banks to get the blessing of the Federal Reserve prior to increasing dividend payments and/or share buyback plans.

Finally, Dodd-Frank created a new regulatory agency called the Consumer Financial Protection Bureau to aide in financial regulatory enforcement and help identify abusive practices.

Dodd-Frank hits a handful of banks particularly hard. Companies such as JPMorgan Chase & Co. (ticker: JPM), Citigroup (C) and Bank of America Corp. (BAC) are deemed “global systemically important banks.” These banks have even higher capital requirements and must submit annual living wills detailing how assets could be liquidated in an orderly fashion during a potential bankruptcy.

A history lesson. Banking booms and busts have been cyclical occurrences in the U.S. over the past century. The Glass-Steagall Act of 1933 was implemented after nearly 5,000 U.S. banks failed during the early years of the Great Depression. The Glass-Steagall Act created the Federal Deposit Insurance Corporation, increased regulatory scrutiny of banks and prohibited commercial banks from participating in certain types of risky investment banking.

The Glass-Steagall investment banking restriction was lifted in 1999. Just like during the period prior to the Great Depression, U.S. banks spent much of the early 2000s exploding in size. Banks milked every cent of earnings they could out of the U.S. housing market during the peak of the bubble.

John Burnett, an associate professor of finance at the University of Alabama in Huntsville, says a repeal of Dodd-Frank could simply proliferate the cycle of banking booms and busts.

“This may seem oversimplified, but to me, the long-term danger of a complete repeal is that we end up in a similar crisis again,” Burnett says. Financial regulations are always a delicate balancing act between protecting consumers and allowing markets to operate smoothly.

“No legislated regulation is perfect. So if the new leadership can make some improvements, that’s great,” Burnett says.

Bankrate senior economic analyst Mark Hamrick says Dodd-Frank has limited U.S. bank lending in recent years, but that doesn’t necessarily mean the law should be completely scrapped.

“Just as a flu shot doesn’t provide full immunity from all strains and colds, Dodd-Frank doesn’t create some kind of sci-fi style forcefield guarding against financial crises,” Hamrick says. “Nevertheless, it doesn’t make sense to forgo the proverbial inoculation because it fails to achieve perfection.”

A path to compromise. As critical as Trump has been of Dodd-Frank, he has also expressed a somewhat surprising interest in bringing back the Glass-Steagall Act’s rules banning commercial banks from risky investment banking activities. While pure investment banks such as Goldman Sachs Group (GS) and Morgan Stanley (MS) may not be impacted significantly by a return of Glass-Steagall, Bank of America, Citigroup, JPMorgan and others could be forced to split their commercial lending operations and investment banking business into multiple entities.

Trump’s chief economic advisor and former Goldman Sachs president Gary Cohn recently said that a return of Glass-Steagall would pave the way for more aggressive bank lending to small and medium-sized U.S. companies.

In Washington’s increasingly partisan climate, the return of Glass-Steagall could offer a rare opportunity for bipartisan compromise. U.S. Sen. Elizabeth Warren, D-Mass., who spearheaded the creation of the Consumer Financial Protection Bureau, has been pushing for a reinstatement of Glass-Steagall for several years.

“The intent of the rule is a good one, and the repeal [of Glass-Steagall] has not harmed clients in a substantial way, as many of the activities that led to the 2008 crisis could still have happened regardless,” says JJ Kinahan, managing director of client advocacy and market structure at TD Ameritrade. “Hopefully before decisions are made, the issue of liquidity in our markets is a primary concern. Liquidity ultimately breeds confidence and opportunity.”

Trump has pledged…

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