Implications of the 2016 Election for Banks, Systemically Important Financial Institutions and Their Investors
Campaign promises rarely turn into specific actions, but when they do, they are necessarily impacted by the dynamics of the legislative process. History suggests, however, that the policies of candidates can be a predictor of likely regulatory trends.
At the very least, a new Democratic administration, along with the status quo in the House and Senate, would, for better or worse, signal some sense of continuity of current regulatory policies. That continuity would appear to include recent policies that may reflect the recommendations of the Federal Reserve, OCC and FDIC that Congress repeal authorizations of financial holding companies provided in 1999 in the Gramm-Leach-Bliley Act to, among other things, engage in merchant banking and commodities investment activities. Those agencies also recommend the repeal of an exemption that permits corporate owners of industrial loan companies to operate outside of the federal regulatory and supervisory framework applicable to other corporate owners of insured depository institutions.1
In this regard, financial services companies know from experience that the individuals who are appointed as regulators and the policies that they bring to those jobs may have a more significant impact on the operation of their institutions than the identity of the president. So when it is known who will fill those regulatory positions, it will be possible to develop a more precise idea of the direction of financial regulation in the next four years. Indeed, if a Democratic president is elected and the Senate ends up with a Democratic majority (hereinafter referred to as a Democratic or Republican Regime, depending on which party ends up in power), there may be a shift at the margin in the profile of the regulators, depending on the tacit or explicit understandings between the campaign and senators who may play an important role in the confirmation process. Regulators in a Democratic Regime are: (i) less likely to have Wall Street experience or to have worked in the financial services industry; (ii) apt to be drawn from academia, think tanks and the Congress; and (iii) more likely to be favorably inclined toward expanding consumer protection, global systemic regulation, housing subsidization, and increasingly stringent regulatory standards.
The unknown commodity that this year’s Republican presidential candidate represents leaves many important questions unanswered. Appointees in a Republican Regime are more likely to be drawn from the business community and to be more business-friendly in the development of regulatory policies. While the Republican platform does include the reinstatement of Glass-Steagall restrictions on the affiliation between banks and securities firms, the most meaningful short-term change may derive from the sense that a Republican administration would immediately reduce regulation that many businesses argue is slowing down such businesses and the broader economy. Whether true or not, that expectation may create an immediate shot of adrenalin into the economy.
In a Republican Regime, certain regulatory restrictions in the Dodd-Frank Act would be targeted to be rolled back or revised. Any Dodd-Frank rollback, at least in the short-term, would generally be viewed as good for bank earnings and therefore their valuations, a factor that should stimulate a greater level of expansion and consolidation that have been at significantly reduced levels since the financial crisis. Whether that initial trend would continue will turn on a variety of factors more directly related to the health of the economy.
Specific Issues Affected by the Election
Mergers and Acquisitions
Perhaps no area in the banking business has been more impacted by the financial crisis and the subsequent regulations imposed by the Dodd-Frank Act than the appetite for, and ability of, banks to consolidate. Closely related to that issue has been the declining interest of private capital to invest in financial institutions.
Actions taken by the FDIC and the FRB during the last crisis, coupled with the regulatory requirements of the Dodd-Frank Act, have convinced private capital that there are generally more limited investor upsides in the banking industry than in the past. Investment appetites have correlated to that belief.
Similarly, the number of large mergers and acquisitions in the banking industry has been a fraction of what it was before the crisis, and even community bank consolidations have lagged behind historical precedents. While community banks now see the current environment as more favorable, there are still significant factors playing some role in reducing their appetite for consolidation, including: the press of new regulations; capital requirements; adverse economic indicators in the market; credit quality; and price expectations of buyers and sellers and their investors.2 It is also likely that current and anticipated regulatory requirements, as well as the trend toward technologically driven financial services, are playing a role in merger decisions. Significant factors are impacting large bank acquisitions that are now subject to new set of regulatory limitations. First, larger institutions are the target of a regulatory tax on growth that imposes greater capital, liquidity and prudential requirements the larger an institution becomes.3 Further, efforts to curtail the “too-big-to fail” phenomenon and the prohibition in the Dodd-Frank Act on acquisitions that may pose an increased risk to systemic stability are limiting the expansion of the largest banks. Whether good or bad, this also has a trickle-down effect – if the top banks can’t make acquisitions, the next 20 have limited potential acquirers, and so on.
A Democratic Regime would not likely include any significant changes that would reverse or alter this current trend. In a Republican Regime, the perception that there may be less regulation might signal that the banking business could become a more profitable, and once again become a business where expansion will in fact be rewarded. But market conditions, pricing expectations and credit quality are also important factors in determining whether and how acquisition habits change in the short- and long-term. Republicans will have a tough time putting the regulatory toothpaste that has been squeezed out in the last six years back in the tube. Wholesale repeal of the Dodd-Frank Act is unlikely, but at the margin, the emphasis and enforcement focus of regulators would change in a Republican Regime, which would at least impact one-half of the dynamics needed to improve the market for consolidations.
Consumer Protection Issues
For understandable reasons, consumer protection became an important part of financial services reform after the crisis. The most significant component of that formula was the creation of the Consumer Financial Protection Bureau (CFPB) under the direction of a single director.
If Republicans are in power, the individuals appointed to the CFPB are likely to represent a different balance between consumer protection and business flexibility. In that regard, there will also likely be continuing efforts to transform the management of the CFPB into a Board so as to diffuse the vast power that the director has among a number of Board members that would represent the views of business as well as consumers.
One important issue that may be on the table in a Republican Regime is the trend for consumer protection regulations to commoditize and simplify financial products (such as mortgages), to reduce the risk of taking advantage of consumers. This question runs directly to the issue of market innovation and presents future regulators with a difficult challenge. While more standardized products may lessen the opportunities for discrimination and abusive practices, standardization may also limit the development of new financial products and services that sophisticated purchasers and markets may want.
Systemic Stability Regulation
The regulation of non-bank financial companies that may be considered to pose a threat to systemic stability could change in a Republican-dominated environment. The principal change would likely be less of a focus on the designation of systemically important financial institutions (SIFIs) and a greater emphasis on building a comprehensive early warning system to better anticipate financial disasters. Republicans will be less likely to subordinate current forms of disclosure-driven market regulation to new prudential regulation of non-banking financial companies.
A Democratic Regime would likely reinvigorate the Financial Stability Oversight Board (FSOC), which is currently dueling with MetLife over how the FSOC may designate companies as SIFIs. The current Treasury Department appears to favor increased prudential regulation – much as is currently applied to large banks – of large non-bank financial companies. In a Democratic Regime, the FSOC might be anticipated to continue to emphasize designation of the SIFIs, if for no other reason than to subject as many large financial companies as possible to regulation and oversight of the FRB – on the theory that greater regulation would lead to less systemic risk and fewer chances of a systemic meltdown if a crisis were to occur. In that regard, if FSOC prevails in the MetLife appeal, insurance companies, asset managers and other financial providers should anticipate continued scrutiny from FSOC. This could potentially lead to more SIFI designations and formal recommendations for increased prudential regulation of activities and products. In that regard, the liquidity, leverage and redemption risks of funds will likely continue to be a focus of FSOC’s future regulatory agenda, with continued pressure on the SEC to go as far in the direction of prudential regulation as it can or is willing to.
The Volcker Rule
The impact of the Volcker Rule has not yet been fully felt by financial institutions nor the economy. A Republican Regime would likely seek to reevaluate the Volcker Rule to ensure that it does not unnecessarily impact profits and market liquidity. A Democratic Regime would continue to lean toward stricter regulation in this and related areas to reduce systemic and institutional risks. The task, as always, will be to balance institutional and systemic risk with the ability to make a reasonable profit. Amendments to the Volcker Rule may be a vehicle to consider the re-imposition of Glass-Steagall restrictions.
Capital, Liquidity and Risk Management
This is an area where there may not be significant quantitative differences between what a Republican and Democratic Regime would do. The characteristics of the regulators that are appointed would be the governing force resulting in any differences in these areas.
Balancing the Cost of Regulation
Studies demonstrate that the Dodd-Frank Act has increased the cost of regulation in the United States. But just as taxes are rarely reduced, financial regulation never gets significantly rolled back. The question involves balancing the cost of regulation against the actual benefits it provides. The former is admittedly easier to calculate than the latter, and neither political party may actually measure either accurately, if at all.
A Democratic Regime would be more inclined to increase regulation in the hopes of attaining a safer and sounder system. A Republican Regime would be more likely to stem the tide of increases in the cost of regulation, while trying to avoid sacrificing safety and soundness. The delta between these approaches– the extent to which something can be characterized as unnecessary regulation – is always in the eye of the beholder. Perception may be as important as reality when it comes to the confidence of the business community and how it impacts the future of the economy.
It may be expected that Republicans will raise the issue of cost/benefit analysis in more of what regulators do, following up on what several courts have noted over the last few years. Without understanding the relative costs and benefits of an action, how can a regulator assert that it is reasonable?
Orderly Liquidation and Too-Big-To- Fail (TBTF)
When a next financial crisis occurs, investors will learn the answers to some very important questions raised by Title II of the Dodd-Frank Act:
- Will regulators ever actually place the largest banks in receivership?
- Is financial assistance for a large troubled institution off the table?
- Will the FDIC be appointed as receiver for large, non-bank financial companies, and what rules would it use?
Real world answers to these questions will determine the future of the TBTF conundrum. It is not at all clear that these questions can be parsed based upon which party is in power after November. It can only be hoped that in any subsequent financial crisis, whoever is in power will rely on the deep experience of those that have lived through prior crises (which didn’t happen this last time) and make decisions that are financially sound rather than politically oriented or motivated. The simple fact that will drive policy in this area is that no party wants a financial crisis on its hands and having to deal with the political fallout that inevitably follows.
Footnotes
1) Report to the Congress and the Financial Stability Oversight Council Pursuant to Section 620 of the Dodd-Frank Act, September 2016, pg. 28, available here.
2) See “2016 Bank M&A Survey,” Bank Director, 2015, available here.
3) See Thomas P. Vartanian and David L. Ansell, “To Grow Or Not to Grow: Regulatory Burdens Increase As Banks Get Bigger,” New York Law Journal, Dec. 2013; available here.
