Thoughts on Dodd-Frank Reform Legislation: H.R. 10, S. 2155 and Hoenig’s Proposal

In an effort to alter the post-crisis regulatory environment following the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act…

In an effort to alter the post-crisis regulatory environment following the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act (and also Basel III), the House passed H.R. 10, the Financial Choice Act of 2017, last year and the Senate has recently responded with S. 2155. In this post, I will compare some of the proposals concerning the regulatory burden, especially those relating to capital requirements.

Like H.R. 10, the Senate proposal aims to address some of the issues that outgoing FDIC Vice Chairman Thomas Hoenig tried to resolve with his proposal last year. Specifically the proposals focus on the small bank regulatory burden and establishing the simple, equity-to-total consolidated asset “leverage ratio” as a measure of capital adequacy (rather than existing complex, risk based measures that do not seem to foster financial stability). After all, the benefits of a simpler, higher leverage ratio seem to outweigh the costs. The differences lie with the fact that the Senate proposes to change less than what the House proposes to change, and unlike the Hoenig proposal, reform is still tied (explicitly or implicitly) to size. Consider a few examples.

Regulatory Relief and Bank Capital

While Dodd-Frank has contributed to greater regulatory burdens for banks, Section 606 of Dodd-Frank did call for bank holding companies to be well capitalized, although the details are left to the regulators, which means that complex, risk-based capital requirements are still in effect. As I recently discussed, leaving the specifics of regulation to the regulators can be an effective arrangement, if Congress and the regulators agree that risk based capital requirements have not been effective. Right now, however, that doesn’t seem to be the case.

To address that, Section 601 of H.R. 10 calls for changing the way capital adequacy gets defined through the simple leverage ratio, in exchange for a lower regulatory burden. Holding companies that have a leverage ratio, equal on average to least 10 percent over the last four quarters, can take the Dodd-Frank regulatory burden “off-ramp.” The benefits of taking the off-ramp are listed in Section 602, and include exemptions from federal laws, rules or regulations concerning capital and liquidity, the distribution of dividends to shareholders, supposed systemic risks or concerns about concentration risks following mergers and acquisitions.

The Senate approach separates regulatory relief from capital adequacy. Regulatory relief comes from Section 401 of S. 2155, which calls for raising the threshold for firms subject to enhanced supervision from at least $50 billion to at least $250 billion. Changes to capital adequacy appear in Section 201 of S. 2155, which proposes that “community banks,” defined as those with under $10 billion in total assets, have a leverage ratio between 8 and 10 percent of total assets. In addition, Section 214 of S. 2155 proposes to lower capital requirements for Highly Volatile Commercial Real Estate (HVCRE) investments, to between 8 and 10.4 percent instead of a minimum of 10.4 percent as regulators have called for. While the change is small, once again, lowering capital requirements is not the way to foster financial stability. (Also, Section 402 calls for eliminating reserves from the leverage ratio, which effectively turns the simple leverage ratio into a risk-based capital ratio.)

The House approach explicitly ties regulatory relief to capital adequacy but implicitly ties regulatory relief to size since larger banks likely won’t take the “off-ramp.” The Senate approach explicitly ties regulatory relief to size. In contrast, the Hoenig proposal separates capital adequacy from size, while at the same time calling for regulatory relief, which seems a more effective way to go about reforming the banking landscape in a way that will benefit customers, through lower cost provision of financial services, while protecting taxpayers from calls by policy-makers to bail out banks deemed “Too Big to Fail.”

Call Report Relief

As I showed in a recent post, call report forms (and the instructions explaining how to fill out the forms) have been growing in line with the growing regulatory burden. Since growing regulatory burdens tend to adversely affect smaller banks more than larger ones, Section 205 of S. 2155 and Section 566 of H.R. 10, each call for smaller banks that report bi-annually, rather than quarterly (as larger banks do), to reduce the amount of information they submit when filling out the call reports. That means complex banks will report lots, while simpler banks will report much less. Both approaches still mean that the regulatory burden for large, complex banks will remain in place, which again creates barriers to entry that work against fostering a competitive landscape.

One notable difference between the Congressional bills is that Section 566 of H.R. 10 makes this reporting change conditional on the bank being well capitalized, while Section 205 of S. 2155 makes this conditional on banking having less than $5 billion in total assets. Once again, if the aim is to foster financial stability, making call report regulatory relief conditional on capital adequacy would offer a more suitable approach than making it conditional on size.

What About the Volcker Rule?

Section 619 of Dodd-Frank, the so-called “Volcker Rule,” sought to limit certain types of trading account activities, as well relationships between holding companies and hedge funds or private equity funds. In a recent post on the Recourse Rule, I discussed how rather than all trading account activities, it was holdings of highly rated, private-label securitization tranches (especially collateralized debt obligations) that helped explain bank exposures to insolvency risk; and I show how those holdings could have related to complex, risk-based capital requirements.

If bank exposures to the risk of insolvency related more to which securities they were holding than which accounts banks were trading from, then that suggests the Volcker Rule is not an effective response to the last crisis. With that in mind, Section 203 of S. 2155 makes slight changes to the Volcker Rule (the new section 13 of the Bank Holding Company Act of 1956, created by Section 619 of Dodd-Frank), while Section 901 of H.R. 10 proposes to repeal the Volcker Rule in its entirety. The Senate proposal implicitly holds that the Volcker Rule was effective, while the House proposal does not; if the aim is to foster financial stability, the House proposal seems correct here. Indeed, the Hoenig proposal calls for trader mandates rather than the Volcker Rule.

Conclusion

The notion that regulation in general should not be one-size fits all is embedded in Federal guidelines, and there’s nothing wrong with that principle. Still, financial stability is not about size or trading activities, but rather capital adequacy. The Senate proposal calls for explicit, size-based differences in regulation, while the House proposal calls for differences in regulation based on capital adequacy that only smaller banks will likely adopt. In that sense, the Hoenig proposal suggests a way forward that differs from Congressional proposals because it puts capital adequacy, rather than size, front and center; the path to ending “Too Big to Fail” is paved by simpler, higher capital requirements rather than regulatory complexity. In short, Hoenig asks “why shouldn’t a capital ratio of 10 percent equity to total assets be the minimum standard for every bank wishing to operate in the United States?”