The House Passed Financial Deregulation, But Needs to Do More

The House of Representatives just passed the modest financial regulatory reform bill already approved by the Senate, the “Economic Growth, Regulatory Relief, and Consumer Protection Act” (S. 2155).  This is not the fundamental reform of the bureaucracy-loving Dodd-Frank Act of 2010 one might once have hoped for, nor is it the much broader reforms proposed by the House Financial Services Committee in its “CHOICE Act” bill.  But everyone agrees the political reality is that the latter bill cannot be enacted, while the current bill it is a step forward which can actually be taken.  A modest step forward is definitely better than standing still.

Small banks, defined in the bill as those with assets of less than $10 billion, will be the principal beneficiaries of its reforms, through reduction in the onerous regulations inspired by the political emotions of 2010, in the wake of the financial crisis.  These banks are less than 0.5% the size of JPMorganChase.  The costs and burdens of complex and opaque regulation are disproportionately heavy for them.

The small banks are enthusiastic supporters of the bill and its expected enactment will be an important victory for them.  Small banks are the vast majority of banks.  There are 5,670 banks (federally insured depository institutions) in the U.S.  Of these, 5,547 or 98% have assets of less than $10 billion.  On a still smaller scale, 4,920 or 87%% of all banks have assets of less than $1 billion, which is less than 0.05% the size of JPMorgan.

Among other regulatory de-complexification, the bill would provide small banks the option of having a high and simple leverage capital requirement (tangible equity as a percentage of total assets) replace the complicated risk-based capital calculations arising from the international negotiations known as the “Basel” rules (named after the city in Switzerland).  It provides for this ratio to be set in a range of 8% to 10%.  The similar idea of the CHOICE Act specified 10%.  If combined with a simple liquidity requirement, this is an excellent idea.

A key improvement in the bill is that for small banks, residential mortgage loans they make and keep for their own portfolio, would be considered “qualified mortgages” for compliance with the Dodd-Frank Act.  This recognition is essential: when a bank keeps the mortgage loan and all its risks, putting up its own capital as “skin in the game,” it is in a different financial world from those who make the loan and forthwith sell it, passing all the risk to somebody else.  Much of the regulatory motivation of the Dodd-Frank Act was trying to deal with the moral hazard of the “originate and sell” mortgage model.  That the “skin in the game” model is fundamentally different should have been obvious all along, but better late than never.  A sad irony is that the “originate and sell model” with the flaws which later became so evident was strongly pushed by government policy, subsidies and regulation.

This regulatory reform bill is pretty complex.  In draft form, it is 192 pages long, with many provisions devoted to particular constituency concerns, as you might expect from something which needed a bipartisan deal to get through the Senate.  You might say it displays Madisonian balancing of competing concerns of interest groups (or as Madison would have said, “factions”).  Everybody cannot like everything in it.

A sampling of its various provisions includes:

-For big banks, increasing the level at which they are automatically considered “systemically important” from $50 billion to $250 billion in assets—subject to regulators’ ability to overrule this provision in particular cases.

-A special deal on the leverage capital requirement for banks whose principal business is custody of assets (there are only a couple of them).

-More favorable treatment of investment grade municipal bonds for purposes of big bank liquidity requirements.  In addition to helping big banks, this is naturally very popular with issuers of municipal securities.

-A regulatory simplification for closed-end mutual funds.

-A break on the treatment of certain brokered deposits, useful to some small banks.

-Easier treatment of some riskier commercial real estate loans.  This is popular with real estate developers, of course.  Since commercial real estate is often at the center of banking busts, this may be the most dubious of all the bill’s provisions.

-A choice for federal savings associations to have regulatory treatment just like national banks.  This is a natural step in the gradual disappearance of a separate savings and loan industry.  It is now hard to remember that a special savings and loan industry was in former days considered an important national financial priority.

-Not to be forgotten is an additional taking of the Federal Reserve Banks’ retained earnings, to help reduce the budget deficit.

-And numerous other special provisions, displaying that the bill is indeed a product of democratic legislative processes.

Taking the bill all in all, it is a positive step.  But it should by no means be the end of regulatory reform.  The House has a lot of ideas for additional steps, many with bipartisan support.  We’ll see if anything happens.