The United States has had its share of contentious elections, and 2016 ranks right up there with such historic elections as Andrew Jackson's in 1828 for its often unpleasant overtones. But apart from the fact that it theoretically pitted the "common man" vs. the "elite" (a key theme of the 1828 election), it also presented two very different views of government and, for our purposes, regulation. President-elect Donald J. Trump struck a "populist" tone when it came to government regulation, and has vowed to take a hard look at regulation that he believes impedes business growth.
The Dodd-Frank Act is now at the center of controversy for financial institutions. Since its passage, in Republican corners it has been met with intense criticism and cries of "repeal and replace" similar to Republican reaction to the Affordable Care Act. Mr. Trump campaigned on a promise that he would nearly "dismantle" the Dodd-Frank Act.1 He also proclaimed that he would "[i]ssue a temporary moratorium on new agency regulations that are not compelled by Congress or public safety," and has vowed to "[d]ecrease the size of our already bloated government after a thorough agency review."2
In the same way that it is arguable whether there is much unique about this election compared to others in our nation's history, experience teaches us that Washington has a peculiar way of reducing stark ideology to practical reality. Republicans have already offered a bill in the Financial Choice Act (the "Act"), which pares back the Dodd-Frank Act, but is different from the type of nuclear option that Mr. Trump has offered with respect to Dodd-Frank's repeal. While the Financial Choice Act recalibrates leverage ratio requirements for banks, ends the notion of "too big to fail" bailouts, scales back the independence of the Consumer Financial Protection Bureau and the Securities and Exchange Commission, and puts tighter reins on the Commodities Futures Trading Commission, it appears to offer additional protections in other areas. Most notably, by offering bankruptcy alternatives for institutions, the Act seeks to prevent a scenario where taxpayers foot the bill for bailouts.3
In fact, from the vantage point of the bill's sponsors, the Financial Choice Act offers further protections for consumers not contemplated in the Dodd-Frank Act, or is a remedy for certain problematic scenarios that have arisen since Dodd-Frank.4 In the Act's Executive Summary, the sponsors delineate several comforting "Key Principles," including the following:
- Consumers must be vigorously protected from fraud and deception as well as the loss of economic liberty;
- Systemic risk must be managed in a market with profit and loss; and
- Both Wall Street and Washington must be held accountable.5
If the Financial Choice Act were to move forward and ultimately be signed into law by President Trump, unlike the banter from the election season (and even some of the post-election rhetoric), a review of the law makes clear that regulation is not going anywhere. For example, the Financial Choice Act imposes what are intended to be tougher standards in computing capital requirements for banks than Basel III. It seeks to move away from a "highly politicized, deeply unreliable risk-based approach to measuring capital adequacy," which introduced an almost "mind-numbing level of complexity" in the calculation of bank capital that only succeeded in making "the largest banks almost entirely opaque to their investors, creditors, and regulators."6 As such, the Financial Choice Act seeks to substitute what is intended to be a more reliable, less opaque, simple 10% leverage ratio that measures the funds available to absorb loss against the total balance sheet and some off-balance sheet assets.7 As the Act's sponsors assert, "[s]implicity must replace complexity, because complexity can be gamed by the well-connected and abused by the Washington powerful."8 Clearly, not all institutions that would be affected by the new regulation agree with this assessment and prefer the current requirement under Basel.
This is because, according to the Act's Comprehensive Summary, this is actually an increase over the current level of capital for the big banks, which is now at an average of 6.6%.9 As such, the proposed Act effectively calls for an increase in capital requirements that cannot be explained away through the complexities of a "risk-based" approach. Quoting FDIC Vice Chairman Hoenig, the Act's sponsors argue that "[h]igher capital doesn't contribute to lower lending."10 They claim, as did the Vice Chairman, that "[b]anks with stronger capital positions maintain higher levels of lending over the course of economic cycles than those with less capital."11 Put succinctly, the Act's sponsors claim that the Republican plan "allows banks that credibly commit to stop betting with taxpayers' money to get out from under the suffocating constraints of Dodd-Frank."12 The proposed new capital requirements are already controversial and likely to be met with opposition.
An "Off-Ramp for Strongly Capitalized, Well-Managed Banking Organizations"
This leads to what is perhaps the most controversial aspect of the proposed Act: relief for institutions that are well capitalized and well managed. This feature is presumably attractive for community banks that have felt the sting of Dodd-Frank and have closed at an alarming rate since its enactment. The Act's sponsors claim that the labyrinth of Dodd-Frank, rather than ending "too big to fail," created "too small to succeed."13 Evidence certainly supports this claim, as only a handful of community banks have opened their doors since the enactment of Dodd-Frank, and many have failed or have merged into larger institutions.14
The solution proposed by the Financial Choice Act is a special exception based upon principles of meritocracy, and is intended to provide relief for well-capitalized, well-managed institutions.15 The Act provides exemption from a number of regulatory requirements for institutions that maintain a leverage ratio of at least 10% and have a composite CAMELS rating of 1 or 2.16 Exemption from requirements includes relief from "the BASEL III capital and liquidity standards and the 'heightened prudential standards' applicable to larger institutions under section 165 of the Dodd-Frank Act."17
In addition to liquidity requirements under section 165, the imposition of risk management requirements has been challenging for smaller institutions. While not specifically required for smaller institutions and community banks, risk assessment and management processes often find their way into examinations in the form of guidelines or through individual requirements such as vendor management requirements. As such, this aspect of the Financial Choice Act is bound to be well received by small and mid-sized banks.
It has been argued by proponents of the Act that the new act promotes and encourages stronger compliance by rewarding institutions that have strong compliance programs. There is a strong incentive for financial institutions to score well on examinations and to avail themselves of the "off-ramp" from the requirements of section 165. A strong compliance and risk management function can result in an institution being able to avoid significant and sometimes overwhelming compliance costs in order to meet the requirements of section 165. In any event, the "off-ramp" undermines some of the more recent histrionics about how compliance is of less significance under the new proposed requirements, as the rating would presumably have a direct impact on the regulatory burden of the institution.
The Future of Risk Management
As implemented, the Dodd-Frank Act, in the best sense, is concerned with risk assessment and risk management. While there were, from an industry perspective, some difficult aspects of Dodd-Frank, the focus on enterprise risk management has been taken to heart, not only by financial firms but also by operating companies. It has become part of our culture and the very air that we breathe in the regulatory world. Bank shareholders and boards want to know what their risks are. Private equity firms wish to understand as much as they can about the operating companies they are purchasing. From an investment management perspective, risk assessment and liquidity have been significant factors in how we now invest money.
As the boomers near retirement, they are growing increasingly cautious about the safety of their retirement assets, so it is unlikely that they will completely welcome a regulatory regime that does not pay serious attention to identifying and mitigating risk. In other words, it is probable that a Republican Congress will think carefully before abandoning the notion of conducting annual risk assessments to be reviewed by senior management and the board of directors, as long as the specter of 2008 still haunts us.
Having strong compliance is encouraged and significantly rewarded by the proposed Financial Choice Act. There is a strong incentive to have a 1 or 2 rating and be well capitalized to avail your institution of the reduced regulatory regime for well-run institutions. Given the incentives for good behavior in the Financial Choice Act, it seems unlikely that we will ever go back to a pre-2008 risk mentality. Regardless of how one feels about the outcome of the election, a candidate or party that ran on a ticket of protecting the working class will likely not want to abandon the constituency that has entrusted them with protecting their retirement assets.
In short, this is not a death knell for compliance and risk management. The new administration may wish to streamline regulation, but the political climate is such that they will not abandon it. Financial institutions should vigorously address their controls, policies and procedures, and risk management practices, because under the new Act, they may be handsomely rewarded for doing so.
[1] See The Presidential Transition, Financial Services, https://www.greatagain.gov/policy/financial-services.html (last visited Nov. 21, 2016).
[2] Trump-Pence 2016, Regulations, https://www.donaldjtrump.com/policies/regulations/ (last visited Nov. 21, 2016).
[3] See Financial Choice Act, H.R. 5983, 114th Cong. (2016).
[4] As discussed below, the Act focuses on the fact that community banks have struggled since the passage of Dodd-Frank.
[5] Financial Services Committee, The Financial Choice Act, Executive Summary 1 (June 23, 2016), http://financialservices.house.gov/uploadedfiles/financial_choice_act-_executive_summary.pdf [hereinafter Executive Summary].
[6] Financial Services Committee, The Financial Choice Act, Comprehensive Summary 8 (June 23, 2016), http://financialservices.house.gov/uploadedfiles/financial_choice_act_comprehensive_outline.pdf [hereinafter Comprehensive Summary].
[7] Id. at 10.
[8] Executive Summary, supra note 5, at 1.
[9] Comprehensive Summary, supra note 6, at 13.
[10] Id. (internal quotation marks omitted).
[11] Id.
[12] Id.
[13] Id. at 3.
[14] See, e.g., Marshall Lux & Robert Greene, The State of Community Banking, Harvard Kennedy School for Business and Government, Working Paper No. 37, 2015, https://www.hks.harvard.edu/content/download/74695/1687293/version/1/file/Final_State_and_Fate_Lux_Greene.pdf.
[15] Comprehensive Summary, supra note 6, at 6.
[16] Id. at 7.
[17] Id.