The Financial CHOICE Act Arrives After the Party is Over
The Financial CHOICE Act is reckless. However, the fears of it resulting in a repeat of 2008 are overblown. While a decreased regulatory burden is always welcome by financial institutions, banks have long since moved on from the culture that created the financial crisis.
The Financial CHOICE Act
The House passed The Financial CHOICE Act last week in the middle of the Comey testimony. CHOICE follows a bi-partisan tradition of ridiculous bill acronyms and stands for “Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs” (If you’re groaning right now, take comfort that at least it wasn’t named The COFVEVE Act.) There’s almost nothing to do with investors, consumers, or even entrepreneurs in the bill, but there are some significant changes coming down the pipeline for how banks are regulated.
CNN characterizes the bill as “effectively gutting the Dodd-Frank financial regulations that were put in place during the Obama administration.” Business Insider’s hits the panic button with the title, “By reversing Wall Street regulations we’re risking another Lehman Brothers but ‘on a larger scale.’” Carter Dougherty of Americans for Financial Reform opined:
“With this bill, fraud becomes easier, consumer abuse becomes easier, reckless lending becomes easier, speculation becomes easier,” … “The chances of another financial crisis rise immeasurably with the passage of this legislation.”
While a lot in this bill is bad, I don’t think it’s going to change the way trading is done at banks, and it certainly won’t bring back the free-wheeling pre-crisis era. The party’s over at banks for two incontrovertible reasons: increased capital requirements and a shift in culture.
The Party Is Over Reason #1: Increased Capital Requirements
It is almost universally agreed by legislators, regulators, and even the banks themselves that banks had far too little capital pre-crisis. (Lehman was comically levered 44:1) Most banks didn’t have a buffer to weather the decline in their mortgage backed securities portfolios; the rest didn’t have the capital to survive the failure of one of their peers.
So, the banks had no CHOICE but to raise a lot of capital and retain more of their earnings. They raised so much additional capital that Jamie Dimon believes that banks have more than 10 times the losses brought about in a crisis. The Act teases financial institutions with a way out of some of the regulatory burden of Dodd-Frank, but only if they raise a lot more capital than they already have:
[B]anking organizations that maintain a leverage ratio of at least 10 percent, at the time of the election, may elect to be exempted from a number of regulatory requirements, including the Basel III capital and liquidity standards and the “heightened prudential standards” applicable to larger institutions under section 165 of the Dodd-Frank Act. The CHOICE Act thus offers financial institutions of all shapes and sizes a Dodd-Frank “off-ramp” ….
From a practical matter, no “too-big-to-fail” bank would choose the off-ramp because 10% is far more onerous then what is required of them today. S&P estimates that the top 10 banks would need to raise a collective $431 billion to get to 10%. JPMorgan alone would be required to raise $107 billion. While the 10% number is arbitrarily way too high, the goal of trading off complex regulations for higher capital requirements feels right to me. Banks have a lot of lawyers to figure out how to get around specific rules, but there’s no getting around higher capital requirements.
Higher capital requirements have had a huge impact in balance sheet intensive FICC businesses where revenue has fallen by 40% since 2012. A slight uptick in Q1 seems unlikely to reverse the general trend — Q2 is already on pace to drop 10%. Less leverage means banks must ration their balance sheets: on-the-run Treasuries are hedged immediately while off-the-run Treasuries have much less liquidity, the credit markets have evolved into an agency model, and mortgage desks do a fraction of the business that they used to. The lack of balance sheet means banks can no longer make the same outsized bets that could sink them, even if they wanted to. They need to conserve capital for their customers, who are only growing in their liquidity needs.
Banks aren’t very fun to work at, and they are even less fun now that you don’t have the ability to take big risks with someone else’s money. So much of the energy that used to be spent on managing a large portfolio is now spent on more mundane tasks like building a better auto-hedging system. This is probably why you see so many articles on why “people are worried about bond market liquidity”. Most of the people commenting about bond liquidity are bored because they aren’t doing a whole lot of trading.
The Party Is Over Reason #2: Culture Change
CHOICE also eliminates the Volcker Rule:
From its inception, the Volcker Rule has been a solution in search of a problem — it seeks to address activities that had nothing to do with the financial crisis, and its practical effect has been to undermine financial stability rather than preserve it.
Some think that the elimination of the Volcker Rule will threaten banks with a bunch of cowboys who can take the firm down with a few risky trades. I’m a seller of that idea. In practice, the Volcker Rule just meant that banks sold off their hedge fund and private equity stakes, which weren’t all that risky to begin with. Five years after Volcker fully went into effect, the Federal Reserve doesn’t seem to be too concerned with the speed in which the banks are disposing of their illiquid stakes.
From a practical standpoint, the Volcker Rule is nearly impossible to enforce on the fixed income trading desks. How do you even begin to differentiate market making from proprietary trading? Nearly all trading with customers is done on a principal basis, so, by definition, traders are taking a proprietary position with every single trade. How does a regulator or supervisor differentiate between a hedging trade, which probably is not the exact same instrument the customer traded with you, and a proprietary trade? What if you don’t hedge — is that good judgement or a proprietary trade? What if you position yourself for future customer demand — is that proprietary trading or smart market making? Don’t even bother answering these questions because they are logical fallacies! Attempting to differentiate between “market making” and “proprietary trading” is not possible because to be an effective market maker you need to prop trade.
However, the Volcker Rule has been very effective in instigating a culture change at the banks. Lisa Abramowicz wrote about this last week:
Even if the regulatory group were to recommend a complete rollback of all financial regulations adopted since the 2008 crisis, it’s unclear how quickly banks would reprise their role of taking substantial risk to facilitate trading, or if they would at all. The world has changed. While many agree that bond trading is evolving and still needs improvement, there isn’t enough desire to shift the model back to what it was before the crisis.
There’s far less risk-taking appetite at banks these days. The scars of the crisis have instituted a very different culture where protecting against downside risks is far more important than blowing out the next quarter. Star traders have fled for the buy-side, while banks have doubled down on the service elements of their businesses:
At this point, the biggest lenders employ traders with more experience matching up buyers and sellers than deciding how to take risks, like the star traders of the past. (Those traders largely decamped to hedge funds, with mixed results.)
All of this may have happened regardless of whether there was a Volcker Rule. A similar evolution happened in the US Equities market fifteen years ago when stock trading became a lot less profitable for banks. The NASDAQ market making desks transitioned to an agency model with star traders moving to hedge funds to start the second gilded age. You can also see the culture change in the talent pipeline. Banks have lost their appeal for attracting new talent. Technology, not banking, is now the top destination for Ivy League grads. It’s hard to even tell the difference between the behavior of the traders in Liar’s Poker and the technologists at Uber these days.
The World Has Changed
This is not to say that the Financial CHOICE Act is not reckless bill. It is, and the Senate should move to kill it through the filibuster if it is ever brought to the floor.
However, the fears of another financial crisis are overblown. Even if the Act miraculously makes it past a Senate filibuster, we’re not going to see a return of the free-wheeling days of pre-crisis banking. There seems to be no appetite among regulators and legislators to change the capital requirements that have shrunk bank balance sheets. Furthermore, changes in the culture at the banks means that there’s little appetite for taking large outsized bets. The best, brightest and most creative are now headed to Silicon Valley instead of Goldman Sachs.
We should celebrate that banking is boring again.
