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How to Deregulate Wall Street (Without Causing a Crash) -- Barrons.com

22 Jul 2017 5:43 am
By William D. Cohan 

Regulatory relief for the country's big banks may soon be on the way -- and not a moment too soon.

For seven years, the unintended consequences of the Wall Street Reform and Consumer Protection Act have clogged the gears of capitalism. Colloquially known as Dodd-Frank, the bill was designed to ensure that big banks would never again trigger a financial crisis. But the law's 848 pages and the 22,000 or so additional pages of related rules and regulations have created a crisis of their own.

The more onerous provisions effectively restrict bank lending and reduce financial-market liquidity, creating a drag on U.S. economic growth, which has slogged along at about 2% a year -- what Harvard University economist Larry Summers has termed "secular stagnation."

The promise of Donald Trump and his economic advisors and a Republican Congress is that loosening the restrictions on Wall Street and other banks will unleash long-hibernating animal spirits and jolt the nation's gross-domestic-product growth into a higher trajectory.

In February, President Trump issued an executive order signaling his intention to dismantle Dodd-Frank. In the past month or so alone, the House of Representatives passed a bill gutting Dodd-Frank and sent it on to the Senate, and the Treasury Department issued a lengthy report calling for Dodd-Frank to be trashed. The most important piece in this puzzle, however, has gotten the least attention. On July 10, the president nominated Randal Quarles to the Federal Reserve Board of Governors and gave him the responsibility for regulating Wall Street and removing the shackles that Dodd-Frank and other postcrisis rules have placed on it.

Quarles, 59, a onetime partner at the Carlyle Group who left at the end of 2013 to start his own private-equity firm, served as a Treasury official in both Bush administrations. Not surprisingly, he is known to favor a lighter regulatory touch than his predecessor, Daniel Tarullo, and will push for the elimination of many of the rules that Wall Street dislikes. In a March 2016 Wall Street Journal opinion column, he criticized the then-popular idea of breaking up the big banks, which he thought would damage the economy.

TEAM TRUMP'S IDEA is that by encouraging banks to lend money to small and medium-size businesses -- those that Dodd-Frank critics say have been more or less starved for capital in the past decade -- hiring, wages, and investment will increase. GDP growth is highly correlated to bank lending and, so the theory goes, encouraging more lending should help the economy break out of its GDP rut. "This has been a great eight years for rich people in New York, in California, but for the average American, they haven't seen wage increases," said Treasury Secretary Steve Mnuchin in a recent interview. "The president understands that, and that's the vision he has, and that's the vision that I signed up for since Day One -- to build an economic plan that would create jobs and create more growth in this country." (At Treasury, Mnuchin keeps a framed copy of a newspaper article about his nomination, with Trump's notation on it: "5% GDP.")

Easier said than done. According to the nonpartisan Conference Board, the consensus GDP estimates for the rest of 2017 and 2018 still are much closer to 2% than to 4%. A recent study from Stanford University's Hoover Institution argued that 3% growth would be possible if the administration's plans were adopted. (Not coincidentally, three of the study's authors are considered possible successors to Fed Chair Janet Yellen.) At the very least, if the administration acts judiciously -- eliminating the worst of Dodd-Frank while bolstering the best -- the changes will strengthen the financial markets and possibly lessen the impact of the next crisis, when it comes.

Deregulation has its dangers, including allowing Wall Street to take too much risk and to concoct products that export that risk to investors around the globe. Trump should be careful not to give the big banks carte blanche. They need and even want smart regulations, in the same way drivers know that seat-belt and drunk-driving laws make the roads safer for everyone.

To ease up on regulatory speed limits without causing another economic calamity, Trump should strike a grand bargain with Wall Street. In exchange for the smarter regulation that the banking industry seeks, and seems on the verge of getting, he should insist that Wall Street adhere to several postcrisis rules, including those that require higher bank capital and reduced balance-sheet leverage and that require derivatives to be traded on exchanges where their prices can be determined more easily. And, as part of the grand bargain, Trump should also insist that Wall Street reform its outdated compensation system, which rewards bankers, traders, and executives for taking big risks with other people's money, but fails to hold them accountable when things go wrong, as happened in 2008.

Bankers, and the politicians who love their political donations, have been silent on the twisted incentives created by Wall Street's longstanding pay practices. But a few responsible voices, including Warren Buffett, Bank of England Governor Mark Carney, and New York Fed President William Dudley, have pointed out the need to tweak incentives to change the culture on Wall Street and the behavior of the people who work there. In a March speech in London, Dudley reiterated his view that "bad incentives" played a key role in the financial crisis -- and continue to be problematic.

"Compensation," he said, "once again seems to be at the center of a scandal," referring to the Wells Fargo fiasco. "Neighborhood bankers were paid based on the volume of new accounts opened, apparently with utter disregard for whether customers wanted them or even knew about them."

While getting Wall Street to change its pay practices won't be easy, there is little question that it would be popular politically. Who could be against a system that better ties compensation on Wall Street to the behavior of the people who work there? Furthermore, there is a historical precedent that bankers and traders on Wall Street will recognize.

Prior to 1970, the Wall Street partnership structure ensured that bankers had plenty of skin in the game -- essentially their full net worth was on the line every day. Requiring that Wall Street's top executives, bankers, and traders again have a significant portion of their wealth at risk would provide much-needed accountability and reinforce the soundness and safety of the financial system. It would also unleash the power of the U.S. economy.

DODD-FRANK HAS MADE IT far more difficult and costly for Wall Street to make loans to companies with below-investment-grade credit ratings, to engage in proprietary trading, and to help clients buy and sell big blocks of stocks and bonds. One result is that small and midsize businesses, in particular, have found it harder to get access to the capital they need to grow, invest in plant and equipment, hire workers, and pay higher wages. GDP growth is highly correlated to bank lending, and in theory, at least, encouraging it ought to help the economy break out of its postrecession rut. (See "Deregulation Could Lift Big Bank Profits 30%.")

According to a Harvard Business School study, smaller businesses have been feeling the pain. "Small-business owners are generally quite adamant that even if they are just as creditworthy as they were in the period prior to the crisis, banks remain either wary or entirely unwilling to lend to them, no matter how many banks they approach," according to the study's authors, Karen Gordon Mills and Brayden McCarthy. "Lack of access to credit for small businesses is problematic because if credit is unavailable, small businesses may be unable to meet current business demands or to take advantage of opportunities for growth, potentially choking off any incipient economic recovery."

The law has also made it increasingly difficult to buy and sell bonds by forcing banks to take a capital charge for holding large inventories of them on their balance sheets. As a result, bid-ask spreads in the bond market have been widening, forcing buyers to pay more while sellers receive less. Wall Street's inventory of corporate bonds is down more than 90% since 2007. "A liquidity drought can exacerbate, or even trigger, the next financial crisis," wrote Stephen A. Schwarzman, co-founder and CEO of the Blackstone Group, in a Wall Street Journal opinion column. "Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds, and financial institutions."

Since President Barack Obama signed Dodd-Frank into law, nearly everything Wall Street does, or tries to do, is subject to oversight. Regulators can scrutinize any loan they like and attend meetings of bank boards of directors. The cost of complying with Dodd-Frank and its related rules and regulations runs into the billions of dollars annually, and it has cost the banking industry more than $36 billion since 2010, according to American Action Forum, a conservative think tank. Smaller local banks, in particular, have been begging for relief from the costs of compliance. "Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis," Schwarzman wrote in the same piece.

NOT EVERYTHING RELATED to Dodd-Frank has been a mistake, however. Big banks are required to have more capital and less leverage. Under pressure from the Fed, for example, banks have boosted their so-called Tier 1, or highest-quality, capital from about 7% pre-crisis to about 12% today. What used to be an assets-to-shareholder-equity ratio of as high as 50 to 1 is now closer to 15 to 1, meaning that a bank's assets would have to fall in value by about 7% before a bank's capital would be wiped out, as opposed to falling 2%, as in 2008. This makes them, and the system, safer.

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July 22, 2017 01:43 ET (05:43 GMT)

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