Dodd-Frank and Another Bank Meltdown

Dodd-Frank (w/Volcker Rule) Is Being Implemented:  So Are We Safe From Another Bank Meltdown?

by Elliott Morss, Morss Global Finance


In 1933, Congress passed the Glass-Steagall Act. It established the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits. It also required banks to get rid of their trading activities: buying and selling stocks was considered too dangerous for depository institutions.

In 1999, Sandy Weil, supported by a coterie of other bankers and lobbyists, got the US Congress to repeal Glass-Steagall: that Act had kept depository institutions safe since the ’30s. With restrictions removed, US banks purchased, packaged and traded mortgages and their derivatives. And in late-2008, the market for these financial packages disappeared resulting in the US banking collapse and the largest global recession since 1929. And European bank purchases and packaging of Greek and other sovereign debt caused another global meltdown.

Nobody wanted a repeat, so the Dodd-Frank was passed in 2010. The 1,000+ page act was supposed to protect the banking industry from another collapse. But in key areas, the legislation was not specific. It was left to Congressional staff, the Financial Stability Oversight Council, and lobbyists to fill in the critical details. So what do we know about the Oversight Council?

The Financial Stability Oversight Council

So who is on this Financial Stability Oversight Council? It is be chaired by the Secretary of the Treasury with the Chairman of the Fed, the Comptroller of the Currency, the Director of the Bureau of Consumer Financial Protection Bureau, the Chairman of the Securities and Exchange Commission, the Chairperson of the Federal Deposit Insurance Corporation, the Chairperson of the Commodity Futures Trading Commission, the Director of the Federal Housing Finance Agency, the Chairman of the National Credit Union Administration Board, and an independent member appointed by the President by and with the advice and consent of the Senate (S. Roy Woodall, Jr., a Washington “insider”. In short, this is a group of politically-driven bureaucrats. They have nice offices at 1500 Pennsylvania Avenue, NW. They are “hard at work”. They just published their 2013 Annual Report. It is 195 pages long.

So what is really happening in Washington? Just after the Dodd-Frank was enacted, I wrote a piece quoting from an article by Binyamin Appelbaum in the New York Times on what will happen next:

“…Brett P. Barragate, a partner in the financial institutions practice at the law firm Jones Day, estimated that Congress had fixed in place no more than 25 percent of the details of that vast expansion….Interest groups have been preparing for months. When the Consumer Bankers Association convened its annual meeting in early June, there was still plenty of time to lobby Congress. But the group’s president, Richard Hunt, told his board that the group should shift its focus to the rule-making process. The board voted to increase the group’s budget and staff. ‘Now we hope to have a good give and take with the regulators on the best interests of the consumer and the industry,’ said Mr. Hunt. One clear consequence is a surge in the demand for lawyers with expertise in financial regulation….Most of the major trade groups are hiring lawyers. The major banks say they are employing more, too.”

Dodd-Frank and the Volker Rule

Former Treasury Secretary Paul Volker does not believe banks should be allowed to trade for their own account – too risky. And a version of his rule is included in Dodd-Frank: Title VI, Sec. 619, (a)(1) reads:

“Unless otherwise provided in this section, a banking entity shall not- (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund….in no case may the aggregate of all of the interests of the banking entity in all such funds exceed 3 percent of the Tier 1 capital of the banking entity.”

But work remained to be done on just what that meant. Lobbying is one reason it took regulators more than two years to come out with a final version of the Volker Rule after they released an initial proposal in 2011. And a third of the hundred of rules mandated by Dodd-Frank remain to be written.

In early December, it appeared that work on the Volker Rule had been completed. I quote from an upbeat Bloomberg news article:

“With the release of the Volcker rule, the Dodd-Frank Act’s regulatory overhaul is largely complete, giving banks a new degree of certainty about the limits of their business in the wake of the 2008 credit crisis. The rule, issued yesterday by five U.S. agencies, bars banks from speculating with their own money.”

This sounds pretty good, BUT….

What the Dodd-Frank Rule Says and Missed

The Legislation is quite clear: “a banking entity shall not- (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund….” Read on.

1. The Hedge Loophole

Reports indicate that the rule will allow hedging if not for speculative purposes! Amazing! As the Speaker of the House of Representatives said recently on another subject: “Are you kidding me?” But that is not all.

Reports also indicate that banks will be allowed to trade! The following was widely reported in news stories. This quote comes from the Bloomberg story referenced above: “In the rule adopted yesterday, regulators granted a broader exemption for banks’ market-making desks, on the condition that traders aren’t paid in a way that rewards proprietary trading.” A market making desk has no other role but to find and make trades. So you allow more trading but do it in a way that staff working those desks are rewarded for not making trades? Okay? Fine?

2. Sales Commissions Not Eliminated

In earlier articles on this subject, I have made a more basic point. In earlier times, banks made money by getting paid more from lenders than they had to pay to attract deposits. In bankers’ parlance, they made money on the spread (the interest rate on loans minus the interest rate paid depositors). Banks knew their survival depended on a positive “spread”, so they were very careful to make low risk loans. And after making them, they stayed in touch and worked with the borrowers to insure interest payments were kept up to date.

Everything changed when banks started selling off their loans. Instead of lending to low risk individuals and firms and worrying about how their borrowers were doing, banks focused on generating commissions by selling off their mortgages and other loans. This constituted a fundamental change in incentive structures – from worrying about the soundness of their loans to writing as many loans as they possibly could for commissions.

Think about it: when loans are sold off, repackaged, and sold off again, nobody knows (or cares unless payments stop) who the borrower is. As long as banks are allowed to sell off their loans for commissions, concern about the quality of loans they make will take second fiddle to earning commissions. This is not healthy for either the banks or the economy. That is why I believe banks should not be allowed to sell off any of the loans they make. Let them hold them to maturity. Let bank survival depend on the quality of the loans they make.

Think about the real estate bubble leading to the global collapse. Would banks have written the all bad mortgages if they had been required to hold them to maturity? Of course not.

3. Bank Regulators Can Deal With the Situation

Dodd-Frank is replete with terms such as “transparency” and “more information for regulators”. I quote again from the Bloomberg piece: “Accounting has become more transparent. Regulators have much better information about the prices realized on completed swap trades, and large hedge funds now report previously secret financial information to regulators.”

This is supposed to make us feel good. Unfortunately, it is based on the faulty underlying premise that getting more information to regulators will help. It is faulty because:

  • Regulators are already overwhelmed with information they do not understand and
  • The Basel Accords (global bank regulations) failed to prevent the US and European bank collapses.

As I have reported, the Basel Accords were interpreted to allow banks to treat government debt (like Greek government debt) as safe as money in calculating their allowable capital ratios – in retrospect, a horrible mistake. And before we get too relaxed over providing more information to banks, I urge you to take a look at what they already have: go to the Fed’s database on banks and click on any bank, then click on create report and you will get a 27 pages of quantitative data. I repeat: the regulators are already overwhelmed with data.

What Big Bankers Think

Joe Nocera, one of the most astute US financial journalist, made two interesting points in his recent review of “The Wolf of Wall Street:

  • Scorsese did the right thing in the movie; he used it to portray the greed of an individual; trying to portray the greed of a banking institution such as Goldman is too complex;
  • Big bankers are essentially salesmen: “The brokers (or traders in the case of Goldman) are, at bottom, salesmen. As the saying goes, ‘Stocks are sold, not bought.’ What is mesmerizing about Mr. Belfort (played in the film by Mr. DiCaprio) is that he is an extreme example of the smooth-talking, I-can-sell-anything, salesman. And he’s hardly the first such type in finance. In the early 1960s, a man named Bernard Cornfeld used to draw people into his financial empire by asking, “Do you sincerely want to be rich?” And they say Charles Ponzi was a pretty good salesman, too. What does Goldman Sachs do if not sell? It’s just a different product.

So bankers have become salesmen.

A good friend is a senior executives at one of our biggest banks. I asked him about Dodd-Frank and related matters. He said:

“In our view, not much has changed. Big banks like ours sell financial products. That’s mostly what we do. All of us have divisions scouring the landscape for some new product we can package and sell. Will we get caught short every so often and lose $6 billion like JP Morgan recently did? Of course, if you take risks you will lose money every so often. But keep in mind JPM’s loss is not all that big [Elliott: JPM’s 2012 net income was $21 billion].”

I asked him about the new regulations.

“The new regs? We will take risks as long as we can. We have large teams of lawyers and financial geeks working to insure we are in compliance. We also have DC lobbyists. Our sales commissions pay for them.”

Banking Futures

What will start the next big banking collapse occur? Table 1 provides data on the world’s largest banks as measured by total assets. It is notable that only three are American.

Table 1. – The World’s Largest Banks


Investment Implications

For the immediate future, we can expect more huge fines will be levied on US banks and there will be the odd mammoth loss such as the one JP Morgan (JPM) just experienced. But except for these problems, times should be good for the big banks. Table 2 lists the 5 largest US banks as measured by deposits.

Table 2. – Largest US Banks

Source: Yahoo Finance and FDIC Data

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