Dodd-Frank: Relaxing Unwritten Rules?

July 21 marked exactly three years since President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law. As of July 1, 2013, only 104 of the 279 mandated rules have been written and finalized—roughly 37%. And lest you think it is just a matter of time before they’re all in place, consider some rules already seem poised for relaxation and/or removal—providing an incremental reduction in regulatory headwinds facing Financials firms.

While there are likely some small fundamental impacts from these changes, in our view, what the shifts say about changing sentiment is far more noteworthy. For example, Dodd-Frank includes a provision requiring issuing financial institutions to hold at least 5% of Mortgage Backed Securities (MBS) and other securitized products they create on their own balance sheets to assume some of the risk—the “skin in the game rule.” Lawmakers presumed this would incentivize them to create better quality securitized products since they now had a vested interest, reducing the “riskiness” of what many labeled “toxic assets” during and shortly after the financial crisis.

Regulators, including the Fed and FDIC, are now considering relaxing the requirement. No, they’ve not publicly acknowledged the assets weren’t as toxic as many presumed. Rather, they cite concerns the rule could negatively affect the housing recovery. By diffusing risk throughout the financial system, securitization can help keep borrowing costs low. The “skin in the game” rule could limit the practice, pinching mortgage issuers’ ability to hedge, potentially driving up mortgage rates. Instead, the Fed and FDIC propose mandating banks hold a slice of only the riskiest of loans, including interest-only loans and those which don’t have proper documentation to support their ability to pay. Banks will not be required to have “skin” in an MBS comprised of traditional mortgages.

Fundamentally, relaxing a requirement tying up a specific amount of capital in a certain type of assets on their books could further encourage more lending. This likely isn’t the biggest game changer in the world, in the sense less than $8 billion in private mortgage-backed securities have been issued in 2013 through June—a far cry from the pre-crisis years—but it’s an incremental loosening of rules. More importantly, it’s a sign regulators’ and legislators’ risk aversion is waning some, which could help Financials’ long-running regulatory fatigue ease further.

The other recent Dodd-Frank development is perhaps an additional incremental sentiment booster. This week a three-year Dodd-Frank mandated moratorium on banking services provided by nonfinancial businesses, or “big-box stores,” expired. The ban was based on Congress’s apparent belief allowing non-bank players into financial services would increase systemic risk, on the grounds that they lacked traditional bankers’ expertise (a funny proposition if you consider Congress’s beef with bankers). Yet big box stores in many other nations have offered financial services without widespread ill effect, and the moratorium’s quiet expiration suggests legislators have noticed.

Beyond the sentiment-related implications, this could have tangible (if incremental) benefits for individuals and businesses. If Congress decides to forego making any changes, these businesses could start offering competitive credit lines, savings accounts—and even CDs—to customers. While many banks would (unsurprisingly) likely be against allowing other non-financial firms into the banking sector, in our view, it would be significantly beneficial for companies, customers and investors. Allowing more firms to provide these services would make prices overall more competitive, so customers win by possibly getting lower interest rates on credit cards, higher savings rates or better terms on products used. Companies win by gaining an additional revenue stream—increasing profitability and adding value for shareholders. That said, if some huge global retailers get in the game, will they be considered “Too Big to Fail?”

The immediate effect and impact of these potential rule changes is likely small. The much bigger aspect worth noting is before Dodd-Frank is even fully written, rules are changing and getting easier. And these changes largely reflect a fairly recent—and significant—sentiment shift.