Growing Up With Dodd-Frank

Four years ago Monday, President Obama put his John Hancock on the biggest package of financial sector regulation since the Great Depression: The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Champions hailed it as a too-big-to-fail-ending, crisis-preventing, Wall-Street-whipping, consumer-defending victory for mankind. Critics derided it as an incomplete, toothless piece of gobbledy-gook that would ensure employment for lawyers. Senator Chris Dodd asked for a delay of verdict, saying, "No one will know until this is actually in place how it works." One might think we could render judgment today, with the law now 28 in dog years, but alas, we can't-several provisions aren't implemented or even drafted.[i] The measures that have taken effect are largely benign, but there is still a chance regulators could write rules markets won't like.

When Dodd-Frank passed, our take was simple: It missed the causes of 2008's panic, by no means prevented future financial crises and was a rather poorly crafted piece of legislation-and because it was "a 2,319-page bill mostly creating studies and deferring action altogether," the world would have to wait and see whether it was a net benefit.

Not much has changed during Dodd-Frank's journey from infancy to preschool-age. When President Obama signed the law, it contained 398 "fill in the blanks" for regulators to write the final rules. As of July 1, 208 of these have been finalized. 96 haven't even been proposed, and 94 are somewhere in between.[ii] One of those initial placeholders-the "Insert Volcker Rule here" blank-spawned over 800 pages of rules and definitions. That tells you what a tangled ball of yarn Dodd-Frank is.

Some of the regulatory bodies envisioned in Dodd-Frank are now live. Like the Consumer Financial Protection Bureau-an agency wrapped up inside of the SEC but accountable to nobody in particular-which has seen to nearly 400,000 complaints about credit cards, collections agencies, payday lenders and the like. The Financial Stability Oversight Council is also up and running, but so far, all they've done is help other regulators figure out who's too big to fail and attract criticism for a lack of transparency. Some give the FSOC grief for being rather ineffectual at ensuring "financial stability," but we'd advise these folks to be careful what they wish for.

Meanwhile, banks have adapted as best they can. Even though they're waiting for several of the finer points, they've long had a broad idea of what Dodd-Frank entails, and they've adjusted accordingly, making business changes based on those expectations. The Volcker Rule is Exhibit A-by the time the final novel was released last December, banks had proactively complied with most of it, shrinking (and in some cases eliminating) proprietary trading desks and liquidating the assets on Volcker's naughty list.

Banks' balance sheets, too, have changed-and not just because they're more capitalized today. The size and scope of the US banking industry is different. Since July 21, 2010:

• US commercial banks have added nearly $2.9 trillion in assets
• Small banks (assets less than $1 billion) have lost $65 billion in assets
• Commercial paper outstanding has fallen by $71.3 billion to $1.03 trillion (down hugely from the pre-crisis peak of $2.2 trillion in July 2007)
• The 25 biggest banks (by assets) attracted $1.7 trillion in new deposits
• Small banks (assets less than $1 billion) have lost $53.7 billion in deposits
• The number of small banks (assets less than $1 billion) in existence has fallen by 906
• But the number of banks with assets over $1 billion has risen by only 38
• So 868 small banks have disappeared-merged with bigger banks or closed

In short: The big banks are bigger, the small banks are smaller, and banks have more assets sloshing around. Regulators point to the decline of commercial paper as a positive, arguing it makes banks less prone to a run on financing, but anyone who watched Cyprus's banking crisis unfold last year knows retail depositors are plenty prone to flight. Less commercial paper doesn't mean banks are "safer"-just that they have fewer financing options. Which is sort of a negative-diversity is good. Another negative: Competition is thinner. Huge capital requirements for the biggest banks were supposed to encourage them to get smaller, but the opposite happened-depositors flocked to the banks with the biggest safety buffers. People are logical like that. Now, we're not ones to call "too big to fail" a problem-see here for more-but shrinking competition in any industry isn't good.

That's one unintended consequence of Dodd-Frank. More might come, but we can't game where they might occur-the process is too opaque. Which is why this is a potential risk for markets-surprises move stocks, and any negative emerging from the completion of Dodd-Frank will be a surprise. The law itself wasn't. Debate played out in the public sphere for over a year before the proposed bill became law. Every committee hearing, rewrite and vote was a chance for markets to digest the rule. But the actual rule-writing isn't so public. Regulators do it behind closed doors, with very little transparency and accountability. They release proposals for public comment, but the final rules often include provisions the public hasn't seen. That gives markets very little time to discover and discount their potential unintended consequences before they take effect, increasing the risk.

We saw this on a small scale when the final Volcker Rule included a surprise provision banning banks from holding collateralized debt obligations backed by Trust-Preferred Securities, long a favorite of community banks for their favorable tax and regulatory treatment. The estimated impact was small at $600 million, and regulators eased the rule after realizing the booboo, but it was a booboo nonetheless. Another Volcker provision would have forced banks to liquidate nearly $130 billion in collateralized loan obligations by 2015, eliminating about 70% of the market for securitized debt. Banks now have an extra two years to comply-which gives regulators an extra two years to figure out how to support securitization (widely seen as necessary to boost lending) without running afoul of Volcker.[iii]

We might see another exercise in unintended consequences this week, when the SEC votes on money market fund reform-another of Dodd-Frank's placeholders. Word on the street is regulators are leaning toward requiring institutional money market funds to drop their $1 fixed share price-which, as some Senators pointed out last week, could have some bizarre tax implications. Regulators also appear to be leaning toward slapping redemption limits on retail money market funds. Which is quite a solution in search of a problem when you consider this all came about because one fund "broke the buck" as a side effect of Lehman's bankruptcy, creating a temporary liquidity issue. This "fix" would create another, permanent liquidity issue: Really, why would investors buy something they can't liquidate if they need to when things go south?

But that's all speculation for now-we'll know more after they vote July 23. Stay tuned.

Don't get us wrong-there are some things to like about Dodd-Frank. The still-in-progress effort to move derivatives trading onto regulated exchanges is a positive-it adds transparency. And while one could argue banks had an incentive to clean up their balance sheets without a Congressional mandate,[iv] bank health has nonetheless improved since the law passed. But we just have trouble calling an unwieldy law with super-secret rule-writing, unintended consequences and small-bank destruction powers a net positive. Bigger US banks appear able to compete just fine, and we think there are plenty of good opportunities for investors in US Financials, but that's all despite the law. Not because of it. As for the broader market, we don't currently see anything stemming from Dodd-Frank that presents a risk to this bull market, but as long as the law remains incomplete, we can't close the book on its potential risks. Perhaps we'll get there before Dodd-Frank is old enough to drive.