The case for maintaining the existing US prudential banking regulations

One of the policy directions of the Trump administration is the deregulation of the banking system. The thinking behind this is that there has been the over regulation of the banking system and that this has stifled loans to the real sector especially the small and medium enterprises. It is believed therefore that deregulation such as the loosening of capital adequacy requirements will make more credits available to the real sector and therefore boost economic growth. However, the Federal Reserve Bank Chairman Janet Yellen has different views. She made her point at the recent gathering of Central Bankers at the annual Jackson Hole Conference. She emphasized the importance of prudential financial regulation and that real progress has been achieved in bringing the banking system to a much healthier status than it was before the Great Financial Crisis (GFC) ten years ago. She has also said that growth in bank lending was a function of loan demand and that under present conditions, banks have adequate capital to lend more. It is also noteworthy that Chairman Yellen’s expressed views run contrary to the recommendations of the Treasury Department which is the proxy for President Trump’s desires thereby diminishing her chances of being nominated for a second term as Federal Reserve Chairman when her term ends five months from now on February 2018. Federal Reserve Bank Vice Chairman Stanley Fischer was even more emphatic about the drive for deregulation. In an interview with the Financial Times, he called “efforts to lessen constraints on banks as dangerous and extremely short sighted.” Stanley Fischer resigned from his position this month.

In order to better appreciate the thinking of Chairman Yellen and Vice Chairman Fischer, it will be useful to go back to the height of the GFC in 2008. At this time the US government realizedthat it needed to bail out the banking system because the crisis created the risk of a meltdown of the economy similar to the great depression of the 1930s. The Troubled Asset Relief Program or TARP was legislated in October 2008 which budgeted funds to bailout banks and other systematically important institutions. It ultimately invested a total of $427.4 billion of which $205 billion went into bank equity shares, $20 billion each went to Citigroup and Bank of America, $67.8 billion went into the American International Group (AIG) and an $80 billion capital injection for the automakers and their financing arms. By December 2014, the US government had more than fully recovered its investments for a total amount of $441.7 billion.

A fundamental policy reaction to the GFC was to avert systemic risk, prevent systemic failure and to avoid using the taxpayers’ money to save institutions considered “too big to fail.” This policy is encapsulated in the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law by President Obama on July 2010. This is the law and its many facets of implementation that the Trump administration wants to “pushback.”

The irony is that the US banks are now perceived as robust and their shares are experiencing appreciating valuations in the stock markets. Earlier this year, it was announced that all the 34 biggest US banks passed the stress test leading to more bullish expectations for the banks and the general economy. By way of comparison, let us consider some events that happened in June of this year involving some banks in Europe where the process of bank reform are in different stages in different members of the European Union:

Banco Popular, the sixth biggest bank in Spain was taken over by Banco Santander for the price of one Euro. This means that all stockholders of Banco Popular as well as the holders of its subordinated debt were wiped out. The acquisition cost of Santander is really more than one Euro because it had to raise capital in order to absorb the assets and liabilities of Bano Popular. The remarkable thing about this bank resolution is that the taxpayers’ money is not involved in bailing out the depositors and senior bondholders of the sixth biggest bank in Spain.

During the same month of June, Italy had a more complicated problem with its banks. Two regional banks, Veneto Banca and Banca Populare di Vicenza were liquidated with part of their assets and liabilities being sold to Intesa Sanpaolo, the biggest bank of Italy. However, the Italian government gave 4.8 billion Euros to Intesa Sanpaolo plus a guarantee on the assets for 12 billion Euros for the assumption of the assets and liabilities of the two failed banks. This means that Italian taxpayers are potentially exposed to a total of 17 billion Euros in this exercise. This event also raised issues with the process of banking integration in the EU.

We can only speculate how the European system would be if the prevailing regulatory framework were as tight as in the US One could say that applying such a regulatory framework would put even more stress on the capital requirements of banks in certain EU member countries. However more stringent regulations can also hasten consolidation and recapitalization of banks. In this way they would be in a better position to provide credits to corporates, small and medium enterprises (SMEs) and consumers. As it is now, the banking system in Italy is so saddled with bad debts that the country has been caught in a vicious cycle of a moribund economy but banks are unable to provide more credits because of the nonperforming loan problems. In contrast, the US banking system is robust with the capacity to expand credit growth to corporates, SMEs and consumers. In this respect, Stanley Fischer seems to be right. There is no need to take the risk of deregulation when things are already working well.

(The opinions expressed here are the views of the writer and do not necessarily reflect the views and opinions of FINEX. You may email Mr. Araneta at vaaraneta@yahoo.com)