Since the populist fervor swept Donald Trump into the presidency last week financials have been rallying based on the feeling that his dovish views on financial regulation will lesson the constraints on the banks. In particular Trump has talked about repealing or significantly rolling back parts of Dodd-Frank the landmark banking regulation that was put in place after the financial crisis. The House Republicans have also recently passed the Financial Choice Act that is aimed at paving the way for changes to Dodd-Frank.
Short of total repeal, what parts of Dodd-Frank could change? What would this rollback entail and what does it mean for hedge funds in terms of bank counterparty risk?
The most significant aspect for this discussion would be modifications or outright repeal of the Volker Rule. There are positive and negative aspects to this potential change. First the positives. Repeal of the Volker Rule will allow the banks to get back to full-fledged market making that would add liquidity to the markets. Second some proprietary trading could help the banks be more profitable since (this revenue stream being turned off by the Volker Rule). The obvious negative is that banks trading for their own account, particularly derivatives, contributed to the financial crisis.
Speaking of derivatives, mandatory centralized clearing, another key part of Dodd-Frank, introduced the clearinghouses as new sources of systemic risk and single points of failure. Additionally the potential risk that the clearinghouses would exacerbate a financial crisis by ratcheting up margin requirements, and draining liquidity from the markets, is another potential unintended consequence of this rule. LSOC is also an unproven protection for the segregation of customer collateral. Look for changes here but not without cost: the banks have already invested heavily to comply with mandated clearing and modifications will come with an additional spend.
The Order Liquidation Authority (OLA), otherwise know as the Living Wills, is another onerous aspect of Dodd-Frank. Whole departments at the major banks do nothing else but work on these plans. The Fed and FDIC evaluation of these plans also have real teeth. Living Wills that are rated unsatisfactory can have consequences for the banks including shedding businesses and restrictions on returning capital. Look for the bank lobbyists to push on this one.
Comprehensive Capital Analysis and Review (CCAR). The annual stress tests are another huge resource drain on the major banks. Like the OLA the test results have real ramifications. Also the Fed keeps raising the bar and making passing the tests tougher each year. A lack of global standard for these tests makes it difficult to compare the results for US and foreign banks. That the US standards are higher could increasingly put the US banks at a competitive disadvantage. I would be surprised if CCAR was abandoned but there could be an easing to the increasing pass/fail threshold.
Basel III, not Dodd-Frank, primarily drive the capital, leverage and liquidity rules. However there are efforts underway both in the US and in Europe to modify the Supplementary Leverage Rule (SLR) calculation to correct some of the issues with the denominator e.g., exempting customer collateral from the asset definition. However the Financial Choice Act’s relaxation of the leverage rules would come with increased capital requirements that would impact banks’ profitability. That said, another benefit of Trump’s lighter touch on bank regulation could be more dialogue on taking a time out and reviewing whether the current regulations need modifications.
Where does this leave us in terms of counterparty risk? Would banks and their hedge fund financing groups be safer with an easing (or repeal) of the Dodd-Frank? The Volker Rule is probably the safest bet for modification or elimination with the benefits cited above. Everything else will be a negotiation between the two parties. Whether those debates are bipartisan or the usual congressional knife fight is too early to tell. The other high probabilities are that further regulation of the major US banks will slow down as this all gets sorted out and that final financial rules will remain in flux for some time. Early in my career someone told me, “uncertainty is always perceived negatively”. Uncertainty can also mean more risk. More to come…