How the Dodd-Frank Act Transformed the Core Business Model of Banks

The Dodd-Frank Act transformed the bank industry in a variety of ways. First and foremost, it requires banks to hold more capital and keep their assets in highly liquid but less profitable forms. If there's one reason it is so unpopular in the financial services industry, this is it.

The Motley Fool's Gaby Lapera and John Maxfield discuss this aspect of Dodd-Frank in this week's episode of Industry Focus: Financials. Listen in to learn about these changes as well as what they mean for banks.

A full transcript follows the video.

This podcast was recorded on Feb. 13, 2017.

Gaby Lapera: So, we're going to talk a little bit about Dodd-Frank now, what it actually means, but something to keep in mind is that Dodd-Frank is a very weighty piece of legislation -- and I don't mean in terms of importance, although it is very important, or else we wouldn't be talking about it... although, I don't know, maybe you think we're just here to waste your time. In that case, don't listen to the podcast. [laughs]

But, no, this is actually a very long piece of legislation. What we're going to talk about now are the main points of Dodd-Frank -- so, the things that people think about when it comes to Dodd-Frank, the things that people are up in arms about when they're talking about this legislation, or the things that they're trying to protect. So, I think the first thing we should start with is capital requirements and increased liquidity, which kind of go hand-in-hand as something that banks have been complaining about pretty much nonstop since Dodd-Frank passed.

John Maxfield: Right. If you go back to the financial crisis, the theory was that what caused it, or at least, what accelerated it, was that you had these things that were called "too big to fail banks." These were massive organizations -- Bank of America, Citigroup, Lehman Brothers, Bear Stearns, Goldman Sachs. And these banks were operating with an enormous amount of leverage.

In Lehman Brothers' case, it was something like $30 worth of assets for every $1 worth of equity. What that means is that if those assets at a bank like that fell only 3%, basically all the capital of that bank would be wiped out, and it would be insolvent, and therefore it would have to go into bankruptcy. So, the thought process was that we need to increase how much capital banks hold, because if we increase how much capital banks hold, they'll be able to absorb those losses that happen when we go through these economic cycles. So, what they did with Dodd-Frank is they did a couple of things. First of all, the really big banks, they carved them out and applied heightened capital requirements to them, which means they have to operate with less leverage. They also instituted -- listeners have probably heard about these -- annual stress tests that tried to determine what would happen to these banks' capital on a yearly basis if the economy were to enter another financial crisis akin to the one in 2008. So, when they go through that crisis, they test what the losses would look like at these banks, and how that would impact their capital, and whether, through that crisis, they would still be able to meet these minimum capital requirements. 

Then, on the liquidity side -- here's a really interesting point about the crisis that I think a lot of people miss: In some of these cases, it wasn't just an issue of capital, or it wasn't even an issue of capital, but it was more an issue of liquidity, because you had all of these bank runs on these banks, and while they had enough capital, the assets they held weren't liquid enough to turn into cash quickly enough to satisfy their depository run. So, what the regulators did was, on top of requiring banks to hold more capital, they're also requiring them to hold a larger percentage of their assets in highly liquid forms like government securities, as opposed to loans, which you can't turn into cash very quickly.

Lapera: And I'm going to interrupt you right here. The reason that banks are upset about this is that if they have larger capital requirements, meaning that they have to keep more cash in reserve, that means that they can't be using that money to make loans or do whatever it is they were going to do with it that would actually make them money. They just have to sit on it, which is upsetting to them, because before the financial crisis, there weren't really that many limits on their capital requirements, not like Dodd-Frank gave.

And on top of that, with the increased liquidity going hand-in-hand with the capital requirements, it means that they have to not only keep all this extra stuff around, all this extra money, but it has to be in a form that's easy for them to liquidate. So, it can't be in loans, because a loan is a promise to pay back money over time, so they can't call in the loans right away. It has to be in a form that is very easy to return to consumers.

Maxfield: That's a great point. When you think about what a bank earns on a loan, let's say it gets a 7% interest rate, or even a 5% on a loan, if you're keeping it in cash, you're not making any money. So, it really attacks the core profitability of banks.

Lapera: Absolutely. Then, on top of that, you have these stress tests that they have to do. I don't think anyone disagrees that you should run what-if scenarios, but the banks are saying that it's burdensome to them because it takes a lot of money to run these compliance tests. You have to pay a lot of people, and it takes a lot of time, and it's time and money that they could be spending making more money. So, they're upset that they are instead spending it to be in compliance with these federal regulations.

Maxfield: Yeah, that's right. And also, if you look at the scenarios that the Federal Reserve tests these banks against, they're almost like Great Depression-type scenarios. Now, that's a good thing, for banks to always be prepared for downturns. If you're a bank, you have to always be considering, and you always have to have in the back of your head that a downturn could be coming down the road. But just, the extreme-ness of these tests makes these banks hold so much more capital, which then, on top of that liquidity stuff, just really drives down their profitability.

Lapera: Right. And then, there's another prong to these stress tests and capital requirements, which are resolution plans, which is that the biggest banks have to tell the government regulators what they plan to do for the next year, like, who are they planning to hire? What's executive compensation like? Why are they planning on having a dividend? And the federal government can basically say yea or nay on a lot of these things.

Maxfield: I'm glad you brought that up. That's actually not the resolution plan, that's part of what's called CCAR, the Comprehensive Capital Analysis and Review process. I mean, there's all these things --

Lapera: No, you're totally right, I have my notes flipped. [laughs] 

Maxfield: But I'm glad you brought that up, because I'd forgotten to mention that. One of the powers that banks lost as a result of Dodd-Frank was -- any other company, the board of directors can sit down and say, "We want to raise our dividend this year," or, "We want to buy back more stock this year than we bought back last year." Because of Dodd-Frank, and the stress tests in particular, banks do not have the sole discretion to do that. They actually have to get approval on an annual basis to increase their dividend or buy back more stocks. It's a really restrictive regulatory scenario for these banks.