Last week, the Financial CHOICE Act, a hulking 600-page piece of legislation regarding the banking industry, made its way through the House of Representatives.
On this episode of Industry Focus: Financials, Motley Fool analyst Gaby Lapera and contributor John Maxfield explain a few of the most important potential changes to the banking industry that the CHOICE Act proposes, what the reasoning behind these changes is, and how the changes could affect the industry in huge ways. Also, the hosts look at how politics are playing into banking legislation in both this act and Dodd-Frank, where the CHOICE Act has to go from here in order to go into effect, and more.
A full transcript follows the video.
This video was recorded on June 12, 2017.
Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, June 12th, 2017. My name is Gaby Lapera and joining me on Skype is John Maxfield, Motley Fool contributor and banking expert. Hey, John! How's it going?
John Maxfield: It's going great, Gaby, how are you doing?
Lapera: I'm doing pretty good. I had an exciting weekend. I was volunteering at Pride with The Motley Fool, so that was really exciting, and I went rock climbing. What a fulfilling weekend.
Maxfield: Nice, that is a really fulfilling weekend. I basically spent the weekend mediating disputes between my five-year-old twin sons. [laughs] That's kind of like the referee in a boxing ring.
Lapera: [laughs] Oh my gosh, I'm very impressed. My brother also has twins, and they are young and also a handful. You have the patience and energy of a saint. Talking about patience and energy, let's turn to Congress. Today, we're going to talk about the CHOICE Act, which stands for Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs. Another in a long line of acronyms that are kind of just jammed in together to try to make something that's fun to say. The CHOICE Act just passed the House on Friday. The whole thing with the CHOICE Act, the reason that we're talking about it on the show, is that it's basically there to repeal Dodd-Frank, which is what was regulating all of the banking stuff that we've been talking about for literally, what, two years now, Maxfield?
Maxfield: Yeah. Or five years. You and I have been talking about it for two years now. One of the ways that I think is really helpful to think about the Financial CHOICE Act is that, in all industries, particularly banking, you can look at it through the lens of cycles, different types of cycles -- the business cycle, the credit cycle, cycles in consumer confidence. But another cycle that you can use to think about, not only in the financial services sector, but in all sectors, is the regulatory cycle, specifically in terms of whether the industry has more power, or the regulators have more power, at any particular point in time. And after the financial crisis, when the Dodd-Frank Act was passed on largely partisan lines, basically just supported by the Democrats, that shifted a lot of power away from the industry over to regulators. And basically what the Financial CHOICE Act does is it reverses that. And it was passed in the house, like we said last week, on largely partisan lines, but the partisan lines were different: This time, it was Republicans supporting it and Democrats not supporting it. What it tries to do is take that power that Dodd-Frank gave to the regulators and give it back to the industry.
Lapera: Yeah. The bill is sponsored, unsurprisingly, by a man named Jeb Hensarling, who is a Republican. As with most things political, things are falling along party lines. I want to take an opportunity to say that Maxfield and I are going to do our best to stay unbiased throughout this discussion, but everyone is a person and we all have opinions, and our opinions don't necessarily reflect that of The Motley Fool, but we're going to try to give you an informed, as objective as possible, discussion. My anthropology roots tell me that there is no way to have a completely unbiased discussion, so I'm going to leave it at that and talk a little bit more about the philosophy behind the CHOICE Act. Basically, a lot of people don't like Dodd-Frank. They think it puts too much pressure on the banks, it's too hard for them to make money the way that Dodd-Frank is structured. There's a few different parts to it, the big parts of the Financial CHOICE Act. But I think the one that a lot of people focus on is, the Financial CHOICE Act is looking to end "too big to fail."
Maxfield: Right. To your point, Gaby, about the partisan basis, I want to address that before I jump into the too-big-to-fail part. The one thing to keep in mind is, even though Dodd-Frank was passed on partisan basis, and the Financial CHOICE Act made it through the House on a partisan basis, the fact of the matter is, almost everybody agrees, most knowledgeable sources agree, that Dodd-Frank went too far. And I'm somebody who thinks that there needs to be a robust regulatory framework around the banking systems, just because banks are so highly leveraged, and because they play a role in the monetary system of the United States and they're kind of, to a certain extent, an extension of the federal government. So you can't let banks go out there and do what they want, because they are acting, in a sense, on the part of taxpayers. So I think that's some good context to keep in mind. But Dodd-Frank, almost everybody would agree that it did go too far. So now the question is, how far do you tailor it back?
Lapera: Yeah. And to get into that about being an extension of the government, it's not just that with the systemically important financial institutions. It's not just our country -- it's the entire world is tied into these financial systems. So people get concerned that if they fail, it's going to be -- to borrow a term from the Vietnam era -- a domino effect with other people's economies. So there is a lot of feelings riding on this, and a lot of this depends on how you view economic theory. I think 90% agree with you that Dodd-Frank potentially went too far. I don't know that the CHOICE Act is the answer, either. We'll see what happens. We'll get a little bit more into it. Let's talk a little bit about the actual components of the Financial CHOICE Act, and what they look like, what they mean in terms of existing legislation. Like I said earlier, too big to fail -- that's one of the big key components, ending too big to fail, of the Financial CHOICE Act.
Maxfield: Right, if we go back to the financial crisis, here's an overarching way to think about this too-big-to-fail component. You had Citigroup, Bank of America, and AIG, you had your Lehman Brothers and Bear Stearns -- these very large financial institutions. These financial institutions hold trillions of dollars in assets on their balance sheets, and oversee a large chunk of the deposits that you and I and everyone else deposits. So if one of those were to fail, it could cause catastrophic damage to the economy. In fact, if you go back to the Great Depression, the thing that caused the Great Depression, or transformed it from a typical recession into the Great Depression, was the failure of a bunch of banks. So that informed this whole too-big-to-fail idea where, even though it's extremely unpalatable to go in and bail out these huge firms with these executives that make tens of millions of dollars a year, and basically save them from their own mistakes, even though that's very unpalatable on almost every level, it does save the U.S. economy. What the CHOICE Act does is it tries to reduce the ability of regulators to step in and bail these banks out. Let me be clear. There is a very solid theoretical framework behind that, because the thought process is, if you go in and bail out these big banks and they know you're going to bail them out in the future, they have much less incentive to act responsibly. That's that whole thought process. If you go back to the financial crisis, the term -- I'm pulling a blank on the term -- but if you go back to the financial crisis, this was one of the main arguments that they asserted. So what Hensarling's act tries to do is dial that back, and it does it in a couple of different ways. No. 1, it removes the regulator's authority to take over these organizations that are troubled and liquidate them in an orderly way, and it transfers that authority over into the bankruptcy code.
Lapera: Just a quick side note for listeners, this is called the Orderly Liquidation Authority, that's OLA, which you might see floating around if you're reading about this online. That's actually codified into law, and it's the way the government stepped in and made sure there was an orderly liquidation during the most recent financial crisis of banks like Bear Stearns and Lehman Brothers.
Maxfield: Right. Also, the term I was thinking about earlier was moral hazard. That's the hazard that, if you're going to step in and bail someone out -- an institution -- that institution has less incentive to act responsibly. And like I said, that's grounded in theory.
Lapera: And it's actually really funny, because earlier you were talking about spending the weekend refereeing between your two children. This is almost just a parenting concept, that if you reward that behavior, you're going to keep getting bad behavior.
Maxfield: Exactly, that's exactly right. And all parents can understand that. Another important thing it does in that too-big-to-fail context is that it seeks to restrict the Federal Reserve's discount window lending to what's known as Bagehot's dictum.
Lapera: There's a lot of words in there. What is a discount-window lending? I mean, what is discount-window lending? I sound like an old person...
"What is the Facebook?" What is discount window lending?
Maxfield: Discount window is, when a bank gets into trouble, one of the things that will happen is, its depositors will know it's in trouble, so they will all run on the bank at the same time to withdraw their deposits. That's known as a bank run. The problem with a bank run is, because banks are so leveraged, and they only hold a small amount of actual cash in terms of relative to deposits that they have, that can cause them to be completely illiquid. They can run out of cash trying to satisfy their depositors. What the discount window does is it allows banks to take some of its assets on its balance sheet, go to the Federal Reserve, use those assets as collateral, and then get cash from the Federal Reserve to satisfy depositors, to thereby stop or prevent a bank run.
Lapera: And it's working, right? Because that was actually a problem. If you watch It's a Wonderful Life, or movies like that, people would actually make runs on the bank -- physically go there and withdraw all their deposits -- and that was a huge problem during the Great Depression. I don't know of a modern bank run, do you?
Maxfield: It happened with... the name of the bank is escaping me right now, but it happened with a major bank that was based in California during the financial crisis. And it was actually that bank that was taken over and turned into OneWest, which was the institution that was associated with Steven Mnuchin, who's now the Treasury Secretary. But it does still happen, but it's much less frequent because there is FDIC deposit insurance now, as well, that reduces the incentive for people to have to feel like they need to run on the banks and take their deposits out, because the FDIC will be there to stand behind the banks, anyway. So what Bagehot's dictum does is it says that the Federal Reserve should only allow banks to access the discount window -- or it says that the way the Federal Reserve could use the discount window is to lend freely and early in times of crisis, which is what happened last time -- but it should only do so to "solvent firms and against good collateral at high interest rates." It's that high-interest rates part that's really significant, because the idea there is, if you were using a punitive interest rate, banks are going to be less inclined to use the discount window. And if they're less inclined to use the discount window in times of crisis, the thought is that, ahead of time, they will be much more careful about the quality of the assets they put on their balance sheets, and the ability to turn those into cash in the public markets as opposed to having to go to the discount window of the Federal Reserve.
Lapera: And you have just revealed the disconnect between Democrats and Republicans -- which is that Republicans believe that banks can be forced to be responsible enough to take care of themselves, and Democrats do not, and that's why they're pushing for all this extra regulation. Right now, that falls along partisan lines. Whatever you think is up to you. That's basically what's going on.
Maxfield: I will say, to take politics out of this, I studied banks pretty intensely for a number of years, and I will tell you that in history, the thing that we know is that you need a strong and independent central bank, you need it at all times, but particularly in times of crisis. So you do want to be really careful in terms of both the authorities you give to a central bank in that situation and, in this case, the authorities that you take away from it. But again, this is something that, it will get worked out, and the pendulum swings back and forth between regulators and industry. And right now, this is a bill that swings at way back on the other side. I would say, just like Dodd-Frank went too far swinging the pendulum into the favor of regulators, Hensarling's act seems to me to go too far in the other direction. Which makes sense, given that Dodd-Frank was partisan on the Democratic side and the Financial CHOICE Act is partisan on the Republican side.
Lapera: Yeah. Actually, you gave me a good segue earlier to kind of slide into this next big thing that the act is going to do, which is that it's going to significantly cut down on the authority of regulatory agencies. I think one of the most important things to note is that they're going to subject financial Regulatory agencies to the REINS Act. The REINS Act basically says that any agency that wants to impose a rule that costs more than $100 million a year needs to run it by Congress first, and if Congress fails to approve a rule within 70 days after it's been proposed, then the rule would go away -- it would be null and void. Which is hard, because if you have partisan control of committees, rules that would go against whatever the nature of that committee is at the moment can just sit for 70 days and never even get heard, and then it just doesn't happen, and that means that regulation is going to happen much more slowly.
Maxfield: Right. The way it works now is that the Federal Reserve, the FCC, the CFPB, all these different regulatory agencies -- and this isn't just in the financial services arena, this is across all regulatory agencies and all industries, that in order to regulate their industries, they are given the authority to pass rules that, like, the Consumer Financial Protection Bureau, to pass rules about appropriate products that can be marketed to customers. And those rules, there is a long process where they get insight from the industry and other interested parties. But then those regulatory agencies have the power to put those rules into place and require the industry to follow them. What the Financial CHOICE Act would do is add another layer in that step, which isn't necessarily a bad thing, but here's the problem. That additional layer is Congressional approval of these rules. And you can imagine that that really adds a lot of complications to that whole process. It's not like you're just adding just one more hurdle. You're adding an extremely high hurdle that, depending on who is in control of Congress and the Senate at any particular point in time, these regulatory agencies may not be able to jump over. Again, I think that's probably the whole point of subjecting them to the REINS Act, which passed earlier this year.
Lapera: Right, it's to reduce the amount of federal legislation that exists, that's really what the point of it is. But it's hard because, yes, maybe regulatory agencies shouldn't be making up rules without Congressional approval, but on the other hand, Congress takes a really long time to do things sometimes. Sometimes, agencies come up with stuff to protect people or help people, and then it gets codified into law, but until then, they're just responding quickly to the needs as they see them. So it's this really hard to push-and-pull thing that you have with government. Let's talk a little bit also about the Fed, which you mentioned is going to be affected by this act. It's hard, because the Fed has also been subjected to the REINS Act, as well.
Maxfield: Right. There's one other piece to this. It's not only the REINS Act that they're subjecting the regulators to. They also subject the regulators to the appropriations process. That's a really important thing. Right now, let's take the Consumer Financial Protection Bureau, which is actually an agency within the Federal Reserve, and the Federal Reserve is an independent agency. So you have multiple layers of independence. But one of the principal pieces of independence is that, in the case of the Federal Reserve, it is a profit-making entity -- it has a huge balance sheet full of assets that earn interest in time. So it doesn't have to go to Congress to get money to operate, which gives it independence from Congress. The same thing is true with the Consumer Financial Protection Bureau. The Consumer Financial Protection Bureau -- don't quote me exactly on this -- since it was put into operation, and in the aftermath of the financial crisis, it has issued a total of something like $11 [billion] to $12 billion worth of fines to the industry, and it can use those fines to do, among other things, fund its own operations. So it, too, is kind of detached or insulated from that political process that is a part of the appropriations process. And what the Financial CHOICE Act does is, it would take away that independence and require these institutions to go to Congress for the funding, which would have a significant impact on them.
Lapera: Yeah. And that's one of the big criticisms of the CFBP, that its critics levied at it, is that the CFPB might start just issuing fines just because it has a financial incentive to, as opposed to doing it because the fines really need to be issued. So that's kind of where that Financial CHOICE Act section, that's what it's trying to get at.
Maxfield: Right. Then, to your point about going straight at the Federal Reserve, the Federal Reserve is one of those institutions that, people either don't know anything about it, or they love it or hate it, or they don't know anything about it, and they love or hate it. And one of the things that people tend to think about when they think about the Federal Reserve is that it's some sort of conspiratorial entity that controls the money supply and does so for the economic elites, and things like that. And one of the reasons that these conspiracy theories are able to grow take on the forms that they're able to take is because it's a relatively non-transparent organization, particularly when it comes to managing the money supply. Another main principle of the Financial CHOICE Act is to increase the transparency of the Federal Reserve, both in terms of its overall operations and in terms of the way it manages the money supply. And what I mean by managing the money supply is, when it decides to raise or lower interest rates, because that's the lever that causes the money supply to expand or contract.
Lapera: Yeah, and it's not just that. For example, the stress tests, no one is 100% sure what's in them.
Maxfield: Exactly. So the stress tests right now, these happen once a year for large banks. The purpose of them is to see how they would perform in a hypothetical economic scenario that is analogous to the financial crisis. This is actually a very good piece of the regulatory pie in the banking industry, because it keeps bankers' eyes on making sure that the assets they put on the balance sheets aren't going to submit them to massive losses if, and when, the economy turns down, like it inevitably will. But the issue with the stress tests is that, when the banks submit all the information to the Federal Reserve for the stress test, when the banks are going through their planning process, in terms of structuring their balance sheets and their operations in a way that will help them make it through the stress test, is that the Federal Reserve doesn't actually give them the exact model that the Federal Reserve is using in the course of the stress test. So the banks are flying blind in this regard. If you talk to bankers, most all of them will say that they think the stress tests are a good thing. I'm talking about the bankers, the CEOs of the very large banks in this country, those are the ones under the most stringent stress-test requirements. They will almost universally say that they think the stress tests are a good thing, but they will also almost universally complain about the fact that the Federal Reserve doesn't share the models it uses in the course of the stress test, so banks are just flying blind.
Lapera: Yeah. That actually is kind of paired with another aspect of the CHOICE Act, which is that they are proposing that if banks hold a certain amount of money on their balance sheet, essentially as an emergency fund, that they won't be subject to quite as much regulation as they are now.
Maxfield: Right. One of the main narratives that emerged from the financial crisis was that the reason the crisis was able to metastasize the way it did was because banks were overleveraged, they were undercapitalized. Which means, a typical bank will hold $1 worth of equity for $10 of assets. At the time, you had, like, Lehman Brothers and Bear Stearns and companies like that -- Lehman Brothers, at certain points, was leveraged by something like 30:1. What that means was, if its assets fell by just 3%, if the value of its assets fell by just 3%, it would render it completely insolvent. In the wake of the financial crisis, all of these additional capital rules came in to require banks to not only hold more capital, but dictated the type of capital that they were supposed to hold. What the Financial CHOICE Act does is say, "Look, let's do away with all these complicated capital rules," and these capital rules are incredibly complicated, "and let's replace them with a simple leverage ratio where banks, all you do is compare how much equity or capital a bank has to its assets, and just use that simple ratio." And if banks meet the threshold laid out in the Financial CHOICE Act, then they can be exempt from all of these additional regulations that Dodd-Frank is imposing, particularly on large banks. So the thought process is, look, if you just make them hold more capital, they're safer, so they don't have to do all these other things.
Lapera: So the thing that the Financial CHOICE Act offers for banks that do this, in particular, that's probably very valuable for them is that, right now, really large banks have to go to the Fed before doing stuff like issuing a dividend or changing their business plan. And in theory, if they meet this leverage ratio under the Financial CHOICE Act, they won't have to ask for permission to do any of that stuff anymore. Of course, it's really interesting, because when you say a simple ratio with assets, just like with people, there are assets that are really easy to move and there are assets that are really hard to move. So I don't know, I personally need a little bit more clarity around what that ratio actually looks like. It's a lot harder to sell a house and get that cash than it is to have cash to pay, and that analogy also holds for banks. They have some assets that are really hard to offload and some that are really easy to offload, so how did they end up calculating that ratio? The reason I don't know the answer to this yet is that I have not actually read all 600 pages of this act yet. I'm working on it, I'll do it eventually. So one of the reasons I haven't read all of it yet is because, it's passed the House and it's about to go to the Senate, and the Senate, in my opinion, is not going to let this pass as originally written. There's probably going to be quite a few amendments, and the language is probably going to change quite a lot, if it passes at all.
Maxfield: And here's another really important point. They're saying that, if a bank holds enough capital to satisfy this simplified leverage ratio under the Financial CHOICE Act, they're calling that an off-ramp -- the off-ramp being, you get off the highway with all these other regulations. Well, one of the really interesting regulations that it's looking like the Financial CHOICE Act is trying to attack and would allow these big banks, in particular, to avoid -- and let me read this from the executive summary of the Financial CHOICE Act. It says it will "exempt banking organizations that have made a qualifying capital election from any federal law, rule, or regulation that provide limitations on mergers, consolidations, or acquisitions of assets or control ... " So what does that mean? Through the 1970s-1980s, the banking industry deregulated. It allowed banks to open up house, operate branches, and allowed banks to operate across interstate lines, which is something that, in the past, they generally weren't allowed to do. Well, the quid pro quo in that case was that they were going to allow these banks to grow and do all these things and have more flexibility in terms of their operations, but on the other side of that, they wanted to stop these things from getting so enormous that if one of them were to fail, it would basically wipe out all the wealth of the United States. So they did that by saying, "If you hold 10% or more of the nation's deposits, you are not allowed to then acquire another depository institution." And right now, there are three banks that fit that -- JPMorgan Chase, Bank of America and Wells Fargo. So right now, JPMorgan Chase, Wells Fargo, and Bank of America, they cannot go out and buy any other banks, they're not allowed to because each one of them holds more than 10% of the nation's deposits. Under the Financial CHOICE Act, if I'm reading it correctly, it's saying that, as long as those banks hold enough capital to meet that threshold in the act, they would then be free to merge together or buy other banks. So you could theoretically, in this case, see a merger between JPMorgan Chase and Bank of America, the two biggest banks in the country. And I really doubt that that would happen because their branch bases completely overlap each other, so there would be too much redundancy in doing that. But people should think about, is that something we want to do? Do we want each individual bank to hold, say, 25% or 50% of the nation's deposits? Is that a direction we want to go in, given the fact that since the Civil War, more than 17,000 banks have failed? So it's a good thing to keep in mind.
Lapera: Yeah, no, that's a really overwhelming thing to think about. We need to wrap up because we've been here for a while. It's partially because there's just so much stuff in this act to discuss. There's so many little things that could end up having really big impact. We'll continue to track the progress of the bill. Like I mentioned earlier, I really, really do not think this is going to get through the Senate completely unchanged. We'll talk about that more when we know more. Was there anything else you wanted to say, Maxfield?
Maxfield: No, I think that's it. The only other thing is, it would dramatically impact the Consumer Financial Protection Bureau. We could talk about that on a different show because that deserves its own conversation. But again, to leave off on the same point I made at the very beginning, the Financial CHOICE Act, like the Dodd-Frank Act, is neither good nor bad. It's just a reflection of the swing of the pendulum back and forth between regulators and industries. We've seen this many times in the past. And generally, when the pendulum swings, regardless of the direction in which it swings, it goes too far. Dodd-Frank went too far. The Financial CHOICE Act went too far. So to your point, Gaby, when this goes through the Senate, it's likely that they're going to tailor it back.
Lapera: Yeah. That seems very likely, especially given everything that we've seen during this Administration so far. Who knows what'll happen? Things in D.C. either move at breakneck pace, or very, very slowly. We'll keep you guys up to date, don't worry. If you guys have any questions, definitely email us at email@example.com, or by tweeting us @MFIndustryFocus, and let us know what you'd like to hear about next. If you tweet us @MFIndustryFocus, I am actually now in charge of our Twitter feed, so yeah, that will actually be me responding to you. Thank you, Austin, for listening to this very long episode about financial regulation. [laughs]
Austin Morgan: Of course.
Lapera: He's looking at me like, "You owe me one, bud."
Maxfield: He's asleep, yeah.
Morgan: Just another Monday.
Lapera: [laughs] As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. I hope everyone has a really great week. I hope that your week is less stressful than mine. I get stressed out every time we talk about politics on this show, so I'm going to go take an antacid and eat some lunch. Everyone, have a great day!
Gaby Lapera owns shares of JPMorgan Chase. John Maxfield owns shares of Bank of America and Wells Fargo. The Motley Fool owns shares of and recommends Facebook and Twitter. The Motley Fool has a disclosure policy.