The Senate's Banking Reform Bill: Here's What Investors Need to Know

The Senate just passed a bill that would loosen regulations on all but the largest U.S. banks. In this episode of Industry Focus: Financials, host Michael Douglass and banking specialist Matt Frankel discuss what's in the bill and which banks could be the winners and losers.

A full transcript follows the video.

This video was recorded on March 19, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, March 19th, and we're talking about the potential reform of Dodd-Frank reforms. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. To be more precise, the United States Senate late last week passed a bill to partially roll back and, in a variety of ways, change the Dodd-Frank reforms that were put into law in the wake of the financial crisis. Now, the first thing we have to say here is, the Senate has passed a bill that. That does not mean the House will pass the same bill, and that certainly doesn't mean the President will sign the bill.

Matt Frankel: Right. This is what's referred to as a draft legislation. Think of it like the first draft of a paper you're writing for school. It's not going to look quite like this when the final bill is voted on. The President has already said he would sign the legislation as written, but the issue is, Republicans in the House of Representative don't quite think it rolls back the reforms enough, and are going to add some things to it. And, this will need some bipartisan support to pass, so there's a risk that once it gets back to the Senate, this could be a real roadblock to this, the reforms of the reforms becoming law.

Douglass: [laughs] Right. So, as per usual with anything on Capitol Hill, there are a lot of moving parts here. We will be diving into some of those pieces. The first thing that we have to talk about here is, this is, in a lot of ways, a theoretical conversation. But, we figured, this is interesting news, this is something we should be talking about because it will make a big difference to a lot of the financial sector if passed in some way, shape or form. And we can do a little bit of speculation about winners and losers a little bit further down. 

But first, let's talk about the biggest part of this legislation, or certainly the headline number, which is the asset requirement to be considered a systemic important financial institution, or, as we call it around here, a SIFI, would rise from $50 billion in assets to $250 billion in assets. But first, let's talk a little bit about what a SIFI is.

Frankel: A SIFI is basically an institution, you've heard the term too big to fail. This would be an institution that, if it fails, could really threaten the stability of our financial system in this country. In the wake of the financial crisis, there were these reforms put into place to control what was defined as a SIFI, first of all, because that's a new thing, and to watch them a little closer than you would, say, a smaller bank. So, the effect of this is, SIFIs have higher regulatory expenses than other banks and are required to keep higher capital levels and don't really control their own dividend and buyback policies and things of that nature.

Douglass: Right. Essentially, if you're a SIFI, it's going to be a little bit harder for you to compete with everyone else. On the flip side of that is this idea that SIFIs also have a scale advantage. They are the largest institutions. And this proposed shift from $50 billion in assets to $250 billion in assets means that the number of banks in that group would drop from around 40 to around a dozen. So, it would really take us to the very biggest ones, and your household names, folks like JPMorgan, Bank of America, Citigroup, Wells Fargo, instead of hopping down further and further into a lot of banks, some of which a lot of listeners of the show will probably have never heard of.

But, let's also consider this on the flip side, thinking about this through the lens of the financial crisis. Lehman Brothers had $600 billion in assets when things started going south. So, they certainly would have been, in this proposed new framework, they would still be considered a SIFI. But subprime mortgage lender Countrywide had $211.7 billion in assets at the end of 2007. Remember that Bank of America bought it in January of '08. So, it would not be considered a SIFI under this new framework. And yet, when Country-Wide failed, a lot of really bad, big things happened pretty quickly.

Frankel: Right. I wouldn't put the Country-Wide failure in the same league as the Lehman Brothers failure in terms of the threat to the financial system.

Douglass: That is very true.

Frankel: But, that's kind of the point of this. And it's kind of a fluid concept. There's no real perfect answer to where the actual cutoff is, which is kind of what they're trying to figure out. When things like the financial crisis happen, you tend to see really knee-jerk reactions to make sure things don't happen again, and rightly so. And what happens is, things tend to go a little too far in the other direction. And what they're trying to do now is find the correct point.

Douglass: It's interesting, because the way they've set it up is essentially, banks up to $100 billion in assets would immediately be not subject to SIFI requirements. From the $100-250 billion in assets group, they would be subject to some of the requirements for a little while longer. And then, further down the line, the Fed would still do some stress tests on that group, and they'd have the ability to demand more regulatory responsiveness from those banks when they needed to, when they felt that was appropriate. But it wouldn't be at the same level of consistency that you would have for the over $250 billion group.

Frankel: Right. And like you said, this is a very fluid idea. There's no telling what it's going to look like in the final draft. But $50 billion is too low. Everyone pretty much agrees on that. Barney Frank himself, who the Dodd-Frank legislation is partially named for, recently came out and said, the real number is probably around $125 billion. He said $50 billion was a little bit low, but $250 billion might be a little too high. It excludes some banks that we really should probably keep a close eye on. He mentioned the Country-Wide situation. So, under what Barney Frank would want to do, Country-Wide would still be considered a SIFI, under his ideal situation. So, we'll see where it actually ends up. There's going to be some wiggle room before the final legislation goes for a vote.

Douglass: Right. And the thing that we just talked about is this piece that, the Fed would have the ability to do some things when they felt it was appropriate. To quote Fed chair Jerome Powell, he gave some testament on this, he said the Fed would have "the tools that we need" to apply where necessary. 

Now I'll say, on the flip side of that is the fact that, when the Financial Crisis Inquiry Commission, which was a panel specifically designed to take a look at the financial crisis and comment on what things should have been done differently, they had some pretty nasty things to say about regulators at the time. The Fed "had a pivotal failure to stem the flow of toxic mortgages." And the SEC "failed to restrict banks' risky activities, did not require them to hold adequate capital and liquidity for their activities." This, thanks for the Washington Post's excellent reporting on that commission's findings. 

So, there's a lot of stuff here that's up to discretion of regulators. And regulators haven't always shown themselves to really be appropriately aggressive. I'll also throw out there, course, that hindsight is 20/20. And my hope would be that people have learned from this, so regulators would be more active when that's appropriate.

Frankel: Right, but there still a big difference between what regulators could do and what regulators have to do.

Douglass: Right, and that's the piece that we're seeing here with this proposed $100-250 billion, I'm going to call it transition zone, between banks that they think are distinctly not SIFIs and those that are distinctly SIFIs, again, that over $250 billion group. What other thoughts do you have on that, Matt?

Frankel: Like I said, it'll just come to where this ends up in the end and what the Fed is required to do and what they have to do. Moving on from that, there are a few other smaller changes that this bill would make that are worth mentioning. One, it would end the Volcker Rule for smaller banks, which was designed to prevent speculation. Proprietary trading is a big thing in the Volcker Rule, and banks are currently damned from doing that, for the most part. This would roll that back for smaller institutions. 

It would also reduce capital requirements on banks that are known as custody banks. These are banks like Bank of New York Mellon, State Street Financial is a big one, that are kind of holding custody assets for pension funds and mutual funds, things of that nature. They would have lower capital requirements. It would ease mortgage regulations for smaller banks. And for the consumers, a big win, credit bureaus Equifax, Experian and TransUnion would be required to freeze people's credit for free. Currently, that costs about $10 per bureau depending on where you live. So, this is a big win for consumers, especially in the wake of that big Equifax breach that we saw last year.

Douglass: Yeah, and it's interesting, because when you look at the bill, one of the comments that a lot of people who are opposed to the bill will say is, they say it's about community banks and small banks, but really, a lot of the big benefits are to fairly large banks, your $50-250 billion asset groups. And that's fair enough. That's a really, really big benefit to those groups. But, there's also a lot of stuff here that's designed to help small banks. And to be clear, it's probably needed. Community banks are on the decline. There are about a third fewer today than there were about a decade ago, according to The Economist. So, that's a big thing. Hopefully this will help provide them with some more stability and a better place to compete. 

Alright, so, winners and losers. Let's talk first about community banks, because those are a pretty clear winner here. As I mentioned before the break, they've been on the decline. There's been a lot of mergers and acquisitions activity because they've had so much, in terms of regulatory stuff that they've had to respond to, that they've had to comply with, that it just hasn't made sense for these really tiny banks with five and seven and nine branches to stay on their own. It makes better sense for them to combine their operations, which can have drawbacks for consumers, as they grow bigger and become more corporate. This will definitely help with their competitive positioning in the market, assuming the bill in its current form is passed.

Frankel: Yeah. What this does is level the playing field between the community banks and the big banks. You mentioned they have the big advantage of scale. Now the community banks would have the advantage of lower regulatory expenses, and it would help them compete a little bit better with companies that, right now, are not competing very effectively. Like you mentioned, there's a third fewer today than there was a decade ago. It's also, at this point, worth mentioning that there is nothing in this bill that specifically would roll back regulations on the biggest banks. So, if anything, I would call them one of the losers.

Douglass: Yeah, I think that's fair to say. When you think about the totally opposite ends of the spectrum -- your tiniest banks are beneficiaries, your very largest banks, at least not beneficiaries. And since everyone else is getting a boost on some level, probably consider them losers. I think that's fair.

Let's talk about banks from $50-100 billion in assets. Now, this is an interesting group, because they are subject to severe requirements. But, if this bill in its current form passes, then they won't be anymore, immediately. And that is going to make their lives a lot easier. Because right now you have -- and this is a well-documented thing across financials -- once a bank starts getting into the upper $40 billion area for its balance sheet, it starts really thinking hard about whether it wants to cross that $50 billion mark. And you've seen plenty of banks raise their dividends and do things, basically, to prevent themselves from growing across that limit. Well, suddenly, if that limit is doubled, that calculus changes, so you may see a lot of these banks that are kind of in that, for lack of a better term, danger zone, start really aggressively investing for growth again.

Frankel: Yeah. One of my favorite banks is a great example of this, New York Community Bank (NYSE: NYCB). In New York, they lend on primarily rent-controlled apartment buildings, and they've grown aggressively over the years in terms of acquiring other banks. That had to come to a halt as soon as they started to approach the $50 billion mark. They've been paying something like a 5-6% dividend yield for a few years now and have been preparing for these excessive regulatory expenses. And now, if this passes, that just won't be an issue for them anymore. They can pursue growth as usual. I would actually call this group the biggest winner of this legislation if it passes.

Douglass: Yes. It simply removes a big overhang for them. And it's funny, if you ever check out New York Community Bancorp's 10-K and you look at the last few years, you'll notice, they've really kept their assets right at or below $50 billion as much as possible. Just a high-level look shows you that they have very clearly chosen not to grow, when you compare that to where they were 10 and 15 years ago. 

The other thing is, that could encourage some mergers and acquisitions in that group, that $50-100 billion in assets group, because suddenly, if you're a $48 billion bank and you've been eyeing this $20 billion bank, but you didn't want to go over the SIFI limit, well, suddenly you won't. So, that could be an interesting opportunity for banks that are, I would say less than half that amount, so your sub-$25 billion banks, so that some of these bigger banks may finally be able to use their elephant guns to go ahead and choose some significant acquisitions for themselves.

Frankel: Yeah, definitely. Another group is the one that this doesn't automatically happen to overnight big banks with $100-250 billion in assets. I want to say a BB&T would fall into this category, I'm pretty sure.

Douglass: Yeah.

Frankel: I would call these winners, just because I definitely wouldn't put them in the losers category here. But we don't know how much of winners they're going to be just yet. We don't know what the Fed is going to be required to do with these banks, how quickly the regulations would actually roll off of them, and what would trigger the Fed's discretionary oversight. So, while these are winners, I wouldn't rush in and buy these banks stocks hand over fist just yet.

Douglass: Yeah. The way I think of it is, they are uncertain winners. The fact is, their competitive positioning will probably get a little bit better. But how much better is very unclear. I think what we'll probably see is a very muted reaction as a lot of these banks say, "Yes, this is probably a net benefit, but we'll have to wait and see as the rubber meets the road and really understand what that benefit looks like."

Now, aside from the largest banks, I think the only other folks you could argue, from a business standpoint, are clear losers, are Equifax and the other credit bureaus, because they have to offer those free credit freeze services. But to be honest, it's not really that big of a downside for them. So, credit freeze services, among other things, are offered in Equifax's Global Consumer Solutions business, which was about 12% of Equifax's top line last year. But it's not clear how much of that business was related to these discretionary credit freezes. Frankly, it's probably not material to them. So, if you're trying to find a formal loser in the bill, you could argue that Equifax and the other credit bureaus fit that bill, but it's really probably not going to be a material difference to them.

Frankel: Yeah, this could actually turn out to be a blessing in disguise to the credit bureaus. Right now, people are of the mindset, Equifax let hackers steal all my data and it's going to cost me $30 to freeze my credit? So now it gives consumers a little bit more power and takes the heat off of the credit bureaus, in some respect. Consumers are actually what I would add to the winners list here. A credit freeze is by far your best line of defense against your identity being stolen. There's credit fraud alerts and credit freezes, and freezes are by far the most effective. And now they'll be free, if this goes through.

Douglass: Yes. And to be entirely fair to the credit bureaus, Equifax offered, and is still offering, free credit freezes to folks through, I think it's mid this year. So, anyone who was affected is getting some short-term protection. But, this would lengthen that and enforce longer, more permanent protection. Which frankly, in the world we live in, where financial data is increasingly being stolen and hacks are unfortunately just a fact of life, I think this is a needed update and I'm glad that we're not just depending on a business' largesse and sense of fairness, but rather codifying this to make sure it's an expectation by consumers from here, and not something that anyone needs to have to go advocate for after this.

Frankel: Yeah. Just for a last-minute public service message here, credit freezes are by far the most effective, only if you do all three credit bureaus. So, Equifax, yes, they offered free credit freezes, but now you'll be able to do Experian and TransUnion for free as well. So, it'll be more of a well-rounded credit freeze.

Douglass: Right, assuming, of course, that this bill passes.

Frankel: Yeah, this whole conversation is contingent on this bill passing.

Douglass: [laughs] Right. But, at the end of the day, the stock market, in my mind, is the art of the possible. It is the art of what might happen in the future. And that is what makes things interesting. And investors who are aware of the potential outcomes and the potential externalities of decisions that are made and regulatory changes that occur are, in my opinion, the folks who are best equipped to make sure that they make smart investment decisions either based on those or despite them.

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Dan Boyd. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!