The looming deregulation of the banking sector under the Trump administration poses a real and tangible risk to the integrity and sustainability of global financial markets. In particular, proposed amendments of the Dodd-Frank Act have the potential to facilitate impropriety in the lending practices of the banking sector. The separation of commercial and investment banking practices underlying this legislation is a hallmark of a responsible and ethical lending landscape. This article briefly explores the evolution of the banking sector and the post-Depression policy response. Parallels can be drawn between this environment and legislative amendments made after the 2008 crisis. Ultimately it is apparent that current deregulation measures run the risk of subjecting the economy to similar destructive forces that we have seen in the past.
Policy Response to the Great Depression
Following the stock market crash in 1929, many called for structural reform of the banking sector. This was instigated after many banks had engaged in high-risk speculative market transactions using retail deposits. This was viewed as a major cause of the crash and the Great Depression. This led policy makers to enact the Glass-Steagall Act in 1932. Sections 20 and 32 of the Act prohibited commercial banks from affiliating with organisations engaged in underwriting or distribution of securities. This wall between commercial and investment banking was intended to protect retail investors from losses sustained by banks trading with customer deposits. Some commentators argue that aggressive interpretations of this Act in the late 1970s began to blur this distinction. In 1986, the Federal Reserve made a ruling on section 20 that allowed subsidiaries of bank holding companies to deal in previously ineligible securities for the first time. In addition, the revenue limit on these subsidiaries was raised in 1996 from 10 to 25%. The gradual erosion of these protective measures culminated in 1999 when the Gramm-Leach-Bliley Act (GLBA) repealed Sections 20 and 32. The subsequent consolidation of banking organisations fostered a ‘too big to fail’ mentality which was a significant influence in the financial crisis that emerged in 2008.
Post Crisis Regulatory Reform
Following the 2008 financial crisis, the Obama administration passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The Act increased reserve requirements so that banks can absorb greater losses in future downturns. In addition, the Act subjects larger banks to annual stress tests, which determine whether the bank can survive a crisis. The Volcker rule contained within § 619 of the reform package seeks to protect against the improper lending practices that were a major cause of the crisis. This imposes restrictions on banks from engaging in speculative trading on their own accounts using customer deposits. The policy approach mirrors the response taken after the stock market crash of 1929.
Commentary on Proposed Financial Deregulation Measures
The Trump administration has repeatedly communicated an intention to deregulate financial markets. In particular, there is likely to be serious amendments made to the Dodd Frank Act. On February 3rd, Trump signed a directive that gives the Treasury regulatory authority to restructure major provisions of the Act. The Act’s current provisions, which restricts proprietary trading, establishes a review board for mortgage lending practices and requires larger institutions to file annual wind up plans in the event of failure are some of the provisions susceptible to review. In addition, Trump also signed a memorandum that defers the implementation of a rule imposing a fiduciary requirement on financial advisers to act in the best interests of clients when providing retirement advice. Critics of the Act suggest that it makes it difficult for banks to function, for small business owners to obtain credit, hinders productivity and represents a significant cost to businesses. There seems to be little data supporting these claims. Since 2014, excess reserves of depository institutions have fallen by over 700 billion from 2.7 trillion to 1.98 trillion in 2017. This fall in reserves represents a significant boost to market liquidity. Furthermore, the Dodd Frank Act largely targets large financial institutions. A recently released 2015 study of the Federal Reserve on small business credit indicated that 80% of small business owners received the financing that they requested, up from 65% the year before. Finally, loans to the private sector in the US have increased steadily from 1.3 trillion in 2012 to 2.3 trillion in 2017.
While there is a higher cost associated with regulatory measures, it pales in comparison to the destructive impacts brought on by a long-term global financial crisis.
The subsequent rally in the stock of the financial sector following proposed deregulations provides little comfort in an environment that is becoming increasingly susceptible to the same risks that facilitated the Great Depression in the 1930’s and the global financial crisis in 2008. The current policy environment has the potential to seriously compromise the integrity of capital markets. In many respects, the current Dodd-Frank Act does not go as far as the Glass-Steagall Act that was introduced in the early 1930s. Any effort to repeal or amend these safeguard provisions should be met with stark opposition in order to promote accountability in the financial sector.