July 22, 2017 1:43 a.m. ET
Regulatory relief for the country’s big banks may soon be on the way—and not a moment too soon.
For seven years, the unintended consequences of the Wall Street Reform and Consumer Protection Act have clogged the gears of capitalism. Colloquially known as Dodd-Frank, the bill was designed to ensure that big banks would never again trigger a financial crisis. But the law’s 848 pages and the 22,000 or so additional pages of related rules and regulations have created a crisis of their own.
The more onerous provisions effectively restrict bank lending and reduce financial-market liquidity, creating a drag on U.S. economic growth, which has slogged along at about 2% a year—what Harvard University economist Larry Summers has termed “secular stagnation.”
The promise of Donald Trump and his economic advisors and a Republican Congress is that loosening the restrictions on Wall Street and other banks will unleash long-hibernating animal spirits and jolt the nation’s gross-domestic-product growth into a higher trajectory.
In February, President Trump issued an executive order signaling his intention to dismantle Dodd-Frank. In the past month or so alone, the House of Representatives passed a bill gutting Dodd-Frank and sent it on to the Senate, and the Treasury Department issued a lengthy report calling for Dodd-Frank to be trashed. The most important piece in this puzzle, however, has gotten the least attention. On July 10, the president nominated Randal Quarles to the Federal Reserve Board of Governors and gave him the responsibility for regulating Wall Street and removing the shackles that Dodd-Frank and other postcrisis rules have placed on it.
Quarles, 59, a onetime partner at the Carlyle Group who left at the end of 2013 to start his own private-equity firm, served as a Treasury official in both Bush administrations. Not surprisingly, he is known to favor a lighter regulatory touch than his predecessor, Daniel Tarullo, and will push for the elimination of many of the rules that Wall Street dislikes. In a March 2016 Wall Street Journal opinion column, he criticized the then-popular idea of breaking up the big banks, which he thought would damage the economy.
TEAM TRUMP’S IDEA is that by encouraging banks to lend money to small and medium-size businesses—those that Dodd-Frank critics say have been more or less starved for capital in the past decade—hiring, wages, and investment will increase. GDP growth is highly correlated to bank lending and, so the theory goes, encouraging more lending should help the economy break out of its GDP rut. “This has been a great eight years for rich people in New York, in California, but for the average American, they haven’t seen wage increases,” said Treasury Secretary Steve Mnuchin in a recent interview. “The president understands that, and that’s the vision he has, and that’s the vision that I signed up for since Day One—to build an economic plan that would create jobs and create more growth in this country.” (At Treasury, Mnuchin keeps a framed copy of a newspaper article about his nomination, with Trump’s notation on it: “5% GDP.”)
Easier said than done. According to the nonpartisan Conference Board, the consensus GDP estimates for the rest of 2017 and 2018 still are much closer to 2% than to 4%. A recent study from Stanford University’s Hoover Institution argued that 3% growth would be possible if the administration’s plans were adopted. (Not coincidentally, three of the study’s authors are considered possible successors to Fed Chair Janet Yellen.) At the very least, if the administration acts judiciously—eliminating the worst of Dodd-Frank while bolstering the best—the changes will strengthen the financial markets and possibly lessen the impact of the next crisis, when it comes.
Deregulation has its dangers, including allowing Wall Street to take too much risk and to concoct products that export that risk to investors around the globe. Trump should be careful not to give the big banks carte blanche. They need and even want smart regulations, in the same way drivers know that seat-belt and drunk-driving laws make the roads safer for everyone.
To ease up on regulatory speed limits without causing another economic calamity, Trump should strike a grand bargain with Wall Street. In exchange for the smarter regulation that the banking industry seeks, and seems on the verge of getting, he should insist that Wall Street adhere to several postcrisis rules, including those that require higher bank capital and reduced balance-sheet leverage and that require derivatives to be traded on exchanges where their prices can be determined more easily. And, as part of the grand bargain, Trump should also insist that Wall Street reform its outdated compensation system, which rewards bankers, traders, and executives for taking big risks with other people’s money, but fails to hold them accountable when things go wrong, as happened in 2008.
Bankers, and the politicians who love their political donations, have been silent on the twisted incentives created by Wall Street’s longstanding pay practices. But a few responsible voices, including Warren Buffett, Bank of England Governor Mark Carney, and New York Fed President William Dudley, have pointed out the need to tweak incentives to change the culture on Wall Street and the behavior of the people who work there. In a March speech in London, Dudley reiterated his view that “bad incentives” played a key role in the financial crisis—and continue to be problematic.
“Compensation,” he said, “once again seems to be at the center of a scandal,” referring to the Wells Fargo fiasco. “Neighborhood bankers were paid based on the volume of new accounts opened, apparently with utter disregard for whether customers wanted them or even knew about them.”
While getting Wall Street to change its pay practices won’t be easy, there is little question that it would be popular politically. Who could be against a system that better ties compensation on Wall Street to the behavior of the people who work there? Furthermore, there is a historical precedent that bankers and traders on Wall Street will recognize.
Prior to 1970, the Wall Street partnership structure ensured that bankers had plenty of skin in the game—essentially their full net worth was on the line every day. Requiring that Wall Street’s top executives, bankers, and traders again have a significant portion of their wealth at risk would provide much-needed accountability and reinforce the soundness and safety of the financial system. It would also unleash the power of the U.S. economy.
DODD-FRANK HAS MADE IT far more difficult and costly for Wall Street to make loans to companies with below-investment-grade credit ratings, to engage in proprietary trading, and to help clients buy and sell big blocks of stocks and bonds. One result is that small and midsize businesses, in particular, have found it harder to get access to the capital they need to grow, invest in plant and equipment, hire workers, and pay higher wages. GDP growth is highly correlated to bank lending, and in theory, at least, encouraging it ought to help the economy break out of its postrecession rut. (See “Deregulation Could Lift Big Bank Profits 30%.”)
According to a Harvard Business School study, smaller businesses have been feeling the pain. “Small-business owners are generally quite adamant that even if they are just as creditworthy as they were in the period prior to the crisis, banks remain either wary or entirely unwilling to lend to them, no matter how many banks they approach,” according to the study’s authors, Karen Gordon Mills and Brayden McCarthy. “Lack of access to credit for small businesses is problematic because if credit is unavailable, small businesses may be unable to meet current business demands or to take advantage of opportunities for growth, potentially choking off any incipient economic recovery.”
The law has also made it increasingly difficult to buy and sell bonds by forcing banks to take a capital charge for holding large inventories of them on their balance sheets. As a result, bid-ask spreads in the bond market have been widening, forcing buyers to pay more while sellers receive less. Wall Street’s inventory of corporate bonds is down more than 90% since 2007. “A liquidity drought can exacerbate, or even trigger, the next financial crisis,” wrote Stephen A. Schwarzman, co-founder and CEO of the Blackstone Group, in a Wall Street Journal opinion column. “Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds, and financial institutions.”
Since President Barack Obama signed Dodd-Frank into law, nearly everything Wall Street does, or tries to do, is subject to oversight. Regulators can scrutinize any loan they like and attend meetings of bank boards of directors. The cost of complying with Dodd-Frank and its related rules and regulations runs into the billions of dollars annually, and it has cost the banking industry more than $36 billion since 2010, according to American Action Forum, a conservative think tank. Smaller local banks, in particular, have been begging for relief from the costs of compliance. “Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis,” Schwarzman wrote in the same piece.
NOT EVERYTHING RELATED to Dodd-Frank has been a mistake, however. Big banks are required to have more capital and less leverage. Under pressure from the Fed, for example, banks have boosted their so-called Tier 1, or highest-quality, capital from about 7% pre-crisis to about 12% today. What used to be an assets-to-shareholder-equity ratio of as high as 50 to 1 is now closer to 15 to 1, meaning that a bank’s assets would have to fall in value by about 7% before a bank’s capital would be wiped out, as opposed to falling 2%, as in 2008. This makes them, and the system, safer.
Indeed, Steve Eisman, a portfolio manager at Neuberger Berman, says that for the first time since 1992, when he started his career analyzing the banking industry, he isn’t worried about the “safety and soundness” of the U.S. financial system. He has an eye for spotting banking crises—his prescience about the 2008 collapse earned him millions and a starring role in The Big Short, Michael Lewis’ best seller about the crash.
Still, the pendulum is swinging. On June 8, the House passed the Financial Choice Act, designed to gut much of the post-financial-crisis legislation. Presumably referring to the stagnant economy, Rep. Jeb Hensarling, a Texas Republican and chairman of the House Financial Services Committee, said, “Every promise of Dodd-Frank has been broken.” His bill passed along party lines. Four days later, Mnuchin’s Treasury issued a 149-page report calling for many of the repeals found in the House bill, including a reduction in bank capital requirements and an easing of Volcker rule restrictions.
Such moves have infuriated Trump’s most vocal critics, including Sen. Elizabeth Warren (D., Mass.), who said in a recent interview, “The Goldman appointments are the tangible demonstration of Donald Trump turning his back on virtually every campaign promise he made.…Donald Trump said over and over that he wanted Glass-Steagall, and that he would break up the banks. And now his Treasury secretary says, ‘No, we’re not gonna do that.’ ”
Even if getting the House bill through the Senate won’t be possible without support from Democratic senators, there is much that the Trump administration can do on its own to loosen banking regulations and make it easier for Wall Street to get back to the business of providing capital to people who want it and are willing to pay a fair price for it. For starters, the administration could have the Securities and Exchange Commission roll back certain Dodd-Frank rules and pull regulators out of Wall Street firms.
SOME WALL STREET EXECUTIVES, including Blackstone’s Schwarzman, applaud what Trump is trying to do. “It was natural you were going to see an increase in regulation after the financial crisis,” Schwarzman, chairman of Trump’s Strategic and Policy Forum, which advises the president, wrote Barron’s in an email. “But I’m not sure anyone really took full account of the unintended, negative consequences that these layers and layers of new rules have had. When you look at the totality of the impact—such as a reduction in liquidity and the number of market makers, which could cause the system to freeze up during a crisis—a number of these regulations have actually made things less safe.”
While some on Wall Street would like Trump to take a sledgehammer to Dodd-Frank, others expect the changes to be incremental. Eisman expects Quarles to make changes on the margins. Regulating the banking industry is “an iterative process,” he says. “There are no tablets from Sinai on how to do that. You have to do it by trial and error. The industry probably does have excess capital. You can do with a little bit more leverage and a little bit more bond liquidity. That’s basically what’s going to happen.”
In all of the talk of Wall Street reform, there has been almost no discussion of changing the industry’s compensation structure, which has been good at rewarding bad behavior and swing-for-the-fences bets with other people’s money, but poor at rewarding prudent risk-taking and accountability. There’s no mention of Wall Street’s problematic incentive system in the Hensarling bill, nor in the Mnuchin report. Few regulators have raised it as a concern, let alone a problem desperately in need of a fix. Addressing the compensation system has become something of a third rail on Wall Street: Everyone knows it’s a problem, but no one dares go near it.
Indeed, on Thursday the SEC and several banking regulators backed off from such a push, which had been mandated by Dodd-Frank, in the interest of moving forward with other deregulation priorities.
And yet it is indisputable that Wall Street’s compensation structure is broken, and has been since 1970, when Donaldson, Lufkin & Jenrette raised capital in the public markets. One Wall Street partnership after another tapped the public equity markets, substituting other people’s money for the partners’ money. In turn, what had been a partnership culture that rewarded prudent risk-taking on Wall Street has been replaced with a bonus culture, rewarding big revenue generators with multimillion-dollar bonuses. Lots of things were lost along the road from private partnerships to pubic companies, but foremost among them was any sense of accountability for individual bankers, traders, and executives for the consequences of their inevitable bad behavior.
In the years leading up to the 2008 financial crisis, bankers, traders, and executives were rewarded with big bonuses for manufacturing questionable mortgage-backed securities. By the time they blew up, necessitating a government bailout of the banking system, the bonus checks had been cut, dispensed, and cashed. Not a single bonus was clawed back or repaid.
In my 2009 book, House of Cards, about the collapse of Bear Stearns, a conversation I had with Jimmy Cayne, the longtime CEO of the firm, proves the point. When I asked him what it was like to lose a billion dollars of his net worth—after Bear’s stock collapsed—he didn’t respond the way I thought he would. “The only people [who] are going to suffer are my heirs, not me,” he said. “Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?” Maybe he would have thought differently about the risks Bear Stearns was accumulating if his full net worth was on the line, as it was before the firm went public in 1985.
Nearly a decade after the second-worst financial crisis in U.S. history, bankers, traders, and executives are still rewarded for taking big risks with other people’s money. In exchange for the comprehensive changes sought by Wall Street executives, Trump should insist that the top 500 or so executives at every big bank—the ones who decide how to deploy capital, which business lines to be in, and who gets promoted and paid—have a significant portion of their net worth on the line every day, as was de rigueur in the days when Wall Street firms were partnerships and imprudent decisions could put an entire firm at risk almost overnight.
There are many ways that lawyers could construct this obligation—giving creditors and shareholders a “contingent value right” tied to their collective net worth, for instance—but regardless of the particulars, the important thing is for Wall Street’s leaders to have skin in the game, just as they once did, to act as a brake on dangerous practices and ensure accountability when things go wrong.
IT WON’T BE EASY to get Wall Street to go along. Why should the industry voluntarily change an incentive system that pays employees millions of dollars a year to take big risks with other people’s money? But that’s just the point. It’s time for Wall Street to do something that will benefit the whole system, and changing the rewards on Wall Street will do just that.
Trump must make this grand bargain. Not only would it be wildly popular across the political spectrum, but also it would be the right thing to do. “Incentives—compensation and promotion, in particular—are powerful tools for communicating the conduct and culture you desire for your firm,” said the New York Fed’s Dudley in his London speech. “A commitment to the long term must be at the core of banking. Incentives within a firm should support that goal, not undermine it.”
WILLIAM D. COHAN, a special correspondent at Vanity Fair and a former investment banker, is the author of Why Wall Street Matters, Money and Power, House of Cards, and other best-selling books.
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