The US Senate has voted to roll back Dodd-Frank rules for banks – what does this mean?

Last week the US Senate passed a bank deregulation bill that would begin the process of rolling back parts of the Dodd-Frank Wall Street reforms, passed during Barack Obama’s tenure. The original bill in 2010 placed restrictions on banks in order to try and prevent another meltdown like the world had seen during the financial crisis.

The new bill passed with 67 votes to 31, but was met with stern opposition from house Democrats, who argued that Republicans were undermining financial stability by voting in favor of reducing rules for lenders.

The new legislation would raise the threshold at which banks become subject to tighter oversight. Under the original Dodd-Frank act, a bank with assets greater than $50 billion is subject to stricter regulation, including stress tests. Now though, the proposed legislation would raise that threshold to $250 billion, a change that affects 25 of the 38 largest banks in the country.

The change would mean mid-level banks such as BB&T would not have to submit to the Federal Reserve’s stress tests (which were designed to make sure a bank could withstand a major financial crisis). Specifically, banks with less than $100 billion in assets would be immediately exempt from the current SIFI rules. SIFI stands for a ‘systematically important financial institution’, one whose failure may trigger a financial crisis. This basically points to a large scale relaxing of the rules and limits on the behaviour of small and mid-level banks.

Crucially, the new legislation gives banks with assets under $10 billion and limited trading assets a pass on the Volcker rule. This rule was put in place to stop banks from using their own accounts for short-term proprietary trading of securities, derivatives, and commodity futures, as well as other instruments. Derivatives in particular are known as riskier investments. 

The concern is that a rolling back of regulations (a common talking point for Trump in his speeches about the American economy) may lead to another financial crisis. The reasons for the crash in 2007/8 were many, but one key driver was deregulation in the financial sector before the crisis, which allowed banks to take on more and more risk, as well as becoming extremely highly leveraged.

It was a lack of oversight of the financial sector that encouraged banks to shift toxic financial products onto consumers, as well as between eachother.

The argument in favour of the changes to Dodd-Frank is that cutting red-tape could spur banks, especially local ones in smaller communities, to lend more, encouraging businesses and individuals to take on projects and generally put their money to work.

Some think the new changes to the bill are overstated. In a note to clients, Jaret Seiberg, an analyst at Cowen & Co said: “We believe this bill is broadly positive for regional banks and trust banks while offering little help to the mega banks.”

Whether or not the bill will really affect the bottom line of the ‘mega’ banks is yet to be seen, but it’s pretty clear investors think it will. Some big bank ETF’s saw record inflows this week. Bloomberg reported that 2 funds run by State Street Corp saw their biggest one-day inflows ever, with the SPDR S&P Regional Banking ETF taking in $606 million, and the SPDR S&P Bank ETF taking in $323 million, thanks to excitement about what deregulation could mean for bank stocks.

However we shouldn’t forget that these ETF’s have been on the up and up for the last year anyway because the Federal Reserve made clear it was raising interest rates, and that’s good news for bank profits. With 3 or 4 rate hikes forecasted for 2018, it’s unlikely investors will be disappointed.

Here’s the worry though – what happens if banks start taking on more risks again? What happens if the aspects of their business that involve trading riskier financial instruments get overlooked by regulators? The world economy is still only just recovering from a crash that was caused by the banks 10 years ago. It’s taken years of low interest rates, quantitiative easing and austerity measures to try and get markets back on an even keel. We are only just seeing central banks begin to talk about rolling back QE and start to push interest rates higher to ‘normal’ levels, yet now the Senate has decided to lower the safeguards 10 years after a crisis in which American households lost roughly $16 trillion in net worth.

Many will argue they have done so in error, but memories are short, and last year’s stock market rally has fuelled an irrational exuberance in the markets which has fuelled more risk taking. These changes to Dodd-Frank could undermine the system again before it’s even recovered, putting investors portfolios at risk.

The prospect of bank deregulation has helped financial stocks to rally over the last year, including JPMorgan Chase, Goldman Sachs, BB&T and Bank of America

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