A balancing act
20 March 2018
It is almost exactly a decade since Bear Stearns collapsed, as the deepest financial crisis since 1929 took hold. Looking back, banks have come a long way from this nadir. The financial sector is now significantly more resilient, spurred on by more stringent regulation (see Chart 2). Bank capital ratios have improved, helping build buffers against potential losses. Stronger underwriting and an improving economic backdrop have also helped support the quality of assets on bank balance sheets. Indeed, just 1% of loans are currently classified as non-performing, accounting for just 5.6% of bank capital. Against the backdrop of these changes, we are seeing few signs of large-scale financial imbalances in the US. Indeed, while there are concerns around pockets of vulnerability in areas such as auto loans, there are few signs of systemically threatening build-ups in leverage (see Chart 3).
The regulatory winds are now again starting to shift. The Crapo bill proposes changes to the 2010 Dodd-Frank Act, the regulatory overhaul enacted after the financial crisis. In its current form, this legislation would raise the size at which banks are deemed systemically important from $50bn (in assets) to $250bn. This would free institutions operating below this benchmark from a range of oversight, although banks holding between $100bn and $250bn in assets could still face discretionary stress tests or tailored oversight from the Fed. The Crapo bill also proposes changes in rules around mortgage lending, disclosure and the Volcker rule on trading for smaller banks. While this represents clear regulatory relief for these institutions, the bill will have fewer implications for larger banks. Indeed, large swathes of the Dodd-Frank legislation including consumer protection, too-big-to-fail provisions and stress testing, remain unchanged. However, there are other avenues whereby regulation is easing. Perhaps most importantly, the interpretation and implementation of current regulatory rules is expected to evolve over coming years. The Treasury Department has issued a number of recommendations on how Dodd-Frank legislation might be fine-tuned to provide targeted regulatory relief for the financial sector. These recommendations are not mandatory, but changing personnel in key regulatory bodies are expected to follow these guidelines. Indeed, the Fed’s leadership has changed dramatically in recent months, with Chair Powell and Vice Chair Quarles now at the helm. Similarly, the Securities and Exchange Commission and Commodities Futures Trading Commission have also come under new leadership. While this is likely to herald a less intrusive regulatory backdrop, the extent and speed of this shift is difficult to estimate.
The impact of these changes on the real economy is also difficult to determine. We are seeing signs of building exuberance as the US cycle matures, with businesses seemingly more prepared to invest and consumers saving less. While this is supporting growth, we will need to watch that over-exuberance is not creeping in. Regulatory relief, if material, could facilitate these imbalances if underwriting standards deteriorate. Indeed, a fine line will need to be drawn between refining Dodd-Frank regulation in order to address some of the issues with the original legislation, and maintaining the hard-won improvements in financial stability secured over the past decade.