The federal government runs out of money on December 11. That's prompted a fair deal of fretting about a government shutdown, perhaps over Planned Parenthood spending. But if you care about holding Wall Street accountable, the bigger story isn’t whether a new spending bill will pass. It’s whether that bill will gut important parts of the Dodd-Frank financial reform act.
This has happened before. Last year, financial lobbyists wrote the actual language put into the government funding bill deregulating a single but important part of Dodd-Frank. The provision snuck in while everyone was debating whether there would be a shutdown. Though liberals like Elizabeth Warren were calling attention to this financial industry effort, President Obama didn’t veto the funding bill. As a result, the financial industry and Republicans got an important victory that never would have passed in the open and on its own merits. It could only succeed as part of a must-pass funding bill.
Wall Street has learned from its success, and this time it wants to roll back Dodd-Frank even more.
2015’s Dodd-Frank changes could be bigger than 2014’s
This year, the financial industry and Republicans not only want to repeat their 2014 strategy, they also want to go for a significantly larger payout. The changes the GOP wants are more expansive and radical than can be handled in one column. But there’s an outline forming of the core demands. They are major acts of deregulation that would substantially reduce the power of Dodd-Frank. And the Democrats need to precommit to blocking serious changes in the budget, because, if last year is any judge, by the time they make it in there it’ll already be too late.
The big changes are rumored to be:
- Increasing the size threshold for automatically designating banks as systemically risky. This would spare a number of banks from the stricter safety measures systemically risky institutions have to follow.
- Reducing the ability of a council of regulators to designate firms as systemically risky, particularly firms that exist in the shadow-banking market outside normal banks
- Reducing regulation of subprime mortgages, including significantly rolling back regulations on mortgages that banks hold on portfolio
- Removing or delaying the fiduciary rule for financial advisers proposed by the Department of Labor, which seeks to require advisers to provide advice that’s in the best interests of their clients
Republicans are trying to pull in a few moderate Democratic senators to vote for these changes. But even if there are a few Democratic votes and a lot of claims about how these changes help community banks, don’t be fooled. These are not cosmetic changes or technical fixes. These go to the very nature of the financial crisis and the growth of the financial industry. The first three provisions would have made it difficult to regulate firms like AIG, Bear Stearns, and Countrywide, or actors that are essential to any reasonable understanding of the financial crisis and what needed reform. And the fourth makes consumers more vulnerable in their everyday interactions with the financial industry.
Why the words "systemically important" matter
The first two changes would reduce the number of firms that automatically face extra regulation and make it much harder for regulators to impose it on their own.
An important way Dodd-Frank deals with financial risk is by determining that some firms pose a threat to the economy, and require extra regulations. These firms, designated systemically important financial institutions (or SIFI, in the lingo), are required to have higher capital requirements, be stress tested to make sure they can survive periods of crisis, and to put together plans to describe how they could be wound down in case of a failure. These requirements scale with the size and complexity of the firm. The idea is to end the "too big to fail" problem that arose in 2008, when banks required huge bailouts to stay afloat, bailouts that ensured the banks they’d be rescued in the future and thus didn’t have to tamp down on risk.
These requirements are serious. In the recent debate, Marco Rubio argued that firms brag about having systemically important status, but this hasn’t happened in the financial markets. Firms go to serious lengths to avoid this designation: General Electric sold off its finance unit; MetLife sued the government to avoid it; activist investors encouraged AIG to break itself up to avoid it; JP Morgan slimmed down to avoid the worst of it.
Right now any bank over $50 billion dollars in size automatically becomes a SIFI. Several prominent regulators have called for raising that threshold slightly, with Janet Yellen saying she was comfortable with a "modest increase." That is often taken to mean raising the threshold to a level around $75 billion to $100 billion.
Richard Shelby, the Republican chair of the Senate Committee on Banking, Housing, and Urban Affairs, originally called for raising that threshold to $500 billion. That would have excluded Washington Mutual, which at $307 billion wouldn’t have been required to have additional capital and a plan for failure during the 2008 collapse. It also awkwardly would exclude banks that are designated globally significant and require more safeguards from international regulators, including State Street (at $243 billion) and New York Mellon (at $385 billion). They’d face tough rules under the Basel Accords — but not from Dodd-Frank.
Worse, this change affects the "resolution authority" process Dodd-Frank introduces, under which the FDIC is allowed to take over and fail a large financial firm. (This provision is what Barney Frank calls "death panels" for banks.) Fans of removing these rules will say that resolution authority can still be accomplished, but a successful bank resolution requires the extra capital and planning that come with the SIFI designation. The FDIC will have a much harder time executing resolutions swiftly and effectively if the planning and capital aren’t there. Too Big to Fail will become more of a problem.
But Republicans also want to weaken the ability to designate non-banks as SIFIs. As Marcus Stanley of Americans for Financial Reform told me, "The FSOC designation procedure is already lengthy and time-consuming and includes numerous procedural protections for firms under consideration. These bills are designed to make it essentially unworkable." This is an invitation to cronyism, as the most connected and well-heeled firms would be able to game the process.
This also goes to the core of regulating shadow banking, or regulating firms that aren’t banks but act like banks. This would also have made it harder to regulate insurance firms like AIG, and would have made it harder for a shadow bank like Bear Stearns (which at roughly $400 billion also would be too small for the threshold), firms that definitely could have used extra capital, stress testing, and plans for failure.
Changing Dodd-Frank to block firms like WaMu, Bear, and AIG from requiring any extra scrutiny and then weakening the process for ending Too Big to Fail is an invitation to the previous crisis.
Deregulating subprime mortgages
The changes being discussed would also hurt the ability to regulate subprime mortgages. Given that subprime mortgages were a core part of the financial crisis, you’d think it wouldn’t be one of the first things people want to deregulate. But it is.
One of the core Dodd-Frank regulations is to put the onus on lenders to make good mortgages that the lenders would reasonably believe could be paid back, or what the CFPB calls "qualified mortgages." To meet this requirement, a mortgage shouldn’t feature negative amortization, be interest-only, or have balloon payments. Debt-to-income ratio shouldn’t be higher than 43 percent. Mortgages eligible to be bought by the Fannie Mae or Freddie Mac, or that are issued by lenders under $2 billion in size, have some exceptions. Qualified mortgages have a safe harbor, or legal protections, in foreclosure. Thus lenders willing to take on that legal risk can make riskier loans. There are exemptions for small lenders in here, as well.
The changes likely discussed would make it so that any firm that held mortgages, instead of selling them off to be securitized, would be subject to weakened rules. This is built on the idea that the problems were only in securitized loans, and the goal here is to protect investors. But many firms, for instance Countrywide, ended up holding mortgages that blew up, causing them significant risks. Weakening this alongside broader regulations is a major risk.
There’s also a consumer protection element that would be weakened. In addition to protecting investors, the qualified mortgages approach gives consumers extra legal protections against getting into a mortgage designed to fail. The safe harbor requires lenders to think twice before making a loan designed to steal collateral or strip equity or otherwise do shady consumer lending. Even if investors are sufficiently protected, weakening these rules would weaken the goal of consumer protection, one central to the post-crisis landscape.
Making it easier for financial advisers to con you
There is also a concern that the budget might be used to weaken, delay or eliminate the Department of Labor’s long-awaited fiduciary rule. This rule would require retirement advisers to abide by a "fiduciary" standard, or one where they have to put their clients interests above their own. With the growth of the 401(k) and other forms of private retirement savings vehicles, ensuring good practices here is as essential as ever. This would eliminate conflicts of interest among financial advisers, conflicts that are estimated to cost investors anywhere from $8 billion to more than $17 billion per year.
The proposed rule has evolved significantly since 2010, incorporating feedback from other regulators and industry. There are new exemptions and limitations that, while weakening the rule, reflects the give-and-take democratic nature of administrative rulemaking. It would be a shock to force a government shutdown in order to benefit the financial industry in such an obvious way, especially after all the work and attention that has been put into the process. But it’s of a piece with the rest of the GOP’s regulatory agenda.
Will Democrats hold the line?
Many of these ideas have a kernel of a good idea to them. Maybe a few too many small firms are designated systemically important, and maybe we want to encourage banks to hold mortgages instead of selling them off. These deregulations will be sold along these lines, and reasonable people can debate that.
But the likely proposals the GOP will try to sneak into the budget will go radically beyond that kernel. These go further and wider, and they will be the kinds of changes you couldn’t get under proper debate in the Senate or past the White House. They’ll amount to a serious assault on Dodd-Frank’s ability to deal with future crises.
Something of a backlash is growing. Reporters are already describing a forthcoming "game of chicken" over "Wall Street gifts." Liberals are trying to hold the line. Elizabeth Warren and Treasury officials are warning about what is likely to come. In her financial reform plan, Hillary Clinton announced she’d "veto any legislation that attempts to weaken the law and would fully enforce its protections," an implicit call for Obama to more forcefully argue the same. But if 2014 is any indication, it’ll be hard to fight off changes when a government shutdown is on the line.