Whither now US banking regulation and innovation bound?

Barney Frank, former US Congressman, chairman of House Financial Services Committee and co-author of the Financial Reform Act, in his opening keynote speech at The Asian Banker Future of Finance Summit 2017, argues that there will be no fundamental changes to the structure of the Act, a more relaxed attitude to possible systemic problems in alternative forms of lending (peer-to-peer) and states wanting a more active role in regulating state-chartered banks.

Here is the transcript of the video:

Barney Frank:   Thank you. I am always pleased and honoured to be included in the great work that Emmanuel Daniel is doing. He’s an extraordinary man, and this is an extraordinary enterprise, and so, I’m pleased to participate. I admire his forward thinking. I will be convinced that he has completely made that transition when you are allowed to pay your fines in Bitcoin. We’ll probably have an appropriate app to do that.

I speak to you not so much as a former market disruptor but rather as someone who was disrupted by the market. I was the chairman of the Committee on Financial Services in the US House of Representatives with jurisdiction over the banking, securities, insurance, and related industries, focusing more on housing, on what America’s role should be with regard to international economics – not trade, which we did not deal with, but our relationships with the IFIs like the World Bank and the International Monetary Fund.

And then, beginning in 2007, I heard regularly from Henry Paulson, who was George Bush’s appointee to be Secretary of the Treasury, and Ben Bernanke, Bush’s appointee to head the Federal Reserve, about the looming problems in the financial industry.

Let me begin by saying that people wonder about the ability of the two major political parties to cooperate in America and where it went. Well, I have a partisan answer to where it went, but I will tell you this. In 2007, when I became chairman of that committee, for the next two years, with Democrats in control of the House and the Senate and the Bush Administration in power, we had a great deal of cooperation. That ended when Obama became president, and I will be glad to tell you whose fault I think that was, but I can tell you that in 2007 and 2008, we worked very closely together.

The result of that was legislation that is known as the Dodd-Frank Act. I will, going forward, not refer to it as that because I’m something of a student of political rhetoric, and in my experience, politicians who refer to themselves by their own name are kind of pompous. The only one who was able to pull that off in my lifetime, which is extended now, was General Charles de Gaulle. He could call himself de Gaulle and seem plausible. So, I will refer to it as the financial reform bill.

I was more of a bipartisan product than people realise. If you read the memoirs of three Bush appointees – Sheila Bair, who was the head of the Federal Deposit Insurance Corporation, Ben Bernanke, and Hank Paulson, who I’ve mentioned – they legitimately take credit for much of what is in our legislation.

For example, one of the things that the Republicans in the House are now talking about abolishing is what’s called Orderly Liquidation Authority, which is the way in which we deal with an institution that has become indebted beyond its ability to pay its debts and at such a level that that failure threatens the stability of the system. The outlines of that were essentially suggested to us by Bernanke and Paulson, and formulated by them and with Sheila Bair who stayed on in the Obama Administration.

So, the question that Emmanuel asked me to address is: What’s likely to happen going forward? There will not be any substantial changes in the legal structure of that financial reform bill. There is a bill pending in the House now. I guess it will be voted on in the US House of Representatives tomorrow. I get confused. It will be voted on Thursday in America. I don’t know whether that’s tomorrow or whatever, but it will be voted on at about 2:00 in the afternoon East Coast time on Thursday.

It will pass the House, and for those of you who slept through the debate in America over healthcare, you’re going to get a chance to see the movie again because what will happen is that the House of Representatives will pass the bill on very partisan lines, and the United States Senate will ignore it. No one I know in Washington expects this bill to go anywhere. Instead, the Senate will take up the subject. There are senators already having conversations about this, but the Republican senators cannot get too public – although one of them has, Senator Moran of Kansas – because they don’t want to be accused by their fellow Republicans in the House of having conspired to undermine their effort to make major change.

But once that is passed and is over, you will see in the Senate some modifications in the basic structure. You will see, I believe, the level at which a bank becomes subject to the extra supervision of the Financial Stability Oversight Council. It’s now $50 billion. That’s what we set in 2010. I believe it was too low. And in any case, we made a mistake then. Any number that we use going forward should be indexed to some appropriate growth mechanism. But that number will be raised to $100 billion or maybe $125 billion.

Secondly, banks under $10 billion in assets will be given relief, for example, from the Volcker Rule. They don’t do anything that the Volcker Rule bans, but they spend a lot of money trying to comply with it. There may also be some relief for the smaller banks if they are prepared to make mortgage loans and keep them in portfolio as opposed to securitising them or selling them.

With those changes made, and I think they will be bipartisan, interestingly, the obstacle might be then in the House. The Chairman of the House Committee, Mr. Hensarling, is a very reasonable man in person, very pleasant, and very civil, and a very committed, very, very conservative believer in free enterprise.

He was the leader of the faction of the Republication Party, which became kind of a majority of the Republican Party in the House, that in 2007 and 2008 became increasingly critical of George Bush on the grounds that his administration was much too interventionist in the economy. These were the people who said, for example when Lehman Brothers failed and no effort was made to pay any of their debts, “Good, that’s free enterprise.” They welcomed not the failure of Lehman – they were unhappy about that – but they welcomed the fact that there was no intervention, and they said, “That’s free enterprise. We have free enterprise in America.”

By the way, for most of America, that lasted a day because the day after Lehman’s failure to pay its debts reverberated, almost everybody else in America was ready to make sure that it didn’t happen again. In fact, I announced that I was going to file a bill to proclaim the day on which Lehman’s failure went without intervention as “Free Enterprise Day,” on the grounds that that day, September 18th, 2008, was the one day in America when we had untrammelled free enterprise. It didn’t last long.

What you have, now, is a Republican leadership, though, that will be so disappointed that the broader set of cutbacks and regulations does not happen that they might be reluctant to go ahead with what I talked about, which is that relief is going to be given to banks at $50 billion and also to banks under $10 billion. Another proposal that’s out there, which I haven’t focused on myself, was to say that banks under $50 billion would not have to undergo stress tests. That’s, though, what I think you are likely to see, relief for smaller banks from some pieces.

The basic structure of the legislation will not change, and I talk about that because that’s what I think you will see people wanting to preserve going forward. First, you do not allow loans to be made to people who have very little chance of paying them back. That may seem unnecessary, but that’s what happened during the period. By the way, Alan Greenspan, when he was Chairman of the Federal Reserve, as he retired, defended making those loans for home ownership to very low income people.

He published his book In the Age of Turbulence in 2007. “Turbulence” turned out to be an understatement. In that book, he said that he realised that making those loans carried a high risk that they would not be repaid, but they were worth making because you cannot have a capitalist society without strong public support for private property, and by lending very poor people money to buy homes, you were making them supporters of private property, only, it turned out, until they lost the property, in which case they became much less enthusiastic capitalists.

But what you have is a Republican Party that might reject what they see as ameliorative efforts. I don’t think that will work. So, what you will get, then, will be the ban on the loans that are unlikely to be made. What happened was that those loans were made, and then they were securitised. The bad loans were made in part, and I will talk about this later when I discuss the securitisation, because the people who made them bore no consequence if there was no repayment. They sold those loans. They were off the hook.

So, the next piece is to say that I believe that securitisation should come with some risk retention by those securitising. You should not be allowed to buy up those loans and sell them in turn unless you have some responsibility if they go bad – not, by far, the bulk of it but some.

And then, finally, what happened was that the loans were made, they were securitised, and then they were bounced around the economy in the form of derivatives, and the key there was that people bought and sold derivatives without having the responsibility, and certainly not the capacity, to pay them off.

The iconic thing here is AIG. AIG went into the George W. Bush administration in September 2008, just after Lehman Brothers, and said, “We owe $85 billion that we cannot repay,” and they were told, “Okay, we’ll have to pay off your debts because we cannot afford a repeat of what happened two days earlier with Lehman, where large debts aren’t paid and everybody else freezes up.” A week later, by the way, AIG went back to Bernanke and said, “Oh, we made a small mistake. We didn’t owe $85 billion that we can’t repay. We owe $170 billion that we can’t repay,” and of course, the Fed paid that off.

Our legislation makes it legally impossible for any entity, through the sale of derivative paper, to incur that kind of debt without having the ability to pay it off. That’s the essentials, and that’s going to stay. There’s also consumer protection which will stay. So, I do not think you’re going to see any fundamental change in the structure. You’re going to see the smaller changes I mentioned.

You will see a significant difference in the level of strictness with which it is applied. Donald Trump will, within a few months, have appointed almost all of the financial regulators, and by April of next year, he will have appointed all of them – a new Fed Reserve chairman, a new Fed regulating vice chairman, heads of the FDIC and OCC and the Consumer Bureau, and heads of the SEC and the Commodity Futures Trading Commission.

They will administer the powers that will remain on the books more loosely than their Democratic counterparts did, although I will say that I cannot conceive of any of them ignoring signs of trouble. The Democrats probably would have been more anticipatory of trouble, but I don’t worry that the Republicans, even though they will be more lax than I thought, will ignore a serious build-up of debt that can’t be incurred, although given the requirement, for example, of central clearing of derivatives, that is much less likely to happen.

 So, that’s where you will be, going forward.

 Then, the question I was asked to address is: What about the future, particularly of innovations that bring in less formal banking, like peer-to-peer, etc.? I talk about two principles. The major motivating principle of the legislation we adopted was to prevent the incurring of debt by large institutions beyond what they could pay off because the experience was that the failure of the large institution to pay off a lot of debt was destabilising. By the way, that means that the focus is not on the size of the institutions. I do not, myself, believe that bigness in the banks is in itself bad. The problem is in the size of the indebtedness they cannot discharge. That’s what you have to hold back.

There is much less fear of that, for example, in peer-to-peer and other sorts of lending. That is, the likelihood of that causing a systemic failure because there are debts incurred beyond the capacity of the debtor to pay off, I do not think you’ll see people worried about that. On the other hand, you may see more of a concern about consumer protection, particularly borrowers. Borrowers, even if they are sophisticated, are lacking the tools to vet lenders. Rather, the problem is on the lenders, who will be putting up their money and who will not, themselves, be in a position to vet the borrowers. So, that is one of the mechanisms that I think you’ll see people will be looking for.

If you have peer-to-peer lending, what is the protection that will go to the lenders by the mechanism that brings them together? Is there some insurance policy that they will be protected against, analogous to bank deposit insurance? What is the process for deciding who are good borrowers and which borrowers you expose people to?

There is a complication, and Emmanuel asked me to say what’s likely to happen. The Office of the Comptroller of the Currency, one of the federal bank regulators, is about to issue a charter for peer-to-peer lenders, particularly with these safeguards in mind. He is being sued by state regulators, and this is relevant. People have asked me, “Why is the regulatory structure in America so complicated?” There are several reasons.

One is that we have, in America, something that few other countries have, which is what we call the “dual banking system.” We have nationally chartered banks and state-chartered banks, and there’s a great deal of controversy. When someone, for example, proposed that all bank regulation be taken from the Federal Reserve, except for the large bank holding companies, and given to the Comptroller of the Currency, the smaller banks objected.

They said, “No, because we’re state-chartered, and we are now regulated by the Federal Reserve. We don’t want to be regulated by the national regulator because that will be ‘one size fits all,’ and we don’t want to be in the same regulator as JPMorgan Chase and Bank of America.”

So, you are going to see, now, an effort by the states, in some cases, to impose more regulation on peer-to-peer lending, one of the obvious candidates for growth. They will almost certainly want to be more restrictive than the federal Comptroller of the Currency. It is clear that the Comptroller of the Currency has primacy if it’s a bank, but it’s not clear that there is a federal primacy in the dispute between the federal and state regulators over a non-bank, and that is where it will play out.

So, just to close, going forward, you will see no change in the basic structure of the financial reform bill, and some accommodations for the smaller and medium-size banks. With regard to other forms of lending – less structured, non-bank lending – I believe you will see a much more relaxed attitude about potential systemic problems because you do not have one large incurrer of debt.

But an effort to figure out what level of consumer may not be the best argument here because you’re talking about protecting not consumers, as they’re technically called, but producers, lenders. What is the form of regulation that will protect lenders in peer-to-peer so they have some assurance that they’re not lending to bad borrowers and have some protection if they do? There will be a fight, I believe, between the federal government, no matter who’s in power, but certainly if its Trump now, and then the state. There will be a number of states that will want to be much more active in intervening on behalf of security for the lenders than the Trump Administration.

Thank you.

Keywords: The FoF Summit 2017, regulation, Dodd-Frank Act, financial crisis, innovation
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