Interpreting the new Executive Order on Regulating the US Financial System

President Trump signed the Presidential Executive Order on Core Principles for Regulating the United States Financial System on Feb 3, 2017. I encourage you to read it. It is succinct and instructive. Interpreting it is more complex especially when attempting to reconcile it with what Trump or his cabinet members have said about regulation in general and financial regulation in particular.

Let's go over the main policy points:

- "a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth"

I support empowering customers. We, in fintech land, stress how vital it is for financial institutions to be customer centric as opposed to product or transaction centric. This policy goal implies that customers be given the right information at the right time to make the right decisions from a cost/benefit point of view. It also means that financial institutions or fintech startups adopt a transparent business and revenue model while selling to customers. This does not necessarily mean overbearing regulatory oversight. It certainly means smart regulatory oversight and strong customer/consumer advocacy and protection. It remains to be seen whether a repeal of the DOL rule or the outright elimination of the CFPB would be congruent with this policy goal. Admittedly, there may be ways to improve the CFPB's approach or to come up with a transparent pricing framework for savings accounts. On the latter I note that the FCA, the UK regulator, was able to implement a sensible rule, similar to the DOL, without penalizing retail investors, see here. Frankly, the way one can achieve this policy goal is to craft regulation that encourages healthy innovation from fintech startups or new entrants, thereby making sure incumbents are nudged to better serve consumers and customers through competition.

- "b) prevent taxpayer-funded bailouts" and c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry"

I am in violent agreement with the intended goal here. We witnessed the destructive effects of the previous bailout that saw taxpayer money rescue major banks as opposed to shareholders bearing the cost of the mistakes made by the banks they were invested in. If current regulation fosters or encourages taxpayer-funded bailouts or moral hazard, it should be eliminated. In so doing, and in order to create vibrant financial markets that foster economic growth, which I presume needs to be resilient and sustainable as opposed to exuberant and unsustainable", the inevitable conclusion is that financial institutions will have to be subjected to high or higher capital requirements and standards. Indeed, no taxpayer money and less systemic risk necessarily translates into more skin in the game for financial institutions. In other words, less regulation is good, smart regulation is better but stringent capital requirements and standards best.

- "d) enable American companies to be competitive with foreign firms in domestic and foreign markets" and "e) advance American interests in international financial regulatory negotiations and meetings"

These two policy goals leave much to interpretation. Are we meant to understand that we shall see the US engaging in regulatory competition while decoupling from international banking regulation or that the US will collaborate with other jurisdictions to ensure level playing field The global financial services industry is so networked and complex that an America First approach to regulation is difficult to fathom. Further, regulatory competition is fraught with danger and may lead to a "race to the bottom". Finally, the US has had as much latitude as it wanted in adopting international banking standards such as the Basel Accords. In the eyes of many industry participants, a unilateral go-it-alone policy towards international markets may have negative and unintended consequences.

- "f) make regulation efficient, effective, and appropriately tailored"

This is by far my favorite policy goal based what it promises potentially. Regulators also need to change. The FCA's sandbox initiatives has shown a regulatory body can derive much value in engaging with startups, new technologies and new business models as early as conveniently possible. Regulators need to develop novel ways to conduct their own businesses and upgrade their own capabilities. Bottom up approaches such as testing environments or initiatives around regtech collaboration are the way forward. If this policy goal nudges US financial regulators to think outside of the box and help them regulate along the lines of what can be possible as opposed to what is not permissible, the US regulatory landscape will have been greatly enhanced. Interestingly enough, the financial regulation passporting concept between the US and the UK floated recently, takes on a much richer meaning when brought within the context of this policy. I expanded on this passporting idea here. Fintech will have recorded a major win.

- "g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework"

My next favorite policy goal. Let's face it, the US financial regulatory landscape is a mess: The OCC, the FDIC, the Fed, the CFPB, the CFTC, the FHFA, FINRA, the FTC, the MSRB, the NCUA, the SEC, the NFA, the Treasury & FinCen, 50 state regulators for banking, insurance, money transfers, debt collection and securities. All these independent yet interrelated agencies were built for the industrial age. Overlaps, redundancies and gaps plague the system and create inefficiencies as well as uncertainties, let alone unnecessary costs for market participants, startups and new entrants. While incumbents, ironically, have historically used this regulatory maze for their benefit as a defensive moat. A major rethink is needed. From this perspective, the intended goal of the OCC with its fintech charter is very interesting, even though in and of itself, due to the aforementioned balkanization, it is doomed to encounter major turbulence. I do understand the Federal vs State issues specific to the US Constitution, still some rationalizing needs to happen. The public accountability part of this policy is laudable too. There, the danger will lie with the potential erosion of regulatory independence should public accountability lead to undue political dependence and interference.

Now, what I find particularly interesting when reviewing the soundbites coming from the Trump administration is how jarringly different they appear compared to the Executive Order itself. Granted, the order may have been worded in a way that allows for latitude and blandness.

Still, let's consider some of these soundbites:

1) “We expect to be cutting a lot out of Dodd-Frank, because frankly, I have so many people, friends of mine that had nice businesses, they can’t borrow money,” Mr. Trump said in the State Dining Room during his meeting with business leaders. “They just can’t get any money because the banks just won’t let them borrow it because of the rules and regulations in Dodd-Frank.” from this  article.

2) "The number one problem with Dodd-Frank is that it's way too complicated and cuts back lending." from this  article.

Are US banks not lending because of too many rules, too much regulation? Are they not lending across the board or only to specific borrowers - subprime as opposed to prime for example? Is the economy so muzzled by the lack of supply or has it been a lack of demand? To be fair, smaller banks may be hit harder by regulation than larger banks. Is it the case that smaller banks are not lending while larger banks are?

Here are two graphics I found on the FDIC site, from the FDIC Quarterly Banking Profile, 3rd Quarter 2016, which cover all FDIC covered institutions.

The first shows loans and leases as a % of deposits.

As you can see lending decreased from a peak of exuberance of 2007/2008 up until 2012 and rebounded for smaller financial institutions from 2012 to 2016 while it stabilized for larger financial institutions for the same period. I guess there are several ways of interpreting this graph. First, the rebound could have been stronger, and if true we are still faced with the supply/demand conundrum. Second, financial institutions have been lending again, and actually smaller ones more so than larger ones which tends to invalidate the "too much red tape is killing lending" argument. Do we really want more exuberant lending to the tune of close to 95% of deposits as the ratio stood in 2007, especially for larger financial institutions?

The second graph, from the same source gives us more perspective.

The change in domestic loans, blue line bar, is clearly on an ascending trend from 2011 to 2016. Net change is positive. Again, maybe not as much as we would like, but still positive, thereby showing banks are indeed lending.

I would venture to say that higher capital requirements and lower leverage ratios have been effective in reigning in exuberant lending. Relaxing these pieces of regulation is not the answer.

This last soundbite is interesting

3)  “The biggest thing we have to fix is that we have to get the United States banking system working again” Cohn said. “We need to get capital available to small and medium size businesses and for entrepreneurs. Today banks do not lend money to companies. Banks are forced to hoard money because they are forced to hoard capital and they can’t take any risks. We need to get banks back in the lending business, that’s our number one objective.” from this  article.

The wording is clearer here, banks are hoarding too much capital and we should allow them to take more risks and lend more by reserving less capital. If that is the case then the objective may not be to rationalize and simplify regulation per se but to relax capital requirements and standards. Should this goal benefit large banks or Wall Street in particular, how will Main Street benefit? Should this goal be achieved by predominantly helping community banks and regional banks then the path towards benefiting Main Street becomes clearer. Changing an existing law is not that easy and it will take Democrat votes for wholesale changes, which of the two paths will be chosen will depend on some type of Congress consensus.

Incidentally, any regulatory path that fosters innovation and competition benefits Main Street - my subtle nudge to help the fintech ecosystem. Clearly systemic risks, economic growth, consumer protection as well as the cost of regulation in aggregate need to be addressed. There is another equally crucial metric, the unit cost of financial intermediation.

According to Thomas Philippon, Professor of Finance at the NYU Stern School, for every $1 of financial services intermediated by financial institutions we pay 2 cents. This metric has remained strikingly constant over time at around 2% for over 130 years. This shows that, despite technology and innovation in financial services for decades, the actual cost to retail and wholesale customers has not decreased at all. Corporate profits and executive compensation have been the overwhelming beneficiaries. Simply put, any regulatory path that will help drive down the unit cost of financial intermediation will benefit Main Street.

See this graph, link to the article here.

While this Executive Order is promising in some way, how it will be carried out by the Executive and the Legislative branches, and how it will be viewed by the Judicial branch is what really matters in the end.