NEW YORK (Thomson Reuters Regulatory Intelligence) - Lost amid the political rancor over the appointment of the U.S. Treasury secretary nominee, Steven Mnuchin, are outlines of a proposal to overhaul Dodd-Frank, and substitute a financial structure akin to the UK’s “ring-fence” structure, which separates commercial and depositing taking activities of banks from trading and riskier activities.
Such a structure might serve to both simplify the complex aspects of Dodd-Frank, and also meet the objectives of the Republican party in overhauling regulation of the industry, experts said. It could also address concerns of some of Wall Street’s fiercest Congressional critics, who in the past have offered similar plans.
During his recent grilling before a Congressional confirmation hearing, Mnuchin tried to strike a middle ground between the Republican Party’s advocacy of reviving a 1930s Glass-Steagall Act structure — as advocated in the party’s election platform last year — and one that recognized some the realities of today’s marketplace, as well as lessons learned from the financial crisis.
Glass-Steagall barred bank companies from engaging in both commercial banking activities and investment banking, and barred investment banks from taking deposits. Its separations were eroded from the 1960s until they were effectively eliminated in 1999.
“Separating out banks and investment banks right now under Glass-Steagall would have very big implications to the liquidity and the capital markets and banks being able to perform necessary lending,” Mnuchin told the Senate Finance Committee on January 19.
“One of the big problems we had during the financial crisis was the intermingling of banks and holding companies and complex securities,” said Mnuchin, a former Goldman Sachs partner and hedge-fund manager. “I don’t support going back to Glass-Steagall as is. What we’ve talked about with the president-elect is perhaps we need a 21st-century Glass-Steagall.”
If confirmed as President Donald Trump’s Treasury secretary, Mnuchin will oversee an effort ordered by Trump last week to review U.S. financial regulations and recommend ways to “rationalize” the regulatory framework, in line with principles that include preventing taxpayer-bailouts and increasing the competitiveness of U.S. firms. The “Volcker rule” prohibiting proprietary trading by banks has been one of the main targets of Republicans seeking to revise Dodd-Frank.
What some observers took away from Mnuchin’s “21st-century Glass-Steagall” reference was the current blueprint for UK-banking reform known as the Vickers plan, named after Sir John Vickers, a British economist at Oxford University who in the past served as the chief economist for the Bank of England.
Formally known as the 2013 Financial Services (Banking Reform) Act, banks in the UK which offer personal, commercial and investment banking services, must separate, or ring-fence, their UK retail and commercial operations from wholesale or investment banking activity.
“If they wanted to offer a substitution for the Dodd-Frank Act, frankly, the most intelligent approach was drafted by the Vickers commission and the ring fencing rule,” said Roy Smith, professor of finance at New York University’s Stern School of Business.
Recognizing the 21st century nature of finance, the Vickers plan permits the ring-fenced traditional bank to provide a safe-haven for market transactions, investment banking, wealth management, and certain payment services now housed under the banking book. The retail side of the institution comes under extra-tough capital requirements and other rules designed to insulate it against the more risk-taking activities of the rest of the company.
“Reflecting this UK approach, Mr. Mnuchin made it clear that he thinks complexity should be pushed out of insured depositories,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a Washington D.C. consultancy, in a recent note to clients.
“Further, he suggested that isolating traditional from complex business lines settles the U.S. orderly-resolution dilemma because what’s in a bank would be handled by the (Federal Deposit Insurance Corporation) . . . and what’s outside of it would have to fend for itself,” she added.
As neat a solution a Vickers-style plan might be, questions nonetheless remain. How high would the capital requirements have to be for the retail bank? How would the foreign banking activities of U.S. bank holding companies be affected, as well as the U.S. businesses of foreign banks?
Petrou said the Vickers approach essentially “allows all permissible activities conducted in Britain or the European Union to land in the ring-fenced bank – or at least it did until Brexit.” For American banks operating in the EU, for example, a key question could be where would the pieces of the company that fall outside the domestic ring-fenced bank reside.
Other questions include the structure of other parts of the organization that currently support businesses across both retail and investment banking operations.
A glimpse of what a Vickers-style blueprint might look like for large U.S. banks comes from UK firms currently working to meet the new ring-fencing rules.
Barclays Plc, for example, formed a new company intended to operate as a standalone unit providing support services to both of its two main operations when they are formally separated - retail and investment banking.
Individuals familiar with the internal project, told Reuters News that the aim is for critical support functions to continue to operate smoothly if either of its two main businesses were to run into trouble, while also keeping costs down by not having several separate back-office units.
Smith, of NYU’s Stern School of Business, who is familiar with Barclays’ efforts, said another major challenge is maintaining the high capital requirement for the ring-fenced bank while also meeting the potential funding needs of the investment bank, at least at the outset.
“The clincher to the Vickers plan is that no capital could be withdrawn from the bank regulated entity until it has met a capital to asset ratio of 10 percent,” said Smith “That’s a pretty tough standard.”
Barclays Capital, the current investment banking side of company, “would therefore have to have at least a Baa bond rating to manage on its own … and it may need some kind of capital infusion before the ring-fencing took effect to give it the capacity to do so,” added Smith.
From the executive order signed by President Trump on Friday, outlining the administration’s core principles in financial regulation, it’s clear the Treasury Secretary will have a lead role in crafting an alternative to Dodd-Frank, whether it’s a Vickers style plan or some other alternative. It’s also clear that the Treasury will have to take account of existing proposals in Congress to dismantle Dodd-Frank – specifically, House Rep. Jeb Hensarling’s Financial CHOICE Act.
A key plank of the CHOICE Act is offering large banks a so-called “off-ramp” to various parts of Dodd-Frank if they maintain a leverage ratio of at least 10 percent, a high hurdle. Wall Street has not shown much enthusiasm for the plan since its unveiling last summer.
“You are not going to see the banks crashing the palace gates to get the Hensarling bill passed,” says Smith of NYU. The numerous proposals included in the CHOICE Act to amend Dodd-Frank might represent too complex a process to gain any real traction this year.
In the next few weeks, Hensarling is expected to release CHOICE Act 2.0 which may be “more ambitious in certain aspects while scaling back some controversial proposals in an effort to win needed support in the Senate,” legal experts at Davis Polk wrote in a recent client note.
However, an American version of the Vickers plan, one that accommodates key aspects of the CHOICE Act, might also be a workable strategy.
“If I were Mnuchin I would try to find a way to release the grip of Dodd-Frank on the smaller banks,” added NYU’s Smith. This is a major objective of the CHOICE Act. “Hensarling gets what he wanted, it corresponds with the policy of the Republican Party, and I believe it might be an easy enough fix to get it done without making a big deal.”
Apart from getting Republican support in Congress, any plan that separates commercial from investment banking activities might also serve to placate Democrats on the left, such as Senator Elizabeth Warren. In 2015 Warren led a bi-partisan group of senators in putting forward a proposal also called the “21st Century Glass-Steagall Act.” A cornerstone of the bill “would separate traditional banks that have savings and checking accounts and are insured by the Federal Deposit Insurance Corporation from riskier financial institutions that offer services such as investment banking, insurance, swaps dealing, and hedge fund and private equity activities.”
It remains to be seen what Warren thinks of a Trump administration plan that might share some of the same objectives as her 2015 bill. At Mnuchin’s appearance before the Senate Finance Committee, of which Warren is a member, the senator spent much of her time questioning his tenure as head of OneWest, a California-based bank that some labelled a “foreclosure machine” after the housing bubble burst. Warren organized a group of foreclosure victims who told of their difficulties in dealing with OneWest during the confirmation session.
- Execeutive order on financial regulation core principles (here)
- Davis Polk client nonte: FinRegReform (here)
- 21st Century Glass-Steagall Act (text fact sheet:here)
(Henry Engler is a North American Regulatory Intelligence Editor for Thomson Reuters Regulatory Intelligence. He is a former financial industry compliance consultant and executive, and earlier served as a financial journalist with Reuters. Email Henry at firstname.lastname@example.org)
This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Feb. 7. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters