Beware of the bank deregulation Trojan horse

When members of the Senate Banking Committee struck a deal to rewrite post-financial crisis rules last fall, the compromise looked like a gift to moderate Democrats. They would now be able to support community bank regulatory relief but oppose the draconian Dodd-Frank Act repeal passed by the House.

Democrats should beware, however, when Majority Leader Mitch McConnell (R-Ky.) brings the bill to the Senate floor, possibly as soon as this month. It is a Trojan Horse.

{mosads}On its face, Senate Bill 2155 — dubbed the Economic Growth, Regulatory Relief, and Consumer Protection Act — contains some sensible reforms. The bill exempts smaller banks from complicated risk-based capital requirements, subjecting them instead to a simple leverage ratio.

The bill also adopts modest consumer protections. For instance, it requires credit bureaus to offer consumers unlimited, free credit freezes. 

For the eleven Democratic co-sponsors of S.2155 eager to embrace bipartisanship, this combination of community bank regulatory relief and new consumer protections was too attractive to pass up.

Like the Greeks’ gift to Troy, however, what is hidden inside S.2155 is what’s dangerous. Three troubling provisions in the bill could presage the next financial crisis.

First, S.2155 rolls back the most significant post-crisis reforms for the United States’ biggest banks. The Dodd-Frank Act mandated enhanced oversight of banks with $50 billion or more in assets to prevent them from becoming too big to fail.

Exercising this authority, my Federal Reserve colleagues and I spent years developing rules requiring these banks to hold additional capital, conduct stress tests and limit counterparty exposures. As new Federal Reserve Chairman Jerome Powell has testified, our “financial system is without doubt far stronger and more resilient” because of these reforms.

S.2155, however, would undo much of this progress. The bill would raise the enhanced oversight threshold to $250 billion, effectively deregulating 25 of the 38 biggest banks in the United States, accounting for nearly one-sixth of the assets in the banking sector.

Freed from enhanced oversight, these institutions would go back to operating under many of the same rules that failed to prevent the financial crisis. 

A limited increase in the enhanced oversight threshold may be appropriate to lighten regulatory burden on less complex regional banks. Indeed, staunch Wall Street critics including Dodd-Frank co-author Barney Frank and former Federal Reserve regulatory chief Dan Tarullo support a modest increase in the threshold. But $250 billion is far too high.

A more appropriate threshold would be $125 billion —about the size of Continental Illinois, adjusted for inflation, when it failed in 1984 and nearly triggered the collapse of the U.S. financial system. 

S.2155’s second hidden threat is that it deregulates the U.S. operations of Deutsche Bank, Barclays and other systemically important foreign banks — firms whose failure could inflict harm on the U.S. economy.

After foreign megabanks experienced destabilizing funding runs during the financial crisis, the Federal Reserve implemented rules requiring large foreign banks to keep capital in the United States and rules preventing those banks from moving assets to their home country when the next crisis hits.

S.2155 removes these important protections and leaves the U.S. economy vulnerable to foreign banks’ misconduct and excessive risk-taking.

Finally, and most troublingly, S.2155 makes it more difficult for the Federal Reserve to regulate the biggest U.S. banks, including Wells Fargo and Goldman Sachs. The bill requires the Fed to tailor its enhanced oversight of the largest banks, taking into account “appropriate risk-related factors.”

While tailoring is a laudable goal, “appropriate risk-related factors” is a legal landmine. Indeed, that is the exact statutory language that MetLife cited last year when it won a court order overturning its designation as a systemically important firm.

MetLife successfully argued that regulators had not fully considered all risk-related factors. S.2155’s tailoring provision would give Wells Fargo, Goldman Sach and their big-bank counterparts a powerful basis on which to challenge enhanced oversight in court.

The good news is that it is not too late for Democratic co-sponsors to drop their support or demand significant revisions before S.2155 comes to the Senate floor. Lowering the enhanced oversight threshold, ensuring that the bill covers foreign banks and modifying the tailoring provision would be an appropriate place to start.

When Senate Banking Committee Chairman Mike Crapo (R-Idaho) speaks about S.2155, he focuses on community bank regulatory relief and enhanced consumer protections. That is because he does not want the American public to know what else is inside the bill.

The core of S.2155 repeals important post-crisis reforms and leaves the U.S. financial system vulnerable to another crash. The Senate must stop this Trojan Horse before it enters the city gates.

Jeremy Kress is a senior research fellow at the University of Michigan Center on Finance, Law & Policy and a lecturer in business law at the University of Michigan Ross School of Business. Kress was previously an attorney in the Banking Regulation & Policy Group of the Federal Reserve Board’s Legal Division.