Saturday, November 19, 2016

Generic Republicans in Power: Financial Regulation

I am optimistic that Republican plans to strip 20 million people of their health insurance and undermine the foundations for countless others will be so unpopular as to fail or, if passed, impose immense political costs on the Republicans.

The rest of their agenda is a different matter.  Republicans will pass a major tax cut with most of the benefits accruing to the top.  That is what they always do when they come into power.  This time will not be any exception.  There is no major public clamor for such a policy, but neither is there sufficient opposition that it will cost them anything.  Most people just don't care.

The same goes for most other regulations Republicans want to gut.  They have generally taken a root-and-branch view towards extirpating anything the Obama Administration has done.  The Obama Administration had two main legislative accomplishments -- Obamacare and the Dodd-Frank financial regulation.  One of the top Republican priorities is to overturn this measure.  And as for Donald Trump himself, there is every reason to believe that he fully shares the generic Republican desire to cut taxes and gut regulations and will eagerly sign anything that Congress passes.  Indeed, he has expressly said so.

What does that mean?  Well, we don't know exactly what form it will take.  Republicans have not come out with a proposal yet.  So, the most useful guidance comes from what they have proposed in the past.  Past proposals to repeal financial regulation differ from past proposals to repeal Obamacare in an important way.  Past proposals to repeal Obamacare could simply repeal and leave replace for later, since they were purely theoretical.  Once Republicans have to face the reality of an actual repeal of Obamacare succeeding, they will be confronted with the specter of 20 million people losing their health insurance.  That will put serious pressure on them to come up with a reasonable alternative.

Financial regulation, by contrast, will cause no immediate and obvious problems if it is repealed.  The most visible change would probably be an increase in credit.  Of course, as the last financial crisis showed, increasing credit is a mixed blessing at best, with the potential to set up the system for a future crisis.  But any such crisis would take place well into the future.  For now, Republicans would pay little prices for a repeal.

So how do they propose to go about it?  The simplest proposal is a one line bill repealing the Dodd Frank Act and replacing it with nothing.  Since there would not be millions of people immediately impacted, why not?  Well, for one thing, banks have adjusted to some degree to the new system and may not want the shock of really radical changes in the regulatory regime, just a general loosening of existing restrictions.

A more serious alternative was proposed last June.  Its proposals appear to be:

  1. Eliminate the Volcker Rule, which forbids banks from using their own money in speculative trades with no benefit to clients;
  2. Weaken the Consumer Financial Protection Bureau;
  3. Prevent regulators from designating certain banks as "too big to fail" and imposing stricter regulations on them;
  4.  Allow banks to avoid new regulatory burdens by having higher capital ratios (at least 10%); and,
  5. Limiting the Fed's authority to lend to troubled but salvageable banks.
The last two measures are the most significant.  Substituting higher capital ratios for tighter regulations could be defensible.  It says, in effect, that banks can invest and run risks as they please, but they must have high equity cushions and be limited in their borrowing.  This had the advantage of not forcing anyone to rely on either banks' or regulators' wisdom.  Instead, it assumes that if banks are kept from over-extending themselves, the harm they can cause will be limited no matter what mistakes they make.  Certainly, in the end all attempts to shore up the financial system are attempts to keep banks from over-extending.  So depending on terrain and circumstances, this might work.

Limiting the Fed's authority to lend to troubled banks is, in effect, forbidding it from saving the economy.  Former Fed Chair Ben Bernanke compared this to shutting down the fire department to encourage fire safety.  Well, pardon my cynicism, but my guess is that Republicans were mostly outraged by the Fed acting to save the economy because it resounded to the benefit of a Democratic President.  With a Republican in the White House, I am sure they will be much more open to letting the Fed prevent and all-out conflagration. And besides, banks won't like it.  I would not expect to see this provision in any financial legislation passed by the Republicans.

And, indeed, the Republicans' current proposal, to the extent it exists, is to weaken the Consumer Financial Protection Bureau by replacing a single director with a panel of five and putting Congress in charge of its budget (no doubt as a prelude to massive funding cuts), weakening the Financial Stability Oversight Council's ability to impose more stringent rules on "too big to fail" institutions, and subjecting future regulations to approval by Congress.  At least lip service is paid to raising capital requirements as regulations are lifted.  Preventing the Fed from lending is apparently not mentioned.  

Although the basic idea of imposing tough regulations on banks to prevent them from blowing up the economy again is popular, the whole subject is too esoteric for most people to follow, and no immediately catastrophic consequences will follow a large-scale relaxation of financial regulations. For those reasons, I expect Republicans to be successful here.

How it will play out in the longer run will depend on whether Republicans are serious about imposing tougher capital requirement in exchange for looser regulations.  If they actually live up to that, it could work out reasonably well.  If (as seems more likely) they go soft on capital requirements, it could lead to trouble down the line.  Not immediately.  In fact, our banks are currently much stronger  than they were in 2008.  The latest stress test indicates that they could survive a severe global recession with a 5-point increase in unemployment without requiring a bailout.  Still, I could see an influx of foreign capital, or perhaps Trump's proposal to cut taxes on returning profits and resulting mass repatriations, combined with lax financial regulations, as causing a bubble down the road.

But not during a first Trump term.  And (one trusts) not on the scale of the 2008 crisis.

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