Alexei Monsarrat, director of the Atlantic Council’s Global Business & Economics program, interviewed Tom Joyce, debt capital markets strategist for Deutsche Bank, on the impact of the Dodd-Frank bill on the finance industry and global markets. A transcript of their discussion follows.
ALEXEI MONSARRAT: Thanks very much, Tom, for taking part in our 5 Questions series to provide your thoughts on the Dodd-Frank bill. There has been a huge amount of dissecting of this legislation and the process to develop it. Now that we seem to have something tangible I’d like to get your sense of what we really have here, how it will affect the industry, and how this will affect the regulatory discussions in other G20 countries, especially in Europe.
The first question is: now that something has come out of the conference committee, what are we really looking at? How does the bill stack up to what the banking industry wanted to see? And how do you see this affecting your business model?
TOM JOYCE: I would say that it is on the aggressive side of our expectations. When I say “aggressive,” I mean it is a very tough piece of legislation on the big banks and on the banking system, in particular.
At the same time, I would say that we have had the opportunity to adjust our expectations in the last two months, in particular, to most of the provisions in there, such as the Volcker rule and the swap push-out provision. There are aspects of many of these provisions that are very good for financial stability and very good for the system, and that we actually did support in various forms. However, we ended up with what we would call the less-than-attractive outcome on most of these provisions as they relate to the impact it would have on the banking industry.
MONSARRAT: How do you see this changing the nature of the way that the banks are working? What are the pieces that you are okay with, and what are the pieces that you see changing how you are going to have to operate?
JOYCE: There are about 8100 banks in the U.S., and the legislation will impact big banks and small banks differently. But almost every major provision of the bill has the side effect of either creating downward pressure on industry profitability – that is likely to be significant – or upward pressure on the amount of capital that needs to be provided in various different businesses.
And once again, most of that is good, but not necessarily all of it. For example, we all believe that all of our businesses should be much better capitalized. As a matter of fact, we have already done that. So the industry is already by and large – U.S. banks, in particular, and Deutsche Bank included in that – is already overcapitalized vis-à-vis what the regulations demand. But what this law does is codify that into law, which is a good thing.
However, once again, almost every provision results in either profitability going down or capital requirements going up. As a result, many on Wall Street would estimate that industry returns on equity are going to go down from about 15 percent on average today to between 11 and 13 percent going forward. Some estimates have it even going even lower.
If you go issue by issue, Consumer Financial Protection Agency is going to have a lot of power. It is going to be inside the Fed, but will be an independent authority and will probably create significant downward pressure on a full-range of fee businesses, different types of mortgage lending and credit card products, etc. for all banks across the country. Aspects of that are probably good. But once again, it will have a significant impact on profitability in the banking system, which will therefore ripple on to the economy in different ways.
The derivatives provisions are certainly much more onerous than we would have liked. Ninety-five percent of all Fortune 500 companies use derivatives. About 350 of those are non-financial corporates — energy companies, consumer retail, et cetera. About 150 are financial companies. For those 150 financial companies, where we ended up on the derivatives provision is reasonably onerous in that they did not receive the same end-user exemptions that corporates received. And so as a result of going through central clearing, there is going to be significantly higher demands on the liquidity of these institutions, in addition to the regulations that were already underway.
And then certainly the swap push-out provision, which was added by Sen. Lincoln a few weeks before her primary election on May 18th, will have an impact on the way the industry is able to interact with the 95 percent of Fortune 500 companies that do use derivatives. The Fed and the FDIC publicly came out in letters that said that they opposed it. Apparently the White House also opposed it. We had all assumed because of that public opposition that it would be removed from the bill. In fact, it was not removed from the bill. It was watered down, which was a positive thing. But it was not removed from the bill.
A big plus for the banking industry is that much of the disintermediation in the banking industry over the last 20 years — meaning the full plethora of non-bank financial companies that were competing with banks — were not regulated. So these entities were competing with banks in many different markets from lending to other products and they were not regulated, so they didn’t have to have the same capital requirements. They were able to do more off-balance-sheet transactions than even the banks were able to do.
So banks as a whole are relative winners from that perspective. But many of the individual businesses that banks across the country used to run are not relative winners. It is certainly positive that banks will not be able to be levered as highly as they had been previously, though many and most have delevered already on their own through the last few years to painful write downs. But with lower leverage, there will be less profitability.
Again, it is probably good for the system and it is the type of change that we all agree with and support. But some of the specific new capital provisions that were added very late in the game, such as the Collins amendment, which would no longer make trust preferreds and other types of securities eligible, is something that was somewhat unexpected prior to the last month. That will be a difficult transition for banks.
MONSARRAT: There has obviously been a lot of anxiety in the markets right now. Is there a little bit of a sigh of relief that at least it is over, and will markets respond positively to a higher degree of certainty? Or do we still have some bumps in the road ahead as the agencies write the rules on this?
JOYCE: I think both points are true simultaneously.
There is some significant degree of comfort that the market will have now that we at least have certainty on the direction that we are going, and on the main provisions of the bill; having said that, there is still quite a bit of uncertainty out there. I don’t want to understate the importance of this certainty. It is a very positive development. There are pros and cons to the United States having done this so much more quickly than most other advanced countries. We are well-ahead of most other advanced economies in Europe and in Asia and Latin America on this topic. The drawback in having moved so quickly will be the regulatory arbitrage opportunities created if other jurisdictions do not adopt the same rules.
On the down side I will just name two or three things quickly, but they are important and shouldn’t be underestimated.
Number one, as you suggest, is the very fact that a lot of the detailed rules still need to be written. It will take six to 12 months or more for the Fed, the SEC, the CFTC, the FDIC, and other regulatory bodies to write those detailed rules. And so there will be some uncertainty around that.
Secondly, there is still a tremendous amount of uncertainty around the economy both in the U.S. and globally.
Thirdly, the European sovereign debt crisis, which is certainly not unique to Europe, impacts the banking sector both in the U.S. and in Europe very directly; much more so than other industry sectors. There is still a tremendous amount of uncertainty on that topic. We are still not at peak default rates in certain products so there is still uncertainty out there.
Finally, the Basel Committee changes, which will largely impact the largest banks, seems to be on a slower timetable, but has certainly created tremendous amount of uncertainty. So a major piece of uncertainty behind us, but there is still plenty of things out there that will, I think, result in a tremendous amount of volatility in markets in the months and year ahead.
MONSARRAT: A lot of your concerns deal with the international side of the equation. How do you see international coordination going forward, and what is the industry hoping to see come out of the G20 meeting this weekend. Do you see any irreconcilable differences emerging here and if so, where?
JOYCE: It is a very daunting task to coordinate everything on a global basis, and so it is hard to imagine that we aren’t going to have a reasonably high margin of error in certain areas. The Basel committee is responsive to the global community, whether it be in a nation-state level or at a bank-industry level, to hear the feedback from institutions on what proposals and what proposal do not work. We do need more testing of proposals so that the full impact of different proposals is fully understood.
I think we all favor the general direction the Basel committee is going, but we want to make sure that things are properly discussed and adequately understood before we begin implementing things too soon. We need to fully understand the implications on economies, on the ability of banks to raise certain amounts of capital, the impact it will have on credit, credit flow in various different economies and so forth.
Our hopes for the G20 vary by topic. I wouldn’t say there are irreconcilable differences. But I would say that the early G-20 summits in2008 and 2009 were very effective in coming together with a cohesive set of meetings that were focused on coordinating the global response to the financial crisis. And that was very positive and very instrumental and some of the turnaround that we have seen in the last year.
The Toronto summit, by contrast – and perhaps understandably to some degree – is setting up to be a more divided meeting on a broad range of issues. We are certainly seeing a division in approach as it relates to global growth. Should we be pursuing more fiscal austerity measures or should we be pursuing policies closer to our fiscal stimulus? There is a clear divide between Europe and the U.S. on that point.
Foreign currency rate management is obviously a divisive issue, with a tremendous amount of focus on the euro and the Chinese yuan on that topic.
Financial regulatory reform will be a third topic where I think we will see a tremendous amount of division. The U.S. has obviously moved quickly and aggressively. Not all other jurisdictions will share the same view on all of the policies and on the timing. There is also clearly a divide on the topic of a bank tax with several nations favoring the tax, Germany, the U.S., U.K., in particular, and other countries such as Canada, Brazil, and Japan who oppose the tax.
And lastly, the whole approach to the sovereign debt issue, sovereign debt crisis. You know, obviously, there will be different opinions on the urgency and the timeframe around those challenges.
So there is a significant amount of divide, but this is all part of an ongoing dialogue and hopefully we can get to a constructive spot sooner than later.
Alexei Monsarrat is director of the Atlantic Council’s Global Business and Economics Program. He previously spent six years with the U.S. State Department in the Bureau of Economics, Energy, and Business Affairs (EEB), where he worked on a range of issues with transatlantic partners, including economic development and poverty reduction, post-conflict reconstruction, strategic economic policy relations, and energy issues. Photo credit: AP.