Perilous timing for financial deregulation

Dodd-Frank overhaul could spur regulatory race to the bottom

On the campaign trail Donald Trump distanced himself from Wall Street, going as far as saying that ‘hedge fund guys are getting away with murder’. In the White House, President Trump has embarked on deregulating the financial services industry. In the latest manifestation of his intention to go easy on US banking, Trump signed two presidential memoranda on Friday aimed at rolling back the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, which President Barack Obama signed in response to the global financial crisis.

Trump’s argument is that financial regulation is inhibiting economic growth by restricting banks’ ability to lend to businesses and households. But this argument is misleading in the light of the relatively low importance of banks for corporate lending in the US, where only 20% of business financing comes through bank loans. The remaining 80% is through financial markets, including corporate bonds that can be purchased by other investors who are not as heavily regulated as banks. In Europe, the ratio is reversed.

In deregulating the financial system, Trump hopes not only to spur domestic lending but also to make US banks more competitive internationally. This may put ‘America first’, but starting a regulatory competition with the European Union and other jurisdictions poses a threat to global financial stability. Several officials from both Europe and Asia have already expressed their concern, including Paul Tucker and Ravi Menon.

The financial crisis catalysed an unprecedented level of global co-operation to strengthen banks and improve the collective health of the financial industry. In the US, the Obama administration spent significant resources in its first term, with support of the G20 and others, to introduce regulation that Wall Street strongly opposed. The operational response to Dodd-Frank’s stricter reserve ratios and greater government supervision was hard and costly for the financial sector. But, almost a decade later, global banks are re-emerging as healthy institutions.

The US deregulation trend may provide a stimulus for lighter regulation elsewhere, especially in Europe. US regulators have long seen Europe’s banking sector as undercapitalised and reliant on sophisticated risk models to minimise capital requirements, and have been pushing for higher capital through proposed changes to the Basel rules. The Basel Committee was close to a deal in December that would have narrowed the capital gap while giving space to the European banking sector to adjust, but Friday’s actions are likely to (at least) delay that agreement further.

US banks do not need the proposed deregulation to enjoy an international competitive advantage. Rather, the opposite may be true with the relaxing of regulation coming at a time when these guidelines might be most needed. The combination of a global savings glut, low interest rates, and lack of investment opportunities is intensifying the search for yield globally.

In this environment, expectations for monetary tightening and a surge in infrastructure spending are making the US stand out as an attractive investment opportunity. This position is further entrenched by weak competition in the light of anaemic economic growth and political instability in other advanced economies. Meanwhile, capital outflows have intensified in China and other emerging markets, raising the supply of capital looking for a new destination. The prospect of hot money flowing into the US makes this a perilous time to overhaul the financial regulations that are meant to curb speculative activity. The result could be a return to the same conditions that preceded the global financial crisis.

Danae Kyriakopoulou is Head of Research at OMFIF.

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