The Financial CHOICE Act is President Trump's administration's way of making good on its campaign promise to reduce regulatory burdens on the U.S. financial sector. Below, we discuss the likelihood of its implementation and the key implications for investors.
With the Financial CHOICE Act, President Trump's administration aims to make good on its campaign promise to reduce regulatory burdens on the U.S. financial sector. Below, we discuss the likelihood of its implementation and the key implications for investors.
What is the Financial CHOICE Act?
During his election campaign, Donald Trump did not hide his views on financial regulation. He has long advocated looser regulation of financial markets. Since taking office, he has been a particularly strong advocate of undoing parts of the Dodd-Frank Act, which was introduced after the global financial crisis (GFC) to regulate financial markets. The result is the Financial CHOICE Act of 2017 1 .
The following are some of the key objectives that the new bill seeks to achieve:
- Restrictions in place with respect to capital requirements are to be eased. The CHOICE Act provides that banks with a capital ratio of at least 10% and a CAMELS rating of 1 or 2 2 are exempt from some financial regulations. Banks that meet these requirements are exempt from Dodd-Frank regulations, Basel III capital and liquidity rules, and other regulatory requirements that took effect prior to the Dodd-Frank Act.
- It is intended to spur growth. Banks that meet the requirements could make unrestricted capital distributions and circumvent the requirement applicable to "living wills" (bank wills) 3. They would also be exempt from Volcker Rule 4.
- The powers of the Federal Deposit Insurance Corporation (FDIC) are to be curtailed. The CHOICE Act would add a new subchapter to the U.S. Bankruptcy Code specifically to address the insolvency of large, complex financial institutions.
- Laws governing "systemically important" financial institutions would be repealed by limiting the authority of the Financial Stability Oversight Council (FSOC), which determines whether financial institutions are considered systemically important.
- Bill provides relief for community banks and credit unions. It would limit the powers of financial regulators, each of which now reports to a single director, by turning them into commissions made up of Republicans and Democrats.
Why the bill is unlikely to succeed
The chances of the bill passing the U.S. Senate in its current form are rather slim. There are some good reasons for this. First and foremost, additional funding of nearly half a trillion dollars would be needed to provide the banking sector with the equity required under the CHOICE Act. The alternative would be for the big banks to shrink their balance sheets by 34. Both measures would, in all likelihood, put a damper on economic growth.
Source: Barclays, U.S. Federal Reserve Fed. *Supplemental Leverage Ratio (SLR) is used here as the leverage ratio.
While passage of the entire bill is doubtful, partial implementation is considered highly likely. Without much fanfare, the U.S. Treasury Department, which reports to Trump-appointed Treasury Secretary Steve Mnuchin, released its statement on the president's "core principles" in a 149-page report.
Why the outlook for investors is good even without CHOICE
As so often in politics, detours are necessary. While the CHOICE Act is currently going through the normal legislative process, we believe the real impetus for change will come from the Treasury Department report.
Unlike the CHOICE Act, many of the Department's proposals can be enacted without Congress and accomplished through a simple change in regulatory interpretation. In other words, the procedure depends on the person in charge.
Treasury proposals most important to investors relate to stress testing, the supplemental leverage ratio (SLR), the Volcker Rule and borrowing. In our view, Treasury's proposals should provide systemic health and improve the return ratio for equity and debt investors for the banking system in the U.S.
For example, the report advocates a less short-term focus. For example, stress tests and bank will assessments will only be conducted every two years – instead of annually as they are now. And more importantly, stress tests would become more predictable and less subject to qualitative aspects.
Moreover, the Volcker Rule was initially only 165 words (and the key points were outlined in just 40 words). As part of the implementation, this text swelled to more than 900 packed pages. Treasury's Volcker Rule proposal is expected to lower risk management costs for investors by increasing market cap. The report also recommends an increase in lending to the real economy, which should benefit the mortgage market.
In addition, it includes proposals regarding international banking standards to align U.S. and global capital and liquidity standards regulations. Global systemically important institutions are likely to benefit, as banking regulators' standards in the U.S. are more conservative than those of the Basel Committee or the Financial Stability Board.
Misleading
Some commentators may be primarily fixated on the uncertain outcome in the Senate's passage of the CHOICE Act. But like all good tricks, the CHOICE Act is likely to be a clever distraction from what is actually happening. In our opinion, the changes proposed in the Ministry of Finance's report will make for a healthier financial system and more satisfied investors.
1 In case you were wondering what the acronym "CHOICE" stands for, "Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs".
2 The CAMELS rating is a supervisory rating system used to classify the overall condition of banking organizations. Banks are rated on (1) capital adequacy, (2) asset quality, (3) management competence, (4) revenue, (5) liquidity adequacy, and (6) vulnerability to market risk. By definition, the term "banking entity" includes (1) insured depository institutions (IDIs), (2) bank holding companies (BHCs) and savings and loan holding companies (SLHCs), and (3) any entity treated as a bank holding company under the International Banking Act.
3 "Living Wills," or bank wills, are annual reports required by the Dodd-Frank Act that list the potential systemic impact of a bank failure. This is one of the key responsibilities of the FDIC.
4 The Volcker Rule prohibits banking institutions from engaging in certain trading activities that the law says would expose the bank, and therefore its customers, to too much risk.