No Panacea for Big Banks
We see Trump’s plans as an opening salvo in an effort to ease the regulatory burden on the nation’s banks. However, efforts to repeal or replace the law in its entirety will be far more difficult, and we don’t expect significant boosts to banks’ profitability in the near future as a result of the rule review alone. According to law firm Davis Polk, only 77.5% of the rules under Dodd-Frank had been finalized by July 2016. The mandated review and any changes to these rules could be painfully slow as well. Furthermore, we don’t think the biggest banks-- Wells Fargo
, Bank of America
, JPMorgan Chase
, and Citigroup
--will be first in line for regulatory relief. We are therefore not making any changes to our fair value estimates or our economic moat ratings, though the capital return potential at Citigroup (which is trading at a 20% discount to our fair value estimate) could be accelerated by an easing of certain restrictions.
The Volcker Rule provides an illustrative example. Section 619 of the Dodd-Frank Act prohibits proprietary trading. However, the final rule defining and identifying prohibited activities was not implemented until Dec. 10, 2013. In our opinion, the final rule could slowly be watered down without legislative action, but the prohibition itself is hard to escape.
In our view, the most likely positive impact of the review for bank shareholders is an eventual easing of capital return restrictions. Again, stress testing is required by the act itself, but methodologies could conceivably be changed to ease both the immediate cost burden on banks and post-stress capital requirements. As stressed capital levels are often a binding constraint in capital return planning, such actions could make it easier for banks to increase dividends and buybacks and potentially run their businesses with moderately higher leverage.
We note that most discussion to date has been focused on easing the regulatory burden on smaller banks, not the Wall Street giants. The Financial CHOICE legislation introduced by Republicans contains its own restrictions on “too big to fail” firms and systemic risk and appears to favor “simplicity.” Thus, the various provisions and rules governing systemically important firms may not be a high priority for change.
In general, we agree that some features of the Dodd-Frank Act are somewhat unnecessary due to changes in the industry. Low-documentation subprime loans are unlikely to come back anytime soon, as the speculative excesses that drove demand from both homebuyers and investors are long gone. However, this also means that scaling back the regulation of such activities will provide no benefit to banks or homebuyers. Along these lines, the new administration’s plans for Fannie Mae and Freddie Mac will have a much bigger effect on the mortgage industry.
Republicans seem set on neutering the Consumer Financial Protection Bureau as well, though it will remain in some form unless Dodd-Frank is fully repealed. Even in that case, the Financial CHOICE Act proposes adding a pro-market mandate to the bureau’s consumer protection functions rather than eliminating it or its consumer protection functions. Furthermore, the same proposal advocates enhanced penalties for financial fraud and corruption. Overall, we think some observers may be underestimating the populist shift in sentiment that has occurred in recent months. We suspect the nation’s biggest banks will not be first in line for regulatory relief.
Possible Easing of Capital Return Restrictions a Plus
While regulatory reform will be a net positive for banking profitability, Trump’s plans to review rules of the Dodd-Frank Act is just a first step in a long process. Efforts to repeal or replace the law in its entirety will face significant hurdles, and we don’t expect significant boosts to profitability in the near future as a result of the rule review alone. Therefore, we are not altering our fair value estimates for any of our regional banks at this juncture, nor do we think moats will be significantly affected. In our view, the most likely positive impact of the review for bank shareholders is an eventual easing of capital return restrictions. While stress testing is required by Dodd-Frank, the methodologies of testing could conceivably be changed to ease both the immediate cost burden and the post-stress capital requirements. Such actions could make it easier for banks to increase dividends and buybacks and potentially run their businesses with moderately higher leverage. We would highlight U.S. Bancorp
as a wide-moat name to consider on any pullback, as it has run up less than most banks in the past four months, and we view it as having one of the best competitive positions.
For our regional banking coverage, several items are likely to have an impact. One of the reform possibilities would be raising the Comprehensive Capital Analysis and Review threshold from $50 billion in assets to something higher, potentially as much as $250 billion. This would in theory decrease the explicit costs associated with this process for all regionals that have between $50 billion and $250 billion in assets, which is most of our regional coverage. However, we would note that this benefit could be smaller than some are expecting for the banks that have been above $50 billion in assets for several years already, which includes all the regionals under our coverage that are currently above $50 billion. Many of the processes associated with CCAR have already been built out for these banks, reducing the potential reduction in explicit costs.
We do believe a combination of an easing of stress-testing methodologies, reduced regulatory stringency regarding approval of acquisitions, and clarity on future tax rates could all be a boon for M&A among banks. Banks that previously would have been penalized for crossing the $50 billion threshold would have that penalty removed. New York Community Bancorp
would be the most appropriate candidate under our coverage for this situation as it seeks a new acquisition candidate.
In addition to the processes associated with CCAR, much of the current regulation in general has already been built into banks’ infrastructure and day-to-day operations, making it potentially difficult to remove completely. The difficulty of coming up with explicit numbers for what regulations cost each bank points to how intermingled they have become with core business operations. So while it will be a net positive for banks, it won’t be a bonanza of cost decreases. The smallest banks will benefit proportionally more, with Cullen/Frost
, Signature Bank
, Silicon Valley Bank
, and New York Community being the smallest banks we cover, all having less than $50 billion in assets.
While decreased regulatory burdens should be beneficial, we also note some proposals that suggest increasing capital requirements as an offset for decreased regulation. The Financial CHOICE Act suggests a leverage ratio of 10%. Currently, Huntington Bancshares
and Cullen/Frost both have ratios under 9%, while the majority of banks we cover have already met this requirement or are within 100 basis points. If banks choose this route, increased capital could at least partially offset an otherwise decreased regulatory burden.
Finally, we believe the talk of regulations alone limiting credit and growth is a bit one-sided. Many banks decided independently to increase credit standards, which is a natural part of the credit cycle after a downturn. There was also less demand for credit from clients, regardless of the willingness to lend. We see a continued pickup in consumer and corporate lending as credit demand increases and as standards ease gradually with the credit cycle progressing, independent of what is likely to be drawn-out regulatory reform.
Time Working Against Near-Term DOL Fiduciary Rule Change
We anticipate that adjustments to Dodd-Frank or the Department of Labor’s fiduciary rule will be neutral to slightly positive for the investment banks, brokerages, and asset managers. At the moment, we are maintaining our fair value estimates and moat ratings. Undervalued companies in these industries include Affiliated Managers Group
, and Invesco
With the investment banks, the Volcker Rule is an issue that receives a lot of attention. Bright-line proprietary trading—in which the investment banks used their own capital to speculate on asset prices--has historically been a fairly small portion of their revenue. Those operations have already been dismantled, and the investment banks have largely said that they don’t intend to bring them back. Where a softening of the Volcker Rule could improve revenue is in market-making. There’s a hazy line between market-making and proprietary trading, and the investment banks have chosen to be more conservative to try to firmly stay on the market-making side of the line. If the Volcker Rule is softened, then investment banks may become more aggressive market-makers.
In regards to the Department of Labor’s fiduciary rule, an executive order can’t directly change or repeal the regulation. To our knowledge, to change the rule, the Department of Labor will have to propose what exact changes it wants to make to the rule and then go through a notice and comment period that would take months. Given an April 10 implementation date, it would likely be tight on timing to go this route. The executive branch can try to create an interim final rule to bypass the notice and comment period, but this could be subject to legal challenge as being arbitrary and capricious. Considering that a couple of judges have already ruled in favor of the Department of Labor and many firms have publicly stated that they’re ready for the April 10 implementation date, an interim final rule may not work.
Regardless of the status of the fiduciary rule, the financial sector has already made multiple moves in the direction of investors’ best interest that won’t reverse course. Many asset and wealth management firms have reduced their fees as investors focus more on costs. Wealth management firms have been increasing their proportion of fee-based accounts for years. Digital advice is being widely adopted by both consumers and wealth management firms. Many wealth management firms are becoming more transparent with their fees and pre-emptively adopting policies in investors’ best interests, as many other countries have already passed fiduciary regulations, and it’s only a matter of time before the United States formally adopts similar rules. These trends will continue.
Many make an argument against the fiduciary rule as limiting choice or raising costs for investors. The more pertinent issue about choice is whether investors are making good choices. With a higher standard of care for advice, investors will make better choices. With a fiduciary-type duty, wealth management firms are also more likely to offer a better suite of products to investors, instead of products that profit them the most.
For costs on investors, there have many recent developments in the financial industry that arguably are a direct result of the fiduciary rule and financial sector firms’ increased focus on putting their clients’ best interests first. Many asset and wealth management firms have reduced their fees. There’s been a string of announcements regarding lower exchange-traded fund management fees over the past year. Asset managers have also been developing more transparent and lower-cost share classes, such as T shares and clean shares. Digital advice or robo-advisor technology has been strongly embraced by investors and advisors. Assets under management at the leading firms increased approximately 100% between 2015 and 2016. The technology underlying robo-advisors is also being offered to human financial advisors so that they can improve their productivity, which enables them to profitably serve lower-account-balance customers. Firms such as LPL Financial and Morningstar have announced lowering of their managed account minimums, so firms are increasingly passing along the benefits of technology to consumers.
We are interested in hearing if Andrew Puzder, the labor secretary nominee, will be asked questions about the Department of Labor’s fiduciary rule during his Senate hearing Feb. 7. Many questions will probably center on his opinion on the minimum wage and treatment of restaurant workers. That said, the fiduciary rule being in the headlines and an issue for the financial sector probably warrants some questions.
For the large alternative asset managers we cover, the proposals on the table for Dodd-Frank suggest the impacts will be relatively small. The industry was required to register with the Securities and Exchange Commission, and subsequent SEC examinations forced the industry to disgorge tens of millions in fines for poor fee disclosures. The registration rule applied for managers with greater than $150 million in assets, and the proposed changes suggest raising that number significantly to alleviate substantial compliance costs on smaller managers. We would agree with the shift, but note that as the larger public alternative managers manage billions, they would not be affected by this particular change.
Michael Wong, CFA, CPA