Is Dodd-Frank Helping Financial Stocks Post-Lehman?
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into federal law by President Obama three years ago. Introduced by former Senate Banking Committee Chairman Sen. Chris Dodd (D-Conn.) and former House Financial Services Committee Chairman Rep. Barney Frank (D-Mass.), the Dodd-Frank Act set in motion the largest financial overhaul since the Great Depression — which is fitting, because the legislation is designed to address the largest financial disaster since the Great Depression.
For many, the bankruptcy of Lehman Brothers, once the fourth-largest investment bank in the world, marks the height of the crisis. The firm filed for Chapter 11 in September 2008, about half a year after Bear Stearns collapsed. A year later, headline unemployment in the United States would reach 10 percent. American gross domestic product contracted for five out of eight quarters in 2008 and 2009, and nearly 2.6 million homes were foreclosed on through 2012. The U.S. Treasury estimates that $19.2 trillion in household wealth evaporated.
While a number of factors came together to cause the crisis, the financial sector was at the heart of it. Major financial institutions and an opaque system of shadow banking, overambitious securitization, and negligent credit ratings cast a pall over the sector. Public opinion turned instantly and vehemently against Wall Street, and even the investing community turned away from the big banks.
Between October 2007 and March 2009, the S&P 500 lost 56 percent of its value. Over the same period, the S&P 500 financials index lost 81 percent of its value, and to this day it remains more than 40 percent below its pre-crisis levels. Data compiled by Bloomberg show that banks accounted for more than 20 percent of the $11 trillion in equity value that was lost from the peak to trough of the financial crisis.
This information is in no way designed to cast a sympathetic light on the financial sector. It is simply to say that financial institutions faced catastrophic losses during the crisis and that most are still suffering because of it — some of that pain is a result of public distrust of banks as an investment. Of the 10 major industries, financial companies are trading at the lowest price-to-earnings ratio, trading at 13.2 times earnings compared to 16.2 times earnings for the S&P 500 at large. And all this despite strong earnings projections across pretty much the entire industry.
In order to try to dissipate some of this bad mojo, banks have generally been eager to comply — and broadcast the fact that they have complied — with the landslide of new regulation coming out of the Dodd-Frank act. JPMorgan (NYSE:JPM), with billions of losses under its belt thanks to the London Whale incident, has put regulatory compliance and internal controls at the top of its priority list. Goldman Sachs (NYSE:GS) recently reported financial stress tests results that showed it can survive a severely adverse economic shock with more-than-adequate reserves. Morgan Stanley (NYSE:MS) has cut its reliance on short-term borrowing — something that many investors see as a bad habit among banks — by increasing its equity and deposits. Bank of America (NYSE:BAC) championed its fortress balance sheet.
Compliance with the Dodd-Frank regulations is certainly a place to start, but it probably won’t be the end of the story. For one, eager compliance with whatever regulation the authorities can think of is not likely to last. As the crisis fades and the recovery narrative fully takes over, financial institutions are bound to protest what could easily be called overly burdensome government intervention.
What’s more, the Dodd-Frank regulations as they stand are questionable and may not fully address the problems that contributed to the financial crisis. To begin with, the regulation is enormously long. Dallas Federal Reserve Bank President Richard Fisher commented in June, “Running 849 pages and with more than 9,000 pages of regulations written so far to implement it, Dodd–Frank is long on process and complexity but short on results.”
According to the Financial Services Committee’s Dodd-Frank Burden Tracker, regulators have written 224 out of the 400 new rules and requirements outlined by the act. Those 224 rules consume 7,365 pages. What’s more, the committee estimates that it will cost private-sector job creators more than 24 million hours of labor each year just to comply with just these first 224 rules. As Fisher put it: “Regulators cannot enforce rules that are not easily understood. Nor can they enforce these rules without creating armies of new supervisors.”
Fisher argues that, by definition, regulators are always one step before market participants. This latency creates an environment where complexity begets complexity and creates opacity instead of clarity. If a mechanism to end “too big to fail” does come about, it will work in part by reducing complexity, not increasing it.
This suggests that not only could eager adoption of regulation be a short-term strategy, but that process of abiding by the regulation may actually add additional complexity to an already byzantine regulatory system.