For all the circumlocution conventional in a confirmation hearing, Treasury Secretary-nominee Mnuchin was remarkably clear: he and President Trump are determined to redesign U.S. banking to segregate traditional activities within the FDIC’s ambit from riskier, complex business lines. And, if there were any doubt about the importance of this initiative, both the President and Vice President included financial reform as a top-priority item up in Philadelphia. A recent client report and a Wall Street Journal story on it provide a more in-depth assessment of what might end up where. Here, I turn to the decisions each financial company with a stake in this battle needs to make – and make soon.
As our reports described, we expect the Trump-Mnuchin plan to have little resemblance to the legislation bearing the 21st-Century Glass-Steagall Act nomenclature Mr. Mnuchin deployed during the hearing. That bill from Sens. McCain (R-AZ), Warren (D-MA), and Cantwell (D-WA) essentially puts all of the pieces of a 21st-century bank holding company back where banking was in 1933. As our analysis of the bill concluded, wishing won’t make it so even if wanting this were right, which it isn’t in terms of U.S. financial system stability, efficiency, or competitiveness.
Recognizing this, the Administration’s plan instead appears based on a real-life 21st-century plan: the Vickers ring-fencing rewrite of the U.K.’s banking system. In its most simple terms, the Vickers plan ring-fences into a highly-regulated, heavily-capitalized bank all of the functions traditionally associated with commercial banking such as consumer and corporate deposit-taking and lending. Recognizing the 21st century nature of finance, the Vickers plan also permits the ring-fenced traditional bank to provide a safe haven for market transactions now housed on the banking book, wealth management, and certain payment services. The ring-fenced bank comes under extra-tough capital (albeit capital not anywhere near as tough as Sir John Vickers wanted) and numerous operational restrictions designed to insulate the retail bank from the rest of the financial company. That part of the bank may continue to engage in all of the high-flying financial services long a hallmark of U.K. banking – trading, advising, merchant banking, and securitizing. All of the fun stuff is then – at least hypothetically – on its own in a crisis even though none of it is exempt from continuing prudential regulation.
Reflecting this U.K. approach, Mr. Mnuchin made it clear that he thinks complexity should be pushed out of insured depositories. Further, he suggested that isolating traditional from complex business lines settles the U.S. orderly-resolution dilemma because what’s in a bank would be handled by the FDIC (aided by bankruptcy reform) and what’s outside of it would have to fend for itself. Mr. Mnuchin also described why he thinks allowing proprietary trading within an insured depository is inappropriate even as he implied it could do just fine in a non-bank affiliate. Take this approach one step farther, as we do in the client reports cited above, and one has Goldman Sachs right back the way it used to be along with a very comfy charter for PayPal, Amazon, and several other bastions of fintech chomping at the banking bit.
Simply sorting out complex banking companies is challenging, but then deciding how the resulting enterprise is governed poses still more critical strategic questions. For example, what type of capital rule applies where across the holding company? Rep. Hensarling wants a ten percent leverage ratio for all banks as a toll to get on a regulatory off-ramp.
However, the Trump plan isn’t so much an off ramp as a divided highway – think the New Jersey Turnpike’s separation of lanes for cars and those for trucks and buses. On the Turnpike, both sides of the road have the same speed limit. Would this also be true for a redesigned U.S. bank? If so and especially if the speed limit were set by a leverage ratio, traditional retail banking would be challenged and capital-markets activities quashed. If, though, the leverage ratio no longer applied to the wholesale side of the ring-fenced banking organization, a lot of capital-markets activities along with clearing, settlement, and wholesale-payment services look a whole lot sunnier. Merchant banking would also come out of the cloud now cast on it by pending FRB regulations.
Another critical question: how would foreign banking activities of U.S. BHCs and U.S. activities of foreign banks be handled? The Vickers approach essentially allows all permissible activities conducted in Britain or the EU to land in the ring-fenced bank – or at least it did until Brexit. Outside the U.S. and U.K., the retail and wholesale activities segregated by Sir John are intimately integrated in what once were called “universal” banks. Where would the pieces land here and how could foreign banking organizations operate? Would they have to choose between a ring-fenced operation essentially cut off from the mother bank and its more exotic activities, carve itself into various pieces in the U.S., or move at least a lot of what it now does into a branch of the home-country bank then separated from at least some dollar-clearing activities? U.S. banks face the flip-side of this dilemma accustomed as they are to the relative freedom Regulation K provides for offshore integration of banking, securities, and even commercial activities.
I’ve outlined just a few of the strategic life-or-death decisions facing larger BHCs in the Trump plan as it shapes up so far. The political decisions are even more challenging because much in what I’ve described above will be strongly supported by community banks and their GOP allies in concert with progressive Democrats and their break-up-the-banks brigades. Essentially reverse-engineering the Gramm-Leach-Bliley Act, the Trump approach could find its biggest problems with libertarian Republicans such as Rep. Hensarling. But, even those most focused on deregulation rather than redesigned regulation may buy into a lot of the new approach if only because it’s not Dodd-Frank and – given broader bipartisan support – this approach could well be enacted.
Given the scope of this proposal and its surprisingly promising political prospects, any bank with a stake in this battle – pretty much all of them with U.S. operations – and any non-bank competitor needs to know and know fast how a ring-fenced U.S. structure could work, what provisions affect its franchise value how, and then what can be done about it. Although non-bank competitors can watch this fight for a while before deciding with whom to side, banks very decidedly do not have this luxury. If they do not fend for themselves, their franchises could be radically redesigned and not very much to their own or their shareholders’ liking.