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      Home » Compliance, Dodd-Frank Act, Regulatory

      The Results Are In and the Winner Is…?

      Submitted by on Friday, November 9, 20123 Comments

      Finally the election is over. Few will argue that this was the most divisive election in our lifetimes, although it is certain that historians will argue about venom in this election compared to that of some of the elections in the 19th century.

      Be that as it may, it is time to take stock of the impact of these elections on the financial services industry.  What do we know for sure? First, the basic makeup of our legislative bodies did not change.  We continue to have a Democratic president, a Democratic Senate, and a Republican House of Representatives. Second, candidates who are “unfriendly” to the industry, such as Elizabeth Warren, won election.  Third, there are much bigger issues than banking issues that the government will have to contend with over the next several years.  The end result of this: expect a continuation of the current path in regard to economic and regulatory concerns for financial service providers.

      Impact 1:  The historically low interest rate environment will continue.

      Rates are at historic lows.  Fed Chairman Bernanke has indicated that he may keep rates at these levels through mid-year 2015.  Mitt Romney had indicated that he would replace Ben Bernanke in 2014, assumedly to change Fed policy, while it is likely that President Obama will keep Bernanke for as long as he is willing to stay.

      There is a three-fold reason that rates are as low as they are.  First, the hope is that low rates will jump-start the economy as it makes it easier for businesses to justify borrowing for expansion.  Second, low rates force investor dollars into equities, thereby driving up equity values, and creating a “wealth effect” that is hoped will spur spending on the part of “wealthier” consumers. Third, and much less discussed, is the reduction in borrowing costs for both the US government and still-overleveraged consumers.  In 2012, the US government paid $360 billion in interest expense on its debt, the lowest level since 2005 ($352 billion), despite dramatically higher debt ($16 trillion).  The reason: historically low rates.  Imagine the impact when Treasury interest rates return to more normal levels.

      But the same is true of consumers.  Consumers remain over-leveraged.  If you examine total consumer debt (real estate debt, personal debt, credit card debt, etc.) to disposable income in the US for the decades from the 1950s through the 1980s the range was typically 50% to 70%, depending on the economic environment.  It began to increase in the 1990s and in the early 2000s surpassed 100%.  It reached its pinnacle in 2007 at over 130% before declining dramatically due to loan defaults.  But it still remains above 100%.  Historically low rates in the past several years have helped the consumer to manage out-sized debt loads.

      What will be the impact of ongoing low interest rates?  The answer is diminishing net interest margins.  The reason is simple; asset yields will continue to fall as assets reprice, but liabilities cannot fall as rapidly, due to the floor rate of 0%.

      The result: plan for lower net interest margins in 2013 and 2014. Cost of funds management will be crucial, but stronger loan growth can help lift asset yields.

      Impact 2: Loan demand likely will remain low due to uncertainty.

      Many factors have driven loan demand to historic lows.  One factor is the over-leveraged condition of consumers as noted above.  But loan demand among businesses also remains low, despite healthy balance sheets.  There has been improvement in some categories of business borrowing. However, most remain below previous levels. For example, commercial and industrial loan volume has grown by 13% in the last year but is still 9% below peak levels seen in 2008.

      With no real change in the political environment, businesses, especially small businesses, are not likely to feel any more optimistic than they have been for the last several years.  Very few business decisions are “categorically yes” or “categorically no” decisions, but hover around the 50/50 mark.  There may be compelling reasons to make an investment, but there are often compelling reasons to not make that same investment.  It is often small factors that often push the decision in one direction or another – to either “yes” or “no.”  And with no change in the political environment, the factors that are tending to push businesses away from making investments – uncertainty in the economy, uncertainty in their own costs – are likely to remain in place.  This uncertainty in the business environment in turn will push economic growth lower.

      The result: plan for tepid aggregate loan growth continuing in 2013 and beyond. The path to achieving loan growth will continue to be “stealing” loans from competitors.

      Impact 3: The Dodd-Frank Act will not be repealed.

      Prior to the election there was some hope that a change in the administration and Congress could potentially lead to the dismantling or outright repeal of Dodd-Frank.  We never viewed this as a strong possibility, but the election results have likely cemented Dodd-Frank into the regulatory framework.

      Dodd-Frank was 848 pages of legislation.  (By comparison, Glass-Steagall in 1933 was 37 pages.)  By July 2012, two years after enactment, about 30% of the Dodd-Frank legislation had been translated into rules and regulations, resulting in about 8,800 pages of rules.  Extrapolating, Dodd-Frank will mean 28,000 pages of rules that financial institutions need to be in compliance with.

      You can see where this is going.  The compliance burden has increased dramatically for financial institutions, and the burden is likely to be much more heavily felt by smaller organizations.

      Moreover, the Consumer Financial Protection Bureau (CFPB), which was created by the Dodd-Frank Act, is likely to engage in significantly greater rule-making and enforcement activity over the next four years than they have over the past two.  The current interim director, Richard Cordray, will see his term end in 2013.  With a Democratic President in place, expect to see the selection of a director who will follow the path that has been laid by Elizabeth Warren and Cordray.

      What is likely to be on the CFPB’s radar? One area is increasing disclosure.  This is clear from the agency’s activities to date.  The other area is overdraft and NSF fees.  This administration has already established its willingness to engage in government price-fixing – Reg II is the clear illustration of this.  It is not beyond the realm of possibility to think that the CFPB could decide to conduct a study of the cost of handling an overdraft transaction with the ultimate goal of capping NSF and overdraft fees.

      It is probably a prudent planning exercise to ask yourself how you would survive with 50% less overdraft and NSF income in the future.

      The result: plan for increased compliance costs as well as future limitations on traditional non-interest income sources. Identifying additional sources of non-interest income, sources that are less likely to subject to regulatory scrutiny, is essential for financial institutions.  Small banks and credit unions will be harder hit than will their larger brethren because compliance costs are largely fixed in nature. Every institution has to read the same rule book regardless of their size.

      Impact 4:  The real estate markets will remain dysfunctional.

      Congress and the administration face very significant challenges in 2013 and beyond.  The most significant issue is the deficits and debt of the federal government (the so-called fiscal cliff) as well as the sorry financial condition of many states such as California and Illinois.  But we will also be dealing with the impact of a decline in the European economies and slowdowns in China, India, Brazil and other emerging economies.

      The result is that Congress is not likely to address an issue that is critical to the effective long-term functioning of the real estate market – the GSEs (Fannie Mae and Freddie Mac). The result is that real estate markets will remain dysfunctional. In the current interest rate environment refinancing of high quality credit has been the key activity, but until GSE reform is addressed, the real estate markets will not function as well as they should.

      The result: don’t anticipate GSE reforms in 2013. If or when mortgage refinancing volume lessens we may feel the impact of this lack of action on GSE reform.

      Impact 5: Interchange income is likely to continue its downward trend.

      As we predicted following the enactment of Reg II, we are beginning to see interchange rates on debit cards decline for even for sub-$10 billion organizations.  While many institutions have offset this with increases in transaction volumes, the trend is worrisome but not unexpected.  The question is, will this trend continue and how likely is it to spread to the other card base – credit cards?

      Our anticipation is that debit and credit card interchange income does not face an imminent threat of catastrophic decline (other than what the $10 billion + organizations experienced two years ago), but instead will see a more gradual erosion.  This is due to both market factors and technological innovation.  Competition and new technology in the payments space are likely to have a greater impact on interchange than will legislation or regulation.

      Having said this, there is no doubt that merchants would love to see a repeat of “Durbin” on the credit card side.  The Dodd-Frank Act gave Senator Durbin the perfect opportunity to impose interchange caps; the Durbin amendment was one small provision in a bill that was likely to pass.  The question is whether any legislator is willing to take on the card issuers in the absence of broader legislation as the Dodd-Frank Act was.  Our best guess is that legislators will be unwilling to put forth legislation to restrict credit card interchange in the absence of a larger bill.

      The result:  expect ongoing gradual erosion in debit card and credit card interchange rates, primarily due to market factors and changes in the payments space.

      So to answer the question posed in the title of this article:

      The winner is – not financial service providers, or by extension, their customers. Financial service providers will see lower net interest margins, higher operating costs due to increased compliance expense, and many of the traditional sources of non-interest income will be threatened. These earnings pressures may drive some institutions to adopt expense reduction strategies, for example through staff reductions. This could lead to lower service levels at these institutions. Institutions may also become even more unwilling to take on risk in their loan portfolios, with the result that fewer loans will be written. Finally, expect an increase in some fee levels and a reduction in the availability of free checking.

      But perhaps the most important reason that the consumer will be hurt in the coming years is that this new environment favors the very large organizations that can better absorb these body blows. When community based financial institutions suffer, consumers and small businesses suffer.

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      3 Comments »

      • Bill Wade said:

        So there is no need to reign in the excesses of the wall street banks after them causing the real estate bubble we all suffered from for the past several years?
        I certainly don’t want to hand them the check book again, even if it means some inconvienence for me.
        We have artifically reduced loan growth this year just to please regulators, but the demand is there and we will go back after it next year. Look for 20% growth.
        What will keep financial institutions down in 2013 is moping around because their PAC’s didn’t succeed in getting candidates elected and grousing about regulations. We will always have regulations and they will always be changing and growing.
        Get over it and get back to running your business.

      • richard said:

        I second the sentiments of Mr. Wade. The business of any business is to maximize profit through customer satisfaction and service in the environment in which it exists – not moan and groan about “coulda, woulda, shoulda”.

        Elizabeth Warren, far from being “unfriendly” to the financial industry, is their unrecognized heroine. She will be a freshman Senator with little power initially, but she will be a beacon for honest appraisal of the fininacial churning that produces nothing (except obscene profits and bonuses for hedge funds and other manipulators).

        Face it, the game is crooked and rigged for the Wall Street robber barons. The little guy pays for all of that eventually with jobs going overseas, deficit spending for “stimuli”, bubbles, and billionares’ money as a legal proxy for speech. It’s time for some tree shaking, not homage to the “old days” when finance was a blank check (or in LIBOR terms, a blank checque).

      • Bryan said:

        While it is true that regulation will always be a factor in this industry and businesses need to find ways to thrive despite those challenges, the article does a very good job of highlighting government’s role in placing additional and unnecessary burdens on financial institutions. There is no doubt that there were numerous unethical players out there. But, regulators are spraying their regulation as opposed to trying to pinpoint it. And, in the case of the Durbin amendment, they are also not entirely thinking through the unintended consequences of their actions, i.e. increased fees elsewhere.

        As for the Wall Street bankers causing the real estate bubble, there were numerous factors that contributed to the problem. Perhaps as big, was the governments meddling in the mortgage business by pressuring banks to lend to the “under-served.” They also went so far as to place pressures on Fannie and Freddie to lower their underwriting standards and purchase these loans to the under-served, thus providing the necessary outlet for banks. So, while Wall Street deserves much of the blame, that blame should also be shared by our political leaders. But, they did a phenomenal job of making scapegoats of the banking industry to avoid taking any responsibility of their own. Instead, they have punished the entire industry, despite the fact that the vast majority of these institution were not even part of the problem.

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