How the Dodd-Frank Act Transformed the Core Business Model of Banks

By Motley Fool Staff Markets Fool.com

The Dodd-Frank Act transformed the bank industry in a variety of ways. First and foremost, it requires banks to hold more capital and keep their assets in highly liquid but less profitable forms. If there's one reason it is so unpopular in the financial services industry, this is it.

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The Motley Fool's Gaby Lapera and John Maxfield discuss this aspect of Dodd-Frank in this week's episode of Industry Focus: Financials. Listen in to learn about these changes as well as what they mean for banks.

A full transcript follows the video.

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This podcast was recorded on Feb. 13, 2017.

Gaby Lapera: So, we'regoing to talk a little bit about Dodd-Frank now,what it actually means, but something to keep in mind is that Dodd-Frank is a very weightypiece of legislation --and I don't mean in terms of importance,although it is very important,or else we wouldn't be talking about it... although,I don't know, maybe you think we're just here to waste your time. In that case, don't listen to the podcast.[laughs]

But, no,this is actually a very long piece of legislation. What we'regoing to talk about now are the main points of Dodd-Frank -- so, the things that peoplethink about when it comes to Dodd-Frank, the things thatpeople are up in arms about when they're talking about this legislation,or the things that they're trying to protect. So,I think the first thingwe should start with is capital requirements andincreased liquidity, which kind of go hand-in-hand assomething that banks have been complaining aboutpretty much nonstop since Dodd-Frank passed.

John Maxfield:Right. If yougo back to the financial crisis, thetheory was that what caused it, orat least, what accelerated it,was thatyou had these thingsthat were called "too big to fail banks." These weremassive organizations --Bank of America,Citigroup, Lehman Brothers,Bear Stearns,Goldman Sachs. Andthese banks were operating with anenormous amount of leverage.

In Lehman Brothers' case,it was something like $30 worth of assetsfor every $1 worth of equity. What that means is thatif those assets at a bank like thatfell only 3%,basically all the capital of that bank would be wiped out,and it would be insolvent,and therefore it would have to go into bankruptcy. So, thethought process was that we need toincrease how much capital banks hold,because if we increasehow much capital banks hold, they'll beable to absorb those losses that happen when we go through theseeconomic cycles. So, what they did with Dodd-Frank is they did a couple of things. First of all, thereally big banks, they carved them out and appliedheightened capital requirements to them, which means they have tooperate with less leverage. They also instituted --listeners have probably heard about these --annual stress teststhat tried to determine what would happento these banks' capitalon a yearly basis ifthe economy were to enter another financial crisis akin to the one in 2008. So,when they go through that crisis, they testwhat the losses would look likeat these banks, and how that would impact their capital, and whether,through that crisis, they would still be able to meet theseminimum capital requirements.

Then, on the liquidity side --here's a really interesting point about the crisis thatI think a lot of people miss: Insome of these cases,it wasn't just an issue of capital, orit wasn't even an issue of capital, but it wasmore an issue of liquidity,because you had all of these bank runs on these banks, and whilethey had enough capital, the assets they held weren'tliquid enough to turn into cashquickly enough to satisfy theirdepository run. So, what theregulators did was,on top of requiring banks to hold more capital, they'realso requiring them tohold a larger percentage of their assets inhighly liquid forms likegovernment securities, as opposed to loans,which you can't turn into cash very quickly.

Lapera:AndI'm going to interrupt you right here. Thereason that banks are upset about this is that if they havelarger capital requirements, meaning that they have to keep more cash in reserve, that means that they can't be using that money to make loans or dowhatever it is they were going to do with it that would actually make them money. Theyjust have to sit on it,which is upsetting to them,because before the financial crisis, thereweren't really that many limits on theircapital requirements,not like Dodd-Frank gave.

Andon top of that, with the increased liquiditygoing hand-in-hand with the capital requirements, it means that they have tonot only keep all this extra stuff around,all this extra money, butit has to be in a form that'seasy for them to liquidate. So,it can't be in loans, because a loanis a promise to pay back money over time, so they can't call in the loans right away. Ithas to be in a form that is very easy toreturn to consumers.

Maxfield:That'sa great point. When you think about what a bank earns on a loan,let's say it gets a 7% interest rate, or even a 5% on a loan, if you'rekeeping it in cash, you're not making any money. So, it really attacksthe core profitability of banks.

Lapera:Absolutely. Then,on top of that, you have these stress tests that they have to do.I don't think anyone disagrees that you should run what-if scenarios, but the banks are saying that it'sburdensome to thembecause it takes a lot of money to run thesecompliance tests.You have to pay a lot of people, and it takes a lot of time,and it's time and money that they could be spending making more money. So, they'reupset that they are instead spending it to bein compliance with these federal regulations.

Maxfield:Yeah,that's right. And also, if you look at thescenarios that the Federal Reserve tests these banks against, they'realmost like Great Depression-typescenarios. Now, that's a good thing, forbanks to always be prepared for downturns. If you're a bank, you have to always be considering,and you always have to have in the back of your head that a downturncould be coming down the road. But just, the extreme-ness of these tests makes these banks holdso much more capital, which then, on top of thatliquidity stuff, just reallydrives down their profitability.

Lapera:Right. And then,there's another prong to these stress tests andcapital requirements, which are resolution plans, which is that the biggest bankshave to tell the government regulatorswhat they plan to do for the next year, like,who are they planning to hire? What'sexecutive compensation like? Why are theyplanning on having a dividend? Andthe federal government can basically say yea or nay on a lot of these things.

Maxfield:I'm glad you brought that up. That's actually not the resolution plan,that's part of what's called CCAR,the Comprehensive Capital Analysis and Review process. I mean, there's all these things --

Lapera:No,you're totally right, I have my notes flipped.[laughs]

Maxfield:ButI'm glad you brought that up, because I'dforgotten to mention that. One of thepowers that banks lostas a result of Dodd-Frank was --any other company, the board of directors can sit down and say, "Wewant to raise our dividend this year," or, "Wewant to buy back more stock this year than we bought back last year." Because ofDodd-Frank, and the stress testsin particular, banks do not have thesole discretion to do that. They actually have to getapproval on an annual basis to increase their dividend or buy back more stocks. It's a reallyrestrictive regulatory scenario for these banks.

Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Bank of America and Goldman Sachs. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.