US financial deregulation: higher growth and risk

5 min
Alexis Garatti
Alexis Garatti Head of Macroeconomic Research
  • President Trump obtained a radical overhaul of the US financial system, including watering down prudential standards and Dodd-Frank
  • US financial deregulation will push community banks to win back credit market shares, help US SMEs and foster growth — it will also boost the general level of risk through cycle positioning and increased complacency

President Trump’s policy represents a turning point in the US as well as global economic history. It is characterized by a strong contrast between a doctrine of laissez-faire on the internal side and a maximum of interventionism on the external side embodied by protectionist measures. We consider here the domestic aspect with the reform of financial regulation, a primary objective of Mister Trump since the Presidential campaign, which was signed into law after a bipartisan support in the Congress on May 24th 2018. We present here the different elements of this new legislation via a chronological approach, which mainly aims at undoing the so-called Dodd-Franck law signed in the aftermath of the subprime crisis to put the U.S. financial system on a stronger footing.

Actual legislation and orientation by the Trump administration

President Trump’s EOs and the House’s Financial Choice Act

Since his election, President Trump and his administration have been determined to consequently reduce the regulatory burden on the U.S. economy through the elimination of supposedly inefficient, useless or obsolete regulations.

Toward this end, President Trump issued four Executive Orders (EOs) in 2017 directing federal agencies to repeal two regulations for every new regulation; to review every existing regulation so as to highlight any case of excessive regulation as well as giving council on how both the financial and energy sectors should be deregulated. This first stance of the newly elected administration on regulatory issues was followed during the summer 2017 of the Financial Choice Act.

This bill aimed at rolling back most Dodd-Frank provisions, as well as improving consumer protection. It had for ambition to grant healthy banks significant regulatory relief and subject banks to stress tests every other year instead of every year as well as repealing a Dodd-Frank provision allowing the government to take over a failing financial firm, known as Orderly Liquidation Authority (OLA), and create new bankruptcy laws instead.

Figure 1  Published Economically Significant Final Rules within 1st year of a Presidential Term

Source: RegInfo, Office of Management and Budget

Economic Growth, Regulatory Relief, and Consumer Protection Act

On March 15, 2018, the U.S. Senate passed a very significant regulatory relief bill, the Economic Growth, Regulatory Relief, and Consumer Protection Act, thanks to a rare bipartisan vote of 67-31.

a. Enhanced Prudential Standards (EPS)

EPS include liquidity and risk management standards and heightened capital but also mandatory and frequent stress testing for large BHCs. Firstly, the bill will significantly increase the asset threshold for subjecting BHCs to EPS, from USD 50bn to 250bn, with staggered implementation dates depending on the institution’s size.

However, the “too big to fail” BHCs, also known as Global Systemically Important Banks (G-SIBs), will be exempted from such regulatory relief, regardless of their asset size.

Concerning supervisory stress tests, BHCs with over USD 250bn in total consolidated assets (TCA) will still be subject to annual supervisory stress tests, but twice rather than thrice. BHCs with TCA comprised between USD 100bn and 250bn would still be subject to periodic supervisory stress tests but their new frequency has not yet been revealed.

Finally, for the smaller BHCs (under USD 100bn in TCA), there would be no more capital stress testing, which is a considerable relief.

Concerning company-run stress tests, the new legislation would exempt all banking organizations with less than USD 250bn in TCA from having to conduct any company-run stress test.

b. Regulatory Capital and Liquidity Requirements

The Senate Bill plans to enforce various capital and liquidity requirements for most banking companies across the country. Nevertheless, the bill requires federal banking agencies to revise their supplementary leverage ratio (SLR) rules for custodial banks to exclude funds that are placed with the Federal Reserve Banks or the ECB. This amendment intends to address recurrent criticisms that the Federal Reserve Board’s enhanced SLR rule imposes an unnecessary burden on BHCs. Bank of New-York Mellon, State Street and Norther Trust, who manage trillions of assets for mutual funds, would be the main beneficiaries. They will be able to exclude some deposits they hold in central banks from their total assets when calculating their leverage ratio.

c. Volcker Rule

The Volcker Rule was implemented within the Dodd-Frank framework in 2010 and had for main goal to restrict U.S. banks from engaging in certain types of trading which do not benefit their customers. This proposal specifically restricts banks and BHCs from engaging in proprietary trading, and from owning or investing in a hedge fund or private equity fund. The new bill exempts from the Volcker Rule all banks and BHCs with USD 10bn or less in TCA and liabilities of 5% or less of TCA, which means it concerns nearly all community banks throughout the country.

d. Community Banks

Republican Congressmen have long been complaining that the Dodd-Frank Act of 2010 was mostly detrimental to the smaller and state-based banks. The Economic Growth Act is not the first attempt to bring relief to smaller banks and to the average consumer by overhauling Dodd-Frank. For such reasons, Title II targets notably capital rules and risk committees for community banks. For instance, banks and BHCs with less than USD 10bn in TCA who also guarantee a “community bank leverage ratio” of at least 8-10% would now be exempt from the general U.S. capital rules originating from the Basel III accords.

e Real Estate and Mortgage Lending

Following the same logic which underlies the amendments brought to the community banks regulation, this bill tries to encourage banks’ capacity to lend money. The bill would strongly increase the number of mortgage loans deemed to satisfy the Truth in Lending Act’s “ability to repay” requirements so as to be treated as “qualified mortgages”. “Qualified mortgage” follow stringent guidelines defined by Dodd-Frank, as the following example shows: a borrower's loan payment must represent less than 43% percent of their income.

Moreover, it will allow certain mortgage loans of less than USD 400k to be exempted from appraisal requirements under the Financial Institutions Reform. The bill will also revisit recent dispositions taken by the Consumer Financial Protection Bureau under the Home Mortgage Disclosure Act, which requires many financial institutions to maintain, report and publicly dispose loan-level information about mortgages. The goal here is to increase small community lenders’ competitiveness in extending mortgage credit.

Federal Reserve proposals and future outcomes

The Fed aims to revise main ratio requirements and stress tests

Banks with assets being lower than USD 100bn will not be subject to stress tests. For banks with assets between USD 100bn and USD 250bn, regulators will have the possibility to stop testing every year and rather control banks on a “periodic basis”. The frequency of controls will be subject to the discretion of the regulator. After several nominations at the top of the FOMC, there is no doubt that its members are now in favor of a lighter approach in terms of regulation.

On April 10-11, the Federal Reserve released two important proposals detailing the first major changes to capital rules under Fed Chair Jerome Powell.

The first proposition, released on April 10, aims to introduce a “stress capital buffer”, to replace the fixed 2.5% portion of the capital conservation buffer, and a new stress leverage buffer within the current CET1 requirement framework. Figure 2 below illustrates how the minimum CET1 capital ratio requirement could be concerned by these proposals.

The additional stress capital buffer would take into account a bank’s worst stress test results as well as its planned dividends.

The second proposition aims to revise the enhanced supplementary leverage ratio (eSLR), specifically designed for US G-SIBs.

As seen below in Figure 3, the new ratio would correspond to 50% of the firm’s G-SIB surcharge from the preceding year and would therefore be both firm-specific and dynamic.

The Fed expects both proposals to slightly increase capital requirements for the largest systemic banks while reducing them considerably for all other banks, notably deposit institutions.

These recent measures are a great encouragement for Fed officials which support a greater deregulating policy. These amendments would allow them to perform stress tests every two years or more, which comes with reduced risk assessment and control. Stress tests are also very important for banks to precisely calculate the level of capital that is mandatory to prevent losses. This means that under such provisions, banks with TCA between USD 100bn and 250bn could easily reduce their capital requirements, knowing they will not be tested. With more than USD 2tn in combined assets, the decrease in protection could end up with considerable losses in a future crisis.

Finally, recent changes within federal agencies’ administration have been another way to see how the Trump administration has been diffusing its aggressive deregulatory dynamic. The first flagrant sign for this was Mick Mulvaney’s appointment as head of the Consumer Financial Protection Bureau (CFPB).

More than his declarations about the CFPB being a “sick, sad” joke, the fact that he has not taken a single enforcement action against any institution more than 160 days after he took over the agency is very representative. Created under the Dodd-Frank Act, the agency is slowly being stripped of most of its powers despite Democrats having managed to block particular amendments during the Economic Growth Act vote days ago. Moreover, last week also saw Jelena McWilliams, President Trump’s candidate, be appointed as head of the Federal Deposit Insurance Corporation (FDIC), a key bank regulator. She is considered to be the final piece of Donald Trump’s regulatory team reshuffling, helping the President’s strongly deregulatory agenda. This sets us to believe that the FDIC should experience a similar future to the CFPB’s recent times, with constant re-examination of past rules and amendments. Comparable momentum awaits the Financial Stability Oversight Council, which shows that even though Republicans have not yet managed to pass bills to entirely overhaul the majority of the Dodd-Frank and other post-crisis regulation, deregulation through law interpretation is already fully under way and efficient since last year

Interpretation of Basel IV shows “America First” spirit at work like in the (protectionist) interpretation of international trade rules  

The new reforms brought to the Basel III accord, dubbed Basel IV by the financial industry, will progressively take effect between 2018 and 2027. They will impose limits to how much the biggest banks’ bespoke models for calculating risk in areas such as mortgages can diverge from the regulators’ most conservative calculations. Since the start of 2017, fear had risen that President Trump’s global deregulatory agenda might prevent or slow down further agreement at the Basel Committee. Finally, the process was supported by the Treasury Department and the Trump-appointed Vice Chairman for Banking Supervision at the Fed, Randal Quarles. In a series of reports over the past year, the Treasury Department has recommended “recalibrating” bank capital and liquidity standards set by the Financial Stability Board. For instance, the provisions contained within Title IV of the Economic Growth, Regulatory Relief, and Consumer Protection Act would cause the U.S. supplementary leverage ratio to considerably diverge from the Basel leverage framework because of its treatment of central bank deposits. Since the Great Recession, the U.S. have had a history of diverging from the Basel leverage ratio towards a greater conservatism, with notably federal banking agencies imposing an “enhanced” SLR buffer requirement on U.S. G-SIBs and their subsidiary IDIs. However, it seems now that the U.S. administration is willing to rework on international agreements by itself, just like what has been done with international trade laws. The interpretation of the Basel IV accord by the U.S. is a sign of increased banking competition and of a desire to decide unilaterally of international standards.

Additional measures to deregulate the banking industry are yet to come

The passing of such bill demonstrates how policy makers have decided to scale back their priorities in order to guarantee support for a bipartisan compromise vote.

The original inspiration bill for the Economic Growth Act, the Financial Choice Act, had been strongly watered down within a year to maintain a chance of passing through the Senate in March of this year.

The Senate bill then experienced numerous revisions between March 15 and May 22.

Indeed, when one takes a look precisely at which dispositions from the Dodd-Frank Act, it is evident that many overhauls were suspended and delayed. If most constraints on banks have been alleviated, especially for community “Main St” banks, it is undeniable that some dispositions were forgotten. For instance, Republican instigators of the bill decided to abandon trying to reorganize the Consumer Financial Protection Bureau, which was strongly opposed by Democrats.

Moreover, the Orderly Liquidation Authority (OLA) to take over failing financial firms stays in the 2010 Dodd-Frank Act, which means there will be no immediate overhaul of bankruptcy law in the U.S., despite strong support from most Republicans and the White House.

Many banking groups are known to have pressed such vote from the House, despite House Financial Services Committee chairman Jeb Hensarling (R-TX) trying to toughen the Senate bill. Mr. Hensarling seems to have emerged from this episode with a commitment from Senate Majority Leader Mitch McConnell (R-KY) to vote on a separate package before the midterm elections, so as to try and pass stronger deregulation measures.

Figure 5  Market share of community banks for specific loans

Source: FDIC Statistics on Depository Institutions

The positive aspects of deregulation

Community bank relief to liberate credit

Since the middle of the 2000s, community banks as a whole have lost significant market share regarding net loans and leases: their share of the total went from 27.8% in 2003Q1 to 20.7% in 2018Q1 as seen in Figure 4. However, the major part of the share loss happened since 2010 and the passing of major financial regulation bills such as the Dodd-Frank Act: this share was still of 26.4% in 2010Q1.

Moreover, community banks have seen their market shares in several lending markets decline heavily, for instance on private real estate or business loans (as shown in Figure 5), which has caused many complications for these banks.

This is why the Economic Growth, Regulatory Relief, and Consumer Protection Act has most strongly targeted the “Main St” banks. Its major amendments will bring relief to banks with less than USD 10bn in assets thanks to the watering down of most of the Dodd-Frank Act, newly accommodative prudential standards as well as lower requirements for mortgage standards and a repeal of the Volcker rule.

We now believe that these measures will strongly help community banks to find back their way towards better times. Indeed, as the qualified mortgage rule will disappear and capital requirements will be reduced overtime, we see community banks managing to regain their total market share on the U.S. lending market back to 2010 levels, right when post-crisis financial regulation was being implemented. We estimate that the return of community banks could strongly boost credit across the country. Indeed, rising from 20.7% to 26.4% of the loan market would liberate up to USD 500bn of additional credit for U.S. customers.

 Considering the rapid decline of community banks, it would take around eight years for these banks to regain their share, which is the time which has passed since the Dodd-Frank regulation bill was voted and signed. Therefore, we estimate the additional credit for one year at slightly over USD 60bn.

The current regulatory burden

The US government has had a very blunt stance on deregulation since President Trump’s arrival in office: the main message is that deregulation burdens growth at all times, because it creates uncertainty and misallocates funding.

As part of a study for the National Association of Manufacturers (NAM), the total cost of Federal regulations to the U.S. economy was estimated in 2012 at ca. USD 2.03tn (or ~ 12% of GDP).

This calculation tries to take in consideration both direct and indirect costs of complying with regulations: performing mandatory operations, hiring compliance officers or alternative use of funds for instance.

We try to see here how government regulation may impact directly on costs and growth to understand how changing the regulatory stance could help the US economy.

Decreased firm investment and policy uncertainty

Both existing regulation and policy uncertainty can be as damageable and dangerous for corporate investment. First, regulation in the product market can be of great help for incumbent producers because it allows them to raise their prices above competitive rates. Regulation and miring “red tape” can be such burdens that they discourage companies to increase their production capacity through investment. In that sense, regulation is dangerous because it can influence the capital-labor distribution by limiting a company’s return on particular inputs. OECD statistics between 1975 and 1998 contribute to the idea that least regulated countries have seen great growth of their investment as share of capital stock while aggressively regulated countries suffer conversely from drastic investment decreases. Finally, uncertainty about future regulations can also be very detrimental to companies. This is particularly significant when such uncertainty is associated with a threshold event – elections for instance. In such cases, firms will tend to delay investment decisions as empirical evidence suggests that both regulation and the prospect of regulation both act as a tax on firm investment.

Cost of Compliance

Regulations can also play a similar role to a tax on production. Indeed, in order to guarantee legal compliance, businesses need to spend additional resources and time on this administrative burden set to diminish production activities. The Council of Economic Advisors (CEA) has shown that US businesses have spent, in 2015 alone, USD 16.8bn on compliance officers’ wages (a +171% increase since 2000). The regulatory burden could also have notable consequences on global corporate financing. Companies tend to abandon the more regulated public capital markets and rather find financing on private markets. Since 1996, the number of publicly listed firms has constantly been on the decline. Research papers tend to explain this continuous decline because of a mix of more important costs and the rise of new, more interesting sources of capital, such as private equity firms.

Regulations as barriers to entry

One of the greatest dangers for regulations, as well-intended as they may be, is how they can work as barriers to entry for other small and novice producers. These barriers generally encourage prices to rise, which in turn causes a decline in output and therefore of investment. Another way for regulation to work as a solid barrier to entry is to implicitly discourage companies through fixed costs. Indeed, strong regulations will prevent new small firms from managing to internalize fixed costs, by forcing them to file registration paperwork, acquire certification or even receive licensure. These practices lead to heavier costs, which are necessarily less bearable for young and small companies than for the already installed big players, which furthermore generally benefit from better and more diverse legal counsel. Such regulations will always tend to decrease competition and therefore increase mark-ups, which is inevitably detrimental to the average consumer.

Distributional Impact

Firstly, the regulatory burden tends to be stronger for low-income households, who spend a greater share of their disposable income on goods like transportation, gasoline, food and health care, which are strongly regulated goods. Another angle through which regulatory measures can also impact income inequalities is entry regulations. Indeed, research has showed that entry regulations may increase the skill mismatch within the US economy, which results in lower wages for such individuals who have been lead to work in fields unrelated to their skills.

Regulatory Delays

Compliance uncertainty over existing and future regulation can considerably impact a business’ capacity to predict future needs. First, a firm may be uncertain as to whether one of its products will actually comply with existing regulation. This generally happens when the details of a current regulation measure are difficult to understand or interpret. Considerable uncertainty also comes from regulatory delay and can negatively impact the firm’s return on investment as well as its innovation programs.

The overall impact of deregulation on growth is ambiguous when taking into account risk

A complete review of literature has led us to understand both major perks to financial liberalization and how it can encourage serious vulnerabilities. Indeed, if financial liberalization will strengthen financial development and contributes to higher long-term growth, it will also encourage greater risk-taking and increase macro-financial volatility, which then tends to cause more frequent crises. This leads to the idea of a trade-off between higher growth and higher crisis risk. Indeed, there are some really consequent benefits to an increased liberalization, such as improved capital allocation and project investment, which in turn boost productive competition. Relaxing credit constraints and broadening global credit access also strongly encourages investment and consumption, as well as it fosters greater competition in industrial sectors, which can help reduce mark-ups and reduce bottlenecks. 

However, this dynamic also brings risks which stem from the continuous boom-bust cyclicality which modern economies continue to experience. The boom phase sees rapid bank credit expansion and some credit risk, which then fosters a decline in bank portfolio quality that can slowly weaken the economy. Such events strongly increase the probability of seeing financial crises take place and correspond to the start of the bust phase, which conduce to a strong negative impact on GDP growth. Moreover, greater financial depth can also have a strong negative impact on income equality and distributional issues, notably in the US. Indeed, as income inequality rises, savings are concentrated at the top of the income distribution and lower income households become more indebted, which in turn increases the risk of financial instability. Globally, we see a rising share of economists questioning a risk of “too much finance” in advanced economies, while the trade-off between growth and financial crises is still positive for middle-income countries.

Financial deregulation will also boost global risk

Small banks are the big winners but they already take on more risks

Community banks (less than USD 10bn in assets) have undergone complicated times since the Great Recession. Indeed, the industry’s momentum is rather deceiving, with approximately 1500 fewer community banks in the U.S. since 2009.2 Moreover, there are strong pressures and the market competition has been quickly increasing. Small banks have started to face enhanced competition from financial technology companies as well as from major banking companies. These institutions have been trying to develop more online and mobile banking services, in order to increase their deposit market share. The goal behind such moves is to create new consumer and commercial lending opportunities.

Moreover, stricter regulations imposed on banks since the Great Recession have strongly impacted community banks as well, despite targeting in priority globally systemic banks (G-SIBs). The Dodd-Frank Act and the most recent Basel accords have mostly been designated as the scapegoats to the small banks’ recent difficulties. The qualified mortgage rule in particular was created to engage banks in maintaining higher lending standards, with banks being asked to guarantee a borrower’s ability to repay the loan. The legal costs associated with more stringent regulation represent a larger share of revenue than for large institutions.

Resulting from these burdens which are difficult to tackle for small actors, the market share of community banks in the credit market has declined from 40 % in 1994 to 20% in 2015. Dodd-Frank has been an aggravating factor in this trend as their share in commercial banking assets has declined at a double rate compared with prior to 2Q10. Today, community banks have a total market share of 18%, 20% for real estate loans, 10% for corporate loans, 50% for loans to SMEs and 70% for agricultural loans.

The Economic Growth, Regulatory Relief, and Consumer Protection Act, despite being watered down compared to the original GOP-written version, represents very good news for small banks. One of the rare middle grounds between Democrats and Republicans over the bill was how the Dodd-Frank Act unfairly harmed small lenders – or community banks – when rather trying to solve systemic banks’ issues.

In this rare bi-partisan atmosphere, small banks have already anticipated an easing of regulation in their favor as they have distributed credits and securitized them at a quicker pace compared with large banks, as shown in Figures 6 & 7.

The pace of credit distribution is rather high and risky segments where small banks have a leadership position, i.e. agricultural loans (see Figure 8) and commercial real estate could entail a significant amount of risk. The agricultural sector is a likely candidate to suffer retaliation by foreign countries following recent US protectionist initiatives.

More importantly, a high level of risk concentration is present in community banks in relation to commercial real estate.

The GAO (US Government Accountability Office) has estimated that while the commercial real estate (CRE) default rates are at record low, community banks have aggressively developed their activity in this area.

In 2017, close to 500 community banks had assets in commercial real estate representing more than 300% of their capital.

Numerous risk management practices were observed in a 41 banks sample of banks largely exposed to CRE. The GAO expects a rapid increase of charge-off rate in this segment over the two coming years.

Shadow banking, a hidden risk behind deregulation

Non-bank financing can provide an interesting alternative to bank lending as well as encourage economic activity. Indeed, it can provide a new source of credit supply and represent a healthy competition for the banking industry.

Nonetheless, this financing can also prefigure of increased systemic risk if it involves additional banking activities such as creating leverage and transforming maturity and liquidity, both directly and through its interconnectedness with the traditional banking system.

We adopt the Financial Stability Board’s (FSB) approach in defining shadow banking. 

All measures of bank and non-bank credit used in this paper come from the publicly available BIS long series database on private non-financial sector credit; the measures cover all loans and debt securities to non-financial corporations, households and non-profit institutions serving households.

In order to successfully estimate non-bank credit and guarantee potential comparison between different countries, we subtract bank credit from total credit, with bank credit defined as all loans and debt securities held by domestic banks.

This allows us to consider a measure encompassing loans provided, and debt securities held, by all other sectors of the economy, such as pension funds, investment funds, insurance companies or households.

This measure includes direct cross-border lending by foreign banks, which should be removed from the calculation.

However, official non-resident bank credit figures are very small - less than 3% of GDP in average, with Luxembourg and Ireland strongly pushing the average up, at 103% and 30% respectively – and for such reasons we have decided to omit this component from our shadow banking data computing.

The U.S. situation

The size of non-bank credit is very different from one jurisdiction to another though some trends do come out when analyzing data: shadow banking is more important in advanced economies than in emerging market economies.

The large size of non-bank credit in certain advanced economies in comparison with emerging economies is in part due to captive financial institutions and money lenders.

Indeed, shadow banking in emerging economies generally does not involve complex and opaque chains of intermediation like it in advanced economies.

We can see strong similarities within advanced economies as seen in the following figure: major EU economies have all experienced a consequent surge of shadow banking activities since the 1980s.

However, there is a great difference between the UK and the three other countries.

The UK, a more strongly financialized economy like the U.S., has seen a strong peak of shadow banking activities as a share of GDP in 2008 (97.7% in 4Q08) and a decrease since, just like the American situation.

Separately, we have decided to build a financial deregulation index so as to measure the evolution of this legal framework since the beginning of the 20th century. This index takes several components into account, including branching restrictions, the Glass-Steagall act, interest ceilings, the separation between banks and insurance companies, restrictions on investment opportunities or post-crisis regulations:

i. Branching:

To capture legislative evolution, we use as an indicator the share of the U.S. population who lives in states having removed branching restrictions via mergers and acquisitions. Interstate branching restrictions were first implemented through the McFadden Act in 1927, preventing branching of nationally chartered banks. Before this, the legal framework was vague so we set this component at 0.3 until 1926. The variable slowly increases until reaching 1 (or 100%) in 1999.

ii. Separation of commercial and investment banks:

The Glass-Steagall indicator is a continuous variable ranging from 0 to 1. It is 0 until 1932 and 1 from 1934 to 1986. As the Glass-Steagall Act was relaxed in 1987, 1989, 1997 and finally repealed in 1999 through the Gramm-Leach-Biley Act, so that the indicator comes back to 0 by 2000.

iii. Interest rate ceilings:

Ceilings first appeared in 1933 and were only fully removed after 1980. This means we set the variable at 0 until 1932 and at 1 from 1934 to 1980. Further deregulation came in the following years, at a progressive pace, so our index gradually moves back to 0 between 1980 and 1983.

iv. Separation of banks and insurance companies:

Since 1956 and the Bank Holding Company Act, BHCs are prohibited from engaging in most non-banking activities. It was only repealed in 1999.

v. Post-crisis regulation:

The Great Recession put new financial excesses in the limelight, notably very lax lending conditions or proprietary trading. This fifth component tries to represent the impact of the Dodd-Frank Act and other banking regulation measures which were implemented post-2008.

Once these components have been computed, the U.S. financial deregulation index is given by:

Deregulation = (i) – (ii) – (iii) – (iv) + (v)

Figure 10  Non-bank credit, as % of GDP

Sources: BIS, Euler Hermes

The following figure shows how shadow banking and financial deregulation may possibly be linked, at least in the U.S. Indeed, there seems to be an interesting correlation between the development of non-bank credit in the U.S. and our freshly built financial deregulation index: simple regression analysis returns a coefficient of determination R²=0.90. The more the financial system is being deregulated, the more funding and other various banking activities become, as intermediaries, easier and less expensive for such institutions. Shadow banking companies take advantage of these eased banking conditions and they thrive from the additional exchanges made. This figure shows well how there has barely been any slowing down for non-bank credit within the second half of the century, with the only remarkable decrease appearing since the Great Recession. Since the financial crisis and the considerable amendments which were brought to banking regulation, most importantly through the Dodd-Frank Act, it has been more difficult for almost all banks to maintain their flourishing activities.

The momentum had strongly decreased for a few years but now, especially with the last bill signed within the week, one can expect a new surge of shadow banking activities.

Risks and consequences of shadow banking

The rise in shadow banking activities could be a potential source of risk for the U.S. economy in such times. For instance, shadow banking institutions nearly doubled their share in the mortgage market from 2007 to 2015, up to 50% from 30%.3 This fast and unregulated growth could potentially expose the traditional financial sector to greater risk in the long-term. It stems from the Dodd-Frank Act because of how it restricted community banks’ capacity to lend.

Moreover, most customers who borrow money from these firms have a tendency to be less creditworthy than conventional bank customers. For example, the use of bespoke tranche opportunities offered by shadow banks, which strongly resembles the notorious collateralized debt obligations – or CDOs –

blamed for the last financial crisis, is a strong sign of a possible credit quality deterioration and must be supervised cautiously.

Economic Policy Uncertainty Indices

We also use various indices to try to measure policy-related economic uncertainty. Our goal here was to compare US overall regulation uncertainty with financial regulation uncertainty and see how the spread between them could help picture regulatory momentum in the U.S. These indices have been developed by independent researchers4 and are based on three precise components: the first one quantifies coverage in leading US newspapers of economic uncertainty, the second one indicates how many federal tax code provisions will expire in coming years and the third one reflects disagreement among economic forecasters. All indices are averaged and standardized homogeneously, which allows us to make direct comparisons between two indices or more.

We calculate the difference between both indices as seen below, analogous to a spread calculation as a yield differential between two bonds. The figure shows well how the recent regulatory atmosphere has been rather less concerned with financial regulation than all other types of regulation. The use of media coverage also gives an insight on the informal momentum surrounding legal and economic affairs. We can see that times during which regulation uncertainty has been lower in the financial sector (positive spreads) correspond with periods during which bubbles have inflated leading thereafter to severe crises. We can see that a similar trend has been already visible since at least 5 years prior to the voting of the Economic Growth, Regulatory Relief, and Consumer Protection Act, underlining the dangerousness of the current situation.