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This report contains a correction.

During his campaign, Donald Trump promised a near-dismantling of the Dodd-Frank Act, the core piece of financial reform legislation enacted following the 2007-2008 financial crisis.¹ He doubled down on that promise once in office, vowing to both “do a big number” on and give “a very major haircut” to Dodd-Frank.² In early February, he took the first step in fulfilling this dangerous promise by signing an executive order directing U.S. Secretary of the Treasury Steve Mnuchin to conduct a review of Dodd-Frank.³ Per the executive order, Secretary Mnuchin will present the findings in early June.⁴ While the country waits for President Trump’s plan, it is useful to analyze one prominent way Trump and Congress might choose to gut financial reform—through the Financial CHOICE Act, or FCA.⁵

Introduced in the last Congress by U.S. House of Representatives Financial Services Committee Chairman Jeb Hensarling (R-TX) and expected to be reintroduced in the coming weeks, the Financial CHOICE Act offers a blueprint for how Trump might view these issues. During the presidential campaign, Rep. Hensarling briefed Trump on his ideas regarding financial deregulation and was reportedly on Trump’s short list for treasury secretary.⁶ The FCA would deregulate the financial industry and put the U.S. economy in the same perilous position it was in right before the 2007–2008 financial crisis. The precrisis regime of weak regulation and little oversight created an environment of unchecked financial sector risk and widespread predatory consumer practices, which precipitated the Great Recession and brought the U.S. economy to the brink of collapse. And the argument repeated by President Trump and other advocates of financial deregulatory proposals—that bank lending has been crushed under the weight of financial regulations over the past six years—has been thoroughly debunked by bank lending data.⁷

Before delving into the specifics of the Financial CHOICE Act, it is helpful to put Rep. Hensarling’s deregulatory efforts in context. To justify dismantling financial reform, President Trump and his congressional allies know that they must outline a problem. President Trump argues that the main problem with financial reform is bank lending. He believes that banks are not making enough loans due to the burdens of Dodd-Frank. What is his evidence? Nothing more than anecdotal remarks that his friends cannot get loans.⁸ As Figure 1 demonstrates, a lack of loans is simply not the case. Overall lending and business lending in particular, has increased significantly since the financial crisis and the passage of Dodd-Frank. Moreover, credit card lending, auto lending, and mortgage lending have increased since 2010, when Dodd-Frank was passed.⁹ Bank profits are also higher than ever.¹⁰

Chairman Hensarling makes similar arguments about the perceived unavailability of credit, adding that financial reform has not encouraged economic growth and has hurt community banks.¹¹ Again, the data contradict these charges. Figure 2 highlights the steady economic growth the country experienced under President Barack Obama. And while the scars of the devastating Great Recession remain, the financial reforms put in place to prevent the recurrence of exactly that kind of economic catastrophe have not damaged growth. Indeed, since the end of the financial crisis and the passage of Dodd-Frank, community bank lending and profitability are both up.¹² It is fair to say that the number of community banks has declined over time. This trend, however, started in the 1980s and is caused by economies of scale, technology, and long-running trends toward banking deregulation, as well as other factors—not the 2010 passage of the Dodd-Frank Act.¹³

Hensarling presents his approach as a moderate adjustment to Dodd-Frank, but in reality it is a thorough demolition of financial reform. This report analyzes how Hensarling’s approach erodes the financial stability safeguards that the real economy needs to thrive, from mitigation of systemic risk to financial sector accountability and consumer protection. It also explains how the bill further concentrates—and makes even more unaccountable—economic power in the hands of those that will serve their own interests at the expense of the real economy. Finally, this report details how the FCA eliminates the consumer and investor protections that guard against the predatory financial practices that wreaked havoc on consumers and investors prior to the financial crisis.

It is necessary to note that just about every provision in this report could fit under the rubric of financial stability safeguards. For example, consumer financial protection protects ordinary consumers from abuses and the broader financial system from the proliferation of dangerous consumer loans that can bring down entire firms and markets. Similarly, the Volcker Rule is a key bulwark against the high-risk bets that brought down major firms in 2008, and yet it also aims to reorient large bank trading toward real economy-serving purposes. That this report discusses certain provisions under one section rather than another should not be taken as a substantive comment on the merit or usefulness of the provision to financial stability. The report’s different sections reflect an effort to highlight how the Dodd-Frank Act and financial reform yield a broad array of public benefits. Similarly, this report highlights examples of broader themes in the FCA rather than focusing on minute details: Failure to discuss any particular provision should not be read as a substantive judgment regarding its relative merits.

This report is based on the version of the Financial CHOICE Act released in September 2016, as well as a memo outlining this year’s planned changes to that version.¹⁴ A new version, which may have some further modifications, is expected to be released in the coming weeks.

Financial reform enacted through the Dodd-Frank Act has made a lot of necessary progress since the crisis. U.S. banks have more substantial loss-absorbing capital cushions, increasingly rely on stable sources of funding, undergo rigorous stress testing, and plan for their orderly failure. President Trump’s intent to dismantle these reforms only helps Wall Street’s bottom line—ignoring the memory of every family who lost their home, every worker who lost his or her job, and every consumer who was peddled a toxic financial product.¹⁵

The question remains: What is the problem President Trump and his allies in Congress are trying to solve? Lending is up. Bank profits are up. Consumer credit costs are down. The economy is steadily improving. Yes, much more needs to be done to make the economy work for hard-working Americans, but financial deregulation is not the path to that end.¹⁶ In fact, it is a path toward exactly the opposite: booms and busts that leave taxpayers holding the bag for Wall Street’s excesses, greater concentration of economic power and less accountability for wrongdoing that harms ordinary consumers and investors, and major changes to financial regulation and monetary policy that would damage the real economy. Now that is a problem.

Chairman Hensarling’s Financial CHOICE Act would take a sledgehammer to the vital financial stability reforms established by the Dodd-Frank Wall Street Reform and Consumer Protection Act.¹⁷ Enacted in 2010 following the financial crisis, this law represents the most significant financial sector regulatory reform effort since the Great Depression. Each prong of Dodd-Frank’s financial stability reforms is directly related to clear and unmistakable lessons learned in the financial crisis. The desire to roll back these reforms demonstrates a willful ignorance of those very lessons at best and a malicious disregard at worst. It is clear, however, what the end result of the FCA’s deregulatory efforts would be: returning the financial sector to its boom-and-bust ways at the expense of middle- and lower-class families and workers, as well as the financial stability that the U.S. economy needs to function. It is essential to remember that the financial crisis of 2007­ and 2008 single-handedly destroyed 8.7 million jobs, sent the national unemployment rate to 10 percent, and eliminated 49 percent of the average middle class family’s wealth compared with 2001 levels.¹⁸

The Financial CHOICE Act prescribes a wide range of steps that would jeopardize U.S. financial stability, including:

• Bank deregulation: The FCA allows banks of all sizes to opt out of the vital enhanced prudential standards mandated by the Dodd-Frank Act, such as living wills, liquidity standards, and stress testing, as long as they maintain a 10 percent leverage ratio, a far from sufficient level of capital to justify such drastic deregulation.
• Systemic risk deregulation: The bill repeals the Financial Stability Oversight Council’s, or FSOC’s, ability to plug the holes in financial regulation that invariably emerge over time as companies and markets evolve. The FCA eliminates the process for designating nonbank financial companies—such as American International Group Inc., or AIG—as systemically important, eviscerates FSOC’s budget, ties up its processes, and prevents it from breaking up financial institutions that pose a grave threat to financial stability.
• Fewer orderly shutdowns and more bailouts: The bill also repeals the Orderly Liquidation Authority, or OLA, the legal authority that allows regulators to shut down large, complex banks in an orderly manner, without resorting to a taxpayer bailout.
• Derivatives deregulation: The bill repeals FSOC’s authority to designate financial market utilities as systemically important.
• Willful blindness on insurance: The FCA also merges the Federal Insurance Office with FSOC’s Office of the Independent Member with Insurance Expertise to create a severely weakened insurance office.

Bank deregulation

Under the FCA, even the largest of banks can choose to opt out of some of the most important provisions in the Dodd-Frank Act, namely the enhanced prudential standards mandated by Section 165. If the bank maintains a 10 percent quarterly leverage ratio—which is only a modest increase from the 6 percent to 8 percent leverage ratios the big banks maintain today—then it can choose to opt out of: 1) risk-based capital requirements; 2) liquidity requirements; 3) risk management standards that improve banks’ own internal risk frameworks; 4) resolution plans, also known as living wills, that outline how the bank can be wound down without a bailout if it fails; 5) credit-exposure reporting requirements that help regulators understand how interconnected firms are with the broader financial sector; 6) concentration limits to prevent a bank from becoming too connected to other financial companies; 7) contingent capital requirements that enable the conversion of debt to equity during financial stress to help avoid bailouts; 8) short-term debt limits to prevent banks from loading up on debt that could run during a time of stress; and 9) enhanced public disclosures that help the market better evaluate the health of firms and the competence of management.²²

While some financial reformers have argued vigorously for a more aggressive leverage ratio—that is, a higher level of loss-absorbing common equity, as opposed to debt, relative to the total size of the bank—the FCA’s approach is unfortunately a sham. The big banks currently maintain equity funding that puts them within striking distance of a 10 percent leverage ratio. But research suggests that the socially optimal leverage ratio—the amount of loss-absorbing equity that a bank would need to be able to withstand losses without shutting down lending, getting a bailout, or engaging in other socially problematic outcomes—is significantly higher than that.²³ It is also unclear how exactly the FCA’s leverage ratio will be calculated—leaving open the possibility that Trump-appointed regulators will use more lenient measures that do not adequately account for many of the off-balance sheet exposures that tore down the financial system during the last financial crisis. Moreover, if an institution that opted out of these vital safety and soundness requirements fell below the 10 percent quarterly leverage ratio, it would have a full year to raise its quarterly leverage ratio back to 10 percent. It would be quite easy for a bank to fluctuate above and below the threshold, restarting the twelve-month clock over and over—gaming the system as they so choose.

But even if bank capital was closer to what they would really need in a crisis, there are other important anti-bailout protections in this important suite of tools. Giving Wall Street the choice to exempt themselves from these enhanced standards would leave multitrillion dollar banks without a solid first line of defense against real world shocks and financial sector mistakes that inevitably will arise. In doing so, the bill puts Main Street jobs and economic growth squarely at risk and puts taxpayers squarely back on the first line of defense.

For example, scrapping risk-based capital in favor of a modest leverage ratio incentivizes banks to load up on riskier assets to maximize profit, as they would no longer be constrained by the risk weighting approach of the Basel III international regulatory framework. Banks would also be exempt from important liquidity rules such as the Liquidity Coverage Ratio and the Net Stable Funding Ratio.²⁴ The former ensures that big banks hold enough liquid assets, such as Treasuries, that they can turn into cash quickly to meet their obligations for a full month during a time of market stress, and the latter makes sure that banks are not relying too heavily on short-term debt, which is less stable and can run during a crisis.

Eliminating these crucial rules disregards some of the most important lessons learned during the financial crisis. Indeed, banks with decent capital positions could be holding risky illiquid assets funded by short-term debt. If the market seizes up and the banks’ short term creditors do not roll over the debt, the bank may all of a sudden be unable to keep itself afloat as it struggles to turn its risky assets into cash to meet its obligations. Struggling to turn the illiquid assets into cash, banks may take massive write-downs as they sell the assets at “fire sale” prices, those well below their real worth, which in turn forces others holding the same assets to take a loss on those assets.²⁵ This type of fire sale was one of the most dangerous negative feedback loops that turned 2008 from a U.S. mortgage and foreclosure crisis into a global financial near-meltdown.

Another first line of defense that the FCA puts on the chopping block is the stress testing that regulators apply to the largest banks every year.²⁶ Regulators test the balance sheets of big banks to make sure they can withstand a severe market downturn without failing and potentially sparking a financial crisis. If a big bank does not pass stress testing, it may be restricted in how much it can return to its shareholders in dividends. The stress tests are particularly useful because they both allow and force regulators to adapt to evolving market conditions and to prevent banks from using window dressing or financial engineering to disguise risk.²⁷ This makes them an important line of defense in addition to capital levels, which are set by regulation.

As if the opt-out were not enough, banks that do not opt out of the Dodd-Frank regulations would undergo severely watered down stress testing.²⁸ Wall Street would love these changes because banks would be able to pay more dividends to their shareholders every year. But those payouts would not take into account whether the money was coming directly at the expense of U.S. financial stability.

Systemic risk deregulation

The FCA also eviscerates the authority and funding of the Financial Stability Oversight Council, a core innovation of financial reform.²⁹ A key lesson from the financial crisis was that there were distinct regulatory blind spots. Regulators did not adequately communicate with one another, and no one regulatory body was tasked with looking at systemic risk across the financial system. FSOC was created to fill in this regulatory gap that had proven so costly during the crisis. It not only serves as a forum for all of the financial regulators to meet, share information across jurisdictions, and discuss risks to U.S. financial stability, but importantly, it has tools to close regulatory gaps in coverage.

In its investigative capacity, FSOC has done excellent work to examine potential systemic risk posed by the asset management industry broadly, as well as hedge funds specifically.³⁰ It has also made significant progress as a practical tool for getting the diverse regulatory agencies to work together. If anything, policymakers should consider strengthening FSOC’s ability to coordinate among regulators and ensure rulemakings are fully implemented.

In order to give FSOC the data and research capacity necessary to successfully execute this much-needed role, Dodd-Frank created the Office of Financial Research, or OFR.³¹ The OFR uses a data-driven approach to help FSOC analyze and evaluate potential risks to financial stability. Like FSOC, the OFR brings together thinking and analytics from across markets, enabling it to bridge analytic gaps. The OFR has also played an important role domestically and internationally in bringing regulators into the data age, pushing the use of uniform legal entity identifiers for corporations and other uniform product and transaction identifiers. Data-driven standardization was sorely lacking prior to the financial crisis, meaning that both regulators and market participants were unable to spot the build-up of dangerous risks across or even within complex financial firms. The FCA eliminates the OFR without even attempting to justify the action.

Critically, FSOC was designed not to just be a convening mechanism but also to have the authority to actually plug holes in regulation. The most important of these tools is its ability to designate for Federal Reserve Board supervision those nonbank financial companies, such as insurance companies or hedge funds, that may threaten U.S. financial stability. Once designated, these institutions are subjected to the appropriate enhanced regulation. FSOC has used this authority to ensure strong regulatory oversight over large insurance companies such as AIG, which was a key culprit during the financial crisis; it received the largest government bailout in U.S. history at more than $180 billion.³² The case of AIG and other nonbank financial companies demonstrated that large threats to financial stability can also build up outside of the traditional banking sector. It is vital to have a regulatory body such as FSOC monitor these risks that build in the insurance or asset management sectors and take necessary action accordingly. The CHOICE Act, however, strips FSOC of this crucial authority. FSOC would no longer be able to subject companies such as AIG to enhanced oversight and prudential regulation. The FCA also takes away FSOC’s power to break up a financial institution that poses a grave threat to financial stability—sending precisely the wrong signal about how regulators should monitor and combat systemic risk. This is what the Financial CHOICE Act means for ordinary Americans: less regulation of the biggest threats to the economy, less accountability, and more bailouts.

Fewer orderly shutdowns and more bailouts

In September 2008, regulators faced two awful choices: let a large, complex financial institution fail and exacerbate the crisis or use taxpayer money to bail out the company.³³ The government chose to let Lehman Brothers Holdings Inc. fail and go through bankruptcy, severely worsening the financial crisis. The next day taxpayer money was used to bail out AIG.

Dodd-Frank created a third option, the Orderly Liquidation Authority, in which the Federal Deposit Insurance Corporation can quickly wind down a failing financial institution and charge the financial industry for any costs incurred during the resolution process, taking taxpayers off the hook.³⁴ The CHOICE Act, however, eliminates this third option and replaces it with an insufficient tweak to the bankruptcy code, which would bring the country back to Lehman Brothers-style catastrophes and AIG-style bailouts.

Former Chairman of the Federal Reserve Ben Bernanke recently outlined the reasons why modifications to the bankruptcy code fall short during a crisis and underscored the need to preserve the OLA.³⁵ He argues that financial regulators are better equipped to manage the failure of a complex financial firm during a crisis, compared with a bankruptcy judge that does not have the necessary expertise or familiarity with the financial firm. Moreover, winding down massive financial institutions with sprawling international business lines and legal entities requires coordination between regulators across international jurisdictions—a role that a bankruptcy judge is not situated to fulfill. Bernanke also points out that it is unlikely that during a crisis, a complex financial firm would have access to private financing while in bankruptcy, making OLA’s liquidity role—with the financial industry on the hook for any losses—so important.

At this point, it should be clear that the FCA is the height of folly. It strips regulators of the tools necessary to fight financial crises once they have developed and to wind down failing institutions in an orderly manner to avoid government bailouts.

Derivatives deregulation

Taking the financial regulatory system back to its precrisis condition is a common theme in Hensarling’s Financial CHOICE Act. This theme holds true when analyzing the FCA’s impact on the regulation of financial market utilities, which is a vital component of derivatives regulation. Derivatives, such as futures that are traded on regulated exchanges, and swaps, which prior to Dodd-Frank were unregulated, are both financial contracts that derive their price from an underlying asset. During the financial crisis, unregulated swaps exemplified the reckless, unchecked risk in the financial sector. When used appropriately and under strong regulatory oversight, swaps and futures can help companies hedge against risks such as drought, fuel price changes, and currency fluctuations. When used aggressively in the shadows, however, these financial instruments can help tear down the financial sector.