I visited the Federal Reserve Bank of St. Louis last week for a discussion among bank CEOs about the Dodd-Frank Wall Street Reform and Consumer Protection Act – aka the financial reform legislation. 

The legislation was a daunting 2,300+ pages with roughly 240 regulatory rules and may increase to as many as 500 rules once all is said and done.  The clear implications of the legislation are higher costs for banks and customers, lower credit availability, and lower industry profits.  Last week’s discussion among local industry experts expounded upon these issues and others.

St. Louis Fed President James Bullard made some opening remarks, but the majority of the discussion was driven by panel members:

   * David Kemper (President and CEO of Commerce Bank)

   * Ronald Kruszewski (Chariman and CEO of Stifel, Nicolaus & Co.)

   * Ernie Chappel (CEO of First National Bank, Vandailia, Ill.)

   * Dr. Anjan Thakor (Professor of Finance at Washington University)

It was clear the panel did not like the legislation in its final form.  Chappel described the legislation as an ugly sweater you receive from a relative.  You don’t like it, but you have it keep it, and you have to wear it.   It is no surprise they feel this way because the legislation treats banks like regulated utilities. 

My summary of the discussion is after the jump.

Perhaps the biggest problem in the eyes of the panel was the unknown problems these new rules will create down the road, a phenomenon referred to as second order effects.   Several panel members warned that the legislation may lead to less credit availability, which in turn would result in lower GDP growth.  Another second order concern the panel shared was that the financial industry will always find a way to innovate around regulation, but this is a bad type of innovation that may cause higher risk in the future. 

This has always been my biggest qualm.  Prescriptive rule-making has limited effectiveness because the next crisis may arise from entirely different issues, some of which could be a result of innovation around these new regulations.  I liked Thakor’s idea of including “sunset provisions” that permit changes to the legislation as financial markets evolve.  This would allow regulators to adapt to changes in the financial markets over time and better prevent risks from new innovations.  Sunset provisions, however, were not included.

The panel expressed disappointment that the legislation did too little to address firms that are seen as “too big to fail.”  In his opening remarks, Bullard said the legislation carried little credibility among market participants and may not gain credibility until a big firm fails.  Kruszewski made several good points on the subject.  He points out that credit ratings would drop five levels for many firms if the market believed big firms would be allowed to fail, yet credit ratings remain high for many risky firms.  Kruszewski notes that having the Fed will identify firms that are “systematically important” distorts the market because it implies they are, in fact, too big to fail.

Almost everyone on the panel agreed that the Consumer Protection Agency was a good idea in theory and that financial education should be the priority of the agency since better consumer knowledge leads to a more efficient and competitive market.  Yet, panel members wanted more clarity for financial institutions in how these rules will be interpreted.  Bullard chimed in that this is important in getting banks to come off the sidelines instead of waiting “two years for the dust to settle” before engaging in lending activities.

Finally, the panel weighed in on interchange fees – the fees firms earn from use of credit and debit cards.  The panel all agreed that it was silly to introduce these regulations because these fees had nothing to do with the crisis.  Kemper explained that banks will need to raise fees on consumers now because card income was so important to the banking industry.  Kemper also talked about the scary precedent the government is taking in setting prices.  Governments haven’t set prices in the past unless there was a monopoly.  There is not a monopoly in this case.  Thakor added that these restrictions are counter-productive as they make banks less profitable and push them to take on more risk to recover lost profits.

Peter Lazaroff, Investment Analyst

www.acrinv.com