Why Trump's Dodd-Frank replacement is dangerously weak

Among President-elect Donald Trump's many promises is to "dismantle" Dodd-Frank, the sweeping reform of the financial industry signed into law by President Obama in 2010. The most likely route will be the CHOICE Act put together by Rep. Jeb Hensarling (R-Texas), who heads up the House Financial Services Committee. This will be easier said than done, however.

Neither Trump nor the GOP want to be seen as the handmaidens of Wall Street. But Dodd-Frank was the big regulatory response to the 2008 financial crisis. Hensarling tries to thread this needle by offering banks and financial firms a choice: Either put up with Dodd-Frank's massive web of rules or meet a 10-percent capital requirement.

On one side of any bank's balance sheet are its assets: The various financial obligations the bank is owed. On the other side of the balance sheet sits the debt the bank owes others, plus its capital — that's, respectively, the amount of money shareholders have invested in the bank, plus all the profits the bank hasn't sent them yet. A 10-percent capital requirement means a bank's capital has to be at least 10 percent of its assets.

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If a whole bunch of assets suddenly default — like what happened in 2008 — high capital requirements mean the bank has plenty of cash on hand to pay off its own debts. The higher the capital cushion, the logic goes, the higher the bank's chances are of surviving a crisis.

So under the CHOICE Act, if a bank meets that 10-percent threshold, it's exempted from complying with a ton of Dodd-Frank's other regulations.

Now, Dodd-Frank is a massively complex regulatory apparatus, which comes with its own problems. Trading all that complexity in for one big and simple rule that ensures a bank is safe from collapse isn't a crazy idea. But the devil is in the details — particularly those that ensure a bank is safe.

Crises can come at a bank from all sorts of directions. Maybe it underestimated how risky its assets are. (Again, see the 2008 mortgage crisis.) Or maybe a bank owes too much short-term debt and not enough long-term debt. That's why Dodd-Frank attempts to regulate all aspects of a bank's balance sheet. But the CHOICE Act relies on capital requirements as its sole line of defense. In which case, 10 percent isn't anywhere near high enough.

For instance, Neel Kashkari, a Federal Reserve official appointed by Republicans, concluded all banks with more than $250 billion in assets should face a 23.5-percent capital requirement — more than twice Hensarling's threshold. And every major bank — JPMorgan Chase, Wells Fargo, Bank of America, Citigroup, Goldman Sachs, etc — falls well above the $250 billion mark. Furthermore, a handful of those financial giants also qualify as "systemically important" under Dodd-Frank's rules; Kashkari said those banks should face a 38-percent capital requirement.

But the CHOICE Act also does away with the government's ability to determine if any bank is "systemically important."

The whole point of this label is it comes with much stricter regulatory requirements. To avoid facing them no bank wants to become big and complex enough to meet the "systemically important" threshold. That's clearly the effect Kashkari was trying to replicate with a 38-percent capital requirement, which would be so onerous, and make it so hard to be profitable, that banks would likely break themselves up rather than be subject to it.

If you're looking to make the financial system safer while also cutting down on regulatory red tape, putting a hard ceiling on how big banks can get is one worthwhile approach. So far, the CHOICE Act has no way of doing that.

Finally, there's the question of enforcement. Under Hensarling's language, any bank that isn't in compliance with the 10-percent capital requirement has one year to get its act together. That's a long lag time: You could imagine a bank having a whole year in which it's neither complying with the capital requirements or the alternative Dodd-Frank regulations. Then if it does come back into compliance with the capital requirement, it could fall back out again. Wash, rinse, repeat.

Alternatively, if it runs out the year and still fails to meet the capital requirement, regulators have to be willing to bring the hammer down on them. That will be the job of the numerous officials Trump and the GOP will appoint to various agencies. Given the Republicans' ideological predilections, I'm not confident they'll appoint people with the stomach to enforce the rules with serious penalties.

This isn't the end of the problems with the CHOICE Act: It's looking to weaken the Consumer Financial Protection Bureau, and it will be throwing out some regulations like the Volcker Rule entirely, not just as part of the tradeoff with capital requirements. It will also scuttle a host of regulations aimed at community banks, based on the (almost certainly incorrect) assumption that those rules are responsible for smaller banks' demise.

But the idea of allowing banks to choose between Dodd-Franks' regulatory scheme and the 10-percent capital requirement is how the CHOICE Act will be sold. That's how Trump and the GOP will claim they aren't doing Wall Street a favor, but just reining in the financial industry with a simpler and more efficient approach.

Even under the best circumstances, it's not clear that tradeoff is a great idea. But this isn't the best circumstances. At a bare minimum, the CHOICE Act's architects need to go back to the drawing board.