The Dodd-Frank Wall Street Reform and Consumer Protection Act, intended to stop banks from taking the kinds of risks that led to the collapse of the financial markets in 2008, turns five on July 21. But U.S. banks, which are subject to thousands of pages of new rules to prevent them from becoming too big to fail, are more globally dominant than ever.
Four of the top five banks by investment banking revenue in the U.S. — JPMorgan Chase & Co., Goldman Sachs Group, Bank of America Merrill Lynch and Citigroup — are also four of the five leaders in the U.K. and Germany, according to Dealogic. Barclays and Deutsche Bank are the only local firms in the top five in those two countries, respectively. In addition, Goldman Sachs ranks in the top five in Japan, Switzerland and Spain, while JPMorgan Chase appears on that short list in Switzerland and Australia. (Euromoney Institutional Investor, Institutional Investor’s parent, owns a minority stake in Dealogic.)
The premise behind Dodd-Frank’s rulemaking was to slim down — and in some cases curtail — banks’ participation in risky transactions like bundling residential and commercial mortgages into securities and proprietary trading of distressed debt and other instruments, activities that contributed to the financial crisis. The act also formalized exactly how a big bank would be dismantled if it failed.
But the Dodd-Frank Act also evolved into a comprehensive set of rules that govern everything from new capital requirements to consumer protection and overseeing how over-the-counter derivatives trade. Although banks have become less active in proprietary and fixed-income trading, for example, asset managers and institutional investors, such as sovereign wealth and corporate and public funds, now play a larger role in capital markets. For one, money managers are directly lending money to small and midsize companies, an area that banks have historically dominated.
These firms aren’t guaranteed by the government, so taxpayers wouldn’t be on the hook if they failed. “Dodd-Frank has encouraged finance to move outside the regulated banking industry,” says Betsy Graseck, a New York–based research analyst who covers large-cap banks for Morgan Stanley. “We do see faster growth in lending and credit extension coming from nonbank financial institutions like private equity shops or peer-to-peer lending.”
Even as lawmakers and regulators continue to refine Dodd-Frank and beef up oversight of banks, the big players are still big. In the first quarter of 2015, JPMorgan Chase was No. 1 in equity and debt capital markets as well as loans, both in the U.S. and globally, according to Dealogic’s Global IB Strategy Review. Goldman was No. 1 in global mergers and acquisitions, leading the business in the U.S., Europe and the Asia-Pacific region. The world’s top five banks were all U.S. institutions, the first time that has happened in the first quarter since 2006.
As with any big investment, banks gain economies of scale when it comes to regulatory and compliance requirements. Larger firms can spread out the cost of policies and procedures over a broader base. “Financial disruption in the banking system and increased regulatory requirements foster consolidation,” says Oliver Ireland, a partner in the Washington office of law firm Morrison & Foerster whose practice focuses on retail financial services and bank regulatory issues. “Bigger banks get bigger.”
As an example of institutions growing when faced with more regulation, Ireland points to Bank of America’s expansion after the savings and loan crisis of the early 1990s. When regulators imposed new rules, BofA bought up smaller banks.
Dodd-Frank has introduced some ups and downs in the markets as banks have stepped back from activities like principal-based fixed-income trading, which requires more capital than before the crisis. “Another implication of Dodd-Frank is there is a little more volatility in the markets, especially in fixed income,” Morgan Stanley’s Graseck notes. “Banks are now acting more as agents than principals due to the Volcker Rule, and as a result dealer inventory is low.” Investors are being forced to hold more cash to account for more-illiquid markets, she adds: “That can be a drag on returns for investors.”
Though it’s been five years since Dodd-Frank was enacted, many of its rules haven’t been fully implemented. Regulators are still phasing in capital and liquidity requirements, for instance, determining a net stable funding ratio and establishing surcharge levels for such things as large-dollar wholesale funding. As a result, Ireland argues, it’s still too early to say if big banks will maintain their dominance.
Bigger banks can better absorb increased compliance costs, but many of the other Dodd-Frank rules affect a bank’s operations and what activities it can engage in. “Banks may not react like they have historically, by getting bigger,” Ireland says. “We have not seen the shakeout from all of Dodd-Frank yet. We have a ways to go before we know how this ends.”
