- Trump’s political process involves repealing the Dodd-Frank Act.
- On a net basis this is good for banks and the economy, as lending is the primary driver for M0 currency expansion.
- If Trump gets elected, I would get incrementally aggressive on large-cap banks and favor JPM within the space.
[EDIT: This article tries to analyze the impact of policies of the presumptive Republican nominee on the banking stocks. We at Amigobulls don't have any political leaning and the opinions expressed are those of author. Please read our full disclaimer.]
Trump could pave the path for repealing Dodd Frank
Anything that can impact the fundamentals or performance of a company is what interests me. And with Donald Trump being the presumptive nominee of the GOP party, I have to wonder how some of his potential policies will affect some of the companies I cover. More specifically, his recent comments on repealing the Dodd Frank Act at his San Jose political rally becomes the forefront of our discussion.
I am not a left-wing or right-wing, but I do have a Trump bias, which is something I’m going to disclose before you continue further.
The challenge with the Dodd-Frank bill is quite large, actually. My greatest source of concern comes from the heightened capital reserve requirements. The panacea to preventing the financial system from falling apart could be the very reason why the economy is not recovering as quickly.
Why this is negatively impacting banks
Prior to the enactment of the Dodd-Frank Act, banks were required to carry 3.5% of core common capital as part of a 50% weighting against mortgage securities and 100% weighting for riskier mortgages. Dodd-Frank Act unravels the money multiplier effect, as it requires banks to carry a higher percentage of shareholder equity excluding preferred equity upon the full phase-in of comprehensive capital analysis and review, which requires banks like JP Morgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) to carry higher core equity of roughly 10.5% or so.
The problem with this is that it diminishes the possibility of banks moving lower in the credit tiers, as prior to Dodd-Frank, the big banks were generally more willing to lend. The issue is a little more convoluted, but deregulation for financial sector stocks is broadly positive with the large cap banks gaining much more upside assuming Trump wins the white house.
The broad economic implications are also positive, as it might spark the necessary tinder to drive substantial economic growth. Generally speaking, money is a function of lending, and the faster banks can lend, the monetary base quickly multiplies. This is driven by the money multiplier function.
Prior to Dodd Frank it was estimated that a bank could retain roughly 3% of client deposits and lend out the remaining 97%, which equates into a 33.33 multiplier, which can be computed by dividing a single dollar by .03. The definition of money multiplier is a little different though because I'm making a comparison of required bank equity as opposed to what the bank can lend as a percentage of client deposits.
So, let’s dive into the gory details
Generally speaking, the required capital ratios net out the banks liabilities from assets, to arrive at core shareholder equity, thus requiring banks to hold onto more shareholder equity in order to lend money. Basically, upon reaching those minimum capital thresholds, banks can lend more, but it requires that a bank hold onto a higher percentage of all profits before returning to conventional banking. It’s hard to make an apple’s-to-apple’s comparison to the bank deposit multiplier, but when looking at JPM’s financial figures, the bank currently has $562.3 billion in client deposits and $445.8 billion in total loans within its consumer banking segment.
This implies that $116.5 billion in client deposits is not being utilized, and the remaining $445.8 billion is lent out, of which JPM backs a decent chunk with its core equity. Basically, the implied money multiplier gets diminished quite significantly, because the bank is holding onto roughly 26.1% of client deposits as a proportion of money getting lent out. This has been the case at a lot of the big banks and many are not lending to those belonging to lower credit tiers.
If JPM’s tendency to shore up capital happened at every bank, we’d be operating a money multiplier effect off of a 26.1% reserve ratio, which implies a 3.8x multiplier. Not good, not for the broader economy, because if we assume banks are underutilizing client assets, I then have to assume deflationary headwinds as inflation is a function of banks propensity to lend as a percentage of all client deposits. Basically, if the big banking franchises reduce lending any further, which will happen upon the full phase-in of capital requirements derived by Basel 3, which is provisioned by the Collin Amendment from the Dodd Frank Act, the monetary base will likely contract.
Source: Federal Reserve
When looking at the money supply, the figures aren’t looking good. Between 2014 and 2016 the bigger banks have acted quickly to deleverage their balance sheets ahead of fully phased-in requirements by 2019. In fact, many of the bigger banks have moved even quicker to reach those minimum capital requirements, so they can return cash back to shareholders.
When looking at financial sector aggregated statistics, the loan/deposit ratio hovers at around 75%, which confirms the observation of JPM’s financial figures, but also industry-wide. If I had to imagine a reason for why CPI metrics aren’t normalizing above 2%, this is probably why.
So, you’d imagine that if banks were to operate at higher capital ratios, that they would continue to add cash to their balance sheet so they can lend more money to consumers, right? Technically, banks can lend more or utilize a lower reserve ratio if they were to hold more cash on the balance sheet. But instead, banks are opting to return any excess above the 10.5% core equity back to shareholders via dividends and share repurchase, which is money not going back into the economy via conventional lending.
This explains why central bank interest rates have had modest impact on lending, and inflation. If banks can’t lend, money can’t multiply, which has nasty implications for inflation. This economic truism can’t be altered even if you’re a Paul Krugman or Janet Yellen in the economist community. Anyone who understands banking, regulation and economics knows that the banks aren’t lending as much to consumers and are retaining deposits at unprecedented rates.
The average credit score is still higher than the prior cycle by a significant margin. Many of the consumers in the United States can’t borrow at a 750 to 760 credit tier (yet this is the average). In other words, tight underwriting standards compounded by regulation that requires higher capital reserves equates into slow consumer loan growth.
Final thoughts and conclusion
I find it highly improbable that consumer banking will make a substantial comeback until the Dodd-Frank Act is removed. While the act favors small banks, it really ignores the reality that much of the banking sector is dominated by large cap franchises. In other words, if you really want an economic recovery you’re likely to get one if Dodd-Frank is repealed.
If Trump wins the White House, the odds are quite high that big banks will do even better. Of the big banks, investors should consider JPMorgan as its core franchise remains strong, and fundamentals will likely drive the stock to $73.93. The entire bank sector may have even more upside though if Trump gets elected for president by year-end. At that point, I may even revise my price target higher. I think every bank analyst is crossing their fingers on this because repealing
I think every bank analyst is crossing their fingers on this because repealing Dodd-Frank would be an even bigger catalyst than low interest rates, asset purchases by the Fed, or other fiscal/monetary policies. If banks lend with fewer restriction, the economy will likely normalize to historical nominal GDP growth rates.
In a future article, I’ll be covering how a Trump's presidency will affect banks in even greater detail.