What if Dodd-Frank and Basel III were to largely go away? Eliminating Dodd-Frank has been a hobbyhorse of Representative Hensarling, the chair of the House Services Committee, for several years and has figured prominently in President Trump’s campaign talking points. But the conventional wisdom has been that any sort of transformational uprooting of the Dodd-Frank and Basel III thicket was unlikely.

That’s what I thought, too. In fact, I have bloviated to that point in the press and on podiums many times. From the moment when everyone’s thinking was refocused that November 9th morning, I had thought that while major disruptions of many things were in the cards, Dodd-Frank and the Basel III architecture really weren’t on the menu. Now I’m starting to wonder. Sure, I still think major retrenchment is not going to happen, but my conviction that it’s impossible is what now gives me pause. Let’s face it, while rarely in doubt, I’m wrong a lot.

So just in case I am wrong, yet again, and some version of repeal or replace happens for Dodd-Frank and Basel III is rejected or slow-walked to death, what might that mean? It’s time to start planning for alternative facts.

Let’s start with what repeal and/or repeal and replace look like. If you are looking for a model of what comprehensive restructuring of Dodd-Frank would look like, there’s no better place to start than with Rep. Hensarling’s Choice Act. The Choice Act, or more formally H.R.5983 – Financial CHOICE Act of 2016, was submitted to the last Congress. It is going to be re-proposed in the current Congress. Choice Act 2.0.

The biggies in Choice for CRE capital formation are:

  • The Off Ramp – The Off Ramp exempts banks that elect to meet higher capital standards from a broad suite of regulations impacting capital, liquidity and many other prudential rule structures. Among these rules are Basel III’s Risk Rating Methodology, Fixed Stable Funding Ratio, Liquidity Coverage Ratio, Fundamental Review of the Trading Book (FRTB) and High Volatility Commercial Real Estate (HVCRE) Rules.
  • The corralling of CFPB. Who could be against consumer protection? Certainly, not this President and therefore the CFPB is not going away, but under the Choice Act, it would be put under congressional supervision and be run on an executive level by a board as opposed to a czar.
  • Small Banks Relief. As a republican report on the Choice Act said, the regulatory burden flowing from Dodd-Frank has not made too big to fail go away, but it did make too small to succeed a threatening reality as smaller banks struggle to even understand and certainly to implement the complexity of rules that have flowed from Dodd-Frank. Under Choice, we would roll back much of the regulatory burden on banks with less than $10 billion in assets (which represents the vast bulk of banks and credit unions in the United States).
  • Ending too big to fail. This would significantly reduce the authority and the scope of responsibility of Financial Stability Oversight Council (FSOC) and transform it into an information sharing institution instead of another power center with the capacity and, of course the urge, to regulate.
  • REINS Act. Materially reduce potential new regulation by applying all new regulations to review under the REINS Act which would subject all new regulations to an ex-post review by Congress. Just as a cherry on top of the sundae, this part of the Choice Act also repeals the so-called Chevron Deference Doctrine by which the courts have given material deference to decisions of the regulators on key issues.
  • Repeal the Volcker Rule. This would once again allow banks to invest in private ventures and to engage in proprietary trading and make market making considerably less risky.
  • Reverse, a picnic basket of Dodd-Frank revered goodies, including risk retention, and a broad swath of intrusive, rule-based, prescriptive prudential supervision.

And if Dodd-Frank is materially scaled back as outlined in the Choice Act or something similar to that, it’s absolutely certain that Basel III will either go away or will be slow-walked or re-invented out of existence. Remember that the Off Ramp would take all of these off the table in the first instance and with the European Central Bank asserting that Basel is an American construct to punish the Europeans (speaking of Alternative Facts), it seems pretty clear that in this alternate universe, if Dodd-Frank goes, then much of Basel goes as well. If Basel goes, all banks and not just the Off Ramp banks, may get relief from Basel III’s capital rules, Net Stable Funding Ratio, Liquidity Coverage Ratio, FRTB, HVCRE. etc.

Look, if some form of the Choice Act actually does pass, my guess is that the Off Ramp is going to be sized to be actually useful. What that means is that many if not most of our major banks, who are the players in the CRE capital markets, are likely to qualify for the Off Ramp and that means that Basel is off the table for those as a starting place. If it plays out that way, you bet we are going to see Basel relief for many, if not most, of our financial institutions.

There’s more here, actually lots more here, and we will have to wait for Choice Act 2.0 and a bit less Choice in Congress to see what all this means, but you get the idea.

So what happens if all these things, or even a large number of these things, occur? Clearly the arc of the story of the American banking system that has been crafted over the past several decades, and certainly over the past 8 years, will change radically. Here’s some of the things we are thinking about here at Dechert:

  • The major banks are going to get their mojo back. We’ve been witnessing something which appears to be a secular rotation of capital formation for commercial real estate from the major banks to the alternate lending marketplace. If capital charges are lightened and the regulatory structure stops picking so many fights, second guess so many business decisions and so many regulatory winners and losers, if it stops advantaging one asset class over the other, the prudentially regulated banks may recapture a portion of the capital formation business that we were all pretty sure was well on its way to have moved out to the shadow banks. Is the secular rotation of the shadow banks over? We don’t think so, but it may have been materially slowed if all these rule changes come to pass.[1]
  • CMBS should be reinvigorated and should be able to grow materially. The single biggest problem facing the CMBS industry right now is probably not risk retention but liquidity. To the extent the proprietary trading rules from Volcker are relaxed and clearer guardrails are built around what is market making and what is not, liquidity should be enhanced and with liquidity the current shrinking CMBS industry should start to reflate. Are we getting back to a $200 billion a year industry? Lovely thought, but I think not. But should we stabilize and begin to grow CMBS again? Likely. And there is a virtuous cycle here. As CMBS volumes grow, the share of CMBS in the Barclays Index grows, some institutional investors are then more willing to buy the sector and investors demand drives supply.
  • Small banks may also find their mojo. This probably will mean that smaller banks will once again seek to grow their CRE loan books (or perhaps more accurately will not continue to worry that they will be forced to shrink those books). Away from the coasts, small banks may again become a more robust competitor to CMBS which has been largely feeding on the abandonment of the middling size bank loan market and secondary and tertiary markets more generally.
  • Corralling CFPB should positively impact multi-family lending. It certainly will empower private label securitization in the resi space and may facilitate the growth of the recent SFR industry.
  • Enhanced legal and regulatory certainty. The rollback of some significant part of Dodd-Frank together with the re-imposition of the REINS Act discipline on future regulatory rulemaking may mean that we have a more stable legal environment in which to conduct business it the years to come and one in which there is more of a positive working relationship between the regulated and the regulators.
  • More will be done for substantive economic reasons and less will be done as a product of the regulatory board game. Oh, let’s be clear – regulations are not going away and I can’t imagine a world in which the words “regulatory arbitrage” will have entirely fall out of fashion, but more substance and less kabuki theater will drive decision making and that has got to be good for capital formation and for the economy writ large (maybe not such much for us lawyers!).

These strike me as alternative facts. It remains hard to believe that Dodd-Frank will be ripped root and branch from American jurisprudence. It’s hard, for instance, to see the risk retention rules brought to us by Dodd-Frank going away after the industry has made enormous investments to prepare itself for risk retention. (Moreover, a significant part of the investor community likes risk retention and risk retention will remain a fact of life in the European Community which remains an important constituency for Wall Street.) While proprietary trading restrictions might be reduced or eliminated so as to return liquidity to the market, it’s sort of hard to see a return to the banking community being entirely free to invest insured deposit funds in private ventures as was done in the past. Will CFPB be somewhat diminished and perhaps domesticated? Maybe but one really can’t be against consumer protection can one? Are all these Basel III rules that are scheduled for implementation over the next few years likely to go away? Again, it seems unlikely but possible, particularly as the Europeans have been complaining that Basel is an American ploy, it probably reduces enthusiasm for Basel III here as well. And let’s not forget that regulatory bloat grows like a grain of sand in an oyster becomes a pearl. Even the littlest bit of sand will eventually a pearl make (and that is admittedly a stressed metaphor and a terrible calumny against pearls, which are really quite lovely). But as soon as the urge to trim abates, the natural, organic, genetically imprinted passion of the regulatory community to regulate will again assert itself. The tide may go out for a bit, but it will most certainly eventually come in.

But in the meantime, the regulatory tide is abating. The devil will be in the details and Choice 2.0 as of February 15 has not been unveiled and God knows what happens when Choice 2.0 and the Trump administration begin to dance. But it’s fair to say that some sort of regulatory relief is in the cards and that regulatory relief should unleash capital formation and increase the supply of debt capital up and down the arc of risk and reward. And we haven’t even mentioned tax reform. That could make a HUGE difference, perhaps dwarfing regulatory change. I got my money on this.

In the meantime, all this sturm und drang whether it leads to material legislative change or not might have a positive impact on the regulated’s relationship with the regulators. Starting now, we may find a more amiable environment for cooperative conversations around the impact of rules, unclarity around the rules, the existence of unintended negative externalities from the rules and the like which could lead to a much more positive working relationship with the regulators. That in and of itself, without anything else happening, would be a fantastic step forward. I for one will be testing that theory here very shortly.