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And Then There Were Two

May 16, 2016 / Jonathan Holtaway and Jacques Rebibo

As the mania around the U.S. presidential election escalates, let’s be realistic. No matter who is the next President, his or her agenda may be all talk. Congress doesn’t approve every policy presented. The questions are – is there a policy worth Congress’ consideration and which policy might leave a viscerally divided Congress with a thumbs up? This will be particularly true in banking.

Based on gambling websites, Hillary Clinton is the favorite to be the next President. Ms. Clinton hardened her language towards large financial companies in recent months as other candidates used banking as a wedge issue. Her stated policies addressing Wall Street focus mainly on large banks.

“Large financial firms would need to demonstrate to regulators that they can be managed effectively, with appropriate accountability across all of their activities. If firms can’t be managed effectively, regulators would have the explicit statutory authorization to require that they reorganize, downsize, or break apart. And Clinton would appoint regulators who would use both these new authorities and the substantial authorities they already have to hold firms accountable.” (hillaryclinton.com Wall Street Should Work for Main Street Fact Sheet)

These are tough words, but firmly within the trends established by the Obama Administration. There are no red lines or activities deemed out of bounds. Regulatory judgement remains the secret sauce. Ms. Clinton would continue the purgatory imposed by the Obama Administration and a moment of “regulatory mission accomplished” seems remote during a Clinton Presidency.

This could bring about the break-up of one or more large banks. Investors could reasonably conclude after years without significant dividends and a sub-book stock price that Bank of America and Citigroup are simply not viable as constructed.

There would be other potential changes. Ms. Clinton proposes a new tax on large bank liabilities other than deposits and she wants to make sure “holding corporations are accountable when they break the law,” instead of treating penalties as a business expense. She seeks to tighten oversight of executives. The goal is “to shield the country from the risk of financial distress created by the behavior of the monetary giants.”

Despite the activist rhetoric, many of the proposed changes fall to regulatory discretion. The mention of “new authorities” suggests a bill modifying Dodd Frank, which requires bi-partisan support. With no near term crisis, difficult proposals will be deferred and banking’s lack of prominence on Ms. Clinton’s website suggests a lack of urgency. It is not unusual in America politics for difficult, complex issues to be highlighted during an election only to be ignored once real power is assured.

For those hoping for small bank regulatory relief, Ms. Clinton wants people to think she is on their side.

“She called for providing relief to community banks that are being squeezed by regulations that don’t make sense for their size and mission — like endless examinations and paperwork designed for banks that measure their assets in the billions — without harming consumers and without letting up one bit on Wall Street.” (2016 Hillary for America, Roundtable from Cedar Falls, Iowa)

The phraseology isn’t encouraging. Endless examinations and paperwork are murky generalizations. The problem is a regulatory regime that has made the capital rules, reserve allowance rules, consumer compliance rules, currency and foreign transaction rules and strategic planning rules so complex that running a small, entrepreneurial bank has become unprofitable. Banks that fail to comply in one area are suffocated by regulators with no checks or balances on the reasonableness of regulatory requirements. As a result, smaller community banks are disappearing via a sale or merger and no new banks are being formed. A policy to force unmanageable large banks to reorganize, downsize or break apart having as collateral damage the decimation of community banking is perverse.

After much blood-letting, the candidate to face Ms. Clinton in the general election is Donald Trump. Mr. Trump hasn’t made a specific proposal about bank industry structure, although he did say he favors the repeal of Dodd Frank. He says that regulators are running the banks and this has led to the banks not loaning money to people who would create jobs. Mr. Trump has been critical of the Federal Reserve’s interest rate policy saying that excessively low rates penalize those who have been disciplined savers and encourages them to buy into a stock market with excess valuation. (Trump Interview – The Hill, October 2015)

Trump’s limited expressed views on banking are solidly popular ground for the Republican base. Nevertheless, a large enough majority to override a Senate filibuster seems unlikely making a repeal of Dodd Frank impossible. This means the biggest changes Mr. Trump can engineer would likely come through appointments at the regulatory agencies. If Mr. Trump’s views were to carry into those organizations, today’s laws could be applied quite differently.

One of Trump’s specific proposals, though, could be a major material change. In his tax policy, Mr. Trump calls for a reduction in the corporate tax rate to 16%. As a captive, transparent industry, banking is one of the biggest payers of corporate tax.

Lowering the corporate tax rate would open up a cascade of benefits particularly powerful for banks and bank safety. Lower taxes could offset all of the increased costs of regulation added over the last several years. It would raise returns to investors offsetting the impact of higher capital requirements. It would decrease the attractiveness of interest-deductible debt in the bank capital structure and “behavior shaping” taxes like Ms. Clinton’s proposed non-deposit liability assessment could be introduced while still decreasing the overall tax burden.

Lower corporate tax rates would be particularly powerful for community banks forced to compete with tax free credit unions. Higher returns would attract capital. For those banks that pay the full on rate, and most community banks do, it would be a 30% permanent upward shift in their earnings stream.

Before getting too excited, rewriting the tax code is a bi-partisan moment. Conceivably, though, either of the two candidates may seek to lower the corporate tax rate. Ms. Clinton could see its value to the overall economy and use it as a bargaining chip in a grand compromise. The current rate is widely seen as too high to be sustainable in a global economy.

Although Mr. Trump seems pro-bank, he has shown himself to be wily and unpredictable. Dramatic policy changes can wrong-foot the economy for an extended period of time. Economic policy adjustments inevitably create losers and banks would be left holding some of that bag. If Mr. Trump wins through to the Presidency, we suspect markets will have a “show-me” attitude when it comes to ascribing value to his leadership.

Mr. Trump has spoken of dramatic trade adjustments, dramatic immigration adjustments and dramatic interest rate policy adjustments. His bully tactics may be effective in getting Congress to enact changes, creating economic surprises both positive and negative. In his rhetoric Mr. Trump shows little concern for those that would get hurt by major changes, either financially or personally.

One of Ms. Clinton’s voter advantages is the perception of a steady continuation of the current economic policies. Nobody loves the current economy, but everyone knows things are better than six years ago. Aggressive new spending initiatives and pressure on the Fed to raise rates seem unlikely during a Clinton first term. Although adjustments to trade and immigration would be goals for Ms. Clinton, nothing as radical as Mr. Trump’s rhetoric is likely. Although some tax rates, like corporate taxes, might go down, overall taxes will likely be higher during a Clinton Administration and accompanied by slow growth and low interest rates. For community banks this would mean an economy trending in the same direction with tighter net interest margins, marginal growth and grinding regulatory burdens.

The lack of emphasis on banking in candidate web-sites suggests our industry isn’t a tier 1 issue. Even good changes may fall victim to the mentality of not wanting the “other side” to have a policy win. Banking is simply a useful political tool to help the candidates flesh out their portrait to voters.

If Ms. Clinton ascends we expect a grinding regulatory complex to be a constant headwind for the larger banks. In spite of the rhetoric, community banks also are likely to face a difficult regulatory environment. The best returns will be created by consolidation and efficiency with maybe a little growth in the best urban demographics. The commitment of the Board and management to achieving a result for the shareholder will play a major role in community bank investment outcomes.

If Mr. Trump wins through then there will be a shift in bank regulation and at least some change in the corporate tax structure. This may roll back the negativity stemming from the Stress Tests and Living Wills, but there will be legitimate worry and skepticism about how the economy will perform during a Trump Administration. However, if one tries to imagine the country that sends Donald Trump through to the Presidency, then even a divided Congress may find it difficult to impede Mr. Trump’s leadership.

Jonathan Holtaway

Jonathan Holtaway

Jon Holtaway is an expert in the banking sector and has been quoted in national publications such as The Wall Street Journal, The Financial Times and The Washington Post. As a hedge fund manager and former investment banker, he has dedicated his career to investment analysis and building relationships in the banking sector. After spending twelve years with a premier regional investment house, Jon has co-founded two companies and has extensive experience working with wealth management and residential mortgage companies. Jon serves on the board of a publicly-listed community bank holding company, Hawthorn Bancshares ("HWBK"). In his free time, he is a passionate reader and writer. He authored “The Growth Penalty: Unfinished Business, Banking and the American Recovery” in 2013.

Jacques Rebibo

Jacques Rebibo

Mr. Rebibo has been a community bank investor for over 30 years. He entered the banking industry in 1985 when he invested in and joined the board of a de novo bank, Fairfax Bank & Trust. In 1999, Mr. Rebibo was an organizing director and subsequently became Chairman for nine years of Access National Bank, which grew to $3 billion assets before selling in 2018. In 2009, Mr. Rebibo co-founded and was Chairman of 1st Portfolio Holding Corporation, a residential mortgage and wealth management company. 1st Portfolio was sold to WashingtonFirst Bankshares, “WFBI” in 2015.