GOP's Royce Would Restrict Powers Given by Dodd-Frank

Second in a series

WASHINGTON — Unlike other House Republicans, Rep. Ed Royce is not looking to repeal outright the Dodd-Frank regulatory reform law, but the California lawmaker is likely to try and clip its wings.

Royce, widely considered a rising star on the House Financial Services Committee and expected to play a leading role next year if the GOP seizes a House majority, is focused on specific "fixes" he wants to make in the law.

They include dialing back the resolution powers given to the Federal Deposit Insurance Corp., subjugating the new consumer protection agency to the banking regulators and abolishing overleveraging throughout the financial system.

"Any reasonable individual would have to say that, if you pass legislation with 2,300 pages, there are going to be unforeseen consequences," Royce said. "There are going to be side effects that weren't anticipated, and I believe that next year, with a Republican majority in the House, we will have an opportunity to address some of these issues from the standpoint that the Dodd-Frank legislation does not end up derailing job creation."

A longtime credit union industry champion and a chief advocate of legislation to create an optional federal insurance charter, Royce is in line to become the No. 3 Republican on the panel. But he has already stood out for his active role during the regulatory reform conference this summer.

In a sit-down interview with American Banker, Royce walked through his top goals for next year, including revamping Dodd-Frank, reforming the government-sponsored enterprises and rewriting derivatives laws to let farmers and small businesses hedge their risks.

High on his agenda is revisiting how creditors of failed, systemically significant companies are treated in resolution. His chief objection to the new law is language that lets the Federal Deposit Insurance Corp. treat similar creditors differently. (The new law limits that power to keeping essential services going and maximizing asset recoveries, and the FDIC has said it would be used sparingly.)

"The creditors to the largest systemically significant institutions know that their likelihood of being rescued in a liquidation is much higher than the creditors to smaller institutions that would be resolved through bankruptcy," Royce said.

The California Republican said he believes systemically significant companies still enjoy a lower cost of capital because the market continues to see them as too big to fail.

"We have seen situations in which secured creditors have ended up receiving less than politically well-connected allies to the administration," Royce said. "This needs to be addressed."

Royce offered amendments to the conference committee in an attempt to address the issue but was rebuffed by Democrats. He said he hopes a House GOP majority would give him a chance to make another attempt.

He has proposed that the FDIC should be forced to estimate at the outset of a resolution what a creditor would have gotten in bankruptcy, then impose an additional haircut of 20% as a form of insurance against writedowns. After a resolution is complete, the FDIC would have leeway to pay back all or part of the 20% premium.

Royce is not seeking to repeal resolution powers altogether, noting that Republicans tried — and failed — to keep the bankruptcy system in place for systemically important institutions.

"I didn't get into the bankruptcy model because we lost that battle," he said. "Instead, what I was addressing was how to overcompensate within the existing law."

Royce said his proposal would turn around perceptions in the market that creditors of systemically significant companies are likely to receive special treatment.

"As time passes and people look at that amendment, I've been approached by regulators, in one case, and economists who said they think that probably is the only way, if we are going to stick with that model, to adjust it for this propensity of the market to assume that one institution will be bailed out and another won't," he said.

Royce said that, without such steps, systemically significant companies could grow to become as unwieldy as Fannie Mae and Freddie Mac.

"Just as Fannie and Freddie wiped out their competition themselves because of their lower cost of capital … this phenomenon will begin to happen with respect to systemically significant institutions and their competition," he said. "It has to be addressed in some way, or you will see the same result."

Royce's concern about systemically significant companies' continuing to grow unsustainably is connected to his broader belief that the root of the recent financial crisis was excessive overleveraging.

"It is my observation that the primary problem was overleverage in the system and that addressing overleveraging is the basic solution going forward to the type of systemic risk that was created," he said. "If we have the transparency in the system, if the regulators can control the overleveraging, then I think we've minimized the danger of systemic risk in the future."

Like most House GOP members, Royce has little positive to say about the recently enacted financial reform, but he does give it some credit for giving regulators better tools to prevent overleveraging. He said that he is glad there is an attempt to address overleveraging worldwide through Basel III but worries that its slow implementation could put the U.S. at a disadvantage. He pointed to a requirement in the Dodd-Frank law that banks begin phasing out the use of trust-preferred securities as Tier 1 capital well before Basel III's 2019 implementation deadline.

"One of our responsibilities is to make certain that we do not see this drawn out overseas and implemented through 2019, whereas under the legislation that we have before us … you are going to see a relatively swift implementation by the FDIC of the new leverage ratios, potentially within the next 18 months," he said.

The potential competitive impact of Basel III on U.S. banks will be a top issue for the committee next year, Royce said.

"If that is not done, then clearly you run the risk of capital flight to other markets, and that's going to be an issue for the committee," he said. "Congress has to keep its focus on two issues. The first is elevating safety and soundness. And second, making absolutely certain that the capital is available in the system for economic expansion and that we do not impair access to capital both for job creation and for consumers."

But Royce would also like to restrict the Consumer Financial Protection Bureau. The reform law made the agency fully independent, though it is housed under the Federal Reserve Board. As he did during the conference, Royce argues that the bureau does not have to take into account institutions' safety and soundness when writing rules.

"We have had regulators of all political stripes … raise the same concern — that if you separate safety and soundness from consumer protection, what you end up with potentially is the model that we had with the government-sponsored enterprises, in which you had bifurcated regulation," he said.

Up until 2008, regulation of the GSEs was split between the Department of Housing and Urban Development, which oversaw their mission, and the Office of Federal Housing Enterprise Oversight, which supervised their safety and soundness. Many Republicans argue that the GSEs failed in part because of unsustainable housing goals imposed by HUD, which led the GSEs to buy poor-quality loans that later went bad.

"If the Consumer Financial Protection Bureau can trump the safety and soundness regulator, you run the risk of creating the same type of environment that was created with the government-sponsored enterprises in which you created moral hazard in the system," he said. "We need to address giving the regulators for safety and soundness the ability to trump the actions on consumer protection if they threaten safety and soundness. Safety and soundness has to be our fundamental concern."

Royce has taken no position on a GSE bill proposed by Rep. Jeb Hensarling, R-Texas, that would phase out the enterprises by winding down their portfolios and beefing up their capital over five years, which is expected to be the Republicans' starting point if they win control of the House.

But he supports the fundamental reform principles espoused by many in his party, such as fostering the confidence needed for a private mortgage market to take off and eliminating the government's guarantee.

"Our goal must be to get back to a private market, resuscitate the private market with respect to housing finance," he said.

Royce said the transition out of the current broken model for housing finance would take a while but that the market will eventually replace the GSEs.

"Part of the problem is that the GSEs grew so quickly with an implied government guarantee that they eliminated all of their competition. They became the market," he said. "It is now going to take a period of time in order to carefully and thoughtfully work through a solution in which we set parameters so that the [former] types of moral hazard and political intervention do not occur again."

Royce would also like to revisit other elements of Dodd-Frank and pursue legislation where there is a consensus. One obvious area to rewrite, he said, would be the derivatives part of Dodd-Frank to make clear that small businesses like farms and others have the ability to hedge their risks.

"A corrections bill might be necessary to address some of this," he said.

Royce has also long been a lead sponsor of legislation to expand credit union powers, a goal he said he plans to keep pursuing next year. He argued that expanding their ability to make small-business loans, for example, just makes sense, given the recent credit crunch.

"We are in a recession, and this would assist the ability of small businesses to access credit," he said.

Another issue that Royce is strongly identified with, establishing an optional federal insurance charter, remains on his "to-do" list.

Royce said that despite the tricky politics — state insurance commissioners and most small agents are opposed — conversion to a federal insurance model makes compelling market sense and is probably inevitable.

"I've been working on this a long time," he said. "But eventually you reach a paradigm shift where it becomes so obvious from the standpoint of competitiveness as well as lower prices to the consumer, you develop the momentum to make change."