This week marks the tenth anniversary of the failure of Lehman Brothers, the second major failure of an investment bank in 2008 - after Bear Sterns collapsed earlier in the year and was eventually purchased by JP Morgan Chase for pennies on the dollar.
In the midst of the worst financial crisis in the U.S. since the Great Depression, rumors quickly circulated about which other big banks might be next as systemic risk, especially in derivatives, threatened to overwhelm the entire industry.
A combination of U.S. government intervention in the form of the Troubled Asset Relief Program (TARP), aggressive action by the Federal Reserve in providing unprecedented amounts of liquidity to the financial system and even private investments – like Warren Buffet’s $5B investment in Goldman Sachs during the height of the crisis – prevented any other major failures. Many small and medium-sized banks and lending operations either went completely out of business or were absorbed by larger companies.
Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as simply “Dodd-Frank.” The act was named for the then-Chairman of the Senate Banking Committee Chris Dodd then-Chairman of the House Financial Services Committee, Barney Frank.
The aim of the legislation was to increase oversight of banks and other financial institutions with the goal of evaluating and reducing systemic risk, increasing transparency in derivatives holdings, providing consumer protections in financial products and allowing for the orderly wind-down of bankrupt institutions to prevent contagious effects. The Act also mandated regular stress-tests of financial institutions with more than $10B in assets to determine how they might perform in a range of adverse circumstances.
Most studies conclude that the effect of Dodd-Frank has improved the financial stability of financial institutions and increased consumer protections, although the Act has also been criticized for increasing the administrative burden of compliance on the institutions it intended to regulate. In May of 2018, President Trump signed into law a bill that intended to ease the regulation and reduce the costs of compliance with Dodd-Frank, especially for medium-sized banks and financial companies.
The 2018 law also allows more latitude and reduced reporting requirements for institutions that engage in market-making trades to facilitate customer business.
Measured from the lows in February of 2009, shares of financial stocks, as represented by the Financial Select Sector SPDR ETF (XLF - Free Report) , have increased approximately 450%, reaching levels not seen since before the crisis and slightly beating the 420% return of the S&P 500 over the same period.
How Healthy are the Banks Today?
As compared to the horrific days at the height of the crisis in 2008/2009, financial institutions as a whole are in great shape today. Earnings are at records highs and expectations for higher interest rates in the near-term promise to add fuel to the earnings fire.
Chris Vanderpool, senior analyst at S&P Global Market Intelligence comments, ‘The industry and the big banks are in good shape. Banks are in a healthy capital position, and we haven’t seen any red flags in terms of credit quality.”
In addition to an optimistic earnings picture, the big banks have been passing the stress tests with flying colors. In the most recent round, the results of which were published in June, Bank of America (BAC - Free Report) , Wells Fargo (WFC - Free Report) , Goldman Sachs (GS - Free Report) , Morgan Stanley (MS - Free Report) and JP Morgan Chase (JPM - Free Report) all demonstrated sufficient capital and effective management and risk controls and were approved to distribute earnings to shareholders in the form of dividends and share buybacks.
The only notable failure in the most recent stress tests was Deutsche Bank AG (DB - Free Report) , which has been struggling with a recent credit downgrade, a series of earnings shortfalls and an exodus of executive talent.
Dodd-Frank a Success?
Though it has been unpopular within the financial community, Dodd-Frank seems to have largely achieved its original goals. The financial picture at banking institutions is as good as it has been in more than a decade and banks continue to post increasing revenues and earnings. Industry participants tend to be critical of regulations on their operations, but the recent rollback of some of the more onerous provisions of the act prove that Washington is making an effort to reduce bureaucratic red tape whole preserving protections for individual consumers and the system as a whole.
Though comparisons to 2008 are inevitable - with a booming economy and stock market and general economic optimism, the situation at the nation’s financial institutions almost couldn’t be more different. Banks and lending institutions are on very solid footing. Any prognostications about another banking-related crisis in the near future are almost certainly overblown.
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