Hey, Maybe Bank Regulation Is Working After All

Ben White wrote a piece in Politico yesterday suggesting that bank regulation has been more successful than most of us give it credit for. Goldman Sachs, he said, is a “shell of its former self,” and other big Wall Street banks have been hemmed in by Dodd-Frank and other new trading rules too.

I was skeptical. Still, as I’ve said in the past, the real test is bank profitability. If it goes down, it means the new regulations are doing their job. And it’s going down:

Wall Street’s earnings season has dashed hopes the sector would bounce back from its post-crisis doldrums, with Goldman Sachs posting weak results in fixed income trading and Citigroup missing analysts’ forecasts for the second consecutive quarter.

….There is still little confidence that trading revenues will return to previous levels. To try to prop up return on equity, a favourite gauge of profitability in the sector, banks are cutting bonuses. Goldman reduced its ratio of pay to revenue to 36.9 per cent, a percentage point lower than last year.

Returns are being limited by regulatory action, particularly new requirements to hold more capital. In the latest move, the Office of the Comptroller of the Currency said on Thursday it was raising the standards it expected for risk management at the largest banks.

It’s still early days, so take this as tentative evidence only. The real evidence that bank regulation has been effective will be longer-term signs that we’re truly seeing a de-financialization of the economy, with the finance industry making up a smaller share of GDP than it has in the past. We’ll only know if that’s happening once all the new regs have been in place for a while and the banks have had a good chance to figure out if they can game them. If they can’t, and finance becomes permanently a smaller share of the economy, we’ll be able to say that Dodd-Frank and Basel III were relatively successful. Until then, we’ll have to wait and see.