The collapse of Lehman Brothers in 2008 highlighted how close we came to a global financial collapse during the Great Recession. In response to the near-collapse, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, in order to prevent further bank failures and/or bailouts that eventually fall onto the backs of taxpayers. Dodd-Frank set new requirements and restrictions on banks to keep them sound and able to withstand a future financial shock.
After five years of Dodd-Frank, are banks any safer? This point is arguable, but one recent development gives cause for concern. Standard & Poor's (S&P) downgraded eight of the largest U.S. banks with respect to their non-operating holding company ratings. Those eight banks are as follows: Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), Wells Fargo (NYSE: WFC), Goldman Sachs (NYSE: GS), Bank of New York Mellon Corp (NYSE: BK), and State Street Corp (NYSE: STT). The operating units are not affected by the downgrades, just the holding companies.
S&P's decision was not based directly on the banks themselves but the uncertainty about whether the U.S. government would come to the rescue if banks were threatened by another market meltdown. Given the focus of Dodd-Frank, that is a reasonable concern. Banks must now undergo regular "stress tests" (formally known as the Comprehensive Capital Analysis and Review) to measure their ability to handle certain worst-case market scenarios, with the intent of making sure that the U.S. government does not have to come to their rescue anymore.
During the last stress test in March of 2015, the major U.S. banks all passed. Why are there concerns if that is the case? Because several of the largest banks required revised proposals to meet the criteria, and one was passed conditionally upon submitting an improved plan in September (which it did). All four of those banks are in the above list of the eight.
The Federal Reserve is keeping the pressure on the big banks to retain more capital in reserve, which goes against their interest — cash that a bank has to hold in reserve is not out in the marketplace, earning the bank more money. Lower returns ensue, as do lower profits.
In October 2015, the Fed released a proposed rule for six of the eight banks to hold an extra $120 billion to meet regulatory thresholds that prevent future bailouts or intense market disruptions. At least the Fed has given banks another year to come up with supplementary leverage ratios — a measure of the amount that banks can borrow relative to assets on hand. Effectively, these are caps on the ratio of money loaned out to money held within.
The global view of the banks is not any better. The international Financial Stability Board (FSB) that was formed in the wake of the Lehman Brothers collapse concluded in November that the 30 largest banks in the world might have to raise up to $1.2 trillion by 2022 to prevent future bailouts. That may not be as grim as it sounds, because the goal could potentially be met by managing the risk of the debt. As old riskier debt matures, replace it with less risky "FSB-compliant" debt. Easier said than done, but still possible.
In essence, the banks are less likely to fail because multiple organizations and agencies are keeping them in check. The real worry will be if foes of bank regulation manage to roll back the current checks on the system. Banks will not adequately regulate themselves.
To see what Americans think about bank safety, check out the results of our exclusive survey in an infographic.