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Dodd-Frank's lasting legacy

The views and opinions expressed in this piece are those of the author and do not necessarily represent the views of S&P Global Market Intelligence. Share your thoughts at zachary.fox@spglobal.com.

While President Donald Trump has pledged to do "a big number" on the Dodd-Frank Act, the law's legacy appears firmly entrenched in banking.

Trump's Feb. 3 executive order promised a full-scale review of the legislation and Vice President Mike Pence has vowed that "dismantling Dodd-Frank" will be a top priority.

However, Dodd-Frank has changed how banks do business for at least some time to come. Even if Congress repeals the hundreds of laws Dodd-Frank effectuated — which seems unlikely many bank executives say they will retain systems the law forced them to build. Dodd-Frank Section 165(i) required any bank with more than $10 billion of assets to conduct stress tests.

For some banks, this was no simple task. Stories proliferate among industry consultants about archaic data systems. For years, banks failed to adequately invest in core operations. Mergers would often mean tacking on one bank's system to existing operations, creating a data chain vulnerable to stale or inaccurate data. Consultants have even reported that some data elements were only stored in paper files tucked in an employee's cabinet.

To properly run a stress test, a bank needs to instantly know a lot about its assets and liabilities. It goes well beyond a borrower's credit score or payment performance. Bankers need to know whether the collateral behind their loans is still reliable, whether securities they own leave them vulnerable to interest rate swings, whether depositors are about to flee to a competitor with a better offer — the list could go on for thousands of pages. Indeed, bank stress tests often do.

Many of the largest banks have spent millions on data infrastructure to pass the Dodd-Frank Act Stress Test. The investment, which enables a live look at a bank's operations, is paying immense dividends. An October 2016 study by PricewaterhouseCoopers found stress tests have made American banks safer and more profitable than their European counterparts, which were held to less stringent standards than those required by Dodd-Frank.

The study found American banks were far more likely to embed stress tests in their day-to-day operations. Banks with embedding produced an average return on equity of 8.3%, more than double the return of banks with little embedding. The higher returns came while maintaining larger capital buffers, with an average leverage ratio of 6.2% compared to 5.5% for banks with a low level of stress-test use in daily operations. Banks that focused on stress testing were "better able to assess tactical decisions such as product pricing and portfolio management," the study said.

Executives have taken notice.

"We run 120 stress tests a week," said JPMorgan Chase & Co. CEO Jamie Dimon at a December 2016 conference. Dodd-Frank only requires the bank run two stress tests a year. "If you said to me, if stock markets are down 50% here, credit loss was 20% there, [foreign exchange] spreads were moved by 10%, we could push a button and tell you what the answer would be on today's trading book," Dimon said.

Dimon is no outlier. Rather, it is hard to find a banker who dislikes stress testing. "I'm a big fan of stress testing. I really am," said Citigroup Inc. CFO John Gerspach.

Stress testing is here to stay, no matter what happens to Dodd-Frank. "Particularly stress testing and recognizing where the risks are, those are better practices. … A lot of those would not go away," said U.S. Bancorp CEO Richard Davis. "We're very proud of the stress testing process that we've built ... That's really not going to change because it's really been rolled into fundamentally how we're running the business," said Zions Bancorp. CFO Paul Burdiss.

Lately, analysts have been probing bankers on how regulatory reform might lower expenses. Mike Roffler, CFO of First Republic Bank, went beyond stress tests, saying he does not expect regulatory spending to fall.

"When we think about the future spend rate, what probably happens is the pace of growth moderates," he said, adding: "Fundamentally, a lot of these things have made us safer and stronger. And so, we would continue them."