Dodd-Frank exchanges - Jonathan Watson

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The global financial crisis has caused a flood of banking regulations, emanating from the US and elsewhere. Are the banks right to push back?

The so-called ‘Volcker rule’ is due to come into force in the US by 21 July 2012. Named after Paul Volcker, a former chairman of the Federal Reserve, it is designed to reduce banks’ ability to take excessive risks by prohibiting them from trading for their own account, or making significant investments in hedge funds or private equity firms. It is one of the large number of reforms included in the Dodd-Frank Act, which was signed into law by President Obama in July 2010 as a response to the financial crisis.

There’s just one small problem – the regulators whose job it is to implement the rule won’t have finished drafting it by July. ‘It is widely accepted that there will be no final regulation on the substance of the Volcker rule by the time the rule comes into effect,’ says Margaret Tahyar, a partner at Davis Polk & Wardwell, a member of the firm’s Financial Institutions Group and former Co-Chair of the IBA Securities Law Committee. ‘It’s a little odd. What we have is two layers: the first is the statutory text, which is written in very broad strokes, and the second is the proposed regulation. What we are looking to now is guidance from the regulatory agencies.’

Some guidance did arrive in April when regulators, led by the Federal Reserve, clarified that banks would not have to comply with the rule by July. Although the rule is still due to come into force then, it contains a two-year compliance period, giving banks time to adjust to the new requirements. Ambiguous regulatory language had previously advised banks they had to be in compliance ‘as soon as practicable’ after July, despite the two-year period, but it has now been confirmed that banks will have the full two years to comply.

However, if Republicans hostile to the Dodd-Frank Act do well in general elections due to be held in November 2012, the Volcker rule could be killed before it is even implemented. Mitt Romney, the Republican candidate for the presidential election – also co-founder and head of private equity investment firm, Bain Capital – has pledged to repeal it if elected.

Wall Street fights back
Such uncertainty is typical of the painfully complex and drawn-out process of implementing Dodd-Frank. According to law firm Davis Polk & Wardwell, as of 1 May 2012, only 108 (27.1 per cent) of the 398 total rule-making requirements mandated by the Act had been met with finalised rules, and rules had been proposed that would meet 146 (36.7 per cent) more. Rules had not yet been proposed to meet 144 (36.2 per cent) rule-making requirements.
Part of the reason for this is that legal challenges to the new rules have started to arrive in US courts. Wall Street banks and other financial institutions have brought a range of lawsuits challenging new rules on the basis of an alleged lack of cost/benefit analysis in their drafting.

‘The purpose of regulation is simply to do what we can to make it less likely that past mistakes are repeated’
Roger McCormick
Visiting Professor, London School of Economics; IBA Financial Crisis Task Force

Last year, a US federal appeals court threw out new rules from the Securities and Exchange Commission (SEC) that had been intended to make it easier for shareholders to eject board members at listed companies. Judges sided with the US Chamber of Commerce and the Business Roundtable, an association of CEOs of major US corporations, who had opposed ‘proxy access’ measures that would force companies to bear much of the cost of proposing alternative candidates in boardroom elections.

And in April, two industry groups sued the US Commodity Futures Trading Commission (CFTC) to prevent the implementation of a rule requiring registration by mutual fund advisers. The lawsuit, filed by the Investment Company Institute and the US Chamber of Commerce, claimed that requiring advisers to mutual funds and other investment firms involved in commodity trading to register with the CFTC represented a reversal of a previous agency position and that the change had not been sufficiently explained to the public. The lawsuit alleged that the agency had failed to weigh the costs of the proposed regulation against its anticipated benefits.

Further challenges are pending from the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association, which lobby on behalf of derivatives traders including JP Morgan, Goldman Sachs and Morgan Stanley.

However, the enormous scope of Dodd-Frank means that it probably would have taken a long time to implement even without any legal challenges. An initial assessment of the legislation by Davis Polk concluded that it amounted to ‘the greatest legislative change to financial supervision since the 1930s’ and that it would affect every financial institution that operates in the US, many that operate from outside the US, and would also have a significant effect on commercial companies.

‘There’s a lot of very good policy in Dodd-Frank,’ says Tahyar. ‘But it is not a statute that does things. It issues a series of instructions to the regulators to do things. It’s a framework document.’

She believes that the key challenge is the ‘impossible and uncoordinated’ deadlines set by Congress when the legislation was enacted. ‘There was a complete lack of reality around those deadlines and a complete lack of thoughtfulness on how things might be put together over time,’ she says. ‘It’s only to be expected that those organisations who are having to live under or be involved in the process of building this new infrastructure are commenting heavily on the regulations and care deeply about them.’ Over 16,000 comments were sent to the SEC on the proposed Volcker rule, for example – although many of these were form letters.

‘I can’t really see why the taxpayer should be standing behind investment banking in the same way that it does behind retail banking’
Roger McCormick

Taking the time to get things right and refusing to erect a sloppy system are more important than sticking to arbitrary deadlines, Tahyar argues. ‘This is a huge new infrastructure build,’ she says. ‘It’s worthwhile taking some time to do it and in many ways the regulators are wise to do that’, she adds: ‘a delay of several months or a year when you’re putting together a system for 50 years does not really matter.’

Rage against the machine
The sheer scale of Dodd-Frank is difficult for the non-specialist to grasp. ‘The regulatory reform in the US is so comprehensive that we have divided it up among ourselves just to survive’, says Randall Guynn, head of the Financial Institutions Group at Davis Polk and a member of the IBA’s financial crisis task force. Guynn has advised the six largest US banks on the impact of the Act.

The Dodd-Frank Wall Street Reform and Consumer Protection Act: key aspects

The Act:

  • Creates Financial Stability Oversight Council to oversee financial institutions. Its purpose is to identify risks to US financial stability that may arise from ongoing activities of large, interconnected financial companies as well as from outside the financial services marketplace; eliminate expectations of government bailouts; and respond to emerging threats to financial stability.
  • Overhauls existing regulatory system for the financial industry by creating several new regulators and altering the responsibilities of existing ones.
  • Reforms securitisation. Key areas include credit risk retention, required disclosures, representations and warranties.
  • Imposes a comprehensive and far-reaching regulatory regime on derivatives and market participants.
  • Increases investor protection.
  • Overhauls the regulation of credit rating agencies.
  • Introduces Volcker rule prohibiting most proprietary trading by US banks and their affiliates, subject to limited exceptions, and restricting covered institutions from owning, sponsoring or investing in hedge funds or private equity funds.
  • Requires new stock exchange listing standards, mandated resolutions for public company proxy statements, and expanded disclosures for all public companies soliciting proxies or consents.
  • Requires the Financial Stability Oversight Council to make recommendations to the Federal Reserve on establishing heightened prudential standards for risk-based capital, leverage, liquidity and contingent capital.
    Adapted from The Dodd-Frank Act: a cheat sheet, Morrison & Foerster

He feels the regulatory burden in the US is becoming increasingly onerous. ‘The proponents say it is worth it,’ he says. ‘The opponents think the costs far outweigh the benefits, and are particularly concerned that the US is so far ahead of the rest of the world that we are creating a problem for ourselves and for others. At a recent conference that included many top US government officials, the distance was described as a Grand Canyon’.Philip Wood, Special Global Counsel at Allen & Overy and another member of the IBA task force, is one of Dodd-Frank’s harshest critics. ‘A lot of the legislation was one long indignant rant,’ he says. ‘It’s just full of rage.’ In a paper published by Allen & Overy’s Global Law Intelligence Unit and presented at a meeting of the Institute of International Finance, a global association of financial institutions, Wood draws attention to the vast amount of extra work it has created. ‘Just learning all the proposed regulations to be spawned by the Dodd-Frank Act … (likely to be somewhere between 10,000 and 15,000 pages) might well take an ordinary diligent student at least five years, never mind all the other countries which are now equally busy,’ he writes.

According to Wood, we had a financial bubble and it is now producing a legal bubble. ‘Altogether I count at least 1,000 proposals out there in all countries so that if we were to spend ten pages dissecting each of them, this work would run to 10,000 pages, never get written and never get read,’ he says in the paper. ‘People will get totally lost in all this intricate detail.’

Wood finds the content of Dodd-Frank every bit as alarming as the amount of paperwork it is likely to generate. ‘Are the proposals relevant to mitigating the risk of the collapse of banking systems in the future?’ he asks. ‘This seems very doubtful for many of them. The amount of regulatory change which is off-target is huge. It is almost as if the legislators decided to use the opportunity to shoot on sight everybody that they did not like so that we have a sort of wild outbreak of random lawlessness as old scores are settled.’

The politicians who gave their name to the Act are standing by their vision. After The Economist came out in opposition to the Act earlier this year, one of its co-authors, former Connecticut Senator Christopher Dodd, defended the legislation in the publication’s letters page. He argued that nothing short of a comprehensive overhaul of the US regulatory structure would suffice. Repealing the Act would mean ‘returning to a world where taxpayers bail out failing financial firms, predatory lenders and unscrupulous brokers prey on vulnerable homeowners, the public absorbs losses because of Wall Street’s risky behaviour, and regulators are left in the dark, unable to prevent another global financial meltdown’, he said.

Tribal not global
Outside the US, regulators have reacted to the financial crisis in many different ways. Germany, for example, has clamped down on naked short-selling; France is planning a financial transactions tax; and the UK looks as if it will implement the Vickers report and insist on some sort of firewall between investment banking and retail banking, although the details of that have yet to be determined. The coalition government’s most decisive response to date has been to order the abolition of the Financial Services Authority (FSA), parcelling out its areas of responsibility between the Bank of England and the new Financial Conduct Authority and Prudential Regulatory Authority.

While the FSA has undoubtedly earned its share of criticism for the way it has acted (or failed to act) in recent years – in the British satirical magazine Private Eye, it is usually referred to as the ‘Fundamentally Supine Authority’ – many are underwhelmed by the UK’s decision to reform its regulatory structure. ‘The break-up of the FSA is a political move rather than a direct response to the crisis,’ says Roger McCormick, a Visiting Professor at the London School of Economics and another member of the IBA task force. ‘When one looks at the downfall of the major financial institutions in the UK during the crisis, it’s very hard to say this would not have happened if only we’d had a twin peaks regulatory structure as opposed to the universal FSA structure with the tripartite system in the background.’

‘The financial crisis was a worldwide phenomenon,’ says former managing director of the UK Financial Services Authority’s Conduct Business Unit Margaret Cole, speaking during a recent IBA webcast. ‘You couldn’t really correlate what style of regulation, or structure of regulation there was in any particular country, whether it was an integrated regulator like the FSA or a twin peaks regulator like Australia or Canada, you couldn’t definitely say one style of regulation worked and another one didn’t.’

Having said that, McCormick does not think the reform will do any harm, and may even do some good. ‘It’s not a bad thing for the regulator to be shaken out of its complacency, which I had think had set in by 2000,’ he says. ‘Maybe this sort of shake-up will do some good, if only to make regulators less complacent than they had become.’

The Bank of England’s governor, Mervyn King, admitted to this complacency in a recent lecture for BBC Radio 4. ‘With the benefit of hindsight, we should have shouted from the rooftops that a system had been built in which banks were too important to fail, that banks had grown too quickly and borrowed too much, and that so-called ‘light-touch’ regulation hadn’t prevented any of this,’ King lamented.

The drive for a coordinated international approach that characterised the initial regulatory response to the financial crisis has now evaporated, McCormick says. ‘You’re now seeing a lot more “go it alone” initiatives where individual jurisdictions are simply deciding what’s right for them even if others don’t want to follow suit.’

The amount of regulatory change which is off-target is huge. It is almost as if the legislators decided to use the opportunity to shoot on sight everybody that they did not like so that we have a sort of wild outbreak of random lawlessness as old scores are settled.’
Philip Wood
Special Global Counsel, Allen & Overy; IBA Financial Crisis Task Force

Hendrik Haag, a partner in the Frankfurt office of Hengeler Mueller and the chair of the IBA task force, says this is not surprising. ‘I never believed in a coordinated international effort because a lot of regulation is led by national politicians who want to be re-elected by their electorate, which is not international but national,’ he says. ‘So you have this debate about a financial transactions tax, for example, which keeps going back and forth and no one wants to introduce it on their own because it will drive business away from their financial centre. There is common ground in that many agree about the need to take a tougher course with the financial industry but what this means in detail varies from country to country.’

According to Wood, this is a big mistake. ‘Legislators draft narrow national regulatory statutes only for themselves, as if we all lived in solitary prisons,’ he claims. ‘In particular, it makes no sense to break banks into bits corresponding to national boundaries. It ignores our interconnectedness, our interdependence. Tribalism is fine for football: it is not fine for our means of exchange or our banking systems. We are one planet now.’
Outside the US, governments and regulators have been more cautious about restricting the trading of certain kinds of products, McCormick says. ‘If you prohibit naked credit derivatives trading in one country, it will simply move to another country. So it may turn out to be a futile gesture whose only effect is to deprive the government of revenue.’

Although derivatives, securitisations and poor practices by rating agencies do bear a large part of the blame for the crisis, McCormick believes that attempting to do away with them is not the right response. ‘One simply has to accept that these things can be used for good or bad,’ he says. ‘We just have to be rather more rigorous as to how these financial instruments are put together, how they are used and how the risks involved are assessed.’

Protecting future generations
One of the provisions of Dodd-Frank requires large complex companies periodically to submit ‘living wills’ to regulators in the event of financial distress. Haag thinks this is an interesting area. ‘Banks need to have a plan for what happens if they run into difficulties – how they can be broken up easily, who is there to help the people take control of the organisation and how this is all going to happen,’ he says.

Living wills are now a hot topic in Europe as well as the US as they will probably require some financial institutions to change the way they are organised, Haag says. This is because the departments and the various businesses within a bank do not necessarily reflect its corporate structure. ‘In order to make a meaningful separation of the parts of the business that need to continue for the sake of the safety of the system, you need business units that can be easily separated from the rest,’ he says. ‘We don’t have that yet.’

'The Dodd-Frank Act represents the most comprehensive financial regulatory reform measures taken since the Great Depression’ '
The Dodd-Frank Act: a cheat sheet
Morrison & Foerster

Although progress may be slow, tighter control of banks is inevitable as regulators seek to ward off another crisis. McCormick believes this is essential to minimise the risk that will inevitably be posed by future generations. ‘The danger is that in a few years’ time there will be a new generation that thinks things will be different this time and will not learn the lessons of the crisis,’ he says. ‘So we have to have new regulations in place.’

His view is that separating investment banking from retail banking in some way is desirable. ‘I can’t really see why the taxpayer should be standing behind investment banking in the same way that it does behind retail banking,’ he says. Like many others, he also believes that more conservative capital requirements are needed. ‘Those two things get us a long way towards meeting the problems that gave rise to the financial crisis,’ he argues.
However, realistic and prudent levels of capital, while obviously needed, do not stop panic. ‘In the 19th century and even into the 1920s, capital ratios were nearly twice what is now proposed,’ Wood says. ‘That did not stop bank crises, it did not stop the Great Depression.’

Many believe that because the banks behaved so badly in the run-up to the financial crisis, they have no right to complain about having to take their regulatory medicine. It’s only fair that they should be punished for their mistakes. But punishment is not really the purpose of regulatory change. ‘The purpose of regulation is simply to do what we can to make it less likely that past mistakes are repeated,’ McCormick says. ‘Banks are entrepreneurs, and we expect entrepreneurs to take risks. It’s just that if banks get it badly wrong, the results affect everyone, and that’s why they have to be heavily regulated. But the aim should be to correct a system that had got out of balance – not to impose some form of punishment.’




Jonathan Watson is a freelance writer. He can be contacted at

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