Reflections on Dodd-Frank: A Look Back and a Look Forward

The impact of Dodd-Frank—like the U.S. financial industry it regulates—is greater than the sum of its parts. Dodd-Frank seeks to oversee and regulate financial markets as a whole, by increasing regulation of individual companies with the potential to compromise market stability, as well as implementing regulation of certain areas of the financial services sector previously not subject to federal supervision and regulation. Dodd-Frank also addresses consumer protection, through the creation of a new agency with broad consumer protection powers and new rules governing residential mortgage markets.

In comments regarding the impact of this historic legislation, Timothy Geithner, Secretary of the Department of Treasury, noted that “By almost any measure, the U.S. financial system is in much stronger shape” than it was prior to enactment of Dodd-Frank. [1] However, a huge amount of change still lies ahead. In the short run, uncertainty regarding the impact of Dodd- Frank on operations, capital and liquidity levels, costs and revenue, and increased litigation and enforcement risk, will continue to impact strategic decisions and valuations of financial institutions of all types and sizes. The long-term impact of the legislation is uncertain, although it could quite possibly usher in a new era of accelerated consolidation in the financial services industry.

In the articles that follow, we discuss in greater detail what has happened over the past year in key areas addressed by Dodd-Frank, including those noted below. In some of those areas at least the outline of final regulations are clear, but in a number of others the parameters of required rulemaking are still uncertain.

Systemic Oversight Regulation of Bank and Nonbank Financial Institutions

Systemic risk provisions of Dodd-Frank recognize that global financial markets are composed of interrelationships among many different types of companies, including commercial and retail banks, private equity and hedge funds, investment banks, derivative market participants, and insurance companies.

These entities interact through shared corporate ownership, capital investments and transactions that ultimately make up global markets. Dodd-Frank’s comprehensive approach to regulating these markets is embodied in the newly-created Financial Stability Oversight Council, which brings together 15 regulators charged with overseeing disparate parts of the nation’s financial system. All major financial market participants—including bank and nonbank financial companies—face the prospect of increased systemic risk oversight and enhanced prudential standards and regulation.

Nonbank financial companies deemed systemically important will be subject to Federal Reserve supervision and regulation and, together with bank holding companies with assets of $50 billion or more, such systemically important financial institutions (“SIFIs”) will additionally be subject to heightened prudential standards, depending upon the risks they present. Critically important rules to identify and classify SIFIs and set out the enhanced prudential standards to which they will be subject have for the most part not yet been proposed.

Capital

The most important of these heightened prudential standards will likely be requirements for additional capital. Dodd-Frank seeks to address three perceived capital shortcomings evident during the crisis:

• capital ratios were too low, especially at the holding company level;
• banking organizations relied too much on forms of capital other than common equity, which were not able to absorb losses on a going-concern basis during the financial crisis; and
• the current risk-based capital requirements did not fully capture many of the risks incurred by banking organizations.

The U.S. banking regulators have been working to address these issues through U.S. regulations and through the Basel Committee on Banking Supervision. While the capital standards under Dodd-Frank have yet to be finalized, changes will include:

• new standards applicable to SIFIs and thrift holding companies that are comparable to prompt corrective action standards applicable to banks;
• exclusion of certain debt and equity instruments (such as trust preferred securities) as regulatory capital for bank holding companies; and
• annual capital plans, dividend and share buyback limitations, and stress testing for certain bank holding companies.

While the largest U.S. financial institutions have already been subjected to capital stress-testing and forced to hold much stronger cushions against the commitments they make, regulators are considering a possible capital surcharge for SIFIs, to reflect any incremental systemic risk these institutions pose to the system.

Although not fully effective until 2019, regulators and financial institutions also are focused on implementing Basel III, core components of which include: increased use of common stock and retained earnings as regulatory capital; increased capital ratios; improved risk calibration through capture of off-balance sheet and counterparty credit exposures; and imposition of short and long term liquidity ratios.

Orderly Liquidation Authority

In addition to new capital requirements, SIFIs will potentially be subject to a new orderly liquidation authority (rather than traditional bankruptcy proceedings) in the event of their insolvency. This change in liquidation authority has potential implications for creditors and other counterparties, and firms subject to the orderly liquidation authority are required to plan their funerals in advance, by preparing complicated “living wills.”

Regulation of Nonbank Financial Companies: Private Equity, Hedge Funds, Derivatives and Insurance

Regardless of whether they are deemed SIFIs, companies and market participants historically subject to little or no government supervision or regulation—including private equity and hedge funds, and participants in derivatives markets—will be subject to significant new regulation under Dodd-Frank. Private equity and hedge funds face new registration and reporting requirements, as well as Volcker Rule restrictions on the sources of their funds. Derivatives that traditionally traded over-the-counter (not on exchanges) and were not subject to clearing rules will now be subject to enhanced supervision and regulation by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Some of these firms may also face new prohibitions on incentive-based compensation arrangements that are deemed by regulators to be excessive in nature or potentially expose such firms to material financial loss.

For insurance companies, Dodd-Frank creates the Federal Insurance Office within the Treasury Department with powers to monitor industry practices, although general supervisory or regulatory authority over the business of insurance remains with state insurance regulators, and is relatively untouched by Dodd-Frank.

Regulator Changes: Consumer Financial Protection Bureau and Office of Thrift Supervision

The regulatory players have changed, with the creation of one new agency and elimination of another.

• The new Consumer Financial Protection Bureau has broad powers to conduct “principles-based” regulation and enforcement with regard to federal consumer financial protection. Significant questions remain as to how this new agency will use its powers and the roles state attorneys general and regulators will play in enforcing federal laws.
• The Office of Thrift Supervision has been abolished and its functions transferred to other agencies. While the thrift charter remains, the likely imposition of bank holding company-type standards to thrift holding companies and other changes raise questions about the long term future of the thrift charter.

Bank and Thrift Holding Companies

In addition to potential new capital requirements described above, bank and thrift holding companies are subject to a myriad of changes to their core businesses under Dodd-Frank that could affect profits. Key among these are:

• Deposit insurance assessments. The FDIC has substantially altered how deposit insurance assessments will be calculated. These changes will affect all insured depository institutions, but especially large and highly complex institutions, which are expected to bear a greater share of the assessment burden as the FDIC replenishes the Deposit Insurance Fund from historic lows.
• Proprietary trading and securities activities. Several provisions cause bank holding companies to discontinue or divest profitable nonbank activities. The Volcker Rule, for example, requires bank holding companies to discontinue proprietary trading and investments in private equity and hedge funds; and the securities push-out provisions require banks to conduct certain kinds of derivative trading activities in separately capitalized affiliates.
• Debit interchange. According to Federal Reserve estimates, new regulations implementing the debit interchange rate-setting provisions of Dodd-Frank could reduce bank revenues from debit interchange by more than 40%.
• Mortgage markets. New federal mortgage origination standards, such as minimum down payments and ability-to-pay requirements, have the potential to significantly constrict the size of future non-governmental residential mortgage markets.

Mergers and Acquisitions

What effect will these broad-based regulatory changes have on bank mergers and acquisitions? Conventional wisdom has been that Dodd-Frank would push smaller banks towards consolidation, as decreased profitability due to more stringent capital requirements, limitations on business activities, government rate-setting and the costs of increased regulatory burdens drive the need for greater efficiencies. A variety of factors, however, have limited acquisition activity to date, including:

• Lack of certainty as to the costs of regulatory reform, most notably capital requirements.
• Environmental and regulatory emphasis for many institutions on strengthening internal operations, capital levels and asset quality before considering growth through acquisitions.
• Continued general economic uncertainty, which continues to make assets difficult to value with certainty and in many cases contributes, among other factors, to a divergence in price expectations between buyers and sellers.

Ultimately, we expect the downward pressures on profitability resulting from Dodd-Frank will contribute to meaningful consolidation activity in the financial services once the economic and regulatory climate has stabilized.

Litigation and Enforcement

The aftermath of the financial crisis has seen an enormous surge in both private litigation and government enforcement actions, many of which focus on mortgage origination and servicing practices. These levels are not likely to recede in the near future. Portions of Dodd-Frank may lead to more government enforcement actions, including new whistleblower provisions, under which the SEC and the CFTC would potentially offer substantial financial bounties to individuals who provide information concerning any misconduct that falls within their jurisdictions.

Endnotes

[1] Timothy Geithner, A Dodd-Frank Retreat Deserves a Veto, Wall Street Journal, July 20, 2011.
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