a short presentation on dodd -frank

7/28/2019 A short presentation on Dodd -Frank

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Banking Regulations in U.S.:

Dodd- Frank Wall Street Reform andConsumer Protection Act

Institutions of Financial Stability, November 2012.

Natalia Nekrasova, Ernest Vakhedi,

Gabriel Guedes Alves, Kunwar Aditya Singh

MIAF 2012


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How did we get here.

Review of US financial markets regulation history

Until 1863 US banks were regulated by the states

In 1863 the Office of the Comptroller of the Currency was formed with theauthority to charter, regulate and supervise national banks; In 1913 - the FederalReserve System was formed as a central bank and lender of last resort

1933 - Glass-Steagall Act: separation of commercial and investment bankingbusinesses; and establishment of the Federal Deposit Insurance Corporation (toprovide insurance for deposits in commercial banks)

Aggressive lobbying by financial services system led to a period of ongoingderegulation in the US financial industry starting from the 80s, the restrictions oninvestment activities for commercial banks were being eased. Development ofshadowbanking system

1999 - the Financial Services Modernization Act was signed. Glass-Steagallwas revoked. Financial Holding Companies are allowed

In response to financial crisis following the housing bubble burst in 2007The DoddFrank Wall Street Reform and Consumer Protection Act wassigned into federal law on July 21, 2010


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Main causes of the crisis

Low interest rates, easily obtained credit, little regulation led to excessive borrowing(by all the participants of the market - banks, companies, households).

Failures in risk management: excessive risk taking; wrong risk assessment of thenewly issued assets by financial institutions and rating agencies (due to the calmand flourishing period of 2003-2007: low interest rates, loan default rates, riskspreads and security price volatility)

Systemic risk and too big to fail: big part of the risk was concentrated in a fewgiant financial conglomerates, which were all interconnected. Failure of such aninstitution would threaten financial stability of the whole system. This in its turncreated expectations of bailout with taxpayer money, it did not provide sufficientdiscipline in the markets

Shadow banking sector: created opacity, stimulated leverage and aggressive risk

taking (without perceiving it risky)

Collapse ofmortgage lending standards, irresponsible lending. Banks andmortgage brokers were interested in the volumes, not in the quality of the loans

In the environment of strong competition management compensation schemeswere encouraging to prioritize short term profits over long-term stability


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Relation between the needand the solution

Problems / needs Solutions

Systemic risk, Too

big to fail- Creation of the Financial Stability Oversight Council, Orderly Liquidation

Authority. Volcker Rule.- Establishment of additional prudential standards for systemically important firms- Stress tests

Excessive leverage New capital requirements (Generally Applicable Risk-Based and LeverageCapital Requirements)

Hidden leverage Off balance sheet entities must be taken into account

Excessive risktaking

Volker rule: prohibits proprietary trading, investment in hedge funds and privateequity funds

Restore consumers

confidence

the Consumer Financial Protection Bureau (CFPB), which aim is to ensure

financial protection of consumers; increase financial literacy

Opacity of derivativesecurities

- over-the-counter derivatives will be regulated by the SEC and CFTC- data collection and publication through clearing houses or swap repositoriesetc.

Control overcompensationschemes

- Shareholders are given a Say on Pay- SEC is given the authority to let shareholders nominate Directors etc.

Collapse of lending - Lending institutions are required to ensure the borrowers ability to repay- -


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Addressing Systemic Risk

The Dodd-Frank act created the Financial Stability Oversight Council to serve as anearly warning system identifying systemic risks. The FSOC is composed of ten voting andfive nonvoting members (heads of relevant federal offices and regulatory agencies) andhas the power to recommend specific prudential measures to financial regulators to applyto any activity that the Council identifies as contributing to systemic risk.

The institution has the whole to harmonize prudential standards across agencies and toavoid the regulatory gridlock that was observed during the 2008 crisis.

The FSOC has the power to designate nonbank financial companies and financial marketutilities as systemically important, bringing such companies under regulation by theFederal Reserve.

The Dodd-Frank Act also established, within the Treasury Department, the Office ofFinancial Research (OFR), which is responsible for improving the quality of financial dataavailable to the FSOC. The OFR is vested with the power to gather vast amounts ofinformation from financial market participants and to require standardization of financialinformation to be reported to the OFR and other regulators.

The FSOC and the OFR


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Differently than the in UK or the in EU, where central banks play the center hole as theresponsible for addressing systemic risks issues, in United states the FSOC and the OFRwere created solely for this purpose.

This segregation of powers among the US financial institutions has its roots in the checkand balances system adopted by the American constitution. This is done to keepinstitutions balanced and to prevent one particular institution from ever gaining too muchpower over the others.

In the new regulatory framework, the Federal Reserve will act as the systemic riskregulator and the FDIC will serve as the resolution authority for firms designated by theFSOC. That means that in a sense the FED will loose regulatory power in comparison to

the situation before the establishment of Dodd-Frank.

It is not clear, from a systemic risk regulator perspective, that it is optimal to have severalentities regulating and monitoring financial markets. Each regulatory agency will requestfinancial market participants different type of information. Therefore, there might not exist aentity that takes into account all the existing information available when implementing anew regulation or when assessing the riskiness of a financial institution.

Differences between the US and EU /

UK


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The fact that financial institutions are required to report different type of financialinformation to different regulatory agencies creates a extra cost for banks to comply withthe regulatory environment.

An Example of impasse among different regulatory institutions has recently happened in

the US. The FSOC considered the money market funds industry as systemic importantrequested the SEC (Securities Exchange Commission) to follow guidelines in order toaddress the issue. The problem here is that the SEC commissioners denied to follow theFSOC guidelines, arguing that they were not necessary. As a consequence, the regulationof money market funds has been discussed over a long period and no concrete action hasbeen taken. This issue exemplifies the potential regulatory gridlock that the US might face

in the future.

This system might create conflicts of action among the several regulatory institutions.Each regulatory agency will address the issues which are related to the financial marketsegment that they regulate. Therefore, it might be the case the regulatory actions imposedby one regulatory agency might not take into account its impact on the financial marketsegments regulated by another agencies.

Critics to the US check and balances

system


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Another interesting exercise that might demonstrate the fragility of the US regulatory is toquestion how would the Lehman Brothers failure be addressed today with the newregulatory framework . In the words of the Ben Bernanke: In September 2008, nogovernment agency had sufficient authority to compel Lehman to operate in a safe and

sound manner and in a way that did not pose dangers to the broader financial system.How would this situation would be addressed today?

On one hand, with the creation of the FSOC, there is a government agency that in theoryhave sufficient authority to address any issue regarding systemic important institutions.

The issue, however, is whether the FSOC has the ability to address this type of issuesquickly or not. As it was exemplified by the recent SEC issue with money markets funds, itmight take a long time until concrete action is taken.

Therefore, one could argue that a Lehman Brothers type of issue would be betteraddressed today, with the use of the FSOC, but the fundamental problem of conflict ofinterest between agencies would still exist.

Critics to the US check and balances

system


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Regulation of Non bankingFinancial Institutions

Nonbank financial companies are companies which are not considered bankholding companies, but which are predominantly engaged in financial activities

Anti-Evasion: even if a company is not considered a non-banking financialcompany, FSOC may decide (based on a number of factors) that its financialactivities should be subject to enhanced standards as I it were a systemicallyimportant non-banking financial company

USFinancial Stability Oversight

Council

EU

European Systemic RiskBoard

UKFinancial Policy

Committee

Mandate Identify US financial stability

risks resulting from ongoingactivities or distress of financialinstitutions Promote market discipline,

eliminating bailout expectations Respond to emerging threats to

US financial stability

Prevent or mitigate

systemic risks to thefinancial system Contribute to smooth

functioning of the internalmarket Ensure sustainable

financial sector economicgrowth

Identify and assess

systemic risks in thefinancial system Selection of the most

appropriate policy tools toaddress systemic risks

Macro-prudential supervision in comparison:


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Consumer Protection Act

Creates a new independent watchdog with the authority to ensureAmerican consumers get the clear, accurate information they need toshop for mortgages, credit cards, and other financial products, andprotect them from hidden fees, abusive terms, and deceptive practices.

Investigative authority, Enforcement authority, Power to issue subpoenas for

records and to compeltestimony that can lead toenforcement actions in

federal court, Authority to write and enforce

new standards for mortgages,credit cards, payday loansand a wide array of otherfinancial products.

The jurisdiction of the bureau

includes: banks,

credit unions,

securities firms,

payday lenders,

mortgage-servicing operations,

foreclosure relief services,

debt collectors,

money transfer agencies and

other financial companies.


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Formed on 21.07.2011

CFPB is an independent unit located inside and funded by the Fed (The Fed is prohibited frominterfering with matters before the Director, directing any employee of the Bureau, modifying the

functions and responsibilities of the Bureau or impeding an order of the Bureau.) CFPB has centralized structure, unlike SEC and FDIC, which have executive boards. This raises

political issues, as Republicans oppose such a structure and has already on one occasion hinderthe nomination of the Director of CFPB.

Main advantages (I)

Independent Budget.

Independent Rule Writing. Examination and Enforcement: Authority to examine and enforce regulations for banks and credit

unions with assets of over $10 billion and all mortgage-related businesses, payday lenders, andstudent lenders as well as other non-bank financial companies that are large, such as debtcollectors and consumer reporting agencies. Banks and Credit Unions with assets of $10 billion orless will be examined for consumer complaints by the appropriate regulator.

Consumer Financial Protection Bureau


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Main advantages (II)

Consumer Protections: Oversees the enforcement of federal laws intended to ensure the fair,equitable and nondiscriminatory access to credit for individuals and communities.

Able to Act Fast. Educates: Creates a new Office of Financial Literacy.

Consumer Hotline.

Accountability.

Works with Bank Regulators: Coordinates with other regulators when examining banks to preventundue regulatory burden. Consults with regulators before a proposal is issued and regulators couldappeal regulations they believe would put the safety and soundness of the banking system or thestability of the financial system at risk.

Clearly Defined Oversight: Protects small business from unintentionally being regulated by theCFPB, excluding businesses that meet certain standards.

Consumer Financial Protection Bureau


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Regulatory Arbitrage

With so much global financial trading activity passing via the US, theeffects of the act will be felt worldwide.

Some describe Dodd Frank as Dodd Franc, i.e. of great benefit to

Swiss banks. Many a sell-side paper has speculated on the uptick inproprietary trading activity that UBS and Credit Suisse in particularwould encounter if Dodd Frank was rushed through as is.

The SEC staff has encouraged international securities regulators thatare contemplating OTC derivatives market reforms to use the Dodd-Frank Act and its regulations as a model for developing robust andcomplementary regulatory regimes.

Because the OTC derivative marketplace already exists as afunctioning global market with limited oversight or regulation,international coordination is needed to limit opportunities for cross-border regulatory arbitrage and competitive disadvantages.


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A comparison of Title VII of Dodd-Frank and the relatively similar EuropeanUnion proposal for OTC derivatives regulation, known as the EuropeanMarket Infrastructure Regulation (EMIR), reveals that even slight variationscan have a significant effect on the risk for regulatory arbitrage andcompetitive imbalance for U.S. based financial institutions competing in theglobal marketplace.

If U.S. commercial banks subject to the Swaps Push-Out Rule do not ceasetheir nonexempt swaps activity altogether, these institutions must either:

(1) divide their swaps activity between exempt and non-exempt swaps and push the non-exempt swaps into anaffiliated entity; or

(2) push the entire swaps business into an affiliated entity.

Irrespective of which organizational structure is embraced by banks impactedby the Swaps Push-Out Rule, the swaps customers will now be engaging inswaps transactions with smaller, less capitalized institutions.


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Another example of a direct competitive imbalance that U.S.-based firmsaffected by the Title VII might encounter is the application of a highermargin requirement for non-U.S. swaps transactions compared to themargin requirement applicable to foreign competitors in the local jurisdiction.

Although the EMIR proposal also contemplates margin requirements forcentrally cleared derivatives transactions and swap entities participating innon-cleared swaps, there is currently no guarantee that the marginrequirements will be equally stringent.

An attractive solution to the competitive imbalance and risk concentration

threats posed by regulatory arbitrage is ensuring that material EU and U.S.derivatives regulations are harmonized. Although the end result ofinternational harmonization efforts hangs in the balance, it is clear thatremoving the attendant risks of regulatory arbitrage will be integral to thesuccess of Title VII and the long-term health of the U.S. financial servicesindustry and the U.S. economy as a whole.


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Orderly Liquidation Authority

Prior to Dodd-Frank, the FDIC authorities were limited to only federallyinsured banks and insured institutions. There was no authority to placethe holding company or the affiliates of an insured institution or anyother non-bank financial company into an FDIC receivership to avoidsystemic consequences.

Dodd-Frank proposes to create a new mechanism for orderlyliquidation of certain bank holdings, companies engaged in financialactivities and systemically non banking financial institutions.

Intended to eliminate the taxpayer bailout for the companies that aretoo big to fail by providing FDIC with the tools necessary to conduct anorderly liquidation of important non bank financial companies.

It is expected that the Liquidation Authority will be used only in verylimited circumstances with the Bankruptcy code remaining the primarymechanism for resolving the non bank financial companies.


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Volcker Rule

The Volcker Rule prohibits an insured depositoryinstitution and its affiliates from:

engaging in proprietary trading;

acquiring or retaining any equity, partnership, or otherownership interest in a hedge fund or private equity fund; and

sponsoring a hedge fund or a private equity fund


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Volcker Rule Aim

Reduce the use of insured deposits to fund more risky activities.

Prohibits bank holding companies from holding any investmentbank, which in a way is similar to Glass-Steagall Act.

Rejects the concept of universal banking attempt to revert tomore conventional banking model.

Hampers the creation of too big to fail banks.

Importantly, tries to curb the systemic risk.

Manage the conflict of interest.


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Capital, Liquidity andLeverage Requirements

All bank holding companies with more that $50 billion asset are deemed as systematicallyimportant institutions and responsibility of supervisory will lie with Fed.

These institution will subject to heightened capital. Liquidity and other prudential standards, risk-management requirements, concentration limits for credit exposure to customers, and will havean obligation to prepare living will as well undergo periodic stress tests.

For an insurance company designated as systemically significant non-bank financial company, itwill have a federal regulator, the FRB.

These companies will have to take permission from the regulator to merge or regulator can alsocompel these companies to divest.

Strict imposition of 15:1 debt to equity leverage ratio.

Non financial company will be permitted to merge with or otherwise acquire another if theconsolidated liabilities of the combined company would exceed 10% of the total financialconsolidated liabilities of all financial companies , or otherwise approved by FRB.


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Capital, Liquidity andLeverage Requirements

All bank holding companies with more that $50 billion asset are deemed as systematicallyimportant institutions and responsibility of supervisory will lie with Fed.

These institution will subject to heightened capital. Liquidity and other prudential standards, risk-management requirements, concentration limits for credit exposure to customers, and will havean obligation to prepare living will as well undergo periodic stress tests.

For an insurance company designated as systemically significant non-bank financial company, itwill have a federal regulator, the FRB.

These companies will have to take permission from the regulator to merge or regulator can alsocompel these companies to divest.

Strict imposition of 15:1 debt to equity leverage ratio.

Non financial company will be permitted to merge with or otherwise acquire another if theconsolidated liabilities of the combined company would exceed 10% of the total financialconsolidated liabilities of all financial companies , or otherwise approved by FRB.


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Will this be the last crisis? (3)

It is very hard to say that Dodd-Frank is going to the last crisis. Butone thing is certain that this regulation does aim to curtail thesystemic risk and excessive risk taking along with theextraordinary levels of leverage that has led to the present crisis.

Also, the Act also reflects the intention of the policy makers to ringfence the depositors and not to use the taxpayers money to rescueany financial institutions in future.

But having said that, it is hard the pinpoint the source of the nextcrisis and given the further fragmentation of the regulators andpossible regulatory arbitrage possibilities, it will perhaps beharder to deal with the crisis, if it occurs, in timely manner.

a short presentation on dodd -frank

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