Does Dodd Frank meet the test of our times?

With financial reform legislation barely a year old, Republican policymakers, urged on by Wall Street's influential figureheads, have been vehemently spinning the yarn of the Dodd Frank Wall Street Reform and Consumer Protection Act (DFA) into new regulatory fabric, trying to ignore the distraction of initiatives to tear up certain aspects of the existing law. They condemn DFA because a vast amount of the rules that put it into effect are yet to be written. Simultaneously they are trying to restrain the control, influence and power of the new Consumer Financial Protection Bureau so as to diminish DFA's authorities by restraining funding and consequently ascertaining less rigorous rules on derivatives trading.

When President Obama signed the DFA into law on July 21 2010, the event was proclaimed as the most comprehensive makeover of financial regulations since the Great Depression of the 1930s. Its 2,315 pages – 10 times longer than Glass Steagall – took around 18 months to produce and have attracted stern criticism from the start. The rules within the DFA call for more stringent liquidity and capital standards, quicker oversight, limitations on certain investments and greater accountability by rating agencies.

However, anti-regulatory Republicans on the House Financial Services Committee are attempting to hinder implementation of several DFA rules which they maintain will hurt the US financial sector. Among those, the Volcker rule, which they believe eradicates proprietary trading by banks for their own accounts and restricts bank investments in hedge funds. The committee states that the law includes “a hastily rewritten derivatives provision that has the potential to do more lasting harm to the US than perhaps anything else in this 2,315-page legislation.” The committee's position on the Volcker rule was as gloomy, saying: “Because no other major European or Asian country has adopted similar restrictions, imposition of these rules on US firms amounts to unilateral disarmament in a highly competitive global marketplace.”

Critical volley
Jamie Dimon, JPMorgan Chase CEO, told the US Chamber of Commerce recently that increased capital requirements intended to protect banks from collapse would “greatly diminish growth” and threaten to “put the nail in the coffin for big American banks.” George Soros, who made billions in international finance and is now considered the 35th wealthiest man in the world, criticised the Dodd-Frank bill, saying: “I can see its failure to address the issues as it was lobbied into incomprehension and inconsistency by special interests of various kinds.” Even former Federal Reserve Chairman Alan Greenspan took a swipe in a recently published FT article, stating that Wall Street under the DFA “may create the largest regulatory-induced market distortion since America's ill-fated imposition of wage and price controls in 1971.”

However, in what seemed the harshest response to critics of financial reforms thus far, Deputy Treasury Secretary Neal S. Wolin said of the Dodd Frank Act: “We will continue to oppose efforts to slow down, weaken or repeal these essential reforms.” Mr Wolin, at an event organised by the Pew Charitable Trusts, hit back at bankers, lawmakers and lobbyists whose aim according to him has been to weaken or delay Dodd Frank's rulemaking.

Targeting the law's critics he questioned whether they had forgotten the damage caused by the financial crisis and the regulatory gaps that facilitated in causing it. “Our response to them remains the same. Regulators have been and are moving quickly but carefully to implement this legislation,” Mr Wolin said.

On the defensive
One by one, Mr Wolin attempted to break down the unrelenting critique he had encountered over the past few months and addressed each in turn.  Among others, he commented on the “pace of reform,” pointing out that some of the critics who demanded quick clarity on Dodd-Frank after the law was passed are now saying that Treasury and regulatory agencies are moving too fast on implementation and are coming out with too much information too swiftly.

He also addressed the critique that “there is a lack of coordination by the regulators,” saying: “Our financial regulatory system is built on the independence of regulators and independent regulators will have different views on complicated issues.” He added: “Dodd-Frank forces regulators to work together to close gaps in regulation and to prevent breakdowns in coordination. We have already worked through the Financial Stability Oversight Council (FSOC) to develop an integrated roadmap for implementation, to coordinate an unprecedented six-agency proposal on risk retention, and to develop unanimous support for recommendations on implementing the Volcker Rule.”

Commenting on increased transparency in the derivatives markets, he said the act will tighten spreads, reduce costs and increase understanding of risks for market participants.

“The critics argue that requiring standardised contracts to be traded on open, transparent markets will harm liquidity. This position ignores the history and the basic structure of our financial system.  The equities market, where stocks are traded publicly and price information is readily available, is one of the most liquid markets in the world, because of, not in spite of, transparency.”

However, despite Wolins' persistence, the act continues to pose numerous issues that are troubling Wall Street. According to leading US lawyers however, there are four key DFA regulatory issues which require close attention:

The Volcker Rule
The Volcker Rule continues to be the focus of much scrutiny and debate. A few financial holding corporations have already taken measures to separate themselves from proprietary trading activity in its purest form. The existing and proposed relationships between banking entities, hedge funds and private equity funds will remain particularly complicated until regulations are in place to implement the substantive provisions of the Volcker Rule. In spite of the ambiguity that remains about the scope of potential exceptions, some organisations have concluded that private equity investment is decidedly non-core to their and have made plans to spin them off.  

Under section 113 of the act, a non-bank financial company may be elected by the FSOC as a systemically important financial institution (SIFI) and become subject to the act's regulation by the Federal Reserve Board (FRB). This includes heightened prudential standards and limitations if the FSOC determines that material financial distress, or the nature, extent, size, concentration, inter-relatedness, or mix of the corporations' conduct could create a threat to the financial stability of the US.  Close attention should be paid by asset managers, insurers, specialty lenders and brokers or dealers to an ongoing proposal by the FRB. It is looking at companies which are “predominately engaged in financial activities,” and has established $50bn or above in total consolidated assets as an asset threshold for non-bank financial companies.

Compensation issues
As part of DFA's compensation-linked reforms, the SEC released for comment proposals to implement section 952, which are terms concerning compensation committees and compensation consultants. The new rule imposes numerous significant executive compensation and corporate governance requirements on public companies. These include shareholder advisory votes on executive compensation and ‘golden parachutes,' heightened independence rules for compensation committee members, mandatory claw-back policies and enhanced executive compensation disclosures.

Participants in the derivatives market and bankers should be watching developments at CFTC, SEC, the FDIC and other banking regulators. The CFTC let loose a flood of proposals designed to regulate – in a thorough manner – the over-the-counter swaps market, while the SEC is trying hard to keep up with its proposals to regulate the security-based swaps market. The Treasury Department, to the delight of many, announced plans to exempt FX derivatives from the new Dodd Frank rules.  However, it is essential that board members keep informed of the probable impact of all of DFA's regulatory developments. The act's derivatives reform is said to bring about an elevated degree of transparency, liability and risk management into the derivatives markets with a greater availability of data.  Questionable however is who will be able to take advantage of it, and how the cost of compliance will impact the effectiveness of the new market dynamic.

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