What Dodd-Frank Did and Did Not Accomplish

By Mark W. Olson, Co-Chair; Corporate Risk Advisors, LLC.
July 30, 2010. American Banker

Let’s start by identifying what the bill does not do.

It Does Not End Too-Big-To-Fail

Almost certainly Congress did not end the too-big-to-fail debate. People seem to have forgotten that the same promise of ending too-big-to-fail was made in 1991 with passage on the Prompt Corrective Action sections of the FDIC Improvement Act (FDICIA). But in less than a decade it was clear that the PCA provisions of that bill did not give regulators the tools necessary to address the financial risks of modern financial institutions. Each crisis has its own unique characteristics, and when a legislative solution is aimed at fixing the previous crisis, as is always the case, the fix does not anticipate the characteristics of the next crisis.

But even more fundamentally, size was not the dominant factor in determining which institutions needed to be bailed out during the recent crisis. The dominant variable in 2008 was the impact an institutional failure could have on the capital markets. If Bear Stearns was considered too big to fail, it is difficult to see why Lehman Brothers was not. In fact, many now believe Lehman also should have been saved. This problem is complicated by an increasingly widespread intolerance for market volatility. Prospectively, regulators need to balance the implications of market interconnectedness against our society’s growing intolerance for the kinds of volatility that other nations experience and seemingly weather. A focus on size as a threshold misses the mark and the commonly heard judgment that “A bank that is too big to fail is too big,” is little more than an inane tautology.

It Will Not Ensure That Financial Institutions Will Never Again Be Bailed Out With Taxpayer Dollars

This promise is unlikely to hold up. There are several reasons why. First, all government activities ultimately involve taxpayer dollars, and any financial rescue will involve government intervention. Second, there is an implicit presumption in the construct of the special assessments provision to cover the cost of a rescue that when one failure occurs other fund participants will be sufficiently healthy to provide the funding. But imagine a repeat of our recent crisis, where much of the financial sector is struggling financially; imposing a levy on the rest of the industry to fund that bailout could imperil the health of the entire sector. Even in an environment of healthy financial institutions, assessments on business will be, in part, passed on to the consumer. Other than indirect taxpayer dollars, there are no other viable funding alternatives.

The Glass Steagall Act Was Not “Reinstated”

Of all the claims, this one is perhaps the most puzzling. Most of the Glass Steagall provisions have been unchanged since passage in 1933. In 1999, the Gramm-Leach-Bliley Act repealed two sections of Glass Steagall, which then allowed banking, insurance underwriting and securities activities to co-exist in separate subsidiaries of the same financial holding company. But restrictions on the banking industry’s ability to mix banking and securities activities are unchanged since the original legislation was passed. Yet even the New York Times has occasionally expressed the belief that “repeal of Glass Steagall” was a contributor to our current financial condition. Importantly, no new authority granted in 1999 contributed to the collateralized mortgage debacle of the last few years. The ability to originate mortgages including subprime mortages, securitize pools of mortgages, and sell those securitized pools into the secondary market has been a common banking practice for decades.

So what did get accomplished in this bill?

When analyzing any new financial legislation, it is always instructive to review the crisis or perceived crisis that inspired the legislation. In our recent experience the factors have included abuses in mortgage underwriting fueled by historically low interest rates, massive pools of liquidity, and dramatic expansion of a secondary market for mortgage products. The crisis was exacerbated by massive mispricing of market and credit risks, complicit rating agencies, and narrowly focused or inattentive regulators. Not content with the investment options available, Wall Street created derivative and synthetic financial products which in some cases mitigated and in other cases magnified risk exposures. All of this occurred at a time when the equity markets were not providing appealing alternatives. As a net result, historically large numbers of people were saddled with financial commitments they did not understand and could not satisfy. As a consequence, financial institutions suffered major losses and many failed. Finally, all this was conducted during a period when expansion of home financing to previously underserved markets was being encouraged and rewarded by federal policy makers. In 2000 pages, the bill manages to address all the above – except for the final point.

Have the Factors Causing the Crisis Been Fully Addressed By the Legislation?

Predictably, an important if not primary focus of the bill was to ensure an improved regulatory environment for consumers. That was addressed through the creation of a new bureau that centralizes and elevates the focus on consumer issues. It will consolidate the responsibilities of existing agencies, be headed by a new Chair appointed by the President and confirmed by the Senate. Rather than being funded like most government agencies through the Congressional appropriation funding process, it will enjoy a dedicated funding source from a portion of the Federal Reserve System’s revenue flow. As a new entity with new leadership, it will be energized to fulfill what it believes to be its mandate to be a better consumer watchdog. This undoubtedly will be the most carefully watched new part of the legislation, and the leadership selection process will be carefully vetted.

The bill also addresses the limitation of regulation outside of insured financial institutions by expanding the coverage of the agency to include non-bank providers of retail financial products. Most banks will welcome this extension of authority as bankers largely believe that the primary abuses in mortgage underwriting and pricing occurred in the lesser regulated segments of the marketplace.

The legislation additionally requires that derivative financial instruments that have for the most part traded outside the exchanges be settled and cleared within entities regulated by the CFTC. This provision, if not exactly welcomed by the financial community, was largely anticipated. In prior years, derivatives avoided the oversight of the SEC and CFTC because they were perceived to be sophisticated financial transactions involving sophisticated financial partners that did not require the level of financial oversight expected of retail products. But the extraordinary growth and reach of derivatives and the systemic risks uncovered during this last crisis ensured that derivatives would now be regulated more carefully.

The so-called Volcker Rule survived the vetting process relatively intact. Though some securities professionals pleaded that implementation of the Volcker rule as originally articulated was difficult if not impossible, the fundamental logic of not allowing banks to assume excessive market risks funded by insured deposits carried the day and the provision is now law. That it carried the imprimatur of one of the revered figures in financial regulatory history also helped its cause.

The creation of a systemic risk oversight body is a welcome concept whose ultimate success or failure will be difficult to gauge until the next crisis. Regulators clearly had difficulty addressing some of the emerging issues of the past crisis beginning with an inability to identify the sources of risk due to lack of transparency in both investment pools and financial products. The history of task forces and bureaus made up of the heads of multiple agencies has not been positive and the possibility of stalemate in that construct is a constant threat. But with the appropriate leadership and focus it can be a positive improvement.

While Congress may not have ended too-big-to-fail, financial regulators, particularly the Fed, now have the authority to require the largest complex financial institutions either to obtain more capital or to divest certain activities when they are deemed to be unacceptably risky to the financial system. Regulators also will have new tools to arrange resolutions for failed institutions. The ability to impose more stringent requirements on larger complex and interconnected financial organizations is an important tool for regulators going forward.

Where Is the Hidden Land Mine This Time?

In recent financial legislation one or two provisions thought at the time to be either boilerplate or benign turned out to be the most controversial (see Sarbanes-Oxley, section 404). What are the candidates this year? While accounting for only 27 pages of this bill, there are two key governance provisions that are beginning to attract attention from both the investor community and corporate boards. These include: 1.) proxy access provisions that allow a small minority of shareholders access to the proxy statement: and 2.) the non-binding “say on pay.” In combination, these two provisions could have a significant impact on the role of compensation committees for all listed corporations.

In sum, the bill is a monumental, perhaps even historic effort. It does not have the reach many had hoped and yet far exceeds what others thought necessary. Like other major legislative initiatives, we will not fully know its value until the next crisis.

Presented by Jeremiah S. Buckley.

In this audio seminar on the Financial Reform Act, attorney Jeremiah S. Buckley, President of Corporate Risk Advisors, and Mark Olson, Co-Chairman of Corporate Risk Advisors, will be interviewed by Andrea Lee Negroni, a senior advisor at Treliant, on the major elements of the Reform Act and what those changes may mean for financial institutions, consumers, and the government.

The discussion will cover:

* Proposals for a Consumer Financial Protection Agency and the persons, activities and laws to be supervised by this agency
* Types of financial businesses subject to federal regulation
* How financial services laws may be enforced under the Reform Act
* What “too big to fail” means and what special rules apply to institutions that pose “systemic risk” to the financial system
* How federal financial reform may affect state enforcement of financial services laws, including enforcement by state attorneys general
* New consumer financial disclosures requirements
* The future of federal preemption of state laws for national banks
* FDIC’s authority to liquidate institutions to preserve national financial stability
* The new “duty of care” applicable to residential mortgage loan originators
* Home mortgage loan terms that will be outlawed without specific consumer disclosures
* Treatment of residential property appraisers and appraisals under the Reform Act
* Provisions requiring lenders to retain some credit risk from their loans
* How the Reform Act deals with executive compensation, and what restrictions on executive compensation may develop
* New SEC regulation of rating agencies
* Highlights from the public hearings of the Financial Crisis Inquiry Commission

This A.S. Pratt audio conference will be 60 minutes long and include a 15-minute Q&A session with the experts so you can ask questions specific to your institution.

Please click here to register for this audio conference. This presentation will also be offered on July 15 at 2 p.m.

Expect the Unexpected: Navigating Today’s and Tomorrow’s Regulatory Landscape

By Mark W. Olson, Co-Chair; Angela Desmond, Managing Director; and Catherine Brown, Managing Director, Corporate Risk Advisors, LLC.
July 1, 2010

As we enter a period of recovery from the economic crisis, we can expect an array of responses from policy makers at all levels. The breadth of the crisis and the impact on the economy and consumers leaves no doubt that reform legislation will pass. As of this writing, the Senate is considering amendments to a committee bill and the House has passed its own bill.

One of the key purposes of the bills is to better manage the risks posed to our economy by large complex financial institutions and resolve for all time the “too big to fail” problem. While the bills would establish an Oversight Council charged with identifying risks to financial stability and proposing actions to prudential regulators, we do not expect the Council to be executory (i.e., the Council could not mandate implementation). The Federal Reserve, which could lose supervisory authority over state member banks, would have authority to establish stringent prudential regulations for systemically important institutions (essentially financial holding companies with greater than $50 billion in assets), including capital, leverage, liquidity, living wills, concentration limits, risk management and credit exposures disclosure. Even without legislation, large and small financial institutions alike already are being subjected to heightened expectations in many of these areas.

No matter what, expect supervisors to continue to require financial institutions to maintain increased levels of high quality capital buttressed by robust and diversified liquidity plans. The financial markets have become skeptical of any element of capital other than net common equity. The crisis revealed that assumptions about liquidity (particularly short term funding markets) can be flawed. Recent FFIEC guidance on managing funding and liquidity risk emphasizes the importance of effective processes to identify, monitor and control these risks. Recommended tools include cash flow projections, diversified funding sources, maintaining a cushion of liquid unencumbered assets, and having a documented, board-reviewed contingency funding plan.

The bills would establish a consolidated consumer protection regulator with most of the current, and some new, consumer protection laws under its purview. The agency (or bureau within the Federal Reserve) would have new authority to define “plain vanilla” products and issue rules prohibiting unfair, deceptive or abusive acts or practices for sales of those it deems to be non-vanilla. Financial institutions can expect some interim confusion as authorities are transferred to the agency, but in the long run your heightened attention to consumer compliance issues is warranted and you can expect that definitions of unfair and deceptive acts and practices will be expanded. Except for institutions with assets greater than $10 billion and their affiliates, financial institutions still would be inspected by their prudential regulators who would retain their enforcement authority. Note that the Senate bill would authorize the agencies to seek damages in enforcement actions, in addition to ordering restitution and rescission.

The recent crisis has focused greatly on the roles of boards of directors and senior managers in assuring that financial institutions balance the goal of profitability with safety and soundness. There is a perception that many financial institutions did not understand products they were selling or buying, and could not measure risk exposures in particular areas and firm-wide. The importance of boards continues to grow as does the supervisory scrutiny of the competence, independence and compensation of directors. Along side traditional responsibilities for setting a company’s culture and strategic goals, are more granular duties of the audit, risk and compensation committees. Processes for setting and monitoring adherence to an institution’s risk parameters must be established and boards must have access to internal and external resources as necessary to fulfill their responsibilities and to inform their judgment. For example, boards and senior management will be expected to manage concentration risk, and do a better job evaluating credit risk over the life of a portfolio/product. Moreover, there will be little tolerance for not adhering to prudent underwriting standards.

Similarly, we can expect heightened scrutiny of proprietary trading and investment activities and their potential to adversely impact a financial institution’s safety and soundness. Financial institutions will be expected to perform stress tests – and in particular forward looking scenario analysis – for boards to use in setting and monitoring adherence to risk parameters. Even if proposals to limit or restrict proprietary trading are not adopted, institutions will be expected to hold more capital to support their trading books and reduce leverage. With respect to derivatives, boards of directors should carefully consider whether their institutions should sell or buy products that are not standardized, centrally cleared and subject to margin requirements. Although margin requirements increase the cost of these products, they protect against counterparty risk. Boards should (and regulators will) ask about their economic purpose, and be comfortable that the products fall well within the institution’s risk parameters.

In the future financial institutions that have access to the federal safety net will be expected to achieve a more “socially acceptable” balance between the risk a financial product or activity poses to the institution (including the greater impact to the financial system) and revenue/market share. Financial institutions that are not able to aggregate, fund and monitor risk across their organizations are likely to find their activities subject to heightened oversight, including increased capital requirements and perhaps restrictions on activities.

Corporate Risk Advisors, LLC specializes in providing consulting and strategic advisory services to financial services companies. Services include strategic planning and corporate governance, risk management, crisis management and regulatory compliance; fair lending; HMDA; due diligence; portfolio evaluation; and financial analysis.