Dodd-Frank: Tossing and Turning

Once it touched down in Washington in 2017, the Trump administration promised to rip apart portions of Dodd-Frank bank rules and present gifts to banks that would ease up regulatory requirements.

In its first year, the administration, addressing other issues and matters, didn't get around to it.

In spring, 2018, the administration and certain Congressional leaders have decided to push Dodd-Frank higher up the political agenda and have begun to thrust bills through Congress to make some initial tweaks.

First, it decided to ease a burdensome criteria of banks not considered in the special category of "too big to fail."  Regulators and supervisors avoid this phrase, "too big too fail," but there is a special category of banks that are deemed so mammoth in size, they could deal blows to the global financial system if they got into trouble too quickly. 

They prefer the term "Globally Systemically Important Banks" or "Significantly Important Financial Institutions." Those banks require extra capital cushion,  non-stop observation of their activities from examiners, full-scale stress tests and more involved scrutiny. The latest Dodd-Frank tweaks will decide which banks (with assets < $250 billion) will not be subject to the annual anxiety-filled stress tests, administered by the Federal Reserve.

Second, this spring, Congress dared to consider revamping the Volcker Rule, Dodd-Frank's prohibition of proprietary trading among big banks. Not quite eliminate it, but ease the taxing burden banks have had in complying with it. 

The rule, as written today, presumes all securities and derivatives trading at banks is proprietary (speculative and hedge-fund-like) unless the banks painstakingly prove the same trading is for the benefit of clients. To prove to regulators they bought a portfolio of equity stocks for the eventual resale to institutional clients is one of the most difficult tasks in banking today, so say compliance officers at big banks.

Small banks (those of the community kind) aren't likely to participate in the whirlwind of derivatives and securities trading.  So Dodd-Frank revisions will consider not even applying the rule to them.

Dodd-Frank, formally, is the title of U.S. banking laws that were enacted on the heels of the financial crisis.  Dodd-Frank is legislation that requires U.S. banks and U.S. subsidiaries of foreign banks to follow Basel III global-banking standards. Dodd-Frank, the 2010-11 version, however, tightened up global standards and enacted a bundle of other requirements--enough to fill over a thousand pages of rules with wiggle room to add even more.

From Dodd-Frank, banks have capital requirements, but there are also rules related to leverage, balance sheets, liquidity, and managing operational risks.  There are rules that require stress tests, prohibit hedge-fund-like trading, and require banks to present liquidation plans, even if they are not likely to liquidate anytime soon.

Even if they don't voice their disagreement and difficulties with Dodd-Frank with public outcries, many banks will privately enjoy this springtime hint of relief, if only because of the burden of compliance.  Most U.S. banks can and do comply with the detailed rules of Dodd-Frank, but they do so by investing millions in people, processes, systems, and compliance.  Ensuring compliance with rules has not been a significant chore.  The task of complying has.

In many ways, Dodd-Frank, the first edition over the past eight years, did its job.  Banks, big and small, are healthy, financially sound, and well-capitalized.  Risks of all kinds--from market risks to operational risks--are identified, measured, quantified, disclosed, and analyzed.  Tests under various worst-case scenarios are conducted, and no bank wants a headline exclaiming it has failed a Federal Reserve stress test. No bank wants pundits from CNBC to declare they don't have sufficient capital or liquidity.

Part 1 of Dodd-Frank revisions have commenced. In May, legislators introduced bills to (a) exempt smaller banks from having to go through regular stress tests,  (b) to re-examine the Volcker Rule and (c) reconsider how it defines "globally systemically important banks" (GSIB's).

In many respects, the current Dodd-Frank revision strategy focuses on making changes in simple ways:

a) Grant relief to smaller, less-complex institutions in their attempts to comply with Dodd-Frank rules. 

b) Don't force smaller banks to perform complex calculations to determine capital for market, credit and operational risks.  Don't force them to conduct arduous stress tests for all of their business operations. 

c) Don't force them to show compliance with Volcker restrictions, mostly because they never engaged in exotic trading that involved equities and derivatives around the globe in the first place.

d) For the rest, tinker with the Volcker Rule; don't over-haul it yet. Revise it in stages.

That dividing line between big and small is $50 billion or $250 billion or $750 billion in assets and depends on whether the topic is stress testing, liquidity requirements, or capital calculations.

Pros and cons about Volcker keep the debate alive.  With big banks reporting record-breaking profits in 2018's first quarter, banks won't be able to argue Volcker must be abolished to permit them to improve earnings from trading and provide more liquidity in capital markets. In late 2018, the SEC distributed a study showing the Volcker rule has not reduced liquidity in bond and equity markets, as banks predicted.

After years of living with Dodd-Frank and the Volcker Rule, banks have adapted, although they welcome compliance relief and the opportunity to focus a more on clients, capital markets, and new regions.  Banks that retreated from sales, trading, securities and derivatives have already funneled related capital and resources elsewhere.  Banks, big and small, have implemented systems and data aggregation to ensure they know what amount of capital (and in various forms) is necessary to support any business they breathe on--mortgages, corporate loans, investment banking, securitization, interest-rate-swaps dealing, currency trading, custody, credit cards, payments and cash management, etc.

While some banks occasionally slip in earnings performance or struggle to meet Return-on-equity (ROE) targets, most banks (at least those above $50 billion in assets) have shaken up balance sheets and risk-management processes to make sure they have excess capital for market, credit and operational risks and for the types of businesses they choose to emphasize. 

Big mega-banks such as JPMorgan Chase, Bank of America, Citi and Wells Fargo manage themselves to ensure they have excess capital. Big regional banks such as PNC and Regions do the same.  And so do banks that specialize in transactions and processing (and not much on corporate and investment banking) like State Street, BNY Mellon and Northern Trust, too.

Yet while Dodd-Frank gets wrung about, twisted and tweaked (but not abolished), all of the above will silently applaud some relief from compliance-process headaches.

Tracy Williams

See also:
CFN: Dodd-Frank Dismantled? 2017
CFN:  Volcker Rule: SEC Weighs Impact, 2017