 |
| Under Review: Will Dodd-Frank be dismantled or just tweaked? |
Less than a month into his term, he has initiated efforts to shake up bank regulation and Dodd-Frank requirements, pushing us back toward an era that pre-dates the days of the financial crisis.
This is the same regulation enacted and signed into law in 2010 as the anchor around which banks would reform and restructure to (a) reduce the likelihood of another near collapse of the financial system and (b) to ensure banks are strong, healthy and sturdy enough to endure a crisis when it occurs again. (It also includes protection for consumers when they engage with financial institutions and when they purchase bank products.)
The Trump administration, much to the quiet happiness of some bankers, wants to eliminate or revise some of the new rules. This would come after years of banks conforming to new rules, arranging to increase capital in large chunks, reduce leverage and reconstitute the risk content of their balance sheets. This would come, too, after banks invested in systems and personnel to comply with hundreds and hundreds of new rules.
So can Dodd-Frank be completely dismantled and done away with? Or will the administration selectively choose rules to keep and rules that will be eliminated? Or will it substitute with a different, more bank-friendly law? If rules are adjusted, changed or eliminated, which ones are likely to be altered?
We can assume not much will change in the short term. Because Dodd-Frank supporters will be able to argue the post-crisis benefits to the banking system and because banks are already adapting quickly to the new environment, there will be fierce debate. (Consumer-finance advocate Sen. Elizabeth Warren will be at the front line. Senior Federal Reserve Bank officials--past and present--will have much to say.)
The substance or essence of Dodd-Frank won't be eliminated. Banks and bank regulators around the world have agreed to comply with the basics of bank regulation defined by the Bank of International Settlements and outlined in what we all know as Basel II and III. Dodd-Frank formalizes and reinforced U.S. banks' compliance global regulation.
Basel III regulation outlines capital requirements for banks of all sizes to absorb credit, market and operational risks. Basel III also set standards for liquidity and leverage. But the BIS and Basel III permit member countries to adapt rules to their respective systems and tighten them up, if they choose to do so.
Dodd-Frank, as expected, toughened many of the same requirements, imposed new restrictions, and added other rules and stress tests. It empowered regulatory agencies to set other rules, as necessary, and fill in the minutiae. (Other countries have done the same. Europe's Dodd-Frank might be what is called "MiFID," or Markets in Financial Instruments Directive.)
The biggest banks have the toughest requirements, subject to Basel III, Dodd-Frank and Federal Reserve guidelines. Throughout the post-crisis era, regulators have worried about the impact of big- bank failures on the financial system. That concern has been a guiding light in writing new rules. With stringent capital and liquidity requirements, let's reduce to tiny probabilities the likelihood that big banks will fail. And if they do, let's minimize the impact on everybody else.
The familiar names (from Bank of America to Wells Fargo) have had little difficulty in complying with every aspect of new regulation--except for the occasional failing of a stress test. Perhaps the greatest direct impact of regulation is banks being forced to do business with much more capital and much less leverage (leading to lackluster to modest returns of equity).
In corporate and investment banking and in trading, what rules are candidates for change and how they might change?
Minimum capital requirements. Basel III requirements for capital for credit, market and operational risks are specifically defined. Rules vary based on how large and how systemically important financial institutions are.
Bigger banks, especially those with foreign operations and complex organizations and complex product offerings, calculate requirements based on advanced, statistical models. Banks deemed "too big to fail" (determined from definitions of size, not based on perceptions of big) have higher minimum-capital ratios (based on "GSIB" designations and regulatory discretions about how much more capital they should have).
An amended Dodd-Frank might tamper with the definitions of "too big to fail," might increase the minimum size of banks subject to advanced calculations of risk capital, might ease the burden of requirements to maintain significant capital for operational purposes, and might be lenient about what forms of debt can be included in the many definitions of capital.
Liquidity requirements. U.S. regulations amended Basel III requirements for liquidity requirements (the amount of cash and cash-equivalents banks must hold in anticipation of meeting obligations over the next 30 days). They made them more onerous for big banks. Cash-equivalent definitions are stricter (Is a CMO considered a cash-equivalent?), and big banks must comply with liquidity metrics everyday, not monthly.
Banks are complying with current rules and will boast quarterly how liquid they are. But they would enjoy filling those liquidity pools with assets Dodd-Frank-related rules limit (lower-rated corporate bonds?). A revised Dodd-Frank might ease the daily requirements and permit a broader range of financial instruments to be included in the pool of cash-like assets. Banks will prefer to meet these requirements more and more with assets that generate a return of some kind.
Leverage. U.S. rules (beyond Basel III) pummeled banks in limiting leverage. Basel III rules limited the size of bank's balance sheets, relative to capital, regardless of risk levels. Banks can "de-risk" balance sheets and, therefore, reduce capital requirements. Yet Basel III's leverage rules still require a minimum level of capital. Dodd-Frank rules led to U.S. banks calculating a tougher "supplementary" leverage ratio, which includes certain off-balance-sheet activities.
A revised Dodd-Frank might eliminate the supplementary leverage or ease the burden of requirements.
Volcker Rule. This rule prohibits proprietary (hedge-fund-like) trading at banks. Banks can engage in sales and trading, but the activity must expedite customer activity. All trading must be tied to customer flows. Banks can hold corporate bonds and equities, as long as they are eventually sold to customers. Banks, especially institutions with large trading desks and a recent history of occasional surges in trading profits, have responded in various ways. Many have reduced emphasis on trading, shed desks, and focused on fewer asset classes. Others have aimed to increase market share, while committed to making money from customer flow.
For banks still with big trading aspirations and large trading positions, the rule is difficult to comply with. Banks must prove to regulators trades on the books exist to meet customer demand or customer expectations. While those trades sit on the books, they can be subject to market losses, but can be privileged with market gains. Whatever is on the books, regulators want to see them eventually off-loaded to customers.
Traders at some banks crave for the days of trading at free will. Many other banks just wish there were easier ways to comply. In the wake of Trump's announcement, there have already been rumblings that the rule might be repealed, modified or eased, although it may be one facet of Dodd-Frank most difficult to overturn. In the eyes of many, undisciplined trading and mismanaged market risks rank among the handful of causes of the mid-2000's crisis. And regulators won't easily allow banks that accept consumer deposits in one part of the organization to engage in hedge-fund-like activity in another part.
CCAR. This refers to the annual stress tests banks conduct (better known as "See-Car"). Banks are handed business and operations scenarios that reflect worst-case situations and extreme scenarios. They must then compute the maximum they will lose in these scenarios and then show they are still in compliance of capital requirements. Failing a test is often a public-relations embarrassment and will lead to reprimands from regulators to reduce risks or boost capital.
The tests are comprehensive exercises and give regulators more beef in their arguments that banks need more capital. To pass the tests, banks now realize they must take them seriously and devote time, attention and resources to do them thoroughly. Most banks have built the exercises into the ordinary course of business. They conduct them routinely for themselves.
Dodd-Frank opponents won't disagree with the purpose of stress tests. They may propose tests overseen by the Federal Reserve be conducted less frequently (biennially?) and pass-fail grades be applied less harshly.
Living Wills (Recovery and Resolution). This Dodd-Frank exercise is a liquidation scenario. Regulators want banks to show how they would liquidate operations in a stress scenario without jeopardizing the financial system. When first implemented, banks might have taken for granted how easy it would be to pass. But large banks are labyrinthine structures with a complex network of holding companies, operating entities, regulated entities, minority interests, joint ventures, special-purpose structures, and deposit-taking operations.
Unwinding these structures is far more difficult than they initially presented in the exercise. It involves legal structures, legal issues, foreign operations, dividends upstreamed, intercompany transactions unwound, securities up for sale, loan portfolios reduced, cash funneled from subsidiaries abroad and siphoned up to the holding company. Not quite on board with the fundamental purpose of the exercise, some banks have not fared well in the exercise. After receiving unsatisfactory grades, they now do.
But if Dodd-Frank is amended, they would hope for relief in the frequency of compliance and in scenario assumptions.
Derivatives Trading. U.S. and global bank regulation, after the crisis, tightened up requirements for where basic derivatives (plain-vanilla interest-rate swaps, credit-default swaps, e.g.) are traded. Regulators seek to push much of the high-volume trading from over-the-counter (OTC) markets to exchanges and central counterparties, trades that would be transparent to most of the market and would be settled by approved settlement organizations.
The transition from OTC to exchanges and central counterparties has proceeded in deliberate fashion (not necessarily the fault of banks), but new regulation works to their advantage. Related credit and market risks are reduced and, therefore, risk-capital requirements.
A revised Dodd-Frank will not likely abolish these requirements, but could push for more swift approval of derivatives exchanges and settlement organizations.
TLAC. Dodd-Frank allowed the Federal Reserve to add another layer of long-term capital requirements. Regulators worry about banks' reliance on unstable funding sources. They are concerned, too, about how extreme risks will erase much of the capital cushion and jeopardize the claims of depositors. Hence, last year they introduced "TLAC" (or Tee-Lac) requirements to increase the amount of "loss-absorbing capital" on the balance sheet. TLAC includes equity capital, preferred shares, subordinated debt and senior, unsecured debt. TLAC, regulators hope, should offset unstable short-term funding and unstable deposits.
Banks are complying and will do so without difficulty, as long as they have investment-grade ratings. But bank CFO's have accepted that long-term stable funding means higher costs of funding (and lower earnings, compared to income statements long years ago). Some might argue that higher liquidity requirements should ease the
Dodd-Frank revisions might support the concept and purpose of TLAC, but could reduce the actual requirement.
Stay tuned. The debate will eventually heat up. Often it won't be easy to follow or understand. But even the slightest changes could have substantial impact on bank capital levels, balance sheets, performance, business operations, and risk levels in the system.
Tracy Williams
See also:
CFN: TLAC to the Rescue, 2017
CFN: Basel III, 2013
CFN: JPMorgan's Regulatory Rant, 2012
Posts
No comments:
Post a Comment