President Barack Obama signed the Dodd-Frank Act into law on 21 July 2010. The main objective of the Act is to avert a repeat of the 2008 financial crisis by making financial institutions more accountable for their actions and by enhancing oversight of the industry to detect and prevent systemic risk before it reaches crisis level. While many have welcomed the Act and have confidence in its ability to better manage a future threat to the US financial system, others have voiced concerns about the enormous task lawmakers have in implementing the many provisions of Dodd-Frank and the challenges it will present to financial institutions in the months and years ahead.
Notable provisions of Dodd-Frank
The Act gives regulators new resolution authority by creating a new council to monitor and address systemic risk. This new office, the Financial Stability Oversight Council, will have the power to demand information from any nonbank financial institution with over $50bn in assets and place them under the supervision of the Federal Reserve should their financial stability be deemed an overall threat to the US economy.
Meanwhile, the new the Consumer Financial Protection Bureau will enhance supervision of large banking institutions and nonbank affiliates.
For the first time, the Act allows the Federal Reserve to regulate insurance companies and investment firms and other nonbank companies if they are deemed to engage in excessively risky financial activity. Based on an evaluation of their balance sheets and other risk-based criteria, these institutions may be subject to regulation by the Financial Stability Oversight Council. Additionally, the Act creates a new Federal Insurance Office to monitor the insurance industry and establish new rules designed to promote uniformity among the States in market regulation of specified types of insurance.
The Volcker rule has been a much-publicised element of the Act, named after former Federal Reserve chairman Paul Volcker, who pushed to restrict banks from making certain kinds of speculative investments if they are not done on behalf of their customers. The rule limits banks to investing a maximum of 3 percent of their capital in proprietary trading, and aims to curb their involvement in private equity and hedge funds, except for small investments allowed by a loophole added to the rule late in the debate. The Act also imposes on hedge funds and private equity funds new requirements for registration, recordkeeping and reporting.
In an attempt to rectify what are perceived to be the root causes of the financial crisis, the Act has introduced a new regulatory regime for the over-the-counter derivatives market. In order to increase transparency, liquidity and efficiency, these markets will be subject to clearing and exchange trading, as well as a number of other requirements. Similarly, under the Act, issuers or originators of asset-backed securities will be required to retain at least 5 percent of the credit risk associated with the assets that they sell into a securitisation. Meanwhile, in order to reduce conflicts of interest and promote transparency, credit rating agencies will also be given new corporate governance guidelines.
More rules, more problems?
The provisions of the Dodd-Frank Act outlined above are perhaps its most publicised and widely discussed, but the Act is vast, covering almost every area of the US financial system. Lucinda O. McConathy, a partner at Richards Kibbe & Orbe LLP, points out that given the complexity, size, interconnected nature and global scope of the financial markets, Dodd-Frank presents an enormous challenge for US regulators. “In September, Mary L. Schapiro, Chairwoman of the Securities and Exchange Commission (SEC), testified before the Senate banking committee that her agency alone is responsible for over 100 rulemaking initiatives, 20 reports, and putting in place five new offices in the next year. Similarly, the Chairman of the Federal Reserve Board, Ben S. Bernanke, testified that the Fed has more than 50 rulemakings and formal guidance on its plate, with joint projects adding 200 more tasks to its load. Meanwhile, the Commodities Futures Trading Commission (CFTC) and other financial regulators similarly have numerous Dodd-Frank rules and studies to produce,” observes Ms McConathy.
And while regulators are busy trying to draft and implement an abundance of new rules and regulations in a very short space of time, many financial institutions are still unclear as to which side of the regulatory fence they sit. In reference to the new Financial Stability Oversight Council, Aaron Seamon, a principal at Squire Sanders & Dempsey LLP, says that the lines are still blurred over which companies will ultimately be subject to this regulation. “Another key concern is whether the coming flood of regulations may cause banks to reduce their commitment to, or exit altogether, certain lines of business, particularly if they are not permitted to adequately price the risk associated with such lines of business, or if they are required to maintain so much capital that returns on equity are considered unattractive,” notes Mr Seamon.
More governance, more pressure for public companies?
Formed with the opinion that in recent years corporate executives were not being held accountable for poor performance, and their interests with shareholders and their companies were misaligned, the corporate governance provisions of Dodd-Frank attempt to ensure executives place the wellbeing of their companies ahead of their own financial rewards. In order to achieve this, the Act contains provisions on proxy statement disclosure, as well as significant changes to the composition and operation of a company’s compensation committee, which will impact advisory votes on executive compensation and golden parachute payments.