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AmericasApril 2 2012

Over-regulation threatens to capsize US financial sector

The regulations implementing the Dodd-Frank Act, which was signed into US law in 2010 in response to the G-20's global financial regulatory reform agenda, are being written, and banks do not like what they see.
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Over-regulation threatens to capsize US financial sector

Banks, investment managers, brokers and other financial firms doing business in the US are riding the biggest wave of regulation since the 1930s – and possibly of all time – as regulators implement the requirements of the Dodd-Frank Act. To complicate matters, this tsunami of financial regulation is happening amid an economic ebb tide in the US and the rest of the world.

The chaos and confusion caused by a dozen regulators struggling to write about 250 rules in a two- to five-year rule-making process is not just impacting US banks, it is also affecting foreign banks’ operations in the US, and in some cases their activities outside the US. Domestic banks are likely to find revenues and returns on capital so depleted by the measures that some will have to exit entire lines of business. Similarly, foreign banks will have to consider whether it is worth remaining in the US.

Reaction to reform agenda

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in 2010, is the response of the administration of US president Barack Obama to the G-20’s global financial regulatory reform agenda outlined in Pittsburgh in 2009. The act’s intention is threefold: to improve the stability of the financial system, to make individual firms safer, and to enhance customer protection.

In essence, the act:

  • creates new regulatory agencies, including the Financial Stability Oversight Council (FSOC), the Office of Financial Research, and the Consumer Financial Protection Bureau (CFPB);
  • introduces a comprehensive new regulatory framework for the financial markets. This includes moving standardised over-the-counter derivatives onto exchanges where appropriate, and the Volcker Rule, which prohibits banks from engaging in proprietary trading and sets limits on how much they can invest in hedge funds;
  • ends the possibility of banks being 'too big to fail'; for example, by creating a bank resolution regime for winding down insolvent banks;
  • improves corporate governance; for instance, by giving shareholders a 'say on pay'; and
  • strengthens consumer protection.

But the act creates many problems, which fall into three categories: the negative impact on the US financial system and banks’ business and operating models; the inability of the regulators to write workable rules in such a short timescale and meet all their other obligations; and the regulatory compliance challenges for banks.

Impact of regulations

Banks fear that the cumulative negative impact will be so great that it could, ironically, have an opposite effect to what the act intended – it could increase market instability, make banks less viable and less safe, and harm customer interests.

Only about a quarter of the 250 regulations required have been written, according to the International Centre for Financial Regulation, and some of them could be reversed by the industry fighting back. In December, the Securities Industry and Financial Markets Association (SIFMA) and the International Swaps and Derivatives Association (ISDA) asked the courts to 'vacate' (rescind) the new Commodity Futures Trading Commission (CFTC) Position Limits Rule on futures, options and swaps contracts.

“Unfortunately, the Position Limits Rule as adopted by the CFTC was poorly crafted based on an incorrect reading of the law, and [without] any sound economic or cost benefit analysis,” says Conrad Voldstad, ISDA’s chief executive, and Timothy Ryan, SIFMA’s chief executive. “It has the potential to harm markets at a time when they can least afford it.” Their rearguard action represents the first serious challenge by the industry to the act. It will be interesting to see if it succeeds and if there will be more.

Until the dawn arrives and the skies clear there will be a hesitancy to make loans, even though banks want to, because they are fearful of what regulators might decide to do after the fact

Frank Keating

Industry frustration

As for the rules that remain to be written, the industry is making a lot of noise, lobbying for proposals to be watered down or deleted, or for consultation periods to be extended. It won a rare, albeit small, victory in December last year when the authorities agreed to extend the consultation on the Volcker Rule from mid-January to mid-February.

Frank Keating, chief executive of the American Bankers Association, has argued that the act and the CFPB should be reformed to reduce the burden on consumer banks. “Until the dawn arrives and the skies clear there will be a hesitancy to make loans, even though banks want to, because they are fearful of what regulators might decide to do after the fact,” he says.

Sean Culbert, a partner in the consultancy firm Capco, says: “Most banks will have enough capital to survive, but they will have to modify their businesses, and hive off some of them to lower their capital obligations. There’s also concern about the overarching capital requirements coming out of Basel III.

“As for revenues, if banks can’t get their fee revenues up, and because their interest rate spreads are thin these days, their return on equity [ROE] will be lower. JPMorgan [recently] reduced its ROE target to 11%. This is likely to be the new normal and that will be reflected in banks’ share prices.”

Robert Priester, executive director of wholesale and regulatory policy at the European Banking Federation, fears that US regulations will deviate from comparable EU ones, which could distort the markets and create regulatory arbitrage. “The Volcker Rule is very much at the top of the list of our concerns,” he says. “Its extra-territorial aspects have taken us aback. The rule has been written to prevent US banks circumventing it, and therefore a number of definitions have been cast too wide, capturing non-US banks doing non-US business.”

Anthony Belchambers, chief executive of the Futures and Options Association, says US regulation can “reach out extra-territoriality” for four reasons: to prevent the evasion of domestic rules by foreign banks; to lessen the economic impact of regulation on US interests at home and abroad; to control foreign banks’ dealings with US customers; and to regulate banks that are deemed to be systemically important in the US, and thus apply rules to banks’ global operations even if their presence in the US is small.

“It’s not yet clear how Dodd-Frank will be applied to non-US banks,” says Mr Belchambers. “A further area of doubt is being created by the US presidential elections. They could create a substantive shift in the policy approaches to post-crisis financial repair. We have heard, for example, that Volcker could come under some form of review.”

[Regulations] have three core duties: to create stability, to promote integrity in the markets, and to protect individuals... Each of them has to map what they believe their mandates are against those core principles

Sean Culbert

The regulator relationship

The long-established regulatory bodies such as the Securities and Exchange Commission, the Office of the Comptroller of the Currency and the US Federal Reserve have had extra responsibilities placed upon them; the new ones such as the CFPB and the FSOC are still struggling to get to grips with their roles; and there are gaps and overlaps between all of them, which are creating confusion and risk.

The regulators engaged in rule-making have an enormous task to complete in a short timeframe. Those with responsibilities for the supervision and inspection of banks are getting bogged down in their preparations. Their tribulations are compounded by the shortage of skilled, qualified staff.

Mr Culbert at Capco says the regulators are a long way off fulfilling their obligations. “They have three core duties: to create stability, to promote integrity in the markets, and to protect individuals,” he says. “Each of them has to map what they believe their mandates are against those core principles, and harmonise their rule handbooks to reduce the gaps and the overlaps. They have not done this.”

In its Regulatory Outlook 2012 report, the ICFR believes political realities are likely to delay, and even derail, Dodd-Frank. “Funding constraints on regulators and anti-regulation politics by some ahead of this year’s US presidential elections may put the implementation of Dodd-Frank at risk,” it says. “These issues raise questions about the appropriate relationship between regulators, the regulated industry, and the political system.”

Regulatory compliance challenges

While the regulatory affairs departments of banks negotiate with rule-makers to water down the rules, their compliance departments are urgently mapping out how to conform to the rules, and preparing for the first supervisory visits and inspections. They are also cringing at the costs.

"There’s a dearth of labour,” says Mr Culbert. “There are fewer people who want to be in compliance than there used to be, and it takes a minimum of 10 years to train someone to the required level. It wouldn’t surprise me if a large investment bank needed to add about 300 extra new heads in the compliance and control function to deal with Dodd-Frank.”

Mr Keating says that smaller institutions have enough capital to support lending, and they want to lend, but they are having to focus more on compliance than lending. That means instead of hiring a loan officer they are having to hire a compliance person, “and that person does not bring any business in the door”, he says.

The final word should go to SIFMA. “The financial services industry has supported responsible regulatory reform from the start,” write John Taft, Jerry Del Missier and Timothy Ryan, the association’s past chairman, current chairman and chief executive officer respectively, in their 2011 Year in Review, published in January 2012.

“We cannot, however, support measures which disrupt market functions or increase systemic risk, ultimately failing to achieve what Congress and the administration sought to accomplish with the Dodd-Frank legislation. In many cases, the unintended consequences we feared have materialised, and no one knows what the final impact will be.”

The battle lines have been drawn.

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