INSIGHT

Dodd Frank - promoting financial stability and other purposes

By Michelle Levy
Banking & Finance Financial Services Government Insurance Private Capital Superannuation

Written by Partner Michelle Levy

What's in a name?

The long title for the Dodd Frank Wall Street Reform and Consumer Protection Act 2010 (that's the short title) is 'an Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes'.

The plain speaking title might be 'an Act to protect Americans from their bankers'. Former Congressman Barney Frank was in Australia a few weeks ago and I asked him if that description was fair – his answer was: 'not only from bankers'.

What's it all about?

The Dodd Frank Act is a bit like the financial system it is trying to regulate – vast, complex and hard to wade through. It has 16 individual Titles or Acts with topics that range from the stability of the financial system, resolution planning for financial institutions, the regulation of swap markets, the supervision of clearing and settlement systems, the regulation of credit rating agencies, and investor and consumer protection rules for residential mortgage lending. It creates a bunch of new regulators on top of what was already a pretty solid cast and gives them wide-ranging powers not only to set capital and liquidity requirements for financial institutions and make rules about what they can and cannot do, but also to shut down or sell off parts of their businesses.

The Dodd Frank Act also gives the Board of Governors of the Federal Reserve the power to determine whether a non-bank financial institution is sufficiently significant to the US economy to require it to be regulated as a bank and subject to the same capital and solvency requirements. So far, the Federal Reserve Board has made a determination that five insurance companies are. MetLife (one of the five) disagrees and is challenging the determination - but it is hard to see how it could win given the breadth of the Board's discretion under the Act.

Who's in charge?

The Act created the Financial Stability Board which is responsible for overseeing the whole system. It will be helped by the Office of Financial Research. Together they are required to collect an enormous amount of information from financial institutions, identify any emerging risks and decide what to do about them. This is a common theme throughout the Act and one risk I have identified is the risk that the regulators won't be able to see the wood for the trees because the trees are so dense and because they don't have the resources or the skills. The Act seems to rely to a large extent on the regulators being better informed and smarter than the regulated. And I don't know that they are things that can be relied on. If I was to assess the severity of the risk, I would say that there is a high risk of it occurring. What isn't clear is how severe the damage might be. That might depend on the effectiveness of some of the other measures. They include some of the things we are familiar with. Increasing capital, attempting to better regulate conflicts of interest and to improve governance and some that we are not.

What's this 'Volcker Rule'?

The 'Volcker Rule' in section 619 of the Act is intended to protect the capital raised by the financial institution from being put at risk by speculative trading. It prohibits banks and other significant financial institutions engaging in proprietary trading and owning hedge funds and private equity funds. But the rules made under the section were subject to intense lobbying, lawsuits and ultimately significant compromises and they now stretch to 40 odd pages, largely of exceptions. Significant among those is that a bank can, despite the rule, hold interests in hedge funds and private equity provided their value does not exceed 3 per cent of its tier 1 capital. When asked about the exception, Mr Frank said 3 per cent of tier 1 capital was the lowest number they could put forward to get the Rules made.

The Financial System Inquiry considered whether a similar rule was required in Australia but decided not as the incidence of proprietary trading by Australian banks was low. It limited its recommendations to increasing capital requirements for banks so that they were 'unquestionably strong'.

And, if it fails?

If these measures don't work, then the Dodd Frank Act requires banks and other significant financial institutions to prepare plans for 'rapid and orderly resolution in the event of material financial stress' (these are their resolution plans). Banks and other systemically important financial institutions have had to prepare and submit resolution plans to the Federal Reserve Board for approval. If the Board doesn't approve a plan, it can ask the institution to change it. If it still doesn't approve the plan, it has the power to restrict the institution's ability to issue financial products or engage in specific activities, it can impose conditions on one or more activities and, if these things aren't enough to mitigate the risk, it can sell or transfer assets to unaffiliated entities. The powers are quite extraordinary and make APRA's powers look reasonably tame.

The Federal Government has endorsed the Financial System Inquiry's recommendation that work continue on strengthening APRA's crisis management powers by giving it broader investigation powers, strengthening directions powers, improving group resolution powers and giving more 'robust immunities' to statutory and judicial managers. In the meantime, APRA wants banks to start preparing their resolution plans.

What are we doing?

In a speech late last year, APRA's Chairman Wayne Byres said that banks needed to have plans to deal with crises management that included recovery and resolution planning. He said that:

APRA will be working further with larger ADIs (and in due course other relevant firms) to ensure they have [recovery] plans that are credible – that is, a realistic and continuously-reviewed menu of actions that can be practically implemented in stressed operating conditions. On resolution planning, we will be commencing more detailed work on the planning required to ensure that we are able to use our resolution powers when needed.

What these crisis management tools and planning don't deal with are the risks posed by the unregulated – the Financial System Inquiry discussed the risk posed by more financial activities being carried on outside the regulated financial system. In the United States, the Dodd Frank Act is pretty clear about the risk – to Mr Frank's point – the Act isn't only trying to protect Americans from the bankers. But whether the regulators are going to be smart enough or well enough resourced to identify new risks and put in place effective ways of dealing with them is a more difficult question.