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It's All In The Execution: The Dodd-Frank Act Two Years Later

Publication date: 12-Jul-2012 12:18:52 EDT

It has been two years since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA)--the most sweeping regulatory and supervisory reform in the U.S. During that time, international regulatory bodies have also been designing and implementing reforms that aim to increase financial sector supervision, thereby promoting financial stability and reducing moral hazard. The common goal of these bodies--which include the Financial Stability Board (FSB) and the Bank for International Settlements (BIS), through the Basel Committee for Banking Supervision (BCBS)--has been to monitor and control systemic risk from the larger global financial institutions. At the same time, Standard & Poor's Ratings Services has also incorporated lessons from the recent financial crisis into its bank rating criteria. (For more details, see "Banks: Rating Methodology And Assumptions," published Nov. 9, 2011, on RatingsDirect).

Today, with a few exceptions, we believe specific rulemaking under the DFA is still very much a work in progress and that the regulatory scorecard on major issues to date has been mixed. When Congress first enacted the DFA in July 2010, we articulated what we thought were its most important changes, as well as some missed opportunities (for more information, see "U.S. Financial Regulations: Positive Change Amid Uncertainty And Missed Opportunities," published Aug. 5, 2010).

So, has our impression changed since then? Our assessment hasn't altered significantly, but we believe that the banking industry is still transitioning. We were right in predicting that the new law would transform the way many U.S. capital markets operate and that it would have global implications. However, our belief that the outcomes would be straightforward to assess was perhaps too optimistic. Indeed, it remains unclear how each of the DFA's key themes--especially in terms of global, cross-border regulatory reform--will collectively and ultimately affect banks' creditworthiness.

We still believe that the DFA improves the framework for identifying and mitigating systemic risk in the U.S. financial system. However, different parts of the law have different implementation periods, with some that were effective immediately and others phasing in over a period of several years. In addition, the law required numerous studies and about 400 rulemaking requirements. According to Davis Polk & Wardell, as of July 2, 2012, the respective regulators have yet to propose rules to meet 142 (36%) of the rulemaking requirements. As such, progress on the DFA will likely stay relevant to the industry for many years.

For now, we don't expect the finalization of rulemaking to lead to significant rating changes for financial services companies. However, isolated rating changes among our rated banks could occur if specific new regulations cause us to revise our scores for business position and risk position, as well as capital and earnings. On the other hand, full implementation of the DFA could, over time, have positive rating implications for U.S. exchanges and clearinghouses. We don't expect the DFA to have a rating impact on other asset gathering sectors, such as traditional and alternative asset managers, hedge funds, independent securities firms, payment processors, and money market mutual funds.

Several Key Themes Emerged From Our Assessment

Our assessment of the DFA two years later revealed four primary themes:

Business models are evolving

Banks are continuing to react to new rules that either eliminate riskier financial activities or require higher capital. Many will need to redesign their credit capacity and underwriting, as well as revamp their strategies for funding operations. They will likely need to raise capital and retain earnings. Management teams will have to revise risk management to address regulatory concerns and potentially move from portfolio risk management to "legal entity" risk management. They will also have to adjust to higher competition from less-regulated nonbank financial institutions. Lastly, DFA requires that banks submit to regulators credible "living wills" with their liquidation scenarios as part of their contingency planning. The first group, which includes the nine largest and most complex banks, submitted their resolution plans on July 2. In the best of circumstances, accepted liquidation plans should untangle complex business operations. In the worst case, regulators could force the divestiture of businesses that they believe cannot be feasibly separated in liquidation, which might ultimately lead to the breakup of the biggest banks at one extreme. In the U.K., for instance, the proposal to ring-fence retail banking from other activities is an example of a structural reform aiming for easier resolution that falls short of a breakup requirement.

Direct costs are rising

The direct cost of implementing the legislation keeps increasing. Not only are individual banks investing more in technology and incurring costs to meet higher capital standards, but they're also facing significant constraints on how they generate revenue. Ultimately, we anticipate reduced profitability for banks in this "new normal," with pretax return on revenue averaging approximately 24%-26% in the coming years--down from 33%-36% before the crisis.

Some unintended consequences may emerge

The jury is still out on the indirect costs of the DFA--that is, the unintended consequences of the bill for banks and the system overall. The playing field may eventually even out between regulated financial institutions and their largest nonregulated competitors in the U.S., but we're uncertain whether this will occur internationally, or how quickly. Moreover, the extended implementation period is delaying the legislation's true impact. Like the BCBS, the Fed has instituted a relaxed timeline of 2013 to 2019 for institutions to adopt Basel III capital rules. However, some specific capital treatments are more strict in the U.S., such as the phase-out of nonqualifying capital securities for banks with more than $15 billion in assets under the DFA's Collins Amendment, which has a shorter implementation period. Deleveraging in the financial system may be protracted and credit may be less available despite a seemingly relaxed timeline (see "U.S. Bank Ratings And Capital Ratios Should Hold Firm Under The Collins Amendment," published June 27, 2012). Higher capital and liquidity standards likely will result in slower economic growth and higher credit costs, which could reduce lending (see "Higher Capital Needs Through 2019 Could Stunt U.S. Bank Loan Growth," published on Feb. 7, 2012). The effects will likely vary depending on the size and type of institution. A key undercurrent of the legislation is preventing banks from growing too large. But the largest banks, with their better economies of scale, may be best able to absorb the heightened regulatory costs and change their product and pricing strategies in response to some of the new rules (see "U.S. Banks Are Changing Their Strategies To Mitigate The Financial Impact Of The Durbin Amendment," published on April 30, 2012).

Domestic and international regulatory coordination is complicated

Coordinating domestic and international regulatory reform poses some significant difficulties. Important questions remain about whether implementation of new regulations will be consistent across borders, as well as whether monitoring tools will be sufficiently transparent and understandable. We acknowledge that some aspects of international coordination are more advanced than others. For example, new rules on over-the-counter (OTC) derivatives markets are moving forward in the U.S., Japan, and the EU and might even be finalized in time for the G-20's December deadline. Other rules, however, are moving more slowly, and some countries are even acting unilaterally. The Volcker Rule is an example of unilateral action in the U.S. Although we believe that U.S. regulators could eventually reconcile any differences among them, international coordination may take much longer, especially with regard to cross-border coordination of countries' varying resolution regimes, the Volcker Rule for cross-border transactions, the supervision of derivatives markets, the regulation of shadow banking, and the convergence of accounting standards.

The DFA touches upon some key features of the financial industry:

  • The designation of systemically important financial institutions (SIFIs);
  • An orderly resolution process for distressed SIFIs, including placing the parent company into receivership and passing its assets to a holding company;
  • Higher minimum regulatory capital requirements;
  • Restrictions on proprietary trading;
  • Shadow banking risk monitoring; and
  • Over-the-counter (OTC) derivatives.

Designating SIFIs In The Context Of Systemic Risk Regulation

The DFA's Title I (Financial Stability) spells out provisions that enhance prudential supervision and capital requirements for SIFIs. For this purpose, Congress created the Financial Stability Oversight Council (FSOC)--which the Secretary of the Treasury chairs and which comprises all the key federal financial regulatory bodies--to fill the gaps in oversight between existing regulatory jurisdictions and create common accountability for identifying and constraining risks to the financial system as a whole. Banks with more than $50 billion in assets (or about 79% of the system), as Fed-covered institutions, need to meet higher minimum regulatory capital standards, present the Fed with annual stress testing exercises, and provide living wills for their credible resolution should they face failure.

However, the FSOC will also determine which nonbank financial companies the Fed should supervise and, consequently, would be subject to prudential standards. The FSOC will also designate which financial market utilities and payment, clearing, or settlement activities are, or are likely to become, systemically important. The market is still awaiting this final determination. On April 3, 2012, the FSOC released its final rules and plans for making these determinations. We expect the FSOC's final rules will apply to only a handful of entities and will have a minimal ratings impact, if any, on traditional and alternative asset managers, independent brokers, finance companies, and insurance companies. (For more information, see "New Regulatory Rules Likely Will Have A Limited Impact On U.S. Nonbank Financial Company Ratings," published May 9, 2012.)

However, the FSOC could also determine that a number of open-end investment companies, specifically large money market funds, pose a threat to U.S. financial stability. In the unlikely event this happens, and if the Fed imposes capital, liquidity, or other requirements on these funds, we believe that money market funds' operational flexibility and ability to compete could weaken.

Moreover, new rules and principles could ultimately prove beneficial for exchanges and clearinghouses. Title I of the DFA excludes these entities from the definition of nonbank financial companies. Instead, the SEC and CFTC will continue to supervise exchanges and clearinghouses according to the less-strict Title VIII: Payment, Clearing, and Settlement Supervision. We believe new regulations could strengthen clearinghouses' financial safeguards by requiring them to hold more financial resources, such as margin, guarantee funds, and clearinghouse capital, to cover member defaults. Consequently, we don't expect the regulations to lead to any downgrades for exchanges and clearinghouses, and we could consider raising our ratings if these entities significantly strengthen their financial resources to the extent that they greatly exceed the regulatory minimums.

Establishing A Viable And Orderly Resolution Process

In tacit recognition that stricter prudential standards and tighter supervision still cannot prevent the failure of a SIFI, Title II (Orderly Liquidation Authority) of the DFA grants an orderly liquidation authority to the Federal Deposit Insurance Corp. (FDIC) as an alternative to bankruptcy under Chapter 11 of the Bankruptcy Code. A financial company governed by Title II would be subject to this process if the FSOC determines, among other things, that the company is in default or in danger of default and the failure of the company and its resolution under Chapter 11 of the Bankruptcy Code would post systemic risk to the U.S. Although setting high prudential standards is positive, we do not believe that legislation alone can ensure market confidence at all times, even though regulators attempt to promote it.

The FDIC has worked toward building a credible resolution process in the past two years. The living wills that banks have submitted as part of their contingency planning will aid this process. The regulator recently has advanced the notion of a single-receivership resolution plan that includes FDIC takeover of the parent holding company but leaves solvent operating subsidiaries operating normally. The FDIC would establish a new bridge holding company with assets consisting mostly of the investments in subsidiaries and loans to subsidiaries. The subordinated debt and equity would remain in receivership, although certain other senior unsecured debt and contingent liabilities may or may not pass to the bridge holding company.

The likely scenario is that preexisting shareholders and subordinated debt would bear losses, and the parent holding company would convert some of the senior unsecured debt to "new" equity sufficient to achieve appropriate capital levels at the parent. Former subordinated debtholders and shareholders would receive either call options on financial instruments to be distributed to senior classes or warrants or other contingent value rights. Therefore, the original parent's creditors would receive haircuts, failing to secure the full value of the debt through a still-undetermined process and in a still-undetermined amount. Limiting resolution to the holding company ensures that only one legal entity fails and, therefore, reduces "legal entity" risk when an entity is involved in multiple intermediate holding companies in multiple state and country jurisdictions, in the FDIC's view.

We see high execution risk for this process, and how it would work in practice is unclear. We also believe it's unlikely that subsidiaries of a holding company in receivership would be able to maintain "business as usual" operations. Counterparties would likely cease doing business with those subsidiaries to distance themselves from potential future losses if losses exceed the funding held at the holding company.

The bridge holding company would recapitalize the insolvent operating subsidiaries as necessary and provide liquidity immediately to all subsidiaries through an orderly liquidation fund. In this sense, the bridge holding company would serve as a "source of strength" for recapitalizing subsidiaries, as necessary, and funnel liquidity downstream through intracompany advances. Equity-solvent subsidiaries would operate and conduct business as usual. Operational restructuring and any divestitures would occur over time through supervisory agreements.

The FDIC contemplates removing only the failed holding company's CEO and replacing the original board of directors, but it is unclear whether the regulator would replace any other senior executives, including the heads of the operating subsidiaries. This would require enough potential CEOs and potential board members to draw from to replace the original management team. The bridge holding company would be held through a "trust" (FDIC could not be an equity owner) and would likely operate under a supervisory agreement that would include a credible operating business plan.

According to the FDIC, there are three major structural requirements for the implementation of this proposed strategy:

  • An adequate amount of unsecured long-term debt issued at the holding company level to absorb losses and recapitalize the firm, with two tiers: subordinate (for recapitalization/losses) and senior (for tail risk);
  • "Business as usual" operations and short-term borrowing at the subsidiary level; and
  • A stipulation that subsidiaries cannot be guarantors for contracts or obligations of the holding company.

We believe that, as resolution under the orderly liquidation authority becomes clear and the risk to senior bondholders of the original holding company rises, the market may move toward not accepting debt at the holding company, and, instead, all future debt may be issued by the operating subsidiary. In this situation, it is not clear what path the resolution would take. Furthermore, the mandates of many institutions that currently invest in unsecured debt limit their debt investments, making these entities unable to hold the converted equity of a new holding company. This has the potential to dampen the market for unsecured debt that is currently outstanding for SIFIs.

We further believe that implementing an orderly liquidation under Title II of the DFA could increase uncertainty in the market at a time when confidence is already low. For instance, dismantling a large financial firm might spur creditors to pull out of other similar financial firms in times of stress. Creditors may react by cutting off funding sooner and accelerating other bank failures. One lesson from the recent crisis is that fund providers' loss of confidence can quickly trigger liquidity events, which can lead to a firm's failure. So, although the DFA constrains the type and form of support that the government can give (requiring that the financial firm be in liquidation), we believe that amendments to the current legislation might prove necessary in future crises. This may especially be the case in circumstances that could depress the real economy and threaten the well being of the population. (For more information, see "The U.S. Government Says Support For Banks Will Be Different "Next Time"--But Will It?," published July 12, 2011.)

The FDIC recognizes the potential difficulties with implementing this process, including a lack of alignment in funding and operations across legal entities, high liquidity needs, and the distribution of operations across several jurisdictions. As for the difficulties in cross-border resolution, the Fed has noted that U.S. bank holding companies with $50 billion or more in assets own, in aggregate, more than 6,000 foreign entities. This includes over 550 foreign branches and entities that engage in a variety of activities, including investment advice, investment banking and securities lending, commercial banking, insurance, trust, fiduciary, and custody activities, and acting as financial vehicles.

The good news is that the FDIC has found that more than 90% of the total reported foreign activity is located in no more than three foreign jurisdictions, and more than 80% of the total reported foreign activity for each of the top five U.S. SIFIs comes from legal entities in the U.K. Moreover, 13 jurisdictions cover more than 97% of top five U.S. SIFIs' total reported foreign activity. Lastly, more than 85% of each SIFI's total reported foreign activity comes from two to four legal entities. However, the concentration of large operations in a few countries can also cause outsized risk, as the recently disclosed JPMorgan trading loss showed.

In our view, however, the greatest obstacle to overcome is the generally localized nature of the mechanisms for resolving distressed financial firms (including the priority of creditor claims and stays or suspension of actions against debtors) because firms' enterprisewide operations are mostly global. In addition, local regulators will need to learn to share information in times of stress. In sum, there is still no definitive framework for the coordinated resolution of cross-border financial groups or conglomerates.

Transitioning To Higher Capital Requirements

We believe that capital regulation is the area in which the regulators have advanced the most. Although capital alone is not enough to ensure banks' safety and soundness, capital should be available to absorb unanticipated losses. Alongside international banking regulators, Congress, with the passage of the DFA, recognized the importance of capital regulation for the prudential oversight of all banks, especially for the largest banking firms. Therefore, regulators are in the process of raising minimum regulatory capital standards that include an extra buffer for SIFIs, for which the Basel committee has recommended be 1.0%-2.5%.

After a long wait, the Fed announced final Basel 2.5 and draft Basel III capital rules for financial institutions on June 7 (see "For U.S. Banks, It's Finally Time For The Full Basel Rules," published June 18, 2012). The proposed rules aim to increase the level and quality of capital and enhance the market-risk sensitivity in the calculation of risk-weighted assets for capital adequacy purposes. For the most part, these rules will apply to all U.S. banks with more than $500 million in assets, although some of the requirements are higher and stricter for larger and more complex banks. However, these proposals do not yet incorporate either the SIFI surcharges or the liquidity and funding thresholds Basel III proposes. Comments on the draft rules are due to the Fed by Sept. 7, 2012. The Fed intends to implement the new minimum regulatory capital ratios and changes in their calculation by Jan. 1, 2015. It will phase in the capital conservation buffer between 2016 and 2018 and fully implement it by Jan. 1, 2019.

The larger banks have already gone through several years of capital planning exercises with the Fed. In the most recent Comprehensive Capital Analysis and Review, these banks submitted capital plans with pro forma capital analyses, including supporting projections, based on four scenarios: their own baseline forecasts, the Fed's baseline outlook, their own stress cases, and the Fed's stress case. The Fed also required the six largest banks (the globally systemically important banks, except the trust banks) to estimate potential losses that could arise from a hypothetical global market shock (see "Most U.S. Banks Passed The Fed's Stress Test, But Shareholder Returns Could Limit Needed Capital Increases," published March 19, 2012).

We monitor banks' performance against regulatory measures, and any weaknesses in these measures can be an overriding factor in our ratings. Absent any breach of regulatory capital minimums, the main factor in our assessment of a bank's capital and earnings, however, is our risk-adjusted capital (RAC) framework (see "Bank Capital Methodology And Assumptions," published Dec. 6, 2010), which offers an alternative, globally consistent measure of capital. Our opinion of a bank's capital position combines our capital and earnings and risk position assessments. We base our capital and earnings assessment primarily on our projected RAC ratios over the next one to two years, and we base our risk position analysis on a qualitative assessment of a bank's financial risks and risk management. Therefore, we do not anticipate any rating actions as the U.S. implements Basel III capital rules. Because the rules are subject to national discretion, which limits their global comparability, in our view, we apply our RAC framework to better capture risks in a globally consistent manner. Still, meeting or exceeding minimum regulatory capital requirements is essential for a financial institution to operate as a going concern in the normal course of business.

Undoubtedly, more capital, especially common equity, is always better. But many of the banks that failed received extraordinary government assistance, or were acquired just before failing during the recent financial crisis, and had high regulatory capital ratios just prior to their distress. Therefore, high regulatory capital ratios alone may not be enough to preempt a "run on the bank" as regulators expect, which reveals the limitations of a rule-based system.

Volcker Rule Needs Thorough Reexamination And Simplification

Section 619 of the DFA, more commonly known as the Volcker Rule, is perhaps the most complex, controversial, and contentious section of the act. The rule--which prohibits banks and their affiliates from engaging in proprietary trading and sponsoring or investing in private-equity or hedge funds--has stirred up disagreements among politicians, regulators, and bankers (or their lobbyists). The issue has become highly politicized in this election year, and we are not certain that banking regulators will issue definite rules before the end of 2012. In the meantime, banks have already changed their business models and are preparing for limits in proprietary trading. However, in our view, bank management teams will eventually succumb to the pressure to improve shareholder returns, and risk will return to the banking system in another form.

The DFA mandated that the Volcker provisions take effect either within 12 months after the issuance of final rules or within two years from enactment of the DFA--whichever came first. Generally, banks must comply with the rules within two years after they become effective, but it's possible to extend the deadline up to three years in one-year increments. Last October, the Fed, the FDIC, the OCC, and the SEC put out a proposal to implement this rule. The CFTC issued a similar proposal later on. The proposals received nearly 19,000 comments before the comment period closed, and final implementation rules are pending. Last April, the Fed clarified that banks will have the full two-year period under the statute (until July 21, 2014) to comply, unless the Fed extends that period.

The first of the Volcker Rules' main issues is one of definition--that is, defining what distinguishes proprietary trading from market-making or hedging activities. Although there are arguments on both sides about whether or not a transaction is proprietary trading, there seems to be unanimity that it's complicated to determine, from the outset, whether a bank is a buying a security for its own trading account or to facilitate the purchase and sale of that particular security for market participants. Some observers suggest that the rule will not hurt markets because there will always be an agent willing to step in and provide liquidity, but we disagree. Ultimately, this potential new player would likely work in the unregulated shadow banking world, which would not be a desirable outcome, we think.

The second contentious issue is the rule's assumption that all proprietary trading is risky and that traditional banking activities are not. Many banks failed because of oversized credit losses from traditional banking products. In our view, it is the failure of risk management that causes a bank to fail. Although it's true that some activities are naturally riskier than others, if the pricing is accurate and the monitoring of embedded risk is adequate, banks can minimize potential losses. The Volcker Rule debate has flared up in the aftermath of JPMorgan's initial report in May of a $2 billion trading loss. Some are asking whether the rule would have prevented such a big loss, the disclosure of which has brought more regulatory scrutiny to both JPMorgan and to the spirit of the rule. Fed Chairman Bernanke's view is that the Volcker Rule's requirements for documenting the rationale for a trade, along with its auditing process, governance rules, and compensation limits, would likely have changed the outcome for JPMorgan. It is difficult to argue the contrary.

Shining A Light On Shadow Banking

The DFA's progress toward greater regulation of the shadow banking sector has been limited, and results are mixed, in our view. The financial crisis revealed that a large proportion of the system's risk is with "shadow banking" participants, which encompass not only special-purpose vehicles that are beyond the Fed's supervision (such as money market funds and government-sponsored entities (GSEs)) but also specific instruments such as swaps, repurchase agreements, and asset securitizations. However, investors can oversimplify investment vehicles. The products are complex and interact very differently with the formal banking system than more traditional products do.

Both international and U.S. banking regulators continue to struggle with designing a regulatory framework that contains systemic risk by eliminating regulatory arbitrage and providing greater transparency in the system. For our part, we believe swathes of shadow banking activity--in both new and existing forms--will continue to operate and grow outside the reach of regulators once the economic recovery is more certain. (For more information, see "A Supervisory Framework For U.S. Shadow Banking Is Progressing Slowly," published May 9, 2012.)

Although some market observers have reported that shadow banking has filled the void left by traditional banking, we do not see evidence of this in the U.S. A sluggish economic recovery, the slow creation of consumer assets, the pronounced retreat from riskier funding activities, and listless securitization markets have all constrained shadow banking. That is not to say that shadow banking won't grow again once investors resume their search for high returns from financial services. In fact, we expect that a subdued outlook for bank returns could spur greater interest in the relatively unencumbered shadow banking segment. Some of that growth could stem from investors' efforts to boost capital by focusing on specific portfolios of assets that may allegedly require less capital for support. Growth could also result from innovation that focuses more on regulatory arbitrage of capital, liquidity, or transparency, as opposed to improving asset-liability management. However, market conditions, not specific banking regulations, determine the level of leverage and access to funding for participants in the shadow banking system.

That is why banking regulators are keen to create a framework that ensures greater transparency in the shadow banking system. For instance, some segments of the market for repurchase (repo) agreements remain opaque, with a lack of information on the volume of transactions not settled using the triparty repurchase mechanism traditional for financing cash-rich entities. In particular, regulators have focused on containing the potential risk from the substantial volume of intraday credit that triparty clearing banks extend. The traditional practice of returning the cash to the investors and the securities to the dealer's account on a secured basis (the "repo unwind") each day creates risk exposure for clearing banks that regulators have been eager to minimize.

The Task Force on TriParty Repo Infrastructure, under the Payments Risk Committee the Fed sponsored in 2009, has initiated a few operational improvements. For example, all repo trades now require three-way confirmation between the lender, the borrower, and the triparty agent. In addition, the task force moved back the time for repo unwinds for most trades to 3:00 p.m. from 8:30 a.m., which reduces the window during which clearing banks extend intraday credit. Nevertheless, regulators continue to grapple with the potential systemic risks of shocks stemming from abrupt changes in the value of the underlying collateral, as well as the lack of transparency in some segments of this market.

Another area of intense regulatory focus is that of money market mutual funds (MMMFs). The Fed and the SEC aim to reduce the perceived vulnerability to runs by addressing the structural weaknesses in this market, including exposure to short-term funding of banks. The SEC has pointed out that there have been about 300 occasions since the 1970s when the money fund sponsors have chosen to support a fund financially. Two ideas involve a shift to a variable floating net asset value (NAV) from a constant NAV and redemption holdbacks combined with minimum capital requirements. However, regulators and industry players have a hard time reaching consensus. If the SEC does not pursue additional regulations for MMMFs, we believe the FSOC retains the discretion to determine whether or not a large money market fund poses a threat to the financial stability of the U.S. If such a designation were to occur, the Fed would supervise that fund and hold it to prudential standards. The credit impact that any regulatory changes have on an MMMF we rate depends on the regulations' effect on the fund's ability to maintain a stable NAV.

Nonetheless, although regulators will subject parts of the nonbank system to greater scrutiny and, potentially, more stringent supervision, we do not foresee a radical departure from the existing two-tier (traditional and shadow banking) structure of the U.S. financial system anytime soon. And we expect some shadow banking activity to continue to grow--and remain unregulated--once the economic recovery picks up.

Increasing Oversight For OTC Derivatives

In our opinion, mandatory central clearing of OTC swaps--mostly interest rate swaps and credit default swaps (CDS)--could alter competition and introduce new dimensions of risk to the detriment of some central clearinghouses' credit health. Although central clearing of OTC swaps is not yet mandatory, the market is already advancing toward this inevitability. For example, exchanger operator CME Group cleared $211 billion notional amount of interest rate swaps and a $72 billion notional amount of CDS in first-quarter 2012, compared with negligible amounts through the first half of 2011.

The CFTC has also finalized internal business conduct rules requiring swap dealers to establish policies to manage risk, as well as to put up firewalls between a dealer's trading and clearing and research operations. Last April, the CFTC and the SEC finished a joint rule that defined the terms "swap dealer" and "securities-based swap dealer." Under these rules, dealers will register with the SEC two months after the SEC and CFTC finalize the second major definition rule of the terms "swap" and "securities-based swap." Swap dealers would be among those that may have to register with the CFTC.

As with other regulatory reforms, the cross-border application of swaps reform remains an open issue. JPMorgan's recent loss, which took place at a London-based trading desk, further reminds us how overseas trades can quickly cause losses in the U.S. Section 722(d) of the DFA states that swaps reforms shall not apply to activities outside the U.S. unless those activities have "a direct and significant connection with activities in, or effect on, commerce of the United States." Therefore, DFA has limited ability to prevent swap losses that originate abroad.

The CFTC plans to release its interpretation and related guidance on this provision for public feedback soon. The proposal will likely direct foreign entities that conduct more than a minimal amount of swap deals in the U.S. to register under the DFA swap dealer registration requirements. It also includes a tiered approach for overseas swap dealer requirements. Entity-level requirements would apply to all registered swap dealers, but, in certain circumstances, overseas swap dealers could meet these requirements by complying with comparable and comprehensive foreign regulatory requirements, or "substituted compliance."

Transaction-level requirements would apply to all "U.S.-facing transactions," or transactions with entities operating or incorporated in the U.S., as well as transactions with their overseas branches. Likewise, this would include transactions with overseas affiliates that a U.S. entity guarantees, as well as the overseas affiliates operating as conduits for a U.S. entity's swap activity. Lastly, the DFA's transaction-level requirements may not apply to certain transactions between an overseas swap dealer and counterparties not guaranteed by or operating as conduits for U.S. entities, including a foreign swap dealer that is an affiliate of a U.S. entity--for example, a transaction between a foreign swap dealer and a foreign insurance company that a U.S. firm doesn't guarantee. The CFTC acknowledges that there is no easy way to prevent the transmission of the risk from a foreign subsidiary to its parent bank. The CFTC also is considering publishing guidance on phased compliance for foreign swap dealers.

The Oversight Of Mortgage Finance

In our view, DFA fails to address the housing finance system under Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac have received billions of dollars in support since they were placed, in 2008, in the conservatorship of the newly created Federal Housing Finance Agency (FHFA). It has been difficult to reconcile the government's aims of promoting housing affordability and preventing foreclosure with minimizing losses in these GSEs. The FHFA's main purpose is to oversee Fannie Mae and Freddie Mac, as well as the Federal Home Loan Banks. To date, the FHFA has focused on mitigating the GSEs' losses and ensuring that mortgages remain available to borrowers through new, modified, or refinanced loans.

The FHFA is also, however, seeking a resolution of the conservatorships of Fannie Mae and Freddie Mac. It has presented a plan with three strategic goals: to build an infrastructure for the secondary mortgage market, to gradually reduce Fannie and Freddie's market dominance by simplifying and shrinking their operations, and to prevent foreclosures and maintain credit availability for new and refinanced mortgages. In our view, there is no simple resolution to Fannie and Freddie. Although these steps should help lead to a solution, we believe they also present a few hurdles. (For more information, see "The Housing Market Remains A Sore Spot For U.S. Banks," published on March 7, 2012, and "The FHFA's Proposed Plan For Fannie And Freddie Could Shrink The Mortgage Market," published March 12, 2012.)

The FHFA's plan strives to create a more level playing field for GSEs and private investors that should help increase private investors' role in the secondary mortgage market. We expect the transfer of credit risk to private investors from the GSEs to have negative implications for the housing market and credit availability over the next three to six years. The mortgage market would likely shrink because mortgage rates would increase and lenders would seek higher-quality borrowers to offset credit risk and higher funding costs relative to the GSEs. In our view, timing will be critical, especially with regard to the transfer of credit risk, since the mortgage/housing market currently is not robust enough to support such a transition without hurting the economy. We further believe that, although proposed strategies for foreclosure prevention would help stabilize the housing market, the pending resolution of representations and warranties claims is a hurdle and may further complicate the transition to a private-sector solution.

Lastly, although the DFA left the reform of Fannie Mae and Freddie Mac to others, it did attempt to lessen risk in the mortgage market and regulate bank mortgage lending by requiring "skin in the game." The DFA's Title IX requires lenders that hope to sell loans into securitizations to hold 5% of securitized mortgages that do not meet FHFA's underwriting guidelines. We're still awaiting final rules on what a qualified residential mortgage will look like, but the standards will probably include guidelines on loan-to-value ratios, payment structures, and income verification, among others, and will go a long way toward determining the future of housing finance and profitability. 

Boosting Consumer Financial Protection, Slowly

The Consumer Financial Protection Bureau (CFPB) has been working to create regulatory rules over the past few months, but consumer protection remains one of the areas of DFA with the slowest progress. High-priority segments for CFPB regulation include nonbank finance companies that operate in the mortgage, private student loan, and payday loan areas, and the bureau has also started defining the regulated segment for debt collection and has decided on some of the new regulations for money transfers. CFPB regulation is especially important because these firms fall outside of the banking regulatory framework (see "Why New Consumer Protection Measures Are Unlikely To Change Many U.S. Finance Company Ratings," published May 9, 2012).

The Need For More Whistles

In our view, the DFA regulatory scorecard shows uneven progress. The most difficult task, in our opinion, remains coordinating global regulatory reform across borders. It is important U.S. banking regulators remain focused not only on keeping to their deadlines but also on achieving international consistency.

We believe that, as a whole, the DFA is a positive step toward providing regulators with the tools and authority to identify serious problems early and to take action. However, it seems to implicitly assume that big bank failures cannot be avoided. Indeed, although the DFA prohibits aid to individual financial institutions, the Fed can design emergency liquidity facilities to support the financial system in general. The markets assume, nonetheless, that if the government has provided support once, it will to do so again. We believe financial market regulators are too focused on eliminating risks to the system and individual firms. Instead, in our view, their focus should be ensuring that risks are managed more effectively.

Related Research

Primary Credit Analyst:Rodrigo Quintanilla, New York (1) 212-438-3090;
Secondary Contacts:Devi Aurora, New York (1) 212-438-3055;
Carmen Y Manoyan, New York (1) 212-438-6162;
Matthew Albrecht, CFA, New York (1) 212-438-1867;
Charles D Rauch, New York (1) 212-438-7401;
Peter Rizzo, New York (1) 212-438-5059;
Craig Parmelee, CFA, New York (1) 212-438-7850;

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