WASHINGTON - With the release of the Volcker rule, the Dodd-Frank Act’s regulatory overhaul is making headway, giving banks a new degree of certainty about the limits of their business in the wake of the 2008 credit crisis.
The rule, issued Tuesday by five U.S. agencies, bars banks from speculating with their own money.
In the three years since Dodd-Frank was enacted, regulators also have completed guidelines on how the government will dismantle the largest financial firms if they fail; have taken steps to make derivatives trading more transparent; have increased the capital that banks must hold; and have defined which mortgages are considered risky.
“You can see the light at the end of the tunnel for the most important components of the rule-making process,” said Isaac Boltansky, an analyst at Compass Point Research & Trading LLC in Washington. “The most visible components of the Dodd-Frank Act are nearly finalized.”
Still, about a third of the hundreds of rules mandated by Dodd-Frank remain to be written or completed, including those governing credit rating firms and disclosure of counter party credit risk. Banks are challenging derivatives regulations in court. They’ve also managed to reduce the impact of some changes through lobbying as the rules are being written.
Among the remaining mandates are higher bank liquidity requirements to comport with international Basel III agreements and removal from Securities and Exchange Commission rules of third-party credit ratings as an acceptable measure of credit-worthiness.
Still, the new regulatory architecture is already reshaping the way financial institutions manage risk and conduct operations.
Banks are holding more liquid capital. Accounting has become more transparent. Regulators have much better information about the prices realized on completed swap trades, and large hedge funds now report previously secret financial information to regulators.
The result could form part of the legacy of President Barack Obama, who took office just after the financial crisis and made Dodd-Frank a centerpiece of his agenda.
The effects of Dodd-Frank began rippling through the financial system even before the rules were written. Barney Frank, the former Democratic congressman from Massachusetts who co-wrote the legislation, said the fact that rules were pending “had a restraining effect” on bank risk-taking.
“What financial institution executive in their right mind would say, ‘There’s about to be a rule on this. I’ll sneak in under the wire and do this thing’?” Frank said.
Anticipating the Volcker rule, many banks shut down their proprietary trading desks or broke off stand-alone groups that traded separately from units that serve clients. New York-based Morgan Stanley spun out Process Driven Trading, a quantitative equity-trading unit, into a hedge fund. JPMorgan Chase & Co. shuttered its commodity proprietary-trading group,while Goldman Sachs Group Inc. closed at least two such units.
Banks “have just guessed what Volcker means, and Goldman Sachs and all the other firms have substantially reduced proprietary trading,” said David Stowell, a finance professor at Northwestern University’s Kellogg School of Management who previously was at JPMorgan’s head of Midwest investment banking.
Nonetheless, banks still fought regulators on the details of the rule, named for former Fed Chairman Paul Volcker, who advocated for it as an adviser to Obama.The lobbying is one reason it took regulators more than two years to come out with a final version after they released an initial proposal in 2011.
Business groups, which have sued to overturn several Dodd-Frank rules based on the quality of regulators’ economic analysis, have signaled that they may challenge the Volcker rule in court.
“We will now have to carefully examine the final rule to consider the impact on liquidity and market-making, and take all options into account as we decide how best to proceed,” David Hirschmann, president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, said in a statement.
In the rule adopted last week, regulators granted a broader exemption for banks’ market-making desks on the condition that traders aren’t paid in a way that rewards proprietary trading.
The rule also imposed tighter restrictions on hedging, providing banks less leeway for classifying bets as broad hedges for other risks. To pursue a hedge, banks would need to provide detailed and updated information for review by on-site bank supervisors.
The proprietary trading rules were issued as regulators are finishing guidelines designed to transform derivatives trading from an unregulated, opaque market to one that regulators have begun to monitor through exchange trading and clearing firms.
The work has largely been carried out by the Commodity Futures Trading Commission, a former backwater agency empowered by Dodd-Frank to oversee the market for swaps after the deals helped ignite the 2008 credit crisis. The results are “one of the more clear-cut actions that seems to be positive,” said Sebastian Mallaby, a senior fellow for international economics at the Center on Foreign Relations.
Wall Street’s biggest lobbying groups spent the past three years trying to temper or delay the Commodity Futures Trading Commission’s changes to the derivatives market.
Even with the regulatory parameters now mostly set by the Commodity Futures Trading Commission, the battles continue in court. Wall Street’s largest lobbying groups banded together to sue the agency over its policy for extending Dodd-Frank rules to overseas trading.
Still, groups advocating strong regulations say the Commodity Futures Trading Commission’s finished product for the most part overcame the push-back.
“There is a structure there that with good enforcement and good implementation, and continued willingness to stand up to efforts to find loopholes, should make a difference in that market,” said Lisa Donner, executive director of Americans for Financial Reform, a Washington-based coalition of consumer, labor and business groups.
Another milestone in the implementation of Dodd-Frank, Donner said, is the setup of the Consumer Financial Protection Bureau, the entirely new agency that monitors consumer lending.
Since starting work in July 2011 the bureau has revamped rules governing mortgage origination and servicing and has defined mortgage terms that will be considered abusive, such as excessive points and fees. The bureau has also recovered more than $760million for 7.9 million defrauded consumers in areas including credit cards, payday loans and mortgages.
Regulators also have set up a system through the Financial Stability Oversight Council for detecting firms that pose a risk to stability and subjecting them to tougher regulation under the Federal Reserve. And the government now has a process to wind down large, complex institutions that it lacked during the crisis, when Lehman Brothers Holdings Inc. failed and American International Group Inc. was bailed out.
“No regulatory reform effort is perfect, but I do think we have made progress on the problem of too big to fail,” said Michael S. Barr, the University of Michigan law professor who helped write Dodd-Frank as the Treasury Department’s assistant secretary for financial institutions from 2009-10.
Information for this article was contributed by Carter Dougherty and Silla Brush of Bloomberg News.
Business, Pages 67 on 12/15/2013