Can Dodd-Frank stop another crisis?

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a statutory response from the United States federal government to the 2008-9 financial crisis.

Dodd-Frank is the most sweeping overhaul of the US financial system since the 1930s. The new law, much of which is still to be written by various federal agencies, basically has three goals: reduction of systemic risk between financial participants; reduction of structural leverage of the financial markets and increased transparency to allow appropriate pricing of risk and, when appropriate, governmental intervention.

Dodd-Frank also attempts to remove the implicit guarantee from the federal government of losses from large financial institutions that are “too big to fail.”

The Act fails, however, to address what many consider two potential causes of the financial crisis: the perhaps artificially low pricing of short-term funding by the Federal Reserve and the role of the government-sponsored enterprises, Fannie Mae and Freddie Mac.

Before discussing the merits of the legislations, it is important to understand the primary provisions of Dodd-Frank and their potential impact on the financial markets. First, Dodd-Frank puts in place several new entities and a statutory liquidation process to deal with systemically risky institutions.

A new Financial Stability Oversight Council has been created to monitor systemic financial risks. The Council will have significant authority to identify potential systemic threats and to direct the regulatory agencies to take action to address those risks.

The Federal Reserve is given new authority to impose increased regulations on bank holding companies and various other nonbank financial institutions, including heightened capital and liquidity requirements and other requirements such as a self-designed resolution plan.

A new process is established for US federal authorities to place bank holding companies and significant nonbanks into a receivership structure similar to the one currently in place for banks under the Federal Deposit Insurance Act. This is intended to give US federal authorities the power to act quickly to respond to potential liquidity or other crises of confidence involving non-depository institutions.

One of the most highly contentious provisions of Dodd-Frank is called the “Volcker Rule,” named after the former Federal Reserve chairman who originally submitted the regulatory proposal. The Volcker Rule prohibits banks and their affiliates from engaging in proprietary trading, subject to exceptions for certain types of assets and certain categories of transactions.

Banks and their affiliates will now face strict limits on investments in and sponsoring of hedge funds and private equity funds. Sponsorship and investment in such funds will be subject to certain conditions and with ultimate investment limited to 3 % of any single fund and an aggregate investment in all funds not to exceed 3 % of the entity’s Tier 1 capital. Existing relationships with funds that are not in conformance with Volcker Rule requirements will have to be divested.

Next, Dodd-Frank attempts to remove the assumed Federal guarantee of derivatives trading by requiring banks that receive assistance from the US government, including equity infusions, debt purchases and the like, to remove risk swap activities to affiliates that do not have access to existing federal guarantees.

Finally, Dodd-Frank establishes a new regulatory framework for the over-the-counter (OTC) derivatives markets. Dodd-Frank now requires clearing and exchange trading for derivatives contracts that are eligible for clearing and accepted by newly established derivatives clearinghouses.

The law will also impose, for the first time, capital and margin requirements and various reporting obligations on OTC swap dealers and most large OTC swap participants. These dealers and swap participants will also be required to register with the Securities and Exchange Commission or the Commodity Futures Trading Commission.

Impact

The three main themes of less risk, less leverage and more transparency run through all of these provisions of Dodd-Frank. For example, the new capital requirements for bank holding companies and the new margin requirements for swap participants effectively deleverages the financial activities of these market participants.

The monitoring by the Financial Stability Oversight Council, and the information that will be provided by market participants to the Council, will greatly enhance market transparency. The prohibition of risk swap activities by federally insured banks assists in de-risking the banking sector.

However, notwithstanding that the legislative text of Dodd-Frank runs to over 2,300 pages, the law is notable for two glaring omissions in its effort to address the causes of the financial crisis. First, Dodd-Frank does not take into account government regulation of pricing of short-term funding by the Federal Reserve. Many people believe that the artificially low pricing of shot-term debt – essentially the federal government subsidising money - was one of the core causes of the overleveraging of the real estate market.

The other shortfall of Dodd-Frank is the lack of attention to the role of the two government-sponsored enterprises, the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

The promotion of widespread home ownership among many US citizens who would have been unable to purchase a home without federal assistance lead to nation-wide foreclosures once their limited equity in their homes eroded due to falling home prices.

Dodd-Frank is a regulatory reset of much of the US financial landscape. Enhanced transparency should promote the proper identification and pricing of risk. Increased capital and margin requirements, if implemented carefully, may be able to deleverage the US financial markets while not overly burdening a capital-deprived US economy.

While Dodd-Frank declined to address important underlying causes of the financial crisis, the new legislation may provide for the necessary groundwork for the establishment of a more transparent, more robust and more reliable US financial system.

Matthew Kerfoot is a counsel in Dechert’s financial services practice in New York

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