At first glance, the recently released Treasury report on banking regulation (Report) adds to a confusing array of proposals to reform U.S. financial regulation. But on closer look, the Report is a relatively balanced assessment of the drawbacks of the existing regulatory framework and a path forward to remedy some of the law’s deficiencies. This is especially true when it is compared with the stark alternative presented by the Republican Financial CHOICE Act, which this blog recently critiqued. The CHOICE Act would abolish several institutional protections established by Dodd-Frank to mitigate systemic risk and minimize taxpayer bailouts, and significantly dilute the strength of other Dodd-Frank protections if a financial institution met a 10% leverage ratio test. The Report does support, but does not aggressively advocate, such an “off-ramping” concept. The Report makes a largely uncorroborated claim that current regulation has “undermined the ability of banks to deliver attractively priced credit in sufficient quantity to meet the needs of the economy.”
The Administration is putting off to a later date consideration of the Orderly Liquidation Authority (OLA), a critical part of Dodd-Frank that is designed to enable regulators to dismantle a large, complex financial institution without undue disruption of the financial markets, as well as proposals to revise the regulation of asset managers, insurers, shadow banking, fintech, and the capital markets. The CHOICE Act would abolish the OLA and replace it with a new chapter of the Bankruptcy Code.
In its essentials, the Treasury plan, unlike the Congressional healthcare and financial market bills, is not structured as “repeal and replace”. In fact, it explicitly accepts the basic premises of the Dodd-Frank Act and would generally keep intact the bulk of its provisions. The Report purports to implement several “core principles” on financial deregulation proclaimed by Presidential order on February 3. Of most relevance here is the principle to “make regulation efficient, effective, and appropriately tailored.” In that vein, the Report offers what it calls a “sensible rebalancing or regulatory principles.”
Highly illustrative of this balanced approach is the Report’s consideration of the Volcker rule, which prohibits proprietary trading and risky investments. The Report agrees with the objective of the rule that banking institutions benefiting from the FDIC insurance backstop should not engage in speculative trading. The Report’s key recommendation is to loosen the rule’s requirements for the market-making exception, to remove “undue compliance burdens” in order to lessen the rule’s negative impact on market liquidity. The rule requires a trading desk to be able to defend the amount of its market-making inventory. An inventory higher than needed to facilitate customer transactions might be used for prohibited profitable speculation. Thus, a trading desk must estimate future investor demand on a daily basis in setting position limits, monitoring these limits, and creating a detailed audit trail. Even Paul Volcker, in a recent Bloomberg interview, agreed that the rule is overly complex: “If they can do it in a more efficient way, God bless them … Everybody wants to see it [simpler].”
In addition, the Administration would completely exempt smaller banking organizations with less than $10 billion in total assets, and large ones (only from the proprietary trading prohibition) whose business model does not include significant trading assets and liabilities.
The Report approaches bank capital regulation in the same manner as it does the Volcker rule. The Report would modify the “most burdensome” of bank capital regulation by raising the total asset thresholds for a wide range of capital rules. It would increase the $50 billion asset threshold that currently triggers enhanced prudential standards. Enhanced prudential standards require large bank holding companies to comply with heightened risk-management and liquidity standards, conduct liquidity stress tests, and hold a buffer of highly liquid, but low-yielding, assets. Even William Dudley, President of the New York Federal Reserve Bank, agrees that the $50 billion threshold should be raised. A higher threshold would also apply for capital-planning stress tests and living wills, both of which would be put on a two-year rather the current annual cycle. Similarly, the Report would raise the $10 billion threshold that imposes annual company-run stress tests and certain risk-management requirements.
But the Report is inconsistent in also arguing that the intensity of regulation should be based on the level of organizational complexity and business model in addition to balance sheet size. Thus, regulators could exempt larger banks based on these subjective factors before Dodd-Frank’s stress testing applies. However, such a tailored approach implies reliance on the discretionary action by the banking agencies, a prospect that both Congressional Republicans and the Administration have harshly criticized. Indeed, elsewhere the Report states that the discretionary nature of the Fed’s qualitative stress-testing component is “too subjective and non-transparent,” and thus should not be the sole basis for objecting to a bank’s capital plan.
The Report would make capital-planning stress testing and the living will review frameworks subject to public notice and comment, meaning that the Fed would need to engage in formal rulemaking before such supervisory tools become effective. This would require the Fed to take into account the industry’s formal objections, subjecting policymaking to industry lobbying even more than is currently the case.
The Report unfortunately recommends placing the Office of Financial Research (OFR), which studies systemic risk and is currently an independent department housed in the Treasury Department, under the control of the latter and subjecting it to Treasury’s budgetary process. The OFR Director would become removable at Treasury’s will. The Report’s recommendation would politicize this important research body, an issue of particular concern in the case of the present Administration.
Implications of the Treasury Report for finance compliance professionals
Projecting the trajectory of future financial regulatory reform and its significance for the compliance industry is a perilous exercise. This is particularly true when the forecast is based on a single Administration report that is part of a planned series of recommendations, and a much more radical proposal, in the form of the CHOICE Act, casts a looming shadow over the existing regulatory landscape.
Several factors point to only an incremental effect on the compliance industry. First, the White House proponents’ finance industry expertise and business acumen in “getting things done” likely played a role in crafting a feasible blueprint for regulatory reform. The Administration desperately wants to achieve a legislative victory. Moreover, the practicality and balanced features of the Treasury plan may be part of a strategy to jump-start a bill that could achieve support across the Congressional aisle. This author agrees with the opinion of one law firm that the Report may be a significant step towards implementable financial regulatory reform.
The Report’s approach to the Volcker rule, a prolific source of employment for compliance professionals, lends support to this argument. The current rule mandates a highly granular level of recordkeeping, monitoring, and compliance policies and procedures. While the Report would loosen the rule in this respect, it would largely leave in place the Dodd-Frank compliance framework. Moreover, the banking industry has invested billions of dollars in a Volcker rule compliance infrastructure. At this point, a loosening of the market-making exception may be a sufficient palliative.
A second point is also in the compliance industry’s favor. The task of the compliance function is first and foremost to monitor and minimize legal and regulatory risk. By eschewing “replace and repeal,” and endorsing and leaving in place the basic legal framework of Dodd-Frank, the Administration’s plan helps to ensure that this fundamental role of the compliance function continues to be a mainstay in financial institutions.
Third, large banks, whose compliance requirements it is argued will continue largely intact, employ a significant portion of the nation’s finance compliance personnel. The need to ensure compliance with Dodd-Frank’s systemic-risk requirements would continue for the large money center and regional banks. Deposit and total assets metrics tell the story. In 2016 the top 15 banks hold more than half of all deposits in the U.S. and the top five banks, nearly half of total assets. And for smaller banks, including community banks, existing supervisory oversight remains intact. From the onset, regulators’ focus under Dodd-Frank has been on the medium-sized and large financial institutions, where only incremental elimination of compliance requirements is predicted.
Nevertheless, the most significant counterargument is the 10% opt-out, a core feature of the CHOICE Act that is a rapidly replicating meme. By achieving a 10% leverage ratio, even the largest banking organizations would be relieved of much of the regulatory compliance burdens imposed by the Dodd-Frank Act. But the Report flags this concept in the form of a passing reference. It is not integral to the Treasury plan. It is much more likely that the Report’s authors are using it as a talking point in negotiating a workable compromise in the forthcoming legislative process.
Moreover, there are the lessons learned in the efforts of Republican leadership to pass their repeal and replace healthcare bill, the sole conservative legislative initiative regarding this critical policy issue. Unlike healthcare reform, the Administration has provided a relatively well-conceived and workable blueprint for revamping Dodd-Frank and other financial market regulation. The Report is a highly feasible and practical alternative to the Republican plan to dismantle Dodd-Frank, and the Republican leadership can’t ignore it in the upcoming negotiations. In addition, it is highly unlikely that the CHOICE Act will be implemented in its current form. And we now have a relevant data point – the faltering campaign by the Republican leadership to repeal and replace Obamacare.
Finally, the Administration is well aware of the populist repercussions if it and their Congressional allies remove legal and regulatory restrictions on the largest national and regional banking organizations. The widespread backlash against potential removal of the core protections of Obamacare has shown the limits of radical reform.
About the Author:
Director of the online Certificate in
Financial Markets Compliance and Clearing Corporation Charitable Foundation Practitioner in Residence, IIT-Chicago-Kent College of Law
Professor Dill is a recognized expert on the financial markets and the regulatory and compliance frameworks that apply to them.
Areas of expertise include corporate and securities law, securities regulation, bank regulation, secured lending, credit ratings, bankruptcy and restructuring, finance industry compliance, and securitization in a wide variety of asset classes.
He teaches securities regulation and business organizations at the Chicago-Kent College of Law. He also is Lecturer in the Financial Mathematics Program at the University of Chicago, where he teaches a course on bank capital regulation and the regulation of systemic risk, the derivatives markets, and counterparty credit risk under the Dodd-Frank Act.
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