UK: Of Roman Gods And Financial Reform - Janus And The Dodd-Frank Act: Looking Back, Looking Forward

Foreword

In Roman mythology, Janus is the god with two faces. One face looks backward, the other into the future, a duality that neatly serves our consideration of the range of views expressed about the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) passed one year ago. The enormous and far-reaching act has been loved and loathed from the moment it was conceived to today. Its place in history is a matter of opinion, its impact a matter of intense debate.

Is it the biggest and most important piece of financial sector regulation since Glass-Steagall in 1933 or a temporary stop-gap that may quickly seem irrelevant as time marches on and circumstances render its principal premises invalid?

Will it achieve its central aim of making the US financial system less vulnerable to crashes and banking industry bailouts, or will it simply push the causes and effects of systemic failures elsewhere?

Put another way, would a meltdown of the financial system be possible in a post-Dodd-Frank world? Or are we fundamentally safer as a consequence of the Act's imposition of macro-prudential, or "systemic," oversight? In this paper we use the Janus principle—we look back over the last year and forward into the future from three very different perspectives:

• Of banks and financial institutions, which are subject to the Act
• Of regulators, who must implement it
• Of consumers of financial services, who face big changes in the future

To put it mildly, it is a very complicated story with multiple and overlapping narratives. As we try to show in the pages that follow, opinions vary across a wide range. We have tried to reflect that range by dividing the discussion into something like a Socratic debate—at each point, we hear from those voices representing different opinions as they set out their positions.

Let us be clear about what we are, and are not, doing in this paper. Deloitte LLP, its subsidiaries, and related entities are not adopting any of the opinions characterized below. Rather, we have sampled the noises and chatter in the market, picking up views that have been expressed on various sides and from various participants. Hence, while structured as quotes, the views described in this paper are not actual quotes from actual participants, and thus we have not attributed any single view to any particular institution or individual. But by sampling these opinions and views and framing them in a semi-Socratic hypothetical way, we aim to set forth in very general terms how the public debate over Dodd-Frank might be characterized—of course, as noted, there is a range of views on Dodd-Frank and many views in that range vary from those set out in this paper.

So, that said, let's start with the banks.

The banks

One of the most common words used to describe the impact of Dodd-Frank is "uncertainty." While it laid out the framework for major regulatory changes, the Act left a lot of the details to be worked out via consultation, study, and rulemaking, all of which take time and leave open the potential for further change and, thus, uncertainty. Furthermore, even for elements of the law that appeared to be relatively clear—a good example is the Durbin amendment on card interchange fees—events, including the banking industry's own intense lobbying efforts, since July 2010 have likely served to muddy the waters. No one can say with any certainty what the end state might be, simply because there are many open issues and it appears that some of them may never be resolved.

The Act is the subject of ongoing debate, with one camp seeking to attack it from first principles and to water down its potential impact, and another defending it as a necessary, if incomplete and imperfect, response to the financial system crisis that is also having unintended consequences. Janus-like, let's look at both sides.

The banks look back

A Banker speaks against: "Dodd-Frank is as unwieldy in practice as it promised to be in preparation. It lacks coherence and is unlikely to reduce the risk of future crises. It imposes needless costs on the banking industry and the consequent reduction in earnings potential will seriously damage the competitiveness of the US financial system in a world of uneven regulatory responses. We're overrun with regulators, and the process of moving from writing the law to the application of the law has been an ongoing nightmare, with complicated rulemaking procedures and overly heavy bureaucracy. It has been almost impossible to make sensible strategy given the degree of uncertainty over issues as basic as capital requirements. As for those institutions deemed to be systemically significant, the so-called systemically important financial institutions (SIFIs), the new prudential framework looks like an ill-thoughtthrough tax based on an institution's size."

A Banker speaks for: "The Act may have shortcomings and its implementation is far from complete. But it has already forced the banking industry to get on with some very useful improvements. There have been notable advances in risk management governance standards, with boards in particular improving their ability to oversee and discuss firms' risk- taking activities. Related to this, the industry has been spending more on improving its data and IT systems, changing for the better banks' ability to aggregate data into more meaningful information that can serve as a basis for enhanced risk management oversight at all levels. Even though they remain works in progress, different aspects of systemic regulation are shaking up how banks look at and report on their core operations. Stress testing has entered the main box of risk management and reporting tools. The parallel efforts to improve legal entity structures and to enhance the ability to wind up a single bank in an orderly fashion represent major advances in the safety of the system as a whole. The SIFI designation is also a big step forward and shows that regulators are taking a much broader view of what can cause problems for the financial system as a whole."

Questions bankers may be asking themselves at the first anniversary of the Dodd-Frank Act being signed:

• What is this reform ultimately going to cost?
• Do we have the wherewithal to restructure our businesses, operating model, and balance sheet to excel in the years ahead?
• Are we adjusting our business model both to mitigate risk as well as take advantage of hidden business opportunities in the long term?
• If we are deemed systemically important, what are the consequences we should be thinking about?
• How many of the rules already proposed will change? Can we expect some of them to be further diluted?
• How do we minimize regulatory implementation challenges and provide the transparency to keep the regulators satisfied?
• When it comes to dealing with the risk-based compensation proposal, just how many people will we have to identify to regulators? Is it 10,000? 5,000? 1,000?
• What are the external impacts of the new capital-related regulations on pricing of products, competitive positioning, and even geographic location of our businesses?
• What will the Consumer Financial Protection Bureau (CFPB) mean to my business on July 21?
• Before we roll out new financial products, should we be thinking about a new financial due diligence process to help ensure the product will stand the test of time?
• Will living wills really work in a time of crisis, especially for the biggest banks?

The banks look forward

A Banker speaks against: "A year from now banks will still be struggling with the regulatory burden of Dodd-Frank. On a positive note, they also have plenty of opportunity to water down the Act's impact. CEOs are already much more vocal in defense of their industry. They will likely carry on their lobbying against specific provisions, as well as seek to influence the rule writing on many others. Meanwhile, they may be able to innovate to find their way past some of the more onerous provisions, in particular the capital and liquidity regime that threatens them with the potential for systematically lower earnings by trapping too much money in low-return businesses. The overall risk profile of the industry is unlikely to shift very much, but there might be changes in where risks sit by way of institutions—the shadow banking system could become much more important, raising the question of whether Dodd-Frank is largely irrelevant. Ongoing political change in the US means there is even the chance of future repeal of key aspects of Dodd-Frank. Meanwhile, other events are already putting Dodd-Frank in the shade. The pressure on sovereign credits in Europe and issues associated with the US mortgage market are just two examples of why the Act may be less and less important over time. And don't forget about the Basel capital rules."

A Banker speaks for: "By July 2012, Dodd-Frank's far-reaching impacts should be much clearer. The banking industry is going to be much more tightly overseen, both internally via improved governance of risk activities and externally via the new regulatory requests for stress testing and the provision of risk information. Banks may need to be much better at managing their counterparty risk exposures and will likely operate with much more efficient deployment of properly costed capital. Although Dodd-Frank did not mandate legal separation of activities, its actual impact may turn out to be as important in the 21st century as Glass-Steagall was in the 20th century. Risky trading activities may be increasingly clearly demarcated from core banking functions and many may accept the principle that institutions will not be bailed out with taxpayers' money, but rather will be allowed to fail in an orderly fashion. The introduction of consumer protection is the beginning of further fundamental change in how the industry relates to its customers and is likely to see profound changes in business practices and product design."

The regulators

The regulators look back

A Regulator speaks against: "A measure of how difficult the task of implementing the Act has been over the last year is the extent to which the rulemaking process is still very far from being complete. As of June 1, according to monitoring by the law firm Davis Polk & Wardwell LLP, only 24 of the Act's required 385 rules had been finalized. A further 28 were behind schedule and 115 were at the proposal stage. A massive 218 rules remain to come. The regulatory process is also rather variable given the time pressures we've been under. One published rule ran to 600 pages, or roughly one-quarter the length of the entire Dodd-Frank Act itself. Other rules are very prescriptive rather than setting out operating principles, a tendency that can complicate the implementation and monitoring of banks' subsequent compliance. Meanwhile, we have had to shift attention away from Dodd-Frank and on to other issues, notably the mortgage market. There is a real danger that as regulators we may have effectively missed our opportunity and that politics has taken center stage once more."

A Regulator speaks for: "Dodd-Frank was a suitably broad policy response to the financial crisis, and it is no surprise that it is throwing up formidable challenges. However, the main regulatory efforts are largely on track and are already having significant impact on the safety and soundness of the banking industry. There has been a lot of progress on introducing systemic oversight, although there remains a lot more to be done. The Financial Stability Oversight Council (FSOC) is up and running and shows promising signs that interagency cooperation can happen. As permanent heads are appointed to fill the numerous institutional gaps that exist today, the structures of oversight will bed down. Consumer protection is moving ahead with hundreds of staff hired and important work underway on mortgage lending. The increased industry focus on risk is a good thing and regulators are playing their part. For example, the Federal Deposit Insurance Corp. alone has increased the number of its risk management assessors from 1,200 at the end of 2007 to 1,900 as of April 1, 2011, according to recent testimony given by its director. Resolution of failed or failing institutions has been streamlined, and the number of bank failures appears low given the severity and proximity of the crisis. This is a more-than-respectable record and a vindication for the principle of regulation."

The regulators look forward

A Regulator speaks against: "By July 2012, the story will likely have been mainly one of 'more of the same,' even though the world will have moved on. More rules and some of the Dodd-Frank mandated studies will likely be behind schedule because the deadlines are just not realistic, symbolizing the fruitlessness of the overall task. As time passes, the relative inexperience of newly hired regulators in some agencies may begin to show up in mistakes and further delays. Those parts of the new regulatory framework that are in place will come under pressure as banks shift their activities into other areas where there is lighter or no regulation, and innovation is easier. Monitoring an industry that might throw off numerous smaller players may become increasingly difficult. The problem of credit availability is likely to worsen as tightening capital and liquidity requirements bite harder on banks. And don't forget that an election looms in November 2012. There could be a fresh regulatory mandate depending upon the results."

A Regulator speaks for: "Look one year ahead and there likely will have been a lot of progress towards the full implementation of Dodd-Frank. With such a huge undertaking, some slippage is inevitable, but critics are carping when they complain about the overall effort. Complaints that there is too much and too heavy a regulatory burden are a distraction from the reality that the financial system is now safer and better overseen, even if some of that is a consequence not of Dodd-Frank but of business pressures resulting from the crisis. Frankly, even if the only aspect of Dodd-Frank to survive is the SIFI designation and the functioning of the FSOC, the historic impact of Dodd-Frank will have been dramatic. Sometimes it genuinely takes time to appreciate the importance of laws that are highly complex and require dedicated care as they are implemented. A lot of what is being done is so innovative from a regulatory perspective that it is only fair to accord the process some leeway."

Questions regulators may consider at the first anniversary of the Dodd-Frank Act being signed:

• Do we need to reconsider our staffing resources and the means to monitor banks effectively?
• Have we explored all of the relevant side effects of proposed regulations? Even more importantly, will the extensive amount of rulemaking cause any unintended consequences?
• What timelines for proposed rulemaking will slip more than intended?
• What should the time frames be for enforcing new rules, and what grace periods will be required for those to get up to speed operationally?
• How best can we accelerate international harmonization of rules, including in the timing area?
• Are we creating an uneven playing field for the domestic industry by regulating in advance or in an asynchronous manner, as compared to other countries?
• How do we prioritize risks to help ensure that the most serious ones are being addressed?
• Given the challenges banks say they are facing in responding to new data-reporting requests, are there best practices we can share so that everyone gets on the same page?

• What is the appropriate level of a SIFI surcharge to drive the desired results of creating well-capitalized banks better able to withstand systemic shocks? " How frequently will stress testing and living will plans be updated?
• How will the CFPB and the Office of Financial Research interact with their regulatory brethren?
• How do we make sure all of the new data we receive from the banks remains private?
• Given the pace of the past year, is our staff nearing a point of regulatory burn-out?
• Do we have enough arrows in our quiver now to successfully tackle the next crisis?

Consumers

Consumers look back

A Consumer speaks against: "Most consumers have hardly noticed Dodd-Frank. This is partly because not much of it directly affects them. But they have also been busy dealing with the personal consequences of the credit crunch and the recession. According to research conducted by the Deloitte Center for Financial Services, one in 10 of retail bank customers has been delinquent or has defaulted on a financial obligation in the last two years. And the ongoing situation in the mortgage market is a huge reality check—it is a far more telling example of what matters to consumers than the thick pages of legislation in Dodd-Frank. As for consumer protection, it might not have much impact. A lot of costs that Dodd-Frank imposes on banks will likely be passed on to customers anyway."

A Consumer speaks for: "The introduction of consumer protection is a landmark in US financial regulation and is the beginning of a fundamental rewriting of the contract between banks and their customers. The early signs are that the CFPB can have a dramatic impact on the clarity of product descriptions, including those that may matter most to consumers, notably mortgages. New proposed risk disclosure forms are already a good step in the right direction. It may take more time, but Dodd-Frank is a huge boost to consumer rights."

Consumers look forward

A Consumer speaks against: "Expect more of the same! The economy and how it evolves will likely be much more important to consumers than the slow evolution of consumer protection. And politics is a strong force here, with a presidential election looming."

A Consumer speaks for: "By July 2012, the CFPB is likely to be well staffed and have an approved director to lead its mission. It will likely gradually extend its reach, fulfilling its initial work to reform the mortgage market and then beginning to examine other financial products. As banks and other financial institutions realize that the agency is here to stay, they may increasingly decide to work alongside it to improve product transparency and thereby lessen their risk of legal backlash. As the agency grows into its role, it may also become clearer that there is a fundamental link between how products are sold and the risks associated with those products for consumer and provider alike—banks can potentially evolve towards a stronger operating model in which there is less operational risk thanks to better disclosure and enhanced business processes around more strictly defined products. The signs are that the history books will call out Dodd-Frank consumer protection as one of the great legislative steps forward of the early 21st century."

Questions consumers may be asking themselves at the first anniversary of the Dodd-Frank Act being signed:

• Is my institution secure?
• Is my information secure?
• Will any of what's happening now result in a higher cost of compliance that might be passed onto me?
• Will these changes make access to credit easier?
• How are financial institutions going to be evaluating me and other customers going forward?
• What do I need to do to get perks from a bank?
• Will this simplify disclosures?
• What are the implications of new requirements for any type of bank customer?
• How does this impact cost and availability of credit for both corporate and retail customers?
• Who will I clear with and why (and how much will it cost)? How much more initial margin will be required?

Stay tuned

Dodd-Frank was an extremely complex piece of legislation and remains so in its implementation phase. There continues to be debate about both the current and future importance of the Act. But the world is far from static, so events are unfolding even as rules and regulations are being written and introduced under the Act's timetable. It is probably too early to judge how the Act will be viewed when the history books are written. But as a practical matter, it is having, and will likely continue to have, a huge impact.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.