With the release of the Volcker rule, the Dodd-Frank Act’s regulatory overhaul is largely complete, giving banks a new degree of certainty about the limits of their business in the wake of the 2008 credit crisis.
The rule, issued yesterday 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 when they fail, taken steps to make derivatives trading more transparent, increased the capital banks must hold and defined which mortgages are considered risky.
Explaining the Volcker Rule
“You can see the light at the end of the tunnel for the most important components of the rulemaking 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.”
To be sure, 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 counterparty 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 Basel III agreements and removal from SEC rules of third-party credit ratings as an acceptable measure of credit worthiness.
Still, the new regulatory architecture has already begun to reshape 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.
Related: Wall Street Exhales as Volcker Rule Seen Sparing Market-Making
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.
“Our financial system will be safer and the American people are more secure because we fought to include this protection in the law,” Obama said in a statement yesterday.
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 in an interview.
Anticipating the Volcker rule, many banks shut their proprietary trading desks or broke off standalone groups that traded separately from units that serve clients. New York-based Morgan Stanley (MS:US) spun out Process Driven Trading, a quantitative equity-trading unit, into a hedge fund. JPMorgan Chase & Co. (JPM:US) shuttered its commodity proprietary-trading group, while Goldman Sachs Group Inc. (GS:US) closed at least two such units across equity and fixed income.
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 yesterday, 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 regulation also exempts some securities tied to foreign sovereign debt.
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 last three years trying to temper or delay the CFTC’s changes to the derivatives market.
In thousands of meetings and in tens of thousands of letters, banks, trading platforms and energy companies sought to limit the reach of the rules requiring most trades guaranteed at clearinghouses and traded on new platforms. Energy companies won a change that limited how many would need to register as dealers, while financial firms successfully limited how much price competition was required before a trade was conducted.
Even with the regulatory parameters now mostly set by the CFTC, 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 CFTC’s finished product for the most part overcame the pushback.
“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 (0205515D:US), 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 CFPB 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 CFPB has also recovered more than $760 million for 7.9 million defrauded consumers in areas including credit cards, payday loans and mortgages.
In July, the Senate ended a two-year fight over the CFPB’s leadership by confirming Richard Cordray, a former Ohio attorney general, to the director’s post. It also turned back Republican attempts to restructure the agency.
The CFPB “is beginning to have an impact on the consumer finance market and that’s only going to deepen and accelerate,” Donner said. “As the crisis taught us, the consumer-finance market and the housing market don’t exist separately from the rest of the banking system.”
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.
Now, regulators and lawmakers are beginning to debate whether the collective effect of all the Dodd-Frank rules will have their intended effect: to end the existence of institutions whose failure would have such a devastating impact on the financial system that the government must bail them 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 to 2010.
“There is an empirical question whether the large institutions can be forced to internalize the cost of their size and the risk they might pose to the system,” Barr said in a telephone interview. “And that is why we have stronger supervision and stronger resolution authority to wind them down.”
Others have doubts that Dodd-Frank has done enough to guard taxpayers against future bailouts. Senator Sherrod Brown, an Ohio Democrat, and Senator David Vitter, a Louisiana Republican, in April introduced a bill imposing even higher capital requirements on the largest banks.
“One thing Congress said it wanted to do with the Dodd-Frank statute was end the possibility of bailouts,” said David Zaring, an assistant professor of legal studies at the Wharton School of Business at the University of Pennsylvania. “I am skeptical that in the end it would do that. I do think it is giving the largest banks something to think about about when they think about whether they should grow.”
Still, Zaring said, by other measures, the agencies implementing Dodd-Frank have accomplished a lot.
“If the question is, are the regulators rolling out a really complicated statute that changes a great deal of what we do in the financial system quickly, then I think the answer is yes,” he said.
The completion of substantial financial regulatory reform could also become a lasting part of Obama’s legacy, said Julian Zelizer, a professor of political history at Princeton University.
“It’s big policy,” Zelizer said in a telephone interview. “It’s the kind of legislation people will talk about decades from now.”
At the same time, he said, the law’s effectiveness at preventing another financial crisis will determine whether it’s a positive or negative part of the Obama record. “It’s the kind of program that not only goes on the scorecard, but it has to work,” Zelizer said.
To contact the reporters on this story: Clea Benson in Washington at firstname.lastname@example.org; Dave Michaels in Washington at email@example.com
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