Written By: Morgan Jones – Corporate Finance
The Barack Obama Administration in the United States passed the Dodd-Frank legislation in 2010. It was supposed to be the foundation for the regulation of finance, put in place in the aftermath of the 2008 financial crisis to rectify the excesses of markets and financial institutions. The Dodd-Frank Act stipulates that commercial banks as well as financial institutions supervised by the US Federal Reserve will no longer be able to speculate on their own behalf unless they invest with clients. Moreover, banks will have to keep 5 percent of loans securitized on their balance sheets and comply with a stricter definition of their own funds.
The Volcker Rule, promulgated in July 2010, introduced an important Wall Street reform. It corresponds to section 619 of the Dodd-Frank Act. The Volcker rule is based on two main points:
- A US banking entity shall not engage in speculation for its own account.
- A banking entity, or its subsidiary, may not retain any participation in capital or interest in a hedge fund and/or private-equity fund.
Lots of criticism expressed.
Criticism of the Dodd-Frank Act relies on the fact that nothing has really been undertaken to reduce the mega-banks, that the role of the rating agencies on the decisions of the regulators has not been abolished, and that progress in the regulation of the derivatives markets has been limited. The law is also criticized for having changed the behaviour of banks in a bad direction, as it has currently limited their lending activities and thus has slowed the growth and competitiveness of the United States. The Volcker Rule has also forced US banks to quickly sell certain securities such as CLOs (collateralized loan obligations). And banks have also closed entire divisions.
The Volcker Rule has pushed banks to implement now established verification systems to ensure that their transactions comply with the new criteria. But one more criticism of the rule is that trading is moving increasingly towards unregulated companies in the “shadow banking” sector. Therefore, instead of disappearing, financial risks only move to other actors.
Finally, not being able to limit the size of banks, US authorities have had to focus on the banks’ trading activities and their relationships to shadow banking (i.e., all players contributing to non-bank financing, the economy).
How have European banks been impacted?
In Europe, if London had first attracted American banks thanks to its slightly lighter regulation, the set of European countries’ regulations would have been drastically reinforced—for the City as well as Frankfurt and Paris. At the end, major European banks have to comply with both European and American regulations.
Credit institutions are required to establish compliance frameworks based on six pillars: written policies and procedures, internal control, corporate governance, independent auditing and training. The Volcker Rule also requires the establishment of governance, to ensure compliance with the rule within it.
Question of timing, or question of contents?
What happened, in fact, is similar to the situation after an accident or problem is discovered in one department of a company: everybody—bosses, regulators, clients, providers—want to know what happened, and they ask for more information, reports, dashboards. The department concentrates all of its energies on justifying, explaining, calming those involved and has no time left for running more value-added business. The first issue is that the dashboards, reports, analyses should have been completed before the problem occurred. And the second, the benefits of all those new reports and dashboards will be seen only after a while.
According to President Trump: “Under Dodd-Frank, regulators ran the banks.” A removal of, or at least a relief from, this law would suddenly make Wall Street more competitive. With Dodd-Frank and the Volcker Rule, the reduction of the requisites of this law could thus be beneficial for the larger US, as well as European, banking institutions, which are now obliged to comply simultaneously with two different schemes. Today, banks with more than 50 billion in assets are classified as systemically important financial institutions, subject to more stringent regulation. If the Trump Administration were to raise this threshold to $250 billion, it could allow many institutions to benefit from increased flexibility that would boost their stock-market valuations.
In conclusion, the administrative processes have become too heavy, masking the core values of these new laws. But the time needed to assess the efficiency of these laws probably should be longer. Doing things in haste could deprive the regulator of a longer-term tool and hide the benefits of those laws. Above all, politics may again change the rules when and if the Democrats get back into the White House.