The US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which came into effect on 21 July 2010, implements arguably the most significant overhaul of the US financial sector in a generation, with the ripples of its impact being felt across the globe. The act not only increases the regulation of banks, traders, hedge funds, insurers, broker-dealers and asset managers to levels never seen before, but shakes up the framework of regulators as well.
Dodd-Frank has hugely lofty aims, including the promotion of the financial stability of the US by improving accountability and transparency in the financial system, protecting consumers from abusive financial services practices, and ending ‘too big to fail’ organisations and the need for governments to sink huge pots of money into bailouts such as those we have recently seen.
The Act introduces around 144 rules, which cover a vast array of topics, ranging from the re-structure of the regulating regime, to specific changes imposed on almost every financial services company operating in the US. These rules will require over-the-counter (OTC) derivatives to be cleared through central clearing parties, and traded on exchanges where possible. Proprietary trading for banks who are subject to Federal Guarantees will become a thing of the past, while transactions of a more risky nature will require more capital to be held, and those firms who were too big to fail have to plan for just that, through the preparation of living wills aimed at doing away with taxpayer intervention through hefty bailouts. In general, banks will need to understand their risk to greater depths, hold more capital and report on almost everything in greater detail.
It doesn’t stop there either. Hedge funds that manage US$100m or more for investment advisors will need to register with the Securities and Exchange Commission (SEC) as will financial advisors, swap advisors and investment brokers who will be subject to greater fiduciary duties, and credit rating agencies are now also subject to greater scrutiny and regulation under Dodd-Frank.
Firms that deal in securitised products now have to retain at least 5% of the associated risk, cannot hedge or transfer that risk. They will need to provide greater levels of transparency and reporting to investors, including due diligence analysis, and asset data around broker, compensation and risk retention. And then there’s investor protection and executive compensation, where Dodd-Frank requires independent verification of client assets being held in custody and shareholder get a say in named executive compensation, and as ever this all comes along with greater requirements for disclosure.
Finally, if this wasn’t enough, Dodd-Frank also mandates a number of studies around short selling, conflict of interest, gaps in retail customer protection and imposing uniform fiduciary duty on financial intermediary advisors. The results of these studies are expected to ultimately result in yet more rules and disclosure requirements.
What Does this Mean for Banking?
In short, Dodd-Frank requires banks to change some of their fundamental processes and products, understand their risk to far greater depths, hold more capital and produce vast amounts of data and reports for external scrutiny by their regulators.
Traditionally, banking systems have evolved over years of changes and enhancements in response to variation in regulation and market drivers. This has resulted in a complex and fragmented system landscape, with banks drawing information for decision making from different sources to that of their regulatory disclosure. The implementation of Dodd-Frank means that banks need to fundamentally re-look at their business, processes, strategic IT and data architecture, with a view to target the business that provides the greatest return on equity, while simplifying their processes, IT and data environments to allow them to respond to the changing regulations quickly and cost effectively within their strategic infrastructure.
The Way Forward
Given the current uncertainty around the detailed rules of Dodd-Frank, there is an impulsive desire to wait and see what is formalised before diving headlong into another Basel II-like programme. This would however be a mistake. It is essential to take the time now to assess compliance across the bank, and actively understand how the various components of the legislation interrelate and act as a whole. While it is certain that an investment is needed to meet the constant storm of regulatory change, it is essential that banks strive to leverage this investment to their own advantage.
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