The fourth anniversary of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) is a perfect opportunity to reflect on the progress that has been made since the Act’s passage in 2010 and to look forward to the required regulations that have to be implemented. The law was a direct response to the financial downturn, and was specifically designed to prevent a similar crisis from happening again. So how are things going so far?
Overall, it’s a mixed bag. Considerable progress toward implementation and reform has been made in some areas, while others are just getting warmed up.
The recent announcement by the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve that banks have not made the progress they would like to see in their so-called “living wills” is one example where much more work needs to be done – more on that later. In several other cases, it’s taken a lot longer to finalize formal rules and guidance. Final regulations for implementing most of the enhanced prudential standards for foreign and domestic banks required by Dodd-Frank came out earlier in the year after extended development. That said, some elements are yet to be finalized.
However, while headlines about missed Dodd-Frank deadlines abound, the industry recognizes that, behind the scenes, supervisors have been mandating risk management requirements and other process improvements that are complementary to Dodd-Frank’s reform agenda, and the industry has responded with some substantive improvements. Several of these enhancements have been put out in new proposed safety and soundness guidelines for larger banks Federal Reserve’s consolidated supervision framework SR-12-17 and the OCC’s proposed “Heightened Standards.” Download Deloitte’s detailed reports for an analysis of the enhanced prudential standards and heighted standards regulations.
As various elements of the formal and informal regulations and guidance that were mandated or inspired by Dodd-Frank come together, some aspects are more significant than others. Here’s a brief look at four key areas that will likely have a major impact on whether Dodd-Frank eventually achieves its intended objectives:
Capital. Coming out of the financial downturn, the Federal Reserve had a head start in this area due to the stress testing that had already been applied to the nation’s largest banks. As a result, there has been more progress here than in other areas. In fact, the capital ratio levels of the nation’s largest financial firms have more than doubled in the four years since Dodd-Frank passed, which is a major achievement. Yet there is still much work to be done. The Federal Reserve has been communicating a lot of information about what firms need to do better, and its expectations continue to rise. They are also trying to be more transparent with the public about what factors drive the Fed’s evaluation of bank capital levels and capital planning. To that end, this year the Federal Reserve identified the specific reasons for objecting to capital plans on qualitative grounds, which also helps put other banks on notice on areas of Federal Reserve emphasis. The reasons ranged from weaknesses in forecasting revenues and expenses, inadequate controls around the forecasting process and lack of internal stress scenarios that address the full range of business activities and exposures.
Looking forward and beyond capital planning, the Basel III final rule has begun to phase in, raising the bar on the quantity and quality of capital levels. Of note, the new supplementary leverage ratio creates an absolute back stop on balance sheet leverage, inclusive of certain off-balance sheet derivative, lending and other exposures. Further, still awaiting proposal and final implementation in the U.S. is a capital surcharge for global systemically important banks that varies between 1.0 and 2.5 percentage points of risk weighted assets depending on the size of the bank’s systemic footprint. While collectively these and other standards are aimed at improving resiliency of the system, these changes are challenging firms to recalibrate their business models in a way that balances required capital against the firm’s own views on risks and rewards.
Liquidity. This is another key area that could really move the needle on achieving Dodd-Frank’s goals. On the rule-writing front, the Federal Reserve has issued formal liquidity risk management and stress buffer standards, and put out for comment liquidity coverage ratio requirements associated with Basel III. Now that most of the liquidity standards are final, there will need to be a significant amount of refinement and implementation work before regulators and the industry can be comfortable that a firm’s liquidity is sufficient to weather the stress of an acute loss of market and customer confidence. Fortunately many supervisors have not been sitting on the sidelines, and considerable advance work in the form of horizontal exams has already been done that has prompted improved risk management and liquidity buffers. This work has not only made the firms more resilient today, but will help them meet Dodd-Frank and Basel III final liquidity expectations much more quickly.
Resolution. This area of Dodd-Frank – which requires certain financial institutions to annually develop a “living will” detailing the organization’s plan for its orderly dissolution in the event of extreme stress and failure – has been particularly challenging for both the banks and regulators. Although little specific feedback was initially provided by the regulators, the Federal Reserve and the FDIC recently identified some key areas of concern, indicating that significant improvements are expected in 2015. Given the significance and complexity of the work toward ensuring that banks are not “too big to fail,” resolution planning is likely to remain a high priority for years to come. Another related aspect of work in this area involves efforts to improve recovery plans that help a firm bounce back from a crisis and avoid insolvency and resolution altogether.
Governance. Dodd-Frank prescribes a number of higher level governance requirements, but for the larger firms, the challenge is also to design a framework of effective checks and balances that permeates the organization. Emphasis on more explicit upfront statements on the firm’s risk appetite and more formalized roles and responsibilities within the risk organization would go a long way toward reducing the likelihood of outsized and unexpected losses. For their part, supervisors are encouraging firms to better design how the front line risk managers and corporate risk functions divvy up responsibilities for assessing and controlling risks. Even as expectations for these first two lines of defense have risen, supervisors are expecting more from audit as the third line of defense in terms of subject matter expertise and more holistic assessments of a bank’s processes and controls. Clearly, the drive for improved governance in financial services will continue for years to come.
Four years after the passage of Dodd-Frank, regulators and many financial services firms can be proud of all that they have accomplished across several fronts. That said, both still have a lot of work to do. However, that really shouldn’t be a surprise. If we’ve learned anything over the past four years, it’s that financial reform is not a one-time event – it’s an ongoing process. While many regulators and bankers would like to look forward to a specific end-date, experience has shown that improvements in regulation and risk management cannot stand still if there is hope of avoiding the crises of tomorrow.
Posted by David Wright, Managing Director, Deloitte & Touche LLP