The most dramatic revisions to U.S. financial regulation in 80 years became law on July 21 when President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Obama's signature, however, is far from the final act needed for implementation. The law, despite being more than 2,300 pages long, is short on the details necessary for enforcement. Enactment has set off a scramble by financial regulators to write the rules needed to put the bill's broad framework into practice.
Regulators face a daunting task. The federal banking agencies, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the handful of new government offices created by the law must complete more than 600 rulemakings, studies and reports to Congress.
With so much to be decided, how any specific financial firm or other company will be directly affected by the Dodd-Frank Act might not be known for another couple of years.
Also a great unknown: whether the core provisions of the law will actually work. Intended to prevent the buildup of potentially catastrophic risk in the financial system and permit the orderly liquidation of failed investment firms, many of the act's linchpin ideas are untested, and there are reservations about how they will be.
For instance, some have questioned whether the Federal Deposit Insurance Corp. can adequately apply its experience winding down failed commercial banks to giant, complex investment houses. Similarly, requiring institutions to hold debt that can be converted into stock or to maintain higher capital in good times so they won't have to raise money in down times runs against decades of industry practice and may not be feasible if investors find the ideas unattractive.
"I consider us to be in the eye of the storm," says Bradley Sabel, co-leader of the financial recovery and reform advisory group at Shearman & Sterling LLP. "We have been through a great amount of legislative work. ... Now we have to wait for the regulations. Once the agencies start putting out the proposed regulations, it will all start up again."
Richard Murray, chairman of the U.S. Chamber of Commerce's Center for Capital Markets and Competitiveness, says the burden placed on regulators is unprecedented. "It's a law comprised of goals and objectives much like the preliminary blueprints for the design of a very complex building," he said at a July 27 chamber conference on the bill.
He noted that the law calls for 530 rulemakings, 60 studies and 90 reports to Congress. "The wiring and the piping and the internal décor that will become financial regulation will emerge from that process," he said.
For comparison he noted that the Sarbanes-Oxley Act of 2002, enacted to address the late-1990s accounting scandals, required only 16 rulemakings, six studies and no reports.
There's a lot of trepidation from within the industry, particularly among investment firms that have avoided the invasive type of regulation imposed on commercial banks. Soon, firms deemed "systemically significant" to the financial system will face much higher capital requirements, limits on their leverage and oversight by the Federal Reserve Board. They must honor requests for data on their operations from the Treasury Department's new Office of Financial Research, which is expected to have open-ended authority to demand information on firms designated as systemically significant.
Which firms will be designated as systemically significant? It's easy to predict that the major money center institutions such as J.P. Morgan Chase & Co., Goldman, Sachs & Co., Bank of America Corp. and a further three or four, but beyond that, nobody knows.
"In spite of the fact that the legislation in draft form was well over 2,000 pages, its specifics are largely a blank slate," says Steven Lofchie, co-chair of the financial services department at Cadwalader, Wickersham & Taft LLP. "For nonbank institutions in the financial space, there is a lot of uncertainty as to which will be designated as systemically significant institutions. That could bring with it just a major burden of regulation."
Designated firms will be regulated as if they own a commercial bank with insured deposits. That's a massive step into a body of rules that includes capital requirements and restrictions on activities and operations, Lofchie says. "Imagine a law that says everybody at your company must speak French. If you are a fully grown company with thousands of employees and no one speaks French, it would be hard to reorganize your company to come into compliance."
Right now, firms can only guess if they will need to study a new language. The act offers no clear test for what will be considered systemically significant -- that's left for the new Financial Stability Oversight Council, the umbrella group of regulators assigned to act on brewing threats in the financial system. "There are no standards as to size or activities, so under the statute alone, you can't feel safe. Maybe once rules are adopted there will be some lines drawn," he says.
Such amorphousness characterizes nearly every element of the law. Until the regulations are issued, institutions won't know how to structure such key businesses as derivatives and proprietary trading, who the likely buyers will be for spun-off subsidiaries, what institutions' capital and liquidity levels must be and so on.
The nervousness of the soon-to-be-altered landscape was exemplified by the dust-up the week of July 19 over credit ratings agencies' legal liability for faulty assessments of debt securities. Concerned that a provision in the new law intended to hold raters liable for failing to adequately review a rated security would expose them to lawsuits any time a graded security turns sour, the agencies announced they would stop assigning grades to new issues.
Fearing the move would snuff out the budding revival of the asset-backed securities market, the Securities and Exchange Commission on July 23 said for the next six months, securitization packages could go to market without being accompanied by a credit rating.
"That was a great relief, but the scramble for clarification last week highlights that in this comprehensive piece of legislation you can't tell everything that will come up," says Tom Hiner, partner in the business practice group at Hunton & Williams LLP in New York. "The good news is the commission has shown a willingness to work with the market to try to facilitate a smooth transition."
The SEC is under more pressure than most agencies. It is still trying to rebuild its reputation after failing to spot the massive run-up in risk that led to the failures at Bear Stearns Cos. and Leh-man Brothers Holdings Inc. or spot the Madoff investment fraud. It now faces a huge number of rulemakings that must be completed in one year. To get a jump on the agency's obligations, SEC Chairwoman Mary Schapiro announced July 27 that the agency has begun soliciting suggestions from industry, investors and the public on 31 proceedings that soon will be opened as a result of the law.
Issues addressed in the requests for comment range from broad, core components of the new statute -- such as procedures for orderly liquidation of failed broker-dealers -- to more arcane details such as adding criteria to disqualify issuers from holding unregistered private offerings under the SEC's Regulation D. "We are expanding our process beyond what is legally required," Schapiro told the U.S. Chamber of Commerce. "The idea is to offer maximum opportunity for public comment and to provide greater transparency."
Among the dozens of rulemakings, Schapiro named five as the most important: setting rules for over-the-counter derivatives, broker-dealers' fiduciary duty, hedge fund registration, corporate disclosure and credit ratings agencies. She said the derivatives rules are at the top of those priorities and will address capital and margin requirements; mandatory clearing; the operation of execution facilities and data repositories; business conduct standards for swap dealers; and public transparency for transactional information. To prevent confusion, the SEC will begin a joint rulemaking with the CFTC, with which it shares jurisdiction over derivatives, to establish definitions of "swaps" and other key terms.
James Wiener, senior partner at Oliver Wyman Group, a financial services consulting firm, says plenty of uncertainty will remain even after the rules are set, namely, whether any of this is going to work. Wiener is skeptical that provisions such as relying on the Federal Deposit Insurance Corp. to wind down failed nonbank firms and requirements such as countercyclical capital (forcing institutions to boost capital during good times so they won't have to raise it when times are bad) and contingent capital (requiring debt that can be converted to equity when more capital is needed) will work.
"Countercyclical capital relies on investors being willing to commit capital at the precise worst moment," he says. "Contingent capital requires finding investors who are willing to accept lower, bondlike returns when times are good and accepting equity exposure when times are bad."
His Oliver Wyman colleague John Bovenzi agrees that the FDIC will be stretched to resolve these firms without well-planned "living wills" mapping out ahead of time how the firms will be wound down. Bovenzi, a former deputy to the FDIC chairman who served as CEO of IndyMac Federal Bank FSB when it was put in federal conservatorship in 2007, says the IndyMac history exemplifies the FDIC's strength and weaknesses when resolving institutions.
"When IndyMac failed, the FDIC closed it on a Friday, reopened it Monday under government ownership. We had to take over 10 or 11 entities with a new board of directors, figure out how these business operations overlapped, identify important contracts and operational issues -- all in a day or so. It would be fairly impossible to duplicate that at a Lehman Brothers without planning all that out ahead of time."
The many unknowns don't mean the legislation is a bust. Shearman & Sterling's Sabel says many ideas, such as the new Financial Stability Oversight Council, are good despite predictable turf squabbles that are likely to arise. "A council like this is inherently unwieldy and will get into a lot of interagency politics, but monitoring the entire financial system in order to issue early warnings and to have a chance to take steps to address any issues is probably a good thing."