Algo WP0111 Dodd Frank

DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT: BUSINESS MODEL IMPLICATIONS
JANUARY 2011
By Mario Onorato and Gabriella Symeonidou
Table of Contents
1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 2. Overview of the Dodd-Frank Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 2.1. Reforms for Systemically Important Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 2.1.1. Enhanced Prudential Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 2.1.2. Bank Capital Leverage Liquidity (Collins Amendment) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 2.1.3. Volcker Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 2.1.4. OTC Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 2.1.5. FDIC Insurance Deposit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 2.1.6. Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 2.2. Reforms for Regulatory Authorities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 2.2.1. Financial Stability Oversight Council . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 2.2.2. Ending Too-Big-To-Fail (Unwind Authority) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 2.2.3. The Federal Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 2.2.4. Bank Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 2.3. Reforms for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2.3.1. Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2.3.2. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2.3.3. SEC and Investor Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 2.3.4. Hedge Funds and Equity Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.3.5. Credit Rating Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.4. Reforms for Consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.4.1. Consumer Financial Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 2.4.2. Other Consumer Protections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 3. Business Model Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 3.1. Downward Pressure on Bank Profitability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 3.2. Re-assessment of Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 3.3. Reform of Operational and Legal Entity Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 3.4. Decrease on Lending on the US Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 3.5. Will the Dodd-Frank Act End Too-Big-To-Fail? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 3.6. Modifications of Tax Procedures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 3.7. Implications for the Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 3.8. Implications for Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 4. Implementation Timelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 5. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 APPENDIX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38
1. Introduction
The recent financial crisis has shown that there is a great need for a properly resilient and robust banking system. Financial output is somewhere between 5% and 10% below what it would have been if the crisis had not occurred, large number of businesses of all sizes have shut down, and unemployment has risen. Direct and indirect costs to the taxpayer have led to fiscal deficits in several countries of over 10% of GDP, which is the largest peacetime deficits ever (Mervyn King, Governor of the Bank of England, 2010)1. At the centre of the 2007-2008 financial crisis was the expansion and subsequent contraction of the balance sheet of the banking system. Other divisions of the financial system did not suffer a great deal. The key issue raised by the crisis is how to stabilize our banking system in order to be able to survive similar crises. The obvious cure is a reduction of debt within the financial system (deleveraging) combined with various forms of reorganization aimed at decreasing the financial systems operating costs (Janez Barle, 2009)2. In June 2009 President Barack Obama introduced a proposal for a sweeping overhaul of the United States financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression . The result was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Obama on July 21, 2010. The final bill was largely consistent with the 2009 proposal upon which it was based, although some additional provisions and differences in implementation from the initial proposal emerged. The stated aim of the Act is,to promote financial stability in the United States by improving accountability and transparency in the financial system, to end too-big-to-fail, to protect the American taxpayer by ending enormous bailouts, to protect consumers from abusive financial services practices and for other purposes The Act changes . the existing regulatory structure and creates a host of new agencies while removing others in an effort to streamline the regulatory process, increase oversight of specific institutions regarded as a systemic risk, amend the Federal Reserve Act, promote transparency, and additional changes. This wide-ranging legislation is considered an attempt to eliminate all the loopholes that led to the recent economic recession, be it bank misbehavior, public deficits or excessive private debt. However, it allows for long enough transition periods to avoid endangering the difficult recovery of the US economy. Few of the provisions of the Act became effective upon its enactment. Most of the remaining provisions for implementing major sections of the Act will be written over the 18 months following enactment therefore by the end of 2011 and only then will the full importance and significance of the Act be revealed. In addition, the rule-making procedure for a number of rules in the Act must be in line with the new Basel III risk-based capital and leverage requirements,which will not be fully implemented until the end of 2012, thereby delaying disclosure of real consequences. This paper focuses on the various business model implications that financial institutions will face throughout and after full implementation of the Dodd-Frank Act. In this document we will first give an overview of the major provisions taking effect in the Dodd-Frank Act, while describing the responsibilities of new agencies established, or amendments on powers of existing agencies. Section 3 will provide a thorough analysis of some of the most important implications of the Act on business models, keeping in mind that the degree of true implications will not be revealed until after the complete implementation of the Act, which will not occur before 2018. Following this analysis, in section 4 we will give the implementation timeline for the major provisions along with the deadline for some of the major studies that need to be conducted under the Act by different regulatory agencies. Finally, in Section 5 we will discuss future prospects for the Act, issues that likely need to be raised throughout the rule-making process, and what to expect in the following years while implementation of all the regulations takes place.
1
Speech by Mervyn King, Governor of the Bank of England on Monday 25 October 2010,Banking: From Bagehot to Basel, and Back Again The Second Bagehot Lecture , Buttonwood Gathering, New York City. Janez Barle, Nova Ljubljana banka d.d.,Global Financial Crisis and its Implications to the Business Model and Risk Management in Banking .
2. Overview of the Dodd-Frank Act

The Dodd-Frank Act is considered the most wide-ranging financial regulatory reform incorporated since the Great Depression. It implements changes that affect banking institutions, large financial companies, regulatory authorities, insurance companies, everyday consumers, small investors and other groups. Although the major weight of the Act falls on large, complex financial institutions, smaller institutions will also have to work in the context of a more complex and expensive regulatory framework. Even though the Act does not become effective immediately, regulators and market participants should begin responding to the new regulations in order to ease the implementation process. Among other impacts, the amendments in the Act influence the oversight and supervision of financial institutions, introduce more stringent capital and liquidity requirements, incorporate the Volcker Rule that prohibits certain important bank operations, changes significantly the regulation of over-the-counter (OTC) derivatives and the securitization market, reforms credit rating agency operations and establishes new regulations on executive compensation and private and equity funds.
2.1. Reforms for Systemically Important Financial Institutions

The banking and thrift industries are the most highly influenced areas under the Dodd-Frank Act. Significant changes are introduced to their prudential supervision framework, and a number of new requirements and limitations are imposed on their business activities. Some of the major effects of the Act will be: enhanced prudential standards for all systemically important financial institutions, such as higher and better quality capital requirements and the establishment of risk committees within management boards; new corporate compliance requirements; the famous Volcker Rule prohibiting crucial banking operations; and important limitations on OTC derivative markets.
2.1.1. Enhanced Prudential Standards

Enhanced prudential standards are introduced for systemically important non-bank financial companies and interconnected bank holding companies. The main purpose is to discourage the excessive growth and complexity of large financial institutions that might jeopardize the financial stability of the economy. We will see later that strict prohibitions are introduced on proprietary trading and hedge fund ownership, as well as new risk-based capital, leverage and liquidity requirements. In addition, rigorous stress testing and concentration limits are imposed on banks. Finally, in order to promote sound risk management practices, risk committees are now a mandatory requirement in management boards for systemically important, publicly traded non-bank financial companies. The risk committees must include a number of independent directors as determined by the Federal Reserve, while at large complex companies at least one risk management expert with experience in risk management must be included.
2.1.2
Bank Capital Leverage Liquidity (Collins Amendment)
The Collins Amendment imposes enhanced leverage, risk-based standards and capital requirements for systemically important companies. Implementing regulations have not yet been fully established, but they have to be issued no later than 18 months after the enactment of the Act, which means by December, 2011. Two significant aspects of the Collins Amendment are the exclusion of trust preferred securities as an element of Tier 1 capital, and floors established for minimum leverage and risk-based capital requirements. Hybrid securities, such as trust-preferred securities, were treated as Tier 1 capital for regulatory purposes before the Act. Under the Act, because Congress did not view these instruments as true core capital, their treatment as Tier 1 capital is being phased out over a three-year period. Also, it establishes a floor for capital that cannot be lower than the standards in effect today, which are shown in figure 1. The minimum leverage and risk-based capital requirements applicable must not be less than the generally applicable risk-based capital requirements the , generally applicable leverage capital requirements and not quantitatively lower than these two requirements, , which were in effect for insured depository institutions as of the date of enactment (Davis Polk and Wardwell, 2010)3. Figure 1: Current leverage and risk-based capital requirements for banks To be considered well capitalized Minimum risk-based capital ratios Minimum leverage ratio* Tier 1 capital ratio Total capital ratio 6% 10% 5% To be considered adequately capitalized 4% 8% 4%
*A 3% minimum leverage ratio applies for institutions if the FDIC determines that the institution is not anticipating or experiencing significant growth, has well-diversified risk, among other factors, and is rated composite 1 under the CAMELS rating system.
For the purposes of meeting leverage and capital requirements under the Dodd-Frank Act, any bank holding company with $50 billion or more in assets, or any financial institution that is identified as systemically important by the Financial Stability Oversight Council (FSOC), must take into account all off-balance sheet activities. The term off-balance sheet activities means an existing liability of a company that is not on the balance sheet, but may move on-balance sheet upon the occurrence of some future event. The definition explicitly includes standby letters of credit, repos, interest rate swaps and credit swaps, among others (Davis Polk & Wardwell LLP, 2010)4. The Collins Amendment must be in line with the Basel III capital and liquidity requirements, and which will come into effect by the end of 2012. As a result, the Collins Amendment will create a statutory floor for Basel III, and US banking regulators will be able to implement Basel III only to the extent it is consistent with the Collins Amendment floor.The Basel III capital and liquidity requirements can be found in Algorithmicswhite paper,Basel III: whats new - Business and Technological Challenges However, a short summary of the main changes are provided here. .
3, 4
Davis Polk & Wardwell LLP,Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act July 2010. ,
In general, the Basel Committee is trying to increase the quality, quantity and international consistency of the capital base, while also increasing capital requirements for certain types of transactions and obligors.They are doing this by addressing general and specific wrong-way risks, accounting for credit valuation adjustment (CVA) losses with capital, requiring higher risk weights for financial counterparties, providing incentives for banks to move trades to central counterparties, strengthening the collateral management function, increasing margin periods of risk, and applying stress testing and back testing requirements. In addition, the Basel Committee has introduced rules to promote pro-cyclicality, which was inherent in the Basel II framework, in order to dampen excess cyclicality, conserve capital for periods of financial distress and protect the overall banking system from excessive credit growth. Finally, they have established a leverage ratio to reduce the buildup of leverage in the overall system. The establishment of a leverage ratio is one of the most important capital requirements in both Dodd-Frank and Basel III. It should be clarified that the leverage ratio will be calculated after applying Basel II netting for all derivatives, including credit derivatives. The new leverage metric allows for the use of uniform credit conversion factors (CCFs) for off-balance sheet (OBS) items, with a 10% CCF for unconditionally cancellable OBS commitments. The leverage ratio has been widely discussed because it is not risk sensitive and does not take into consideration specific elements of different business models. Finally there are the liquidity requirements, which are quite innovative. The main element is the introduction of two liquidity ratios, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). Banks must keep these at a minimum at all times so as to ensure they maintain sufficient liquidity to withstand cash obligations even under extreme stress conditions.The LCR focuses on the shorter time horizon and basically requires that banks hold enough liquid assets to offset the sum of all cash outflows expected over the next 30 days. The NSFR on the other hand focuses on the medium-term horizon and on the structural balance between maturities of a banks assets and liabilities. Along with the two ratios, the Basel Committee considers a few additional tools that should be used in monitoring activity, such as contractual maturity mismatch, concentration of funding, available unencumbered assets and market-related monitoring tools.
2.1.3.Volcker Rule
The main purpose of the Volcker Rule is to limit bank activities in higher risk businesses such as proprietary trading and hedge fund and private equity businesses. Subject to certain exceptions and a specified transition period, the Volcker Rule prohibits any banking entityfrom engaging in proprietary trading or sponsoring or investing in , a hedge fund or private equity fund.The term proprietary trading in the Act means,engaging as a principal for the trading account of the banking entity or non-bank financial company supervised by the Board in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any options on any such security, derivative, or contract... (Dodd-Frank Act, 2010)5. Additionally, it requires systemically important non-bank financial companies to carry additional capital and comply with certain other quantitative limits on such activities.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010.
However, due to the importance of some of these restricted activities, the Volcker Rule allows for certain exceptions and long transition periods.The exceptions from the banned activities on proprietary trading are investments in the US government, agency, state or municipal debt, investments in small business investment companies, market-making related activities, risk-mitigating hedging activities, activities on behalf of customers, activities conducted by a banking entity solely outside the US, unless the banking entity is directly or indirectly controlled by a banking entity in the US, and activities by regulated insurance companies. The restrictions on investing in hedge funds or private equity funds are not as strict. Banks are allowed limited fund investment of no more than 3% of the funds capital, and they cannot invest more than 3% of their Tier 1 capital. In addition, banks can sponsor and act as trustee or general partner of a fund as long as it is done for bona fide trust, fiduciary or investment advisory services. Also, banks are prohibited from bailing out a fund in which they have invested. Meanwhile, limitations on proprietary trading and investment funds do not apply to systemically important non-bank financial institutions (Deutsche Bank, 2010)6. The transition periods can actually take as long as five years if the Federal Reserve finds it appropriate.There are some additional limits within the Volcker Rule, known as concentration limits, which do not allow any merger that would result in a company with liabilities greater than 10% of the total liabilities of all financial companies at the end of the prior calendar year. The significance of the Volcker Rule is enormous, which is why studies aimed at determining how to implement the policy as effectively and painlessly as possible are expected to be conducted and finalized by the Federal Deposit Insurance Corporation (FDIC) by the end of 2011.
2.1.4. OTC Derivatives

The Act imposes a comprehensive set of new rules that aim to reduce counterparty risk and increase transparency in the over-the-counter (OTC) derivatives market. It should be noted that the Dodd-Frank Act simply establishes a broad outline of the regulations, with the details of the rules to be determined by regulators within the Commodities Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC), in the coming months. Several key features in the Act pertaining to OTC derivatives will lead to changes in relation to central clearing procedures, exchange trading and treatment of swaps. The activities of swap dealers or major swap participants (MSPs) will be subject to greater oversight and regulation. The SEC and the CFTC, in consultation with the Federal Reserve Board, are expected to issue regulations and guidance on numerous topics by July 2011. They need to provide details for the designation and registration of swap dealers and major swap participants, and for the minimum capital and initial and variation margin requirements they must fulfill. In addition, the SEC and the CFTC must determine which contracts will be centrally cleared. All clearable swaps must be executed through a regulated exchange or central clearing entity, unless there is no exchange that will list the swap or security-based swap. In addition, all cleared swaps must be traded on a registered exchange or board of trade that has accepted the product,in accordance with the rules thereof However, there . are some exemptions of products or trades for which mandated exchange trading might threaten liquidity in a given instrument or market (PWC, 2010)7.The Act requires that if a swap is not listed for trading on an exchange or swap execution facility (SEF) then it may be transacted only with central clearing.
6 7
Deutsche Bank;Tom Joyce,Francis Kelly and Callie Smart,The Implications of Landmark U.S.Reg Reform The Dodd-Frank Wall Street Reform and Consumer Protection Act July 2010. , PWC,A Closer Look: Impact on OTC Derivatives Activities August 2010. ,
Another important provision on OTC derivatives is the push-out rule. US insured depository institutions that are swap dealers will only be able to engage in derivatives transactions which reference interest rates, foreign currencies, certain metals such as gold and silver, and cleared investment-grade credit default swaps (CDS). Some of the derivatives which will have to be pushed out of bank transactions, and instead traded through a non-bank affiliate, are equity contracts, commodities, credit derivatives that are not centrally cleared, and energy and metals contracts other than gold and silver. Finally, the CFTC and the SEC are required to prescribe rules for execution facilities to make public timely information on price, trading volume and other trading data. Swap market participants must maintain daily swap trading records and supporting information to provide complete audit trails. These are just some of the many reforms of OTC derivatives that are bound to occur. After the completion of the numerous studies and the promulgation of regulations, more related issues will probably come to light.
2.1.5. FDIC Insurance Deposit

Section 331(b) of the Act directs the Federal Deposit Insurance Corporation (FDIC) to base deposit insurance assessments on an insured depository institutions average consolidated total assets, minus its average tangible equity, as opposed to its deposit base, which was used before the Act.This reform will shift the distribution of assessments to the larger banks, which fund a greater percentage of their balance sheets through non-deposit liabilities. Another provision includes the abandonment of the upper limit for the reserve ratio designated by the FDIC each year. However, the minimum designated reserve ratio increases from 1.15% of insured deposits, or the comparable percentage of the assessment base that was before the Act, to 1.35%. Another major effect of the deposit insurance reforms is to increase the maximum deposit insurance amount from $100,000 to $250,000 under the Act, while notwithstanding any other provision of law, the increase in the standard maximum deposit insurance amount shall apply to depositors in any institution for which the Corporation was appointed as receiver or conservator on or after January 1, 2008 and before October 3, 2008(Dodd-Frank Act, 2010)8.
2.1.6. Insurance
The Dodd-Frank Act establishes a new agency, the Federal Insurance Office (FIO), which has a generally weak enforcement power but has significant participation in oversight and coordination between the US insurance market and the international insurance market.The establishment of the FIO is an attempt to pursue greater uniformity of the insurance regulatory environment in the US, which means its main duty will be to collect and analyze information for the insurance industry. In particular, the director of the FIO is required to conduct a study within 18 months of the enactment on how to modernize and improve the system of insurance regulation in the US. In addition, all large insurance companies designated as systemically important will be required to register with the Federal Reserve Board and be subject to enhanced prudential standards similar to the ones applied to systemically important bank holding companies. These standards include leverage, risk-based capital, liquidity requirements, resolution plans, concentration limits and stress tests, among other considerations.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010.
2.2. Reforms for Regulatory Authorities

Under the Dodd-Frank Act, regulators are being given greater enforcement power and several new responsibilities. New financial agencies are being created in order to monitor risk arising from financial distress, and new powers are being given to already existing regulatory agencies. The Federal Reserve, in particular, is tasked with examining all systemically important financial institutions, and forcing them to impose enhanced capital, leverage and liquidity standards, if it finds it necessary for the protection of the US financial stability.
2.2.1. Financial Stability Oversight Council

The Dodd-Frank Act creates a new financial agency, the Financial Stability Oversight Council (FSOC,the Council), the duties of which is to monitor risk that might arise from the material financial distress or failure of large financial institutions and make recommendations to regulators. In order to make recommendations to the regulators, the Council should gather data and information, and monitor and identify any gaps in the current regulation. One of the most important responsibilities the Council has is to designate financial institutions or activities and practices as systemically important. In addition, the Council is entitled to make recommendations to the Federal Reserve on the establishment of enhanced prudential standards and reporting so as to prevent or mitigate risk to US financial stability that could arise from the material financial distress of these systemically important companies. Finally, it is allowed to make recommendations on heightened standards for financial activities or practices of a company if it grows in size and complexity, and hence threaten financial stability. Overall, the Council has a strong systemic oversight role where it can make various recommendations, but it has extremely limited enforcement power.
2.2.2.
Ending Too-Big-To-Fail (Unwind Authority)
One of the main aims of the Dodd-Frank Act is to resolve the widely discussed issue of too-big-to-fail. The bankruptcies of companies that were considered to be financial colossi during the financial crisis cost the U.S. economy, the government and the American taxpayer trillions. Under the Act, the Federal Deposit Insurance Corporation (FDIC) gains additional powers so it can unwind large failing financial institutions. The new orderly unwind and liquidation mechanism requires the Treasury, the FDIC and the Federal Reserve to agree that a company is in financial distress. It is then the Treasurys responsibility to either obtain the consent of the companys board of directors, or be granted an order from the US District Court authorizing the appointment of the FDIC as receiver. In the latter case, shareholders and unsecured creditors bear losses (similar to the provision of the bankruptcy code that was in effect before the Act), and of course management boards are removed. The FDIC is actually entitled to recover two years worth of a senior executives compensation should that senior executive be substantially responsible for the financial failure of a company.The major improvement of the new mechanism is that taxpayer funds will no longer be used to rescue failing financial companies. Instead, the costs will be raised by the financial industry after a company collapses, with funds raised via a levy imposed on financial firms with total assets greater than $50 billion. Of course, government, as before, will be the first in line for repayment. Finally, large, complex financial institutions are required to produce periodic resolution plans that map out how they could be safely wound down in the case of failure without any government help, and they must submit these to the Federal Reserve for approval.
2.2.3. The Federal Reserve

The Federal Reserve becomes the preeminent financial regulator, with broadened supervisory scope and subject to the highest levels of transparency in its 96-year history (Deutsche Bank, 2010)9.The Federal Reserve will be offered a large number of new responsibilities that lets it supervise and regulate financial institutions but at the same time keep its existing bank supervisory powers on both large and small banks. In particular, by the end of 2011 the Federal Reserve will be responsible for establishing enhanced prudential risk-based capital, leverage and liquidity requirements, be responsible for overall risk management requirements, resolution plans, credit exposure reporting, concentration limits, and for prompting corrective action to apply to systemically important financial institutions.The powers of the Office of Thrift Supervision (OTS), which is abolished under the Dodd-Frank Act, are redistributed among the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the FDIC. In addition, extended transition periods in relation to the numerous provisions for systemic risk are allowed only after approval by the Federal Reserve. All financial institutions designated by the Council as systemically important will be brought under regulation by the Federal Reserve, and the Federal Reserve has the discretion to decide which types or classesof financial institutions will be exempted from its enhanced supervision. As seen earlier, the Federal Reserve works closely with the Council for setting heightened standards for financial activities and practices if there is increased risk for liquidity, credit or other problems. It is responsible for creating 54 regulations during the rulemaking process, such as defining a significant bank holding company and a significant non-bank financial company. The Federal Reserve is also responsible for the creation of risk committees within management boards in systemically important financial companies, and for the approval of their resolution plans. It is responsible for determining whether an institutions resolution plan is credible, and it has the right to impose more stringent capital, leverage or liquidity requirements if the firm fails to adopt an acceptable plan. Finally, the Federal Reserve is responsible for conducting annual stress tests for all systemically important financial firms under at least three scenarios. Nonetheless, the Federal Reserve faces new rules on governance and will be subject to ongoing audits. The Governmental Accountability Office (GAO) is liable for conducting studies and audits on the Federal Reserve by the end of 2011.
2.2.4.
Bank Supervision
Bank supervision is subject to significant change. Firstly, the Office of Thrift Supervision (OTS), which was the federal supervisor for thrifts and thrift holding companies before the Act, is now abolished. Its supervisory and rule-making responsibilities are distributed to the Office of the Comptroller of the Currency (OCC) for national banks and federal thrifts of all sizes, and also holding companies of national banks and federal thrifts with less than $50 billion in assets. Meanwhile, the Federal Reserve Board (FRB) takes on supervisory and rule-making responsibilities for banks and thrift holding companies with more than $50 billion in assets, while the FDIC is responsible for state banks and thrifts of all sizes, and bank holding companies with less than $50 billion in consolidated assets. We saw earlier that particular banking activities, such as proprietary trading or investments in hedge funds, have been restricted, and stronger lending limits imposed, which will eventually change the whole banking system.
Deutsche Bank;Tom Joyce,Francis Kelly and Callie Smart,The Implications of Landmark U.S.Reg Reform The Dodd-Frank Wall Street Reform and Consumer Protection Act July 2010. ,
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2.3. Reforms for Investors

The Dodd-Frank Act will have significant changes on the regulatory regime governing investment advisers, particularly for private funds such as hedge funds and private equity funds. Investment advisers are under more stringent registration rules with the Securities and Exchange Commission (SEC). The Act tries to concentrate the SECs time and resources on large advisers that could present a greater systemic risk to the US economy than smaller advisers. In addition, the private adviser exemption which exempts an adviser from the registration requirements if it has , fewer than 15 clients, is eliminated under the Act. However, new exemptions will be created. Credit rating agencies are also under reform in order to prevent financial companies from choosing the rating agent of their preference.
2.3.1. Securitization
Securitization is one of the few financial activities not significantly impacted by the Dodd-Frank Act. Both buy and sell sides have been moderately impacted by the credit retention requirements. The main scope of the Act concerning securitization is to support the interests of asset-backed debt with asset-backed securities investors, and to reduce the risks posed by asset-backed securities.The only provision mentioned in the Act concerning securitization is that securitizers of asset-backed securities must maintain 5% of the credit risk in assets transferred, sold or conveyed through the issuance of asset-backed securities. As we will see when examining the implications of the Act, this is significant since financial institutions are now forced to reserve 5% more equity in their balance sheet, which they will not be able to invest.
2.3.2. Executive Compensation

The Act requires greater disclosure on compensation, and provides shareholders with rights to non-binding votes and corporate affairs.The Act includes provisions relating to compensation arrangements at financial institutions and public companies.Two important provisions within the Act on executive compensation are the say on payand say on golden parachutes rules. The say on pay right is offered to shareholders once every three years at an annual meeting. It is a non-binding vote offered to shareholders in order to approve the compensation of executives as disclosed in agreement with the SEC rules. The say on golden parachutes is the shareholders right to a non-binding vote in order to approve payments made to any named executive officer in connection with an M&A transaction that needs to be approved in a meeting. For both say on pay and say on golden parachutes rights, institutional investors are required to report annually how they voted. In addition, listed companies are required to disclose to the SEC whether employees and directors are allowed to hedge the value of any equity securities.
2.3.3. SEC and Investor Protection

The Dodd-Frank Act attempts to protect investors and improve the management and accountability of the SEC. It gives the SEC the authority to raise standards for broker-dealers who offer investment advice, and hold brokerdealers to fiduciary duty similar to investment advisors standards. In addition, two new offices are established: the Investor Advisory Committee, which advices the SEC on its regulatory priorities and practices; and the Office of Investor Advocate, which identifies areas where investors have significant problems dealing with the SEC, and provides them with assistance. Finally, the Act aims to encourage whistleblowers to report any kind of securities violations by offering rewards of up to 30% of funds recovered.
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2.3.4. Hedge Funds and Private Equity Funds

Hedge funds and private equity funds with assets greater than $150 million, or funds that are designated as systemically important, are under a few rigorous regulations. Primarily, registration with the SEC, in order for periodic examinations to be performed, is mandatory. Funds that are registered with the SEC must report information about trades and portfolios handled by the fund. It is remarkable that the Act increases the asset threshold for federal regulation of investment advisers from $30 million to $100 million in order to allow more entities to be under state supervision. In other words, federal regulation has increased the budget for regulating investment advisers more than three times, which means that regulators are aiming to impose a greater degree of regulatory examination on certain types of advisers. In general, with the implementation of the Dodd-Frank Act hedge funds and private equity funds will be under thorough regulatory examination and reporting.
2.3.5
Credit Rating Agencies
Credit rating agencies were not severely impacted by the legislation.The SEC is responsible for conducting a twoyear study that will result in the creation of a new mechanism preventing asset-backed securities issuers from picking the agency they think will provide the highest rating, but instead randomly allocating rating agencies to financial firms. The Office of Credit Ratings is created within the SEC with the role of administering rules and promoting accuracy and transparency in ratings. Finally, rules have been implemented on people who wish to work on ratings, such as a prohibition on compliance officers in the role. There are also new reporting regulations to the SEC for rating agency employees who have been working for a company that was rated by the agency within the past year.
2.4. Reforms for Consumers

In general, the Dodd-Frank Act has a wide-ranging impact on anyone providing retail financial services in the United States. It creates a new independent regulatory agency, the Consumer Financial Protection Bureau, which is housed at the Federal Reserve. The Act also contains a series of mortgage reforms that cut across various aspects of the mortgage origination and servicing businesses.The main aim of the Act is to ensure that consumers receive mortgage loans on terms that reflect their ability to repay without being deceptive or abusive.
2.4.1.
Consumer Financial Protection
The Dodd-Frank Act establishes a new independent regulator and supervisor, the Consumer Financial Protection Bureau (CFPB), housed at the Federal Reserve. It has the authority to promulgate rules for consumer protections governing all financial institutions, banks and non-banks offering consumer financial products or services.The aim is to help consumers evaluate mortgages, credit cards and other financial products, and to protect consumers from hidden fees, abusive terms and deceptive packages.
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2.4.2. Other Consumer Protections

Under the Durbin Amendment in the Act, the Fed has the authority to limit interchange, or swipe fees, that mer, chants pay for debit-card transactions, and to ensure that fees are reasonable and proportional. Retailers can offer discounts based on forms of payment and refuse credit cards for purchases of less than $10, and merchants will be permitted to route debit-card transactions on more than one network. In addition to the rules on interchange fees, the Dodd-Frank Act creates a mortgage reform which ensures that borrowers can repay loans that are sold. It prohibits activities which during the recent financial crisis encouraged lenders to lead borrowers into more costly loans, and it establishes penalties for irresponsible lending.
3. Business Model Implications

The recent crisis should have been anticipated. We can now see that a number of signs were suggestive of forthcoming difficulties. For example, banks balance sheets have grown so fast in the last fifty years that in the UK today those balance sheets are over five times annual GDP, while previously the size of the banking sector relative to GDP was broadly stable at around 50%. The size of the banking sector in the US has grown from around 20% to around 100% of GDP today (Mervyn King, Governor of the Bank of England, 2010) . This fast-paced increase in balance sheets or even asset holdings was bound at some point to collapse. Of course, as expected the explosive increase of banks balance sheets caused risks associated with balance sheets to explode as well. Since the late 80s banks were using more short-term, wholesale funding, exploiting capital arbitrage opportunities through securitization and thus producing a significant increase in financial leverage. In fact, over the past thirty years in the US, the average maturity of wholesale funding issued by banks has declined by around three quarters, while reliance on wholesale funding has increased. Of course this resulted in a higher degree of maturity mismatch between bank long-dated assets and short-term funding. On top of everything else, banks held a lower proportion of liquid assets on their balance sheets, so that in the event of short-term funding drying up they were more exposed. In addition, money market funds and other similar entities in the US had total call liabilities of over $7 trillion, and they on-lent significant amounts to banks, both directly and indirectly via chains of transactions.This has had two consequences. First, the financial system has become exceedingly interrelated as a result of the numerous rules that need to be written from the various new and existing federal agencies. This creates problems in promoting stability of the system as a whole within a regime of regulation of individual institutions, and it increases the probability of failure.The large interconnectedness among the regulators, their responsibilities and the large number of rules that actually need to be written by joint operation of regulators (which can be found in figure 2) are issues that will bring perplexity to the financial system. Second, although many of these positions net out when the financial system is seen as whole, gross balance sheets are not restricted by the scale of the real economy, and so banks were able to expand at an exceptional pace. At the beginning of the crisis the uncertainty that existed with regard to where losses would ultimately fall led to confidence in banks seeping away.
Deutsche Bank;Tom Joyce,Francis Kelly and Callie Smart,The Implications of Landmark U.S.Reg Reform The Dodd-Frank Wall Street Reform and Consumer Protection Act July 2010. ,
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Figure 2 Agency Bureau CFTC Council FDIC Federal Reserve FTC GAO OCC OFR SEC Treasury Total** All rulemaking* 24 61 56 31 54 2 0 17 4 95 9 243 One-Time Reports/Studies 4 6 8 3 3 0 23 2 1 17 1 67 New Periodic Reports 5 2 4 1 3 0 2 2 2 5 1 22
* This estimate only includes references to explicit rulemakings in the Act, and thus likely represents a significant underestimate. ** The Total count eliminates double counting for joint rulemakings. Source: Davis Polk Wardwell
The significant interconnectedness of all the functions within the financial system magnifies any problems that may arise in services that are crucial for the proper functioning of the economy, such as the payments system, the services of money and the provision of working capital to industry. Institutions responsible for these services are too important to fail, and in the case where some of these are materially endangered, governments will always act to come to their rescue.Greater risk begets greater size, most probably greater importance to the functioning of the economy, higher implicit public subsidies, and hence yet larger incentives to take risk is described by Martin Wolf 11 as the financial doomsday machine .This concept in the main motivates highly risky banking institutions to take on more risk by taking advantage of the fact that, if things go well then they will enjoy the rewards, while if things go wrong then the government will suffer the losses. Since their assets are risky and they are also highly leveraged, banks were bound to suffer from the recent crisis. This has left banks heavily exposed and with very high debt-equity ratios, which means small movements in asset valuations are enough to wipe out an institutions equity, leaving it insolvent. Post the recent crisis, reforms were bound to occur. A number of implications will result from the Acts implementation, which will reveal themselves slowly in the coming years. Clearly, its beneficial elements are easier to discover and almost impossible to quantify. However, the implementation of new regulatory reforms as significant as the ones in Dodd-Frank will inevitably produce some unintended consequences.The business model is one of the most highly affected areas of the DoddFrank Act. Unfortunately, it is impossible to expect to prevent the financial world from reliving a crisis similar to, or even worse than, the crisis of 2007-2008, without capital or profits or economic recovery being influenced. The lengthy implementation timeline of Dodd-Frank, together with the long transition periods for numerous of its rules, will certainly setback the economic recovery of the still wounded US financial market.
11
The Financial Times by Martin Wolf,The challenge of halting the financial doomsday machine April 2010. ,
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3.1. Downward Pressure on Bank Profitability

Several provisions included in the Dodd-Frank Act will directly put strong downward pressure on bank profitability. In addition, administrative and transition costs associated with implementing and complying with the various new requirements will not be insignificant. From a regulators point of view, the new requirements will have to be stringent. On the one hand, capital and liquidity resources will have to increase simultaneously. On the other hand, Leverage will have to decrease in such a way as to ensure the financial system has the strength to withstand a crisis of the size and persistency of the recent one without governmental or public support. This, however, will come with a cost in that profit margins can be expected to narrow.This comes as a result of increased pressure on returns due to the additional costs associated with implementation of the different provisions of the Act, which were analyzed earlier. The business lines that are subject to the Volcker Rule, such as proprietary trading, have been among the most profitable ones in recent years for many large financial institutions.Therefore, exiting or modifying these business lines will inevitably reduce earnings, as well as risk, significantly. Proprietary trading enables firms to trade stocks, bonds, currencies, commodities, or other financial instruments with the firms own money rather than customer money, so it can make a profit for itself. Prohibiting such activities will certainly eliminate a significant amount of a banks income, thereby decreasing the firms earnings. However, the nature and extent of this reduction is largely dependent on the outcomes of the rule-writing process, which become effective in coming years. This is one of the main reasons why the Volcker Rule is to be implemented with a large number of exceptions and lengthy transition periods. The estimated impact of the Volcker Rule on bank profitability, and in particular on proprietary trading and potential earnings per share (EPs), is illustrated in figure 3. An average drop of 2 4 % is estimated to occur on banks trading revenues. However, there are banks that could be hit by a decrease as high as 5-10 %. As a result of this decline in trading revenues, banks are expected to face a high impact on their earnings per share (EPS), which are bound to decrease significantly. In the case of Goldman Sachs, for example, a 25% decrease in the last twelve months trading revenues could cause up to a 27% decrease in EPS.This is obviously a very significant impact that will be highly detectable in the balance sheet. However, even lower declines of trading revenues will have an impact on EPS. Finally, the last table in figure 3 gives an estimate of the Volcker Rule impact on Tier 1 capital for five top US banks. An estimated increase of 3% is assumed for capital equity in the figure, but no one will know for definite what the figure will be until after full implementation of the Dodd-Frank Act.
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Figure 3: Estimated Impact of the Volcker Rule 2009 Core Trading Revenues for Banks
40 35 30 25 20 15 10 5 0 37.3
Potential Hit to Prop Trading from Volcker Rule

1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1.5
2-4% of trading revenue Some estimates as high as 5-10%
$ billions
20.5
23.8 12.2
0.4
0.5 0.2
Bank of America
JPMorgan Chase
Goldman Sachs
Morgan Stanley
Bank of America
JPMorgan Chase
Goldman Sachs
Morgan Stanley
Potential EPS Impact

Potential 2011 EPS Impact 5% Goldman Sachs Morgan Stanley Citigroup JPMorgan Bank of America 5% 4% 2% 2% 2% 10% 11% 7% 5% 4% 3% 15% 16% 11% 7% 6% 5% 20% 21% 15% 10% 8% 6% 25% 27% 19% 12% 10% 8%
Volcker Rule Capital Estimate

Tier 1 capital Bank of America JPMorgan Citigroup Goldman Sachs Morgan Stanley
$ in billions, as of Q1 2010
Est. 3% Tier 1 $ 4.7 3.9 3.6 2.1 1.5
155.41 131.4 120.1 68.5 50.1
Estimated impact on 2011 EPS due to % decline in LTM trading revenue.
Source:Wall Street Journal Saturday June 26,2010;Credit Sights FinReg:Banks Brave New WorldJune 28,2010;Deutsche Bank,The Implications of Landmark U.S.Reg Reform,2010.
Due to the major negative impact the Volcker Rule is bound to have on banks profit margins, banks are already trying to find loopholes in the legislation that will enable them to avoid the prohibition on proprietary trading as much as possible. Although banks on the one hand are showing a willingness to adapt to the Volcker Rule prohibitions by shutting down proprietary desks, on the other hand they have already found ways to bypass the proprietary trading banning. The Volcker restrictions do not apply to principal investments, which are banks direct purchases of securities, companies and property assets, because they are regarded as longer-term commitments and carry higher capital charges. According to a Financial Times article12 banks are now trying to sidestep the Volcker Rule by using principal investments as their main trading operations.These principal investments have in the past proven to be quite profitable for banks, even though they have also caused major losses and carry with them the exact same kinds of risks that regulators tried to eliminate with the Volcker Rule. In addition, trading strategies can move to marketmaking units or be sold off to clients, which are activities exempt from the Volcker prohibitions. But the situation remains fluid. Either regulators will have to do an extremely thorough rule-writing process and outlaw activities that endanger financial stability and impose systemic risk, or financial institutions will again find ways to invest in similarly risky activities.
12
The Financial Times by Francesco Guerrera, Justin Baer and Tom Braithwaite,Wall Street to sidestep Volcker Rule, November 2010.
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In the Collins Amendment described earlier, it is stated that capital requirements in the Dodd-Frank Act should comply with the Basel III capital requirements that appear in the consultative document, Strengthening the resilience of the banking sector After the Basel Committee proposed the new requirements, major financial insti. tutions responded to several of its provisions, partly positively and partly negatively, based on the severe consequences that these provisions will have on their balance sheets. Here we will describe their main considerations and the way these provisions will assist in narrowing profit margins13. In general, the Committees definition of Tier 1 capital is considered too narrow by most financial organizations. In particular, the eligibility criteria in the Consultative Document will raise competitive equity issues for banking organizations located in the US. It limits the use of hybrid instruments, which have proven to be extremely loss absorbent, and consequently the flexibility of raising capital for banking organizations will be reduced. It is likely that over the long term the after tax cost of capital will increase for banks quite significantly. Prior to the Basel III requirements, common equity had to be the dominant(>50%) component of the Tier 1 capital for U.S. banks.The balance could consist of qualifying Tier 1 components such as trust-preferred securities (up to 25%) and non-cumulative perpetual preferred stock. By optimally structuring their capital with this combination of securities, U.S. banks reduced their after-tax cost of capital, improved returns on common equity and earnings per share and enhanced their franchise values. The new Basel III requirements will increase the common equity component of Tier 1 capital from at least 51% to approximately 82% (7% common equity relative to 8.5% Tier 1 capital). Similarly, common equity will increase as a percentage of total capital from a minimum of 51% to approximately 67% (7% common equity relative to 10.5% total capital). By requiring far greater amounts of common equity relative to non-dilutive, tax-deductible forms of capital, the cost of capital for U.S. banks will therefore increase14. Figure 4 illustrates how the weighted average cost of capital is going to change as a result of the new Basel III rules. Figure 4: Illustrative Cost of Capital Under Current Rules Common Equity Pre-Tax Cost After-Tax Cost Percentage of Tier 1 Weighted Average Cost of Capital 15.00% 15.00% 51% 7.65% Trust Preferred Securities 8.00% 5.20% 25% 1.30% Non-Cumulative Perpetual Preferred 10.00% 10.00% 24% 2.40% 100% 11.35% Total
Illustrative Cost of Capital Under Basel III Common Equity Pre-Tax Cost After-Tax Cost Percentage of Tier 1 Weighted Average Cost of Capital
Note: Assume 35% tax rate.
13 14
Trust Preferred Securities 8.00% 5.20% 0% 0.00%
Non-Cumulative Perpetual Preferred 10.00% 10.00% 18% 1.80%
Total
15.00% 15.00% 82% 12.30%
100% 14.10%
See appendix for detailed comments and analysis on capital requirements for HSBC,Barclays,Goldman Sachs,Bank of America,Citigroup,JPMC,Morgan Stanley,Credit Suisse and Deutsche Bank. Thomas W.Killian,Basel III and Its Implications: A Closer Look September 2010. ,
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In addition,most banks do not support the Committees proposal on completely deducing all deferred tax assets from Tier 1 common equity. Deferred tax assets tend to rise during economic downturns, and their blanket deduction, irrespective of recoverability, would have consequential pro-cyclical effects on the measurement of capital.Their full deduction can create a strong disincentive for prudent loan loss reserving and will greatly increase pro-cyclicality in capital requirements.Therefore, it will again limit loss absorbency and, inevitably, result in a decrease in profits. The proposals on investments in the capital of certain banking, financial and insurance entities basically restrict ordinary market-making activity within the trading book. However, this restriction may well drive the business to less regulated sectors of the market,increasing costs and reducing both liquidity and price transparency (HSBC,2010)15. On top of that, large significance was put upon the proposal of the Committee to implement regulatory downturn probabilities of default (PDs) when addressing Pillar 1 cyclicality. All banks that made a reference to this disagree with the Committees proposal. HSBCs view was clear when its representatives stated that the introduction of any new measures, which would have to be developed for capital buffer purposes only, would significantly increase costs while having very limited benefit. This means that costs will increase significantly in order to implement the new measures, but no significant rewards will be produced to outweigh the losses. In addition, leverage allows a financial institution to increase the potential gains or losses on a position or investment beyond what would be possible through a direct investment of its own funds (DHulster,2009)16.Financial institutions work to ensure they do not exceed their desired risk, and hence maintain the same risk appetite. On the whole, under the Basel III requirements for enhanced capital prudential standards, financial institutions have to increase their total equity.This will cause leverage to decrease, which is also one of the main objectives of regulators. It will therefore also decrease returns. Similar to the case of capital requirements,banks have expressed their considerations on the new leverage requirements proposed by the Basel Committee. Here we will describe the main issues17 raised and the negative effect banks profit margins will have to face by implementing the new leverage requirements. The majority of financial institutions claim that credit derivatives should not be included in the leverage calculation since including them will probably reduce liquidity and increase spreads, and therefore increase costs of funds. By increasing costs of funds profit margins are bound to decrease. In addition, it was noted that the inclusion of offbalance sheet exposures in the leverage metric is incorrect since it produces an overstated leverage and will probably reduce credit availability,and hence increase customers borrowing costs since demand will remain the same. As with capital and leverage requirements, financial institutions have reacted to the new liquidity requirements18 by relating it to the consequences they will have to face. In order for banks to maintain a satisfactory NSFR (Net Stable Funding Ratio) they may have to suffer a severely negative impact on their ability to perform maturity transformations, obtain funding and extend credit to customers. All of these will immediately narrow their profitability since they constrain the institutions overall investments19. The increase in the standard maximum deposit insurance amount from $100,000 to $250,000, which appears under the Federal Deposits amendments, is an amount reserved by a bank and hence not able to be invested in some way. This revised assessment methodology may incentivize institutions to shrink their balance sheets in order to comply with it. By shrinking their balance sheets, financial institutions will inevitably face decreasing earnings. However, this change is more likely to have a greater impact on larger depository institutions that are more reliant on non-depository sources of funding, such as investment banks, rather than retail banks.
15 16
HSBC,Comments on Consultative Document BCBS 164 Strengthening the Resilience of the Banking Sector . Katia DHulster, Crisis Response; The Leverage Ratio A New Binding Limit on Banks December 2009. , 17 See appendix for detailed comments and analysis on leverage for HSBC, Barclays, Goldman Sachs, Bank of America, Citigroup, JPMC, Morgan Stanley, Credit Suisse and Deutsche Bank. 18 See appendix for detailed comments and analysis on liquidity requirements for HSBC, Barclays, Goldman Sachs, Bank of America, Citigroup, JPMC, Morgan Stanley, Credit Suisse and Deutsche Bank. 19 Algorithmics white paper,Basel III: What's New? Business and Technological Challenges September 2010. ,
18
Extremely important are the restrictions on OTC derivatives, which will inevitably decrease bank profitability. In particular, complying with these restrictions constrains OTC transactions, and relationships between a fund advised by a bank, or an affiliate of the company, and any entity within the group.Therefore, many banks might be required to spin off parts of their operations or otherwise dispose off their interests in the trading portfolios and businesses of hedge fund and private equity funds. By removing these operations from their trading portfolios, banks will decrease their derivative trading revenues. Finally, banks should consider the impact that the implementation of these new requirements will have on their profit margins. Financing, for example, all of the new reporting and recordkeeping requirements, as well as compliance and new governance standards, will definitely have a negative impact on banking profitability. In addition, as we will examine in detail later, the new regulations will produce changes to the tax procedures of financial institutions. It is apparent, for example, that if banks do not manage to find other tax efficient instruments that have hybrid-type characteristics to replace the use of trust-preferred securities, then they should anticipate large tax increases, and therefore a negative effect on their profits. The above are just a few of the numerous issues that will one way or another result in narrowing profit margins. JPMorgan Chases research was quite illustrative of this. Its researchers discovered that current proposals could result in a sharp drop in global bank average ROE from 13.3% to 5.4% in 2011, affecting both wholesale and retail banks. Under these conditions it would be difficult to attract private capital, if necessary, to meet higher regulatory standards, to fund growth, and to maintain the same level of profitability and pricing on products (retail banking, commercial banking, investment banking) would have to increase by 33% (JPMorgan Chase, 2010)20. However, at a time when competition is a source of pressure on profits, the last thing financial institutions will want to implement is price increases on their products, which would leave them facing the risk of losing valuable customers.
3.2. Re-assessment of Balance Sheets

It is expected that after a huge regulatory reform such as the Dodd-Frank Act, balance sheets will be reformed. Financial institutions affected by the numerous provisions will have no option but to perform some restructuring to their activities as a result of the limitations or prohibitions imposed upon different activities.This is why the reassessment of the balance sheet is actually linked to the additional costs imposed on institutions and the reduced profit margins analyzed earlier. In particular, increased focus will be placed on the allocation of capital due to expectations of higher capital and liquidity cushions, placing added pressure on returns and therefore leading to a re-assessment of some business models. As the Volcker Rule prohibits proprietary trading it has a great effect on balance sheets. The main impact of this exclusion is on assets that are held for trading and on equity capital. Obviously, the amount of an institutions own capital that is held for trading for no other reason other than to make money for itself is either decreased or eliminated completely under the Volcker Rule.Therefore, the assets that are held by the institution for trading purposes will inevitably decrease, and consequently more capital will become available in comparison with total assets. It is worth mentioning that the major banks that appear in Deutsche banks analysis Goldman Sachs, Morgan Stanley, Bank of America, JPMorgan Chase21 and Citigroup have already started winding down the operations of proprietary trading despite the large transition period allowed for with the implementation of the Volcker Rule22. Some proprietary trading desks have already been shut down and traders have either been shifted to client-facing desks or to asset-management businesses, where they trade outside investor capital. Clearly, the amounts used for proprietary trading activities has now been removed from trading assets, and institution capital as a proportion of
20
JPMorgan Chase, Comments on the documents Strengthening the Resilience of the Banking Sector and International framework for liquidity risk measurement, standards and monitoring . The Financial Times by Gregory Meyer and Francesco Guerrera,JPMorgan to close prop trading division September 2010. , 22 The Financial Times by Justin Baer,Proprietary traders weigh up new options .
21
19
total assets will eventually have to increase. However, we saw earlier that although banks want to show a supportive attitude towards the implementation of the Volcker Rule, they are trying to find a loophole so they can trade some of their capital in order to minimize their losses. The risk weighting is also impacted. A sophisticated protocol of revised risk weightings is proposed in Basel III that will likely increase the risk weightings on trading, derivatives and securitization activities. Complicating this process is the Dodd-Frank requirement that banks no longer rely on published debt ratings for purposes of determining appropriate risk weightings of investments in debt securities. This has created a scenario where banks cannot be sure how they will determine the creditworthiness of securities that will then drive risk weightings. We expect to see rulemaking settle uncertainties such as whether each bank will have to prepare its own analysis of risks to determine the appropriate risk weighting, or whether banks may rely on a report by a third party other than a nationally recognized statistical rating organization, or rating agency. Next, we consider the liquidity requirements and the impact that the introduction of the two new liquidity ratios, LCR (Liquidity Coverage Ratio) and NSFR (Net Stable Funding Ratio), will have on balance sheets. In general, the Basel Committees aim in introducing these liquidity ratios is to raise new funds that can be invested to build a liquid asset buffer, which will allow the bank to be self sufficient from a liquidity perspective for a reasonable period of time ranging from 30 to 90 days.The LCR aims to ensure that each bank owns the appropriate amount of liquid resources in order to fulfill all short-term obligations even under severe stress situations.These liquid resources are most likely assets that are held until maturity and/or available for sale in order to assist the financial institution in the event of financial distress. Therefore, Basel III and subsequently the Dodd-Frank Act, force institutions to maintain higher amounts of high quality liquid assets, and therefore increase assets Held Until Maturity and/or Available for Sale . On the other hand, there is the NSFR, which aims to prevent banks exposing themselves to extreme maturity transformation risks by funding medium and long-term assets with very short-term liabilities. Basically, the NSFR endeavors to solve the problem mentioned in Mervyn Kings, Governor of the Bank of Englands, speech on 25th of October 2010, concerning maturity mismatch between short-term funding and long-dated assets. In recent years this maturity mismatch had risen to an incredibly high level. The NSFR was created to limit this mismatch as much as possible. Obviously, the introduction of the NSFR affects the entire liabilities side of the balance sheet a great deal. Collins Amendment and Basel III have the objective of implementing better quality and higher capital requirements, and decreasing leverage.The capital buffers will also promote more forward-looking provisions, conserving capital for use in periods of stress and protecting the overall banking system from excessive credit growth. Loans, for example, are impacted by the forward-looking provisions, and the avoidance of excessive growth through the definition of the credit expected loss (namely the Credit Value Adjustment, CVA) that takes into account the counterparty credit risk exposure in a much more precise way. This new procedure for calculating CVA is described in detail in other Algorithmics papers23, 24. Here, we just make a brief note on CVA to show its importance on the re-assessment of balance sheets.This increased focus on the new and better calculation of excessive credit growth through CVA is certainly welcome, and already most financial institutions now consider calculating CVA a priority.This methodology allows banks to properly measure the increased capital charge for mark-to-market losses in comparison to losses due to defaults that appeared before the crisis. Up until recently, financial institutions have controlled counterparty credit risk (CCR) by setting limits against future exposures and verifying potential trades against these limits.This approach basically permits trades that moderately reduce or increase exposure, and rejects trades that exceed certain limits. The new CVA approach grants enterprises the additional benefit of representing CCR as a dynamic quantity,pricing it directly with new transactions,in association with future losses,and in relation to existing positions.The better estimation of excessive credit growth will enable banks to constrain it as low as possible
23 24
Algorithmics white paper,Credit Value Adjustment: The changing environment for pricing and managing counterparty risk December 2009 , Algorithmics white paper,Towards active management of Counterparty Credit Risk with CVA July 2010 ,
20
Ultimately, one of the most important provisions within both the Dodd-Frank Act and Basel III is the requirement of introducing a leverage ratio, which affects both assets and liabilities on the balance sheet.The more costly forms of capital will reduce earnings, as explained earlier, and therefore reduce balance sheet assets. On the other hand, by simply increasing the equity capital of a financial institution, the liabilities of its balance sheet are affected.The whole purpose of establishing a leverage ratio is to constrain the build-up of leverage, which was incredibly high before the crisis. In particular, in figure 5 we examine the relation between return on equity (ROE), which is the ratio of net income over equity, and leverage for major financial institutions using Algorithmics data elaboration as a proxy. In this Algorithmics research we have assumed an increase in capital equal to 3% and the likely decrease in total assets and return on assets (ROA) established through the Dodd-Frank Act provisions that should produce a decrease in ROE as illustrated in figure 5 of approximately between 25% and 30%. Figure 5 therefore provides an estimate of the impact that the increase in capital and the decrease in assets will have on returns on equity. We observe that for some institutions this is bound to be extremely significant. Nonetheless no one will remain unaffected, and the size of the effect will appear after the complete implementation of the Act. In addition, it is important to note the uneven ROE among different financial institutions, which proves the irregular efficiency of financial institutions at generating profits from equity, even if they operate services of similar type. Figure 5: ROE and Leverage Relation. 12% 11%
Return on Equity
10% 9% 8% 7% 6% 6.47% 6.48%

Leverage
6.99%
8.07%
ROE (before)
ROE (after)
The re-assessment of balance sheets will be enormous. However, the degree of re-assessment will vary according to the size of the financial institution and the degree to which it will be affected by the Act. It is obvious that with the numerous exceptions not all institutions will be impacted equally by the provisions, and therefore the reforms that each institution will have to implement will differ extensively.
3.3. Reform of Operational and Legal Entity Structures

The unresolved issues and extended time frames of the Act will certainly increase the complexity, potential conflicts and ambiguity that surround bank capital. Until these variances and timing considerations are resolved, the uncertainty will negatively impact bank growth strategies and lending activity, and therefore directly or indirectly cause changes to the operational and legal entity structures of financial institutions.
21
The CFTC and SEC are required to promulgate final rules implementing the provisions of Title VII within one year of the enactment of the Act, hence by July 2011.The limitations on OTC derivatives will definitely affect the operational and legal entity structures. As mentioned earlier, complying with these requirements will constrain transactions and relationships between a fund advised by a bank and any entity within the group. Therefore, many banks may be required to offload parts of their operations or otherwise remove their interests in their trading portfolios, and private equity and hedge fund businesses. For example, the Act restricts a banks ability to engage in certain swaps or similar agreements by requiring these swaps be transitioned to separately capitalized affiliates. Therefore, some banks will need to restructure their operations to separate those swap activities.The example given by Ernst & Young was quite descriptive of this.Taxpayers that rely on certain mark-to-market, hedging and/or integration rules for tax purposes will need to analyze the effect of any restructuring on their ability to properly utilize these rules if the hedges and associated assets or liabilities are required to be in separate entities(Ernst & Young, 2010)25. In combination with the derivatives limitations, the Volcker Rule prohibitions will also restrict a banks ability to engage in certain operations that before the emergence of the Act occupied a reasonable amount of its investments. In addition,resolution plans will also affect the operational and legal entity structures.Resolution plans should outline how financial institutions will wind down their businesses if faced with severe financial distress or failure. In order for large institutions to develop and sustain these recovery plans, they will have to rationalize some aspects of their operational and legal entity structures.The Federal Reserve and the FDIC have the power to jointly determine that a submitted resolution plan of a company is not credible and hence would not facilitate an orderly resolution under the US Bankruptcy Code. In such a case, the company will be required to submit a satisfactory revised plan, and if they fail to do this then the Federal Reserve and the FDIC can jointly impose more stringent capital, leverage or liquidity requirements and restrictions on growth, activities and operations of the company. Finally, even if after imposing stricter capital requirements the company does not submit an acceptable plan over a period of two years, then the FRB and the FDIC may require the divestiture of certain assets and operations in order to facilitate an orderly resolution in the event of a bankruptcy. This verifies that failure to comply with the resolution plan requirements gives the right to the FRB and the FDIC to force the company to reform its operational structures, by perhaps limiting certain operations, or in more extreme circumstances eliminating them completely.
3.4. Decrease on Lending in the US economy

The Dodd-Frank Act will unavoidably affect lending within the entire US financial economy.The amount of lending in the US market is definitely expected to decrease. The restrictions and prohibitions on some of the most important and most profitable activities of financial institutions,such as proprietary trading and derivatives activities,will encourage non-US based companies to move their operations onto other jurisdictions.It will encourage the flow of risk and capital to less regulated jurisdictions, which can be considered as creating global regulatory arbitrage opportunities. The growth opportunities in the US will start to decrease, or in the best case scenario will remain constant for the following years until the Act is perfectly established and the US economy is fully recovered. The several new rules that still remain to be written and established, and the lengthy transition periods that follow the new requirements, will unfortunately hold back the US economic recovery. Banks in the US make up 25% of the countrys total credit supply26, and the Dodd-Frank Act impacts almost every one of the key sources of credit in the US economy, such as banks, asset-backed securities issuers and finance companies, at a time when they have not fully recovered from the financial crisis.The question remains whether these key credit sources will manage to survive the enhanced requirements of the Act and recover at the same time.
25 26
Ernst & Young,US Financial Reform Act has significant tax implications 2010. , Deutsche Bank;Tom Joyce,Francis Kelly and Callie Smart,The Implications of Landmark U.S.Reg Reform The Dodd-Frank Wall Street Reform and Consumer Protection ActJuly 2010. ,
22
3.5. Will the Dodd-Frank Act End Too-Big-To-Fail?

The term too-big-to-fail became prolific after the 2007-2008 financial crisis. A financial institution is considered too-big-to-fail if it is thought to be so central to a countrys economy that its failure will be disastrous, such that it becomes a recipient of beneficial financial and economic policies from governments and central banks. Companies implicitly consider this as a beneficial characterization, as lying within this category allows them to take highly risky positions since they are able to leverage these risks based on the advantageous treatment they receive. A number of critics believe that large institutions should be left to fail if their risk management is not effective. This issue was one of the most important ones raised after the recent crisis, and it is one of the primary objectives of this legislation. Unfortunately, although the Act hugely dampens the too-big-to-failissue, it far from eliminates it. The condition of some of the biggest financial institutions not long after the onset of the crisis in the US is summarized in figure 6. In particular, the top four U.S. banks represent more than 50% of total U.S. industry assets, while the top 10 represent almost 80%.These percentages are huge, and it is highly unlikely that the Dodd-Frank Act will manage to decrease them significantly, at least not in the next few years. It is also worth mentioning that the United States had the smallest percentage asset concentration in its top three banks during 2009 compared to other major jurisdictions. The highest was Germany, which had almost twice the asset concentration of the U.S. In addition, total U.S. banking derivative contracts of five of the top six U.S. banks accounts for almost 95% of the total derivative contracts of all U.S banks, which sums up to near $300 trillion. Finally, the amount of assets lost from the top 10 US bankruptcies during 2009, and in particular from the top two, Lehman Brothers and Washington Mutual, is extremely high. This amount of assets, which was approximately $1,500 billions, accounts for almost 10% of the total asset banking concentration in US banking, where the total was $10,344.6 billions. Clearly, this proves that the bankruptcies of 2009 have caused a great deal of damage to the US economy. Figure 6 Top 3 Banks Asset Concentration (2009)
Assets of 3 largest banks (%)
U.S Banking Asset Concentration (2009)

As of Q3 09 Company Name 1 Bank of America 2 JPMorgan Chase 3 Citigroup 4 Wells Fargo 5 Goldman Sachs 6 Morgan Stanley 7 MetLife 8 PNC Financial 9 U.S. Bancorp 10 Bank of NY Mellon Total Assets ($bn) 2,251.0 2,041.0 1,888.6 1,228.6 882.2 769.5 535.2 271.4 265.1 212.0 10,344.6 % of Industry Assets Bank Cumulative 17.0% 17.0% 15.4% 32.4% 14.3% 46.7% 9.3% 55.9% 6.7% 62.6% 5.8% 68.4% 4.0% 72.4% 2.0% 74.5% 2.0% 76.5% 1.6% 78.1%
70 60 50 40 30 20 10 0
ce
pa n
an y
in
ad
ly Ita
ita
Fr an
rm
Ca n
U.S. Banking Derivative Contracts (2009)

National Value Outstanding (USD trillion)
90 80 70 60 50 40 30 20 10 0
Ge
Br
Ja
U.
S.
10 Largest U.S. Bankruptcies

Lehman Brothers Washington Mutual WorldCom
81.1
77.9 47.8 39.1 31.7
General Motors CIT Group Enron Conseco Chrysler
Sa M ch or ga s n St an le y Ci tig ro up
or ga
er
ica
Thornburg Mortgage Pacific Gas & Electric
Am
JP
an
Go ld
100 200 300 400 500 600 700

Assets ($ billion)
Source: Deutsche Bank,The Implications of Landmark U.S. Reg Reform 2010; Capital IQ; BIS,World Bank,WSJ, OCC, Bloomberg, FDIC. ,
Ba
nk
of
23
A suggestion for resolving the too-big-to-failissue would be to increase tax requirements. Under the Dodd-Frank Act, tax procedures are influenced, although not directly, with financial institutions probably subject to a harsher tax regime. An increased tax burden will limit size up to a certain point.The tax increase appears in the Dodd-Frank Act through enhanced capital requirements that are progressive to the size of the business as measured by value added, the size of the balance sheet or other metrics (Willem Buiter, 2009)27. In addition, financial institutions considered too-big-to-failmust create a bankruptcy contingency plan outlining how the financial institution would resolve itself quickly and efficiently in the case of financial distress, without the help of the government or the American taxpayer. Resolution plans will force institutions to track and report their exposures much more carefully than previously, and in a timely manner.
3.6. Modifications of Tax Procedures

Finance and tax regulations will be subject to a few amendments,although not directly and not to a significant extent. The prohibitions or limitations on certain activities and the introduction of new capital requirements along with new regulations, such as the resolution plans, will eventually have implicit tax implications.Failure to consider these implications could effectively increase the costs of complying, and therefore financial institutions that are liable under the Act should modify their operations in order to comply with the new rules in the most tax efficient manner possible. In order to meet their capital requirements, financial institutions have in part used trust-preferred securities (TPS), which are hybrid securities treated as Tier 1 capital for regulatory purposes,but as debt for US tax purposes.The Collins Amendment phases out the treatment of TPS as an element of Tier 1 capital over a three-year period beginning January 2013.The phase out process of these hybrid securities means that financial institutions may lose a tax-efficient form of raising capital (Ernst & Young, 2010)28.As a result, financial institutions will face a significant tax increase under the Act, unless the TPS are replaced with another hybrid-type security that can qualify as debt for US tax purposes. The trading of swaps with standardized terms could lead to more swaps requiring upfront or other non-periodic payments. The tax treatment of non-periodic payments could have significant tax consequences with respect to how companies account for these payments for income tax purposes (Ernst & Young, 2010)29. Finally, the need of some banks to restructure their operations in order to separate those swap activities that are limited in Title VII of the Act could have significant tax consequences.
3.7. Implications for the Insurance Industry

The Federal Insurance Office (FIO) will play a prominent role in oversight and in coordination between the US insurance market and the international insurance market. Large global insurance companies that will be designated as systemically important non-bank financial institutions will face a significant impact on their regulatory future, and will eventually face the same implications as the ones analyzed earlier for bank holding companies. Insurance companies must be prepared to see increased coordination of regulatory examinations by the FIO, which will focus on the collection and analysis of information related to the insurance industry for the purposes of evaluating potential systemic risk of insurers on the US insurance market and at the global level. In addition, insurance companies that own banks or thrifts are subject to the Volcker Rule, which prohibits banking entities from engaging in proprietary trading activities with certain exceptions. Finally, insurers are exempt from the prohibition of trading in financial instruments.
27 28, 29
Willem Buiters Maverecon,Too big to fail is too big June 2009. , Ernst & Young,US Financial Reform Act has significant tax implications .
24
3.8. Implications for Hedge Funds

In general, the hedge fund industry is one of the most severely impacted areas of the Dodd-Frank Act.The largest hedge funds run the risk of being designated systemically important institutions. The Act does not clarify on size thresholds, but rather leaves this to the discretion of systemic risk regulators (Fed and FSOC). Hedge funds that will be designated as systemically important will be impacted by strict regulatory oversight, higher capital levels and tight monitoring activities. Hedge funds might also be under a few extra requirements, such as registering with the SEC if their total consolidated assets are equal to or greater than $150 million.This will result in stricter reporting and recordkeeping. These requirements will produce consequences similar to the ones that bank holding companies will have to face, such as narrower profit margins, re-assessment of their balance sheets, amendments to their operational and legal entity structures and modifications to their tax procedures. The strict regulatory oversight and the higher capital level, but also the central clearing requirements on derivatives, will force hedge funds to restructure their operations and shrink their balance sheets in order to comply with the Act.Therefore their profit margins will inevitably decrease.
4. Implementation Timelines
The Dodd-Frank Act has a lengthy implementation timeline and long transition periods that vary significantly for each provision. In figure 7 we will try to summarize the main implementation and rulemaking dates of the Act along with the main transition periods allowed. It should be noted that in the table the enactment date is the date when the Act was signed, on July 21, 2010, and the transfer date is 12 months after the enactment; that is, July, 2011.
25
Figure 7: Implementation Timeline for major Dodd-Frank Act provisions

Dodd-Frank Rules Volcker Rule Major Provisions within the Rules Within 6 months of enactment: (i) Council study on effective implementation, (ii) Transition rules must be issued. 9 months after studys completion: (i) Regulators must issue implementation rules and (ii) Government Accountability Office (GAO) study on proprietary trading must be completed. Phase-out period of Trust Preferred Securities begins Jan 1, 2013 and ends Jan 1, 2016. Effective date is the earlier between (i) 12 months after the issuance of implementation rules and (ii) 2 years after the enactment. Transition periods: For large banks: 2 year phase-in period from the effective date and up to 3 1-year extensions for liquid funds and up to 5 1-year extensions for illiquid funds.
Bank Capital
Within 18 months of transfer date: (i) Leverage and capital requirements must be implemented and (ii) GAO must conduct 3 studies and report them to the Congress.
Consumer Within 6-18 months of Protection Bureau Financial enactment: Changes become effective. Interchange Fees Within 9 months of enactment: Fed gathers data and sets debit card interchange fees. Within 18 months of transfer date: Impose liquidity requirements. Changes become effective 1 year after enactment.
Possible extension of up to 2 years from enactment. The provisions take effect 1 year after enactment.
Liquidity
Possible extension of up to 6 additional months. Within 1 year of the enactment: GAO must complete a study on feasibility of forming a self-regulatory organization to oversee private funds. 2 years after derivatives requirements are effective, the swap push-out rule becomes effective. The swap push-out rule is subject up to 3 year transition period.
Hedge / Private Equity Funds
Derivatives
Provisions become effective 1 year after the enactment. Within 6 months of the enactment: Rules issued by the Comptroller of the Currency and FDIC. Within 1 year of the transfer date: Rules must be issued by the Fed. Regulations become effective 1 year after publication of the final rules in the Federal Register for RMBS and 2 years after such publication for other securities. Within 1 year after the enactment: SEC must adopt rules.
Executive Compensation
Risk Committees
Within 15 months of the enactment: Rules become effective.
Securitization
Credit Rating Agencies
2 years after enactment: SEC conducts study to create new mechanism preventing ABS issuers from picking the agency of their preference.
OTS elimination
3 months after transfer date, OTS is abolished.
26
5. Conclusion
No one can doubt the great need for changes in the regulatory system, and the Dodd-Frank Act is definitely a significant attempt towards that change. However, it is unrealistic to expect it to confront all issues raised by the crisis. In practice the situation is a lot more complex.The significant interconnectedness among the regulators and their responsibilities is an issue that has to be taken into consideration when estimating future implications.The reality is that no real boundaries exist for separating the rights and obligations of each authority, and this will make the rule-making process extremely difficult to apply. In the end, the Act might not come to be seen to be as perfect as it was intended to be. Its intense complexity and the lengthy transition periods it encompasses could force regulators to depart from their initial aims. In addition, the extended timeframe of the rule-making process will offer affected parties the opportunity to influence the shape and scope of the rules being written. Banks will always try to find loopholes in new regulations in order to legally maintain as many of their profitable operations as possible. A good example of this is the Volcker Rule, where banks on the one hand are showing a willingness to adapt to the Volcker Rule prohibitions by shutting down proprietary trading desks, while on the other hand they have already found ways to bypass the ban on proprietary trading. It falls to the regulators to manage and complete the rule-making process in such a way as to prohibit all kinds of proprietary trading, and therefore avoid once again risking US financial stability. Moreover, there are several issues that still require clarification from the regulators during the anticipated rulemaking process. Who will be designated systemically important? What does proprietary trading include? What does financial stability stand for? These are just a few of the many issues that need to be addressed in the rulemaking process by the regulators. At the moment the powers granted are very broad and ill-defined, such that no one is in a position to truly understand them let alone establish them.The legislation is complicated and characterized by ambiguity, which will not be eliminated until rules and regulations are established, and even then many issues are likely to remain that will require further consultation with the staff of the various regulatory agencies involved. The characterization of a financial institution as systemically important is one of the most crucial points in the entire legislation.The Act encompasses specific reforms for companies that are designated as systemically important. However, nowhere in the Act is the term systemically important clearly defined. Rather, it defers to the systemic risk regulators that is, the Federal Reserve and the FSOC to determine what is meant by a systemically important financial institution. Clearly, this is crucial for a financial institution, since being designated as systemically important will immediately signify huge implications on capital, liquidity and business operations, similar to the ones described earlier. Another issue that needs clarifying is proprietary trading prohibitions. The numerous exemptions in the Volcker Rule can easily cause confusion concerning what is allowed and by whom. For example, it is generally difficult to make a distinction between what is considered a customer order and what is considered proprietary trading. Regulators need to give a further interpretation of this, since it is one of the major effects in the Act that will ground some of the most innovative amendments in the financial regulatory system. In addition, the concept of financial stability needs to be carefully considered. It is mentioned almost everywhere in the Act, but nowhere is there a clear definition of what financial stability is and what it represents.The main aim of the Act is to promote financial stability in the United States, but to accomplish this regulators and participants need to understand the concept that underpins financial stability. This will only be done if, in the rulemaking process, regulators bring greater clarity to their definition.
27
These and many more issues need to be clarified in order to ease the implementation of the Act and cause as little distress as possible to affected parties.Vague definitions can give affected parties the opportunity to interpret things to their convenience, and therefore result in even greater confusion and ambiguity. As has been shown in this paper, the implications for financial institutions will be enormous.They will have to face reduced profitability, re-assessments of their balance sheets, modifications to their tax procedures and much more. Nonetheless, the ultimate consequences are unknown and will remain unknown until years after the regulations are finalized, once agencies are established and power is distributed among the bureaucrats. The question as to whether or not the Dodd-Frank Act will manage to prevent any future financial crisis like the recent one still remains unresolved.The truth is that no one knows, and no one will ever know, until the next crisis actually occurs. Unfortunately, as innovative as the new rules may be, they still rely on looking backwards in an attempt to prevent the last disaster from happening again. History has proven that while the origins and outcomes of boom-bust cycles are similar, the asset classes and mechanisms are almost never the same. Therefore, trying to prevent the next asset class boom by looking to the past for guidance may be counterintuitive. The Dodd-Frank Act is definitely a step closer to a stronger and better regulated economy. However, the lengthy transition periods and the numerous exemptions will prevent smooth implementation of the new requirements, and therefore cause ambiguity within financial institutions and regulatory agencies. At the moment, all we can do is hope that the implementation of the Act is executed as efficiently as possible, so as to ensure that the implications identified above are kept to a minimum.
28
Appendix
In this appendix, there are three tables summarizing the main issues raised by a number of banks concerning the new requirements that the Basel Committee has introduced. The first table is focused on the new capital requirements, the second table on the introduction and structure of a new leverage metric and finally the third table is focused on the new liquidity requirements. Below each table, there are some comments given by the banks representatives explaining their concerns or agreement with the Basel III requirements. Figure 1: Summary of issues raised on capital requirements.
Capital Requirements Agree with the objective that enhanced potential capital standards are needed for the banking sector Yes Yes Yes Agree with the exclusive of ordinary equity minority interests from Tier 1 common equity Agree with the Agree with the bond-equivalent introducing methodology stressed EEPE as fore the CVA an additional calculation measure of general wrongway risk Agree with the deduction of all deferred tax assets from Tier 1 Common Equity Agree with Agree with the providing introduction of evidence for a Leverage ratio the calibration of the 125 multiplier for the asset value correlation Yes Yes Yes Yes N/A Yes No Yes Yes Yes No No Yes Yes Not entirely Yes Yes Not entirely Agree with measures to reduce proCyclicality Agree with implementing regulatory downturn PDs when addressing Pillar 1 cyclicality No No N/A No N/A No N/A N/A No Agree with building buffers through capital conservation (in the context of Pillar 1) No No N/A No N/A No N/A No No
HSBC Barclays Goldman Sachs
No No N/A N/A N/A N/A Yes, partially Yes, partially No
No No No No N/A No No No No
No No No Yes, partially N/A Yes, partially No N/A Yes, partially
No Not entirely N/A No No No N/A Not entirely No
Yes Yes Yes Yes Yes Yes N/A Yes Yes
Bank of America Yes
Citigroup JPMC
Yes Yes
Morgan Stanley Yes Credit Suisse

Yes
Deutsche Bank Yes
HSBC (Letter Response to Basel Committee on Consultative Document BCBS 164 Strengthening the Resilience of the Banking Sector 2010): , They raise the following issues: The proposal to exclude minority interests has a number of flaws. Minority interest is available to support the risks in subsidiary to which it relates and so, it supports the Group as a whole. The full deduction of all deferred tax assets is extremely harsh because they tend to rise during economic downturns and their deduction would have consequential pro-cyclical effects on the measurement of capital. The bond equivalentproposal for calculating CVA risk is not suitable since it does not appropriately capture the volatility of CVA charges. The stressed EEPE is sufficiently conservative Clarification is required concerning the calibration method of the multiplier for the assets value correlation for large financial institutions. Measures to lessen pro-cyclical effects should be implemented; however, HSBC disagrees with developing capital buffers or using downturn PDs to address Pillar 1 cyclicality.
29
Barclays (Letter Response to Basel Committee on Strengthening the Resilience of the Banking Sector 2010): , The major comments made by Barclays are: The proposed changes to the counterparty risk regime will significantly overstate the Committees aim of increasing capital requirements for counterparty risk. The approach taken to calculate CVA does not reflect the way CVA is managed by banks and so it must be refined. Stressed-EEPE may end up increasing overall risk. DTAs should not be completely deducted but use an approach where no adjustment is made for DTAs up to the lesser of (i)DTAs reversing within 12 months and (ii) 10% of Tier 1 capital. The complexity and interconnected nature of these proposals will probably have unintended consequences for banks and for the wider economy. Goldman Sachs (Letter Response to Basel Committee on Strengthening the Resilience of the Banking Sector Consultative Paper, 2010): They are concerned about the following aspects of the proposals: The stressed EEPE approach has a number of disadvantages, such as: Performing the stressed calculation is not straight forward conceptually for banks that use market-implied parameters or combinations for historical data and market-implied parameters. It is not clear that the output of these stressed computations will serve a useful risk management purpose. The validation, documentation and back testing requirements that must be satisfied for EPE model approval are sometimes too prescriptive. It is important for banks to have the ability to design tests that they find useful for uncovering model inadequacies. Instead of introducing a further series of measures for reducing cyclicality, tools that already exist in the Basel framework should be amended to address this issue.The inputs to the existing capital calculation for counterparty credit risk are already designed to reduce pro-cyclicality, through the use of inherent parameter conservatism. Bank of America (Letter Response to Basel Committee on Banking Supervision, Consultative Document, Strengthening the Resilience of the Banking Sector 2010): , Although Bank of America is supportive of the efforts to strengthen and harmonize global capital regulations, they expressed the following concerns: The exclusion of trust preferred securities (TPS) should be reconsidered due to the loss absorption capacity of their long lives approaching economic perpetuity and their dividend deferral rights for up to 20 consecutive quarters. The proposed deductions (unrealized gains/losses, intangibles, financial investments and deferred tax assets) are overly rigid and punitive.These deductions will result to increased volatility and pro-cyclicality of capital, impacts to market liquidity and disincentives for forward-looking provisioning. The calculation of both current and stressed EPE will increase operational risk and require additional computing capacity and processing time. Instead, they suggest including a period of significant stress in the EPE calculation.
30
The peak probabilities of default (PDs) in the risk-weighted assets (RWA) calculation would double-count the systemic component of credit risk already captured via the asset correlations in the capital formula. Therefore, additional clarity and guidance for through-the-cycle PD estimates would yield a greater impact towards reducing cyclicality. Citigroup (Letter Response to Basel Committee on Proposals to strengthen Capital Regulation): Citigroup agrees with the main concepts in the proposal. However, there are a few details that need to be calibrated to promote a responsible and sustainable financial system. In particular, they are concerned with certain deductions from Tier 1 capital, including mortgage servicing rights, deferred tax assets and investments in unconsolidated financial institutions above a 10% threshold. JPMorgan Chase & Co. (Letter Response to Basel Committee on the consultative document Strengthening the Resilience of the Banking sector 2010): , Based on research JPMorgan Chase has conducted, the impact of current proposals could result in a sharp drop in a global banks return on equity from 13.3% to 5.4% in 2011, affecting both wholesale and retail banks. Concerns mentioned in their letter to the Committee are: While the inclusion of a stressed period will serve to reduce spikes in the calculated results, the following issues are raised: The use of stress data inputs to the EPE model for day-to-day risk management and hedging will effectively create a parallel but separate regulatory exposure calculation. The methodology for a proper stressed market-based EPE is considerably more complex than that of stress market risk value-at-risk (VAR) due to the longer horizons involved for derivatives. Instead of using the bond-equivalent approach to measure the risks from the CVA portfolio, they can be more effectively captured under the regulatory market risk framework where the portfolio is internally managed and hedged within the trading book. Morgan Stanley (Letter Response to the Basel Committee on the consultative document Strengthening the Resilience of the Banking Sector 2010): , Although they support the initiatives of the proposal, they state that the way it is written will likely make the financial system more fragile and further hamper an economic recovery. The subsequent issues were raised in their analysis: The increase of the scaling factor of 1.25 applied to the correlations of large regulated financial institutions (assets > $25bn) and all unregulated financial institutions (e.g. hedge funds) will increase the RWs. The bond-equivalent approach is a poor approximation of the actual risks of the CVA especially because of the use of stressed EPE, alpha=1.4 and longest netting sets maturity. In removing minority interests from Tier 1 capital, the Committee should also exclude capital deductions, such as goodwill and intangibles.
31
Credit Suisse (Credit Suisse comments to Basel III consultative papers #164 and #165, 2010): Key specific issues of concern on capital requirements raised by Credit Suisse: The exclusion of innovative hybrids requires further clarification as to exactly what features are to be phased-out, other than step-ups. Appropriate grandfathering and phase-in provisions will be essential to managing the impact of the new requirements. They disagree with the full deduction of DTAs and they suggest that (i) the disallowance should be limited to DTA arising on Net Operating Losses (NOL) only and (ii) the disallowance of NOL DTA should only be partial. Firms should have the option to use their actual CVA sensitivities instead of the bond-equivalent measure of the counterparty exposure, in order to align the regulatory capital and economic impacts more closely. Minorities do provide equity to parts of the group and minority interests are therefore loss absorbing from a consolidated perspective.Their words exactly were, Minority interest will only be eligible for inclusion in the common Equity component of Tier 1 if it belongs to a qualifying minority. Deutsche Bank (Detailed Comments on CP 164 Strengthening the Resilience of the Banking Sector 2010): , Although Deutsche Bank supports the Committees efforts to enhance the quality of bank capital, they believe that the proposals are too conservative and do not meet the stated objectives.The major areas that are in need of consideration, according to Deutsche Bank, are discussed below: The full deduction of DTA would increase pro-cyclicality in the financial sector. Non-recognition of minorities and at the same time full recognition of RWA is asymmetric and ignores the risk-bearing capacity of minorities in the entity. The stressed parameters included in the EPE calculation may cause undesired effects such as: The directionality of the effect of increasing volatilities and correlations on the overall exposure is highly dependent on the portfolio composition. The ongoing design of new financial products will limit the availability of relevant historical data to estimate these parameters. Figure 2: Summary of issues raised on leverage ratio calculation
Leverage Ratio Agree with the introduction of a Leverage ratio Remain within Pillar 2 / not moved to Pillar 1 Differentiating credit derivatives from the LR calculation Include off-balance sheet items in the calculation Prohibiting netting completely
HSBC Barclays Goldman Sachs Bank of America Citigroup JPMC Morgan Stanley Credit Suisse Deutsche Bank
Yes No No Yes Yes Not entirely Yes Yes Not entirely
Yes Yes Yes Yes N/A N/A Yes Yes Yes
Yes N/A N/A Yes N/A No Yes No Yes
No No Not entirely No N/A No No Yes No
No No No No N/A No No No No
32
HSBC (Letter Response to Basel Committee on Consultative Document BCBS 164 Strengthening the resilience of the banking sector p.6, 2010): , HSBC mentions that leverage ratios are not risk-based, and as such they can provide both false comfort and inappropriate incentives, both by encouraging the use of off-balance sheet vehicles and a move towards higher risk assets... Although HSBC is not 100% in agreement with a leverage ratio, they argue that it can be useful as an early warning indicator as part of the prudential regulators Pillar 2 toolkit. In particular, they raise the following issues: Legally enforceable netting or any other form of credit mitigation which gives a distorted view of the actual exposure and which is not related to the economic substance should not be ignored. 100% conversion factors should not be applied to off-balance sheet products since they do not reflect actual or potential exposure. In the case where sold CDS protection positions arise as a result of market making activity, they should be excluded from the leverage ratio. Including them will reduce liquidity and increase spreads and hence increase costs of funds in the commercial sector. Barclays (Letter Response to Basel Committee on Strengthening the Resilience of the Banking Sector ,p.4,2010): Barclays has strong reservations about introducing a leverage ratio.Their reservations are based on the following: The existence of a leverage ratio in other jurisdictions did not prevent the crisis. It is not a risk-based measure, and regulators now should focus on risk-based measures of capital adequacy The grossed up balance sheet will discourage activity that is either appropriately risk managed or provides important risk management and funding tools for banks and their clients. Nonetheless,they discuss a few issues that should be considered by the Basel Committee should a leverage ratio be introduced. The Supervisory Review should be undertaken under Pillar 2. Tier 1 capital should be used as a measure of capital in the calculation of the leverage ratio. In the exposure measure, netting should be allowed and a 100% credit conversion factor should not be applied since it will increase exposure and will not match the balance sheet treatment. Goldman Sachs (Letter Response to Basel Committee on Strengthening the Resilience of the Banking Sector Consultative Paper, p.2-3, 11-12, 2010): Goldman Sachs was the sole institution to express a completely negative opinion regarding the introduction of a leverage ratio. In particular, they stated that they do not consider a leverage ratio to be a meaningful measure of risk or of capital adequacy.They mentioned a number of issues illustrating the negative nature of a leverage ratio. The grossing-up of the balance sheet in an economically illogical manner.The prohibition of netting secured funding transactions with the same counterpart will negatively impact the leverage ratio, even if there is no actual increase in risk. It will become the binding capital limitation for most banks Cash collateral received from counterparties to OTC derivatives transactions would lead to both the receivable and the cash collateral being counted in the leverage exposure measure, causing a bank to be effectively penalized for pursuing risk management practices that should generally be encouraged.
33
Bank of America (Letter Response to Basel Committee on Banking Supervision, Consultative Document, Strengthening the Resilience of the Banking Sector p.3, 16-17, 2010): , In general, Bank of America supports the notion of a leverage ratio as a component of Pillar 1. However, they do comment that, the Committee (should) reconsider the methodological choices for the denominator,including the treatment of netting and use of notional amount of CDS and off-balance sheet exposures. They argue that netting should not be disallowed since both netting and margin agreements have been demonstrated as reliable during periods of stress. Finally, they argue that the inclusion of off-balance sheet exposures overstates actual leverage and might end up reducing credit availability and increase borrowing costs for their customers. Citigroup (Letter Response to Basel Committee on Proposals to strengthen Capital Regulation): Citigroup agrees with implementing a leverage ratio and believes that many of the concepts in the proposal help control excessive leverage. However, they have expressed their concern on changes made in the calculation of the leverage ratio, such as the proposed treatment of legally-enforceable netting and margin agreements, the treatment of sold CDS contracts and the treatment of both cancellable commitments and wholesale credit commitments. JPMorgan Chase & Co. (Letter Response to Basel Committee on the consultative document Strengthening the Resilience of the Banking sector p.17-20, 2010): , Similar to the other major financial institutions, JPMorgan Chase also had concerns about the usefulness of a binding leverage ratio, rather than a complementary measure to other risk-based measures. In particular, they argue that, a leverage ratio is not risk sensitive since it ascribes the same capital rate to all exposures and this may lead banks to pursue risky assets to increase return on capital. Nonetheless, since the Committee has decided to go ahead with the adoption of a binding leverage measure, JPMorgan Chase commented on some issues that the Committee should consider: The inclusion of un-netted off-balance sheet exposures will have a negative impact on business activities of banks. Credit card lines and commitments should not be drawn down completely at the same time because it is too extreme and does not provide a good representation of the future balance sheet. Morgan Stanley (Letter Response to the Basel Committee on the consultative document Strengthening the Resilience of the Banking Sector p.3, 13, 2010): , Morgan Stanley clearly supports the institution of a leverage metric, as long as it is based on Tier 1 capital and remains within Pillar 2. In particular, they argue that total Tier 1 would provide a sound basis for the calculation of a leverage ratio. They urge the Committee to incorporate counterparty netting, margin agreements and credit risk mitigants in the leverage ratio. In addition, they argue that derivative trades must be represented in the ratio only by the use of onbalance sheet values.
34
Credit Suisse (Credit Suisse comments to Basel III consultative papers #164 and #165, p. 15-17, 2010): They support the need for instituting the leverage metric under a Pillar 2 approach. However, they express the following suggestions: Avoid prohibiting netting completely, and in particular they suggest applying the regulatory netting rules from the Basel II framework. It is not appropriate to ignore hedges completely since their exclusion will create misleading incentives. They agree with considering off-balance sheet items in the leverage measure, but only by capturing their leverage by a separate off-balance sheet LR calculation. Deutsche Bank (Detailed Comments on CP 164 Strengthening the Resilience of the Banking Sector , p.15-17 2010): DB suggested using a leverage ratio only as a trigger for further discussion and analysis because the Committees proposed version is extremely simplistic and not risk-based. In particular, they argue that over-reliance on the proposed metric would have catastrophic consequences since it does not consider the different business models that appear in the industry. However, should the Committee decide to proceed with the implementation of the specific metric, Deutsche Bank make a few proposals for better defining the leverage ratio: It should reflect legally enforceable netting and regulatory netting allowed under Pillar 1. Pillar 1 credit conversion factors should be applied to the off-balance sheet commitments and guarantees. It should only include the net written credit protection in the leverage ratio calculation. Figure 3: Summary of issues raised for Liquidity requirements.
Liquidity Coverage Ratio Agree with the general liquidity approach in Basel III Unrealistic stress scenarios Definition of high quality assets is too narrow Exclude US Agency and US Agency MBS from high quality liquid assets N/A N/A No No N/A No No No N/A Net Stable Funding Ratio Review assumption on stable funding amounts Yes Yes Yes Yes N/A Yes Yes Yes Yes Uncertainty around inclusion of off-balance sheet liabilities Contractual Maturity Mismatch Assessment Monitoring Tools Concentration Agree with of funding proposal on Available Unencumbered Assets N/A No N/A N/A N/A N/A N/A No N/A N/A Yes N/A N/A N/A N/A N/A Yes N/A
Liquidity
HSBC Barclays Goldman Sachs Bank of America
Yes Yes Yes Yes Yes Yes Yes Yes Yes
Yes Yes N/A Yes N/A N/A N/A No N/A
Yes Yes No Yes N/A Yes Yes Yes Yes
N/A Yes N/A N/A N/A N/A N/A Yes N/A
N/A Yes No N/A N/A N/A N/A No No
Citigroup JPMC Morgan Stanley Credit Suisse Deutsche Bank
35
HSBC (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): HSBC is very supportive of all intentions to strengthen the liquidity risk standards across the banking sector. However, they had a few concerns on specific elements of the requirements, such as: The harmony of international reporting requirements and a standard and consistent format of regulatory reports. The definition of liquid securities should be extended. Consolidated reporting should be applied to an individual legal entity level Barclays (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): They agree with introducing both the LCR and the NSFR, in particular the LCR since it is consistent with the Individual Liquidity Guidance (ILG) issued by the FSA. However, they have commented on the calculation of both ratios and showed concerns on elements of their calculation. For example, the LCR uses extremely conservative short term stress scenarios, while the standards used in the NSFR may have a negative impact on a banks ability to perform maturity transformation. Goldman Sachs (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): They are supportive of the conceptual perspective of both the LCR and the NSFR requirements. However, they argue that, the highly prescriptive nature of the proposals will result in a one-size-fits-all mentality when it comes to liquidity risk management . On the LCR calculation, they support the definition of a liquid asset buffer as it includes a narrow definition of assets that are expected to remain liquid in both an idiosyncratic and market-wide stress scenario. Bank of America (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): BoA, as well as most other institutions, argues that the LCR and the NSFR are standardized stress models that do not fully account for fundamental differences across financial institutions In particular, liquidity should be evaluated . within the context of an institutions earning profile, capital adequacy and overall risk management practices. In addition, they note that the NSFR is overly prescriptive and does not reasonably consider the numerous action steps management needs to undertake to continue maintaining operations and finance the firms activities. Citigroup (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): Although Citigroup agrees with strengthening the quality of liquidity in the financial sector, they argue that,the new quantitative liquidity proposals contain assumptions that may inhibit the ability of financial firms to perform their traditional roles of intermediation and maturity transformation and may hinder the flow of funding and capital to the private sector.
36
JPMorgan Chase (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): JPMorgan Chase agrees with the concept of many of the principles embodied in the proposal. However, they comment on the extreme definitions and assumptions and on the fact that they bear no resemblance to their actual experience through numerous stress events. Morgan Stanley (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): Similar to most banks, Morgan Stanley agrees with the introduction of liquidity ratios. However, they believe that the asset classes included in the equations and associated factors require careful examination. For example, they argue that the definition of liquid assets is too narrow and that the inclusion of securities issued by Government Sponsored Entities, such as Agency Securities, should be considered. Credit Suisse (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): Credit Suisse, although in accordance with the general concept of the consultative document, they believe that the proposals set various minimum standards on the composition of eligible liquidity buffers, minimum outflows on retail, wholesale and contingent liabilities, and on inflows of corresponding assets. In addition, they are concerned by the fact that the stress scenarios proposed are applicable only to the LCR and not to the NSFR. Deutsche Bank (Letter Response to Basel Committee on Consultative Document BCBS 165 International framework for liquidity risk measurement, standards and monitoring): Again they agree with the Committees initiative to harmonize liquidity regulation on a global basis. However, they noted the following issues: The overly rigid quantitative requirements imposed by regulators will reduce incentives for banks to use and develop internal risk models and tools. There is lack of differentiation on wholesale deposits. The definition of high quality liquid assets needs clarification. The proposed rules represent a one-size-fits-all approach, neglecting differences between institutions. Finally,they note that the proposal must be applied by all international banks in order to maintain a level playing field.
37
References
1. Algorithmics white paper,Basel III: What's New? Business and Technological Challenges September 2010. , 2. Algorithmics white paper:Credit Value Adjustment and the Changing Environment for Pricing and Managing Counterparty Credit Risk December 2009. , 3. Algorithmics white paper,Towards Active Management of Counterparty Credit Risk with CVA July 2010. , 4. Algorithmics white paper, Response to the Basel Committees request for comments on the consultative document: Countercyclical capital buffer proposal September 2010. , 5. Algorithmics research paper,Response to the Basel Committees request for comments on the consultative document: International framework for liquidity risk measurement, standards and monitoring April 2010. , 6. Basel Committee on Banking Supervision,Strengthening the Resilience of the Banking Sector December 2009. , 7. Basel Committee of Banking Supervision,International Framework for Liquidity Risk Measurement, Standards and Monitoring December 2009. , 8. The Dodd-Frank Act Wall Street Reform and Consumer Protection Act, July 2010. 9. Speech by Mervyn King, Governor of the Bank of England on Monday 25th October 2010,Banking: From Bagehot to Basel, and Back Again The Second Bagehot Lecture Buttonwood Gathering, New York City. , 10. Janez Barle, Nova Ljubljana Banks d.d.,Global Financial Crisis and its Implications to the Business Model and Risk Management in Banking . 11. Davis Polk & Wardwell LLP,Summary of the Dodd-Frank Wall Street Reform and Consumer Protection ActJuly 2010. , 12. Davis Polk & Wardwell LLP, Client Memorandum:Collins Amendment Minimum Capital and Risk-Based Capital Requirements . 13. Davis Polk & Wardwell LLP,Senate House Conference Agrees on Final Volcker Rule . 14. Deutsche Bank;Tom Joyce, Francis Kelly and Callie Smart,The Implications of Landmark U.S. Reg Reform The Dodd-Frank Wall Street Reform and Consumer Protection Act July 2010. , 15. PriceWaterhouseCoopers,A Closer Look: Impact on OTC Derivatives Activities August 2010. , 16. Katia DHulster, Crisis Response; The Leverage Ratio A New Binding Limit on Banks, December 2009 17. Ernst & Young, US Financial Reform Act has significant tax implications. 18. Willem Buiters Maverecon,Too big to fail is too big June 2009 , 19. The Daily Capitalist by Jeffrey Harding,The Dodd-Frank Wall Street Reform and Consumer Protection Act: The Triumph of Crony Capitalism . 20. HSBCs Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 21. Barclays Comments on the Consultative Documents Strengthening the Resilience of the Banking Sectorand International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 22. Goldman SachsComments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. ,
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23. Bank of Americas Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 24. Citigroups Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 25. JPMorgan Chases Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 26. Morgan Stanleys Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 27. Credit Suisses Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 28. Deutsche Banks Comments on the Consultative Documents Strengthening the Resilience of the Banking Sector and International Framework for Liquidity Risk Measurement, Standards and Monitoring April 2010. , 29. The Financial Times by Justin Baer,Proprietary traders weigh up new options 2010. , 30. The Financial Times by Francesco Guerrera, Justin Baer and Tom Braithwaite, Wall Street to sidestep Volcker Rule 2010. , 31. The Financial Times by Gregory Meyer and Francesco Guerrera,JPMorgan to close prop trading division . 32. The Financial Times by Telis Demos,New regulations set to hit banks profits . 33. The Financial Times by Martin Wolf,The challenge of halting the financial doomsday machine .Because of its scope of use, economic capital needs to be measured as accurately and robustly as possible. Anything less can quickly lead to badly-formed decisions, loss of profits, or worse. Its links to both profits and survival make it a key competitive advantage to the firm adopting it.
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About Algorithmics
Algorithmics is the worlds leading provider of enterprise risk management solutions. Algorithmicssoftware, analytics, and advisory services enable financial institutions to make risk-aware business decisions, maximize shareholder value, and meet regulatory requirements. Supported by a global team of risk experts based in all major financial centers, Algorithmics offers proven, award-winning solutions for market, credit, liquidity, and operational risk, as well as collateral and capital management. Algorithmics is a member of the Fitch Group.
www.algorithmics.com
2011 Algorithmics Software LLC. All rights reserved.You may not reproduce or transmit any part of this document in any form or by any means, electronic or mechanical, including photocopying and recording, for any purpose without the express written permission of Algorithmics Software LLC or any other member of the Algorithmics group of companies. ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO FOUNDATION, ALGO FINANCIAL MODELER, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics Trademarks LLC. Algorithmics Trademarks LLC & Algorithmics Software LLC, c/o Algorithmics Incorporated, 185 Spadina Avenue, Toronto, Ontario, Canada M5T 2C6

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DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT: BUSINESS MODEL IMPLICATIONS

By Mario Onorato and Gabriella Symeonidou

2. Overview of the Dodd-Frank Act

2.1. Reforms for Systemically Important Financial Institutions

2.1.1. Enhanced Prudential Standards

Bank Capital Leverage Liquidity (Collins Amendment)

2.1.4. OTC Derivatives

2.1.5. FDIC Insurance Deposit

2.2. Reforms for Regulatory Authorities

2.2.1. Financial Stability Oversight Council

Ending Too-Big-To-Fail (Unwind Authority)

2.2.3. The Federal Reserve

2.3. Reforms for Investors

2.3.2. Executive Compensation

2.3.3. SEC and Investor Protection

2.3.4. Hedge Funds and Private Equity Funds

Credit Rating Agencies

2.4. Reforms for Consumers

Consumer Financial Protection

2.4.2. Other Consumer Protections

3. Business Model Implications

3.1. Downward Pressure on Bank Profitability

Potential Hit to Prop Trading from Volcker Rule

Potential EPS Impact

Volcker Rule Capital Estimate

Est. 3% Tier 1 $ 4.7 3.9 3.6 2.1 1.5

155.41 131.4 120.1 68.5 50.1

Estimated impact on 2011 EPS due to % decline in LTM trading revenue.

Trust Preferred Securities 8.00% 5.20% 0% 0.00%

Non-Cumulative Perpetual Preferred 10.00% 10.00% 18% 1.80%

15.00% 15.00% 82% 12.30%

3.2. Re-assessment of Balance Sheets

10% 9% 8% 7% 6% 6.47% 6.48%

3.3. Reform of Operational and Legal Entity Structures

3.4. Decrease on Lending in the US economy

3.5. Will the Dodd-Frank Act End Too-Big-To-Fail?

U.S Banking Asset Concentration (2009)

U.S. Banking Derivative Contracts (2009)

10 Largest U.S. Bankruptcies

77.9 47.8 39.1 31.7

General Motors CIT Group Enron Conseco Chrysler

Thornburg Mortgage Pacific Gas & Electric

100 200 300 400 500 600 700

3.6. Modifications of Tax Procedures

3.7. Implications for the Insurance Industry

3.8. Implications for Hedge Funds

Figure 7: Implementation Timeline for major Dodd-Frank Act provisions

Hedge / Private Equity Funds

Within 15 months of the enactment: Rules become effective.

Credit Rating Agencies

3 months after transfer date, OTS is abolished.

HSBC Barclays Goldman Sachs

No No N/A N/A N/A N/A Yes, partially Yes, partially No

No No No Yes, partially N/A Yes, partially No N/A Yes, partially

No Not entirely N/A No No No N/A Not entirely No

Yes Yes Yes Yes Yes Yes N/A Yes Yes

Bank of America Yes

Morgan Stanley Yes Credit Suisse

Deutsche Bank Yes

Yes No No Yes Yes Not entirely Yes Yes Not entirely

Yes Yes Yes Yes N/A N/A Yes Yes Yes

Yes N/A N/A Yes N/A No Yes No Yes

No No Not entirely No N/A No No Yes No

HSBC Barclays Goldman Sachs Bank of America