by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin
In this series, I will be looking at the impact – to-date – of the largest and the most significant set of regulatory changes in the U.S. financial services in some seven decades: the Dodd-Frank Act. You may find Part 2: Too-Big-to-Fail and to Regulate here.
Five years ago, on July 19, 2010, President Barak Obama signed the most far-reaching regulatory reform of the U.S. financial system since the end of the Great Depression – Dodd-Frank Wall Street Reform and Consumer Protection Act.
The Act has three core pillars:
- enhanced protection of consumers;
- expanded regulatory reach over risk management (including the markets for derivatives), and
- the Too-Big-To-Fail (TBTF) safeguards.
Given its ambitious scope, the Act was designed to shape American response to the Global Financial Crisis, both in terms of addressing some of the underlying causes, and mitigating future systemic risks. Not surprisingly, the passage of the Act was lauded at the time as a historic moment.
Consumers First
Dodd-Frank Act, in theory, puts consumer protection outside the remit of banking regulators and supervisors, entrusting it to a stand-alone agency: the Consumer Financial Protection Bureau (CFPB). The advantage of this approach is that it promises to reduce potential conflicts within and between financial services’ supervisory agencies that, before the Act, were tasked with ensuring both the stability of the system, and consumer protection.
The idea of consolidated and independent consumer interest oversight is a laudable one. However, effective protection of end users’ interests in the financial system is subject to two key constraints:
- The ability of the enforcement agency to actually manage the data flows associated with retail customers interactions with the financial services providers; and
- The ability of the new system infrastructure to enhance consumer experience.
The first constraint runs into the problem of just how much of the financial sector data flows will the new agency be able to collect, process, analyse and action. Past experience of numerous agencies involved in consumer protection is not encouraging. Even financial sector regulators, let alone consumer protection agencies, have experienced difficulties in dealing with the data deluge generated by the financial markets and providers.
The second constraint arises from the overall impact of Dodd-Frank on competition in the financial services in the U.S. as discussed below.
In fairness to the CFPB, from the first year of its operations, the agency moved to rather actively execute its functions. By the end of 2014, over USD10 billion of fines and compensation was generated for U.S. consumers, although most of this arises from cases prepared before the CFPB began its operations. CFPB also strengthened regulation surrounding mortgages issuance, including the introduction of ‘qualifying loan’ concept that now requires lenders to assess whether or not a borrower can reasonably be expected to repay the loan they are signing for. Again, promising in theory, the concept is hard to implement effectively. CFPB is currently investigating allegations of market abuse in student loans and is likely to regulate the sector more aggressively in the near term.
The problem, so far, is that CFPB has not been as active in pursuing investigations into more technical operations and practices at larger U.S. banks and investment intermediaries, where matters are more technical and complex.
Where There’s Risk… There Are Derivatives
The second pillar of Dodd-Frank Act was tackling the issue of risk management within the financial system. The focus fell, as it always does, on a large, but somewhat tangential area of derivatives regulation. The premise for this was the impact of one type of derivative instruments – the credit default swaps (CDS) relevant primarily to two U.S. players in the crisis: AIG and Lehman.
To ‘prevent’ future spillover from misplaced derivatives risks, the U.S. authorities have decided to move these contracts from over the counter trading to on-exchange trading. This, in theory, should provide for increased:
- transparency (via commoditisation of contracts traded),
- centralisation (via information flows) and
- aggregation (concentration) of risks.
In practice, of course, all of this is just that – theory. To see this, you can dive deep into derivatives markets and structures – which are complex, non-standardised and not always listable. But you don’t need to have a PhD in finance to spot the glaring problem: derivatives might have helped to bring down one large player (as mentioned – AIG), but (a) these were specific contracts written by and for AIG, and (b) there were no other major implosions triggered by derivatives beyond the CDS-type contracts. Instead, securitised credit and sub-prime mortgages did infinitely more widespread damage.
Nonetheless, the Dodd-Frank allocated derivatives regulation to the Commodity Futures Trading Commission (CFTC), which went straight to the task: by late 2013, CFTC wrote volumes of new rules and launched the first swaps trade execution facility. Success followed, with more than half of interest rate swaps indices and seven out of ten CDS indices migrating to the new facilities within 2014 alone.
The system is not all bad – centralised exchanges do hold promise to significantly improve risk pricing relating to basic derivatives contracts. But the limits of these new facilities are also substantial.
For one, derivatives oversight has left the domain of different regulators with SEC running a separate show from CFTC. There remains little transparency over the prices and derivatives clearing. Cross-border traded derivatives are yet to be reigned in, despite the fact that these involved the bulk of swaps that blew up in the case of AIG, Lehman, Citi, and Bear Sterns.
The longer term issue is the use of derivatives in structuring regulatory capital cushions – something approved by the U.S. Federal Reserve in the past and something that was the primary driver for AIG reliance on CDS. Ditto for the Special Investment Vehicles (SIVs) similarly approved by the Fed for the purpose of reducing capital costs. Both practices remain the risk to capital structures post-Dodd-Frank, but more significantly, both highlight the risk of regulatory slippage that can be magnified by the Dodd-Frank approach of setting up super regulators (e.g. CFTC and CFPB). For example, the Act has greatly expanded the powers of the U.S. Federal Reserve – the very same institution that was instrumental in creating the main drivers of the most recent crisis.
