Five Years After the Dodd-Frank Act- Part 2: Too-Big-to-Fail and to Regulate

by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin

In the previous post, we looked at the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act in areas of consumer protection and derivatives risk management. As noted in the first post, the third pillar of the new U.S. financial regulation legislation was the objective of dealing with the systemic risks presented by the too-big-to-fail (TBTF) institutions.

Perhaps the most politically sensitive aspect of the Dodd-Frank Act is the promise to end the dominance of the TBTF banks by pursuing two key objectives:

1. Reducing the likelihood of TBTF bailouts by enhancing capital buffers, and
2. Creating a clear process for dealing with any potential future failure by a TBTF institution.

Capital: Quantity and Quality

Stabilising the TBTF regulatory environment primarily involves improving capital buffers both in terms of quantity of capital and its quality. This means that all banks, including smaller ones, have to hold more equity capital as opposed to debt, and all will have to hold more capital overall. Furthermore, the Dodd-Frank Act created a special category of institutions, the so-called Systemically Important Financial Institutions (SIFIs), or entities with more than USD50 billion in assets, which have to hold even larger capital cushions.

Enhanced quality requirement on capital buffers is non-trivial. Under the Dodd-Frank, banks will have to stress test their capital reserves to withstand a 30-day liquidity panic. And the Act reflects complex nature of capital structure. Which is the good news. In line with this, the Act allows regulators to stress importance of increasing the risk-weighted capital ratio and leverage ratios.

The Act also opens up room for automatic capital stabilisers. For example, once bank’s capital or leverage ratio falls below a defined threshold, the bank will be forced to forego all dividend payouts until it regains capital ratios consistent with secure risk buffers.

Finally, significant role in terms of stabilising the banking sector, is assigned to the Volcker Rule – a restriction on larger banks’ ability to engage in risky trading on their own or proprietary accounts. The rule was introduced formally at the end of 2013 and will come into power in 2017.

The problem, of course, is that making banks less vulnerable to exogenous shocks and reducing the banks’ ability to engage in proprietary trading is costly: capital rules and the Volcker rule are bound to reduce banks’ profitability. This has two consequences not intended under the original Dodd-Frank Act.

The first one is reduced competition in the banking sector. Smaller banks simply will not be able to compete with larger, SIFIs, resulting in reduction in the number of smaller players in the sector, a fall off in new entries, and associated fall in sector innovation.

The second one is increased pressure on banks lending margins, which is likely to translate, in longer term, into higher cost of banking in the U.S.

One way to help mitigate these consequences of the Dodd-Frank Act is to increase, significantly, the SIFI threshold from the current USD50 billion to USD200-250 billion.

Shutting Down Systemically Important Banks

The other problem is that despite its promise to address the issue of TBTF failures, Dodd-Frank still comes short of creating a fully functional mechanism for shutting down large failing institutions.

The FDIC-designed ‘single point of entry’ concept that would transfer failed banking institution to a management or work-out entity to wind down orderly, leaves unanswered the key questions as to how exactly the losses will be shared across the equity and debt holders and the taxpayers over and beyond the already existent legal frameworks. Given that these frameworks failed the robustness test in the 2007-2008 crises, the Dodd-Frank Act seems to be more promises and less delivery.

The unmentioned elephant in the room of the Dodd-Frank Act is the need to ensure that TBTF institutions are not a prominent feature of the financial landscape. The only way this can be done is by breaking up existent entities that hold market-dominant levels of assets, say in excess of USD300-400 billion. But the Dodd-Frank Act may actually incentivise the already big institutions to become even bigger – through suppressing profitability of mid-sized banks and increasing the cost of innovation and entry in the financial services.

To compensate for this, there is a need to impose much stricter and significantly larger capital requirements on larger banks. Dodd-Frank Act to-date has failed to do so, opting for some increase in costs to the SIFIs compared to smaller competitors, but, arguably, not enough.

As noted above, Dodd-Frank has expanded U.S. Federal Reserve powers over the financial sector, just at the time when the world is coming to a realisation of the damage done by the Fed in creating some of the most prominent pre-conditions for the 2007-2008 crisis. For example, in relation to the SIFIs, the Fed is now tasked (under Section 165) with oversight of these institutions, and it will also supervise non-banking entities defined as systemically important by the Financial Stability Oversight Council.

Those who, in the past, actively allowed questionable risk management practices in capital formation are now expected to reign in the very same practices and safeguard against such practices emerging in different areas. The Fed will also consolidate supervision over broker-dealers, financial market payment, clearing and settlement providers, and clearing houses. With supervision from the Fed, the above entities can also, potentially, gain access to Fed funding, making them a new class of TBTF institutions.

Conclusion

Marking the fifth anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act one gets the sense of the greater promise of the regulatory reforms yet to be fulfilled by the U.S. regulators than a sense of any great accomplishment set in the record of the past. For all the accolades that the Dodd-Frank Act has managed to gather in recent years, the transformation of the financial services it engendered to-date has been largely positive, by generally underwhelming.

Most importantly, however, the greatest legacy of the Act’s first five years, has been increasing the regulatory burden and complexity of compliance systems in the U.S. financial services. The risk this legacy poses – that of reducing competition and severely restricting new entry by innovative, disruptive firms and start ups – has a good chance for undermining the very core objective of the Act: the objective of improving stability and performance of the sector by successfully challenging TBTF institutions’ dominance.