Some comments on systemic risk and Dodd–Frank Act: Wall Street Reform and Consumer Protection Act

1. Some comments on systemic risk and Dodd–Frank Act: Wall Street Reform and Consumer Protection Act by Krzysztof Ostaszewski

2. Systemic Risk • The crisis of the Fall of 2008 was presented widely as an extreme case of systemic risk problem: One financial institution linked so widely and so greatly to others and to the economy in general that it can bring the whole economy down with its failure. • Yet U.S. financial regulation disintegrated: SEC, Federal Reserve, FDIC, OTS, Department of Labor supervision of pensions, state insurance regulation.

3. New systemic risk agencies • EU: European Systemic Risk Board established December 16, 2010. European Central Bank is its parent agency. • USA: Financial Stability Oversight Council, formed July 21, 2011. Headed by Secretary of Treasury, but technically not a subsidiary of the Department of Treasury. • Did integrated financial supervision perform better in this crisis?

4. The Last Fairy Tale … • When my daughter Angelica was little, we read her fairy tales to put her to sleep. My wife did most of the work, I was studying for actuarial exams. • I noted that Angelica asked for more stories by asking: “The last one, please, the last one …” • When the feds saved creditors of Continental Illinois, of lenders to Latin America, or creditors of LTCM, it was always “the last one.”

5. Dodd-Frank Act • Signed into law by President Barack Obama on July 21, 2010. • The law was initially proposed on December 2, 2009, in the House of Representatives by Barney Frank, and in the Senate Banking Committee by Chairman Chris Dodd.

6. Provisions • Title I - Financial Stability • Title II - Orderly Liquidation Authority • Title III - Transfer of Powers to the Comptroller, the FDIC, and the FED • Title IV - Regulation of Advisers to Hedge Funds and Others • Title V – Insurance • Title VI - Improvements to Regulation • Title VII - Wall Street Transparency and Accountability • Title VIII - Payment, Clearing and Settlement Supervision

7. Provisions • Title IX - Investor Protections and Improvements to the Regulation of Securities • Title X - Bureau of Consumer Financial Protection • Title XI - Federal Reserve System Provisions • Title XII - Improving Access to Mainstream Financial Institutions • Title XIII - Pay It Back Act • Title XIV - Mortgage Reform and Anti-Predatory Lending Act • Title XV - Miscellaneous Provisions • Title XVI - Section 1256 Contracts

8. Key issues in Dodd-Frank • Systemic risk oversight. • Supervision and liquidation of failed institutions that were considered to be out to be too big to fail in the past. • Regulatory restructuring and increased regulatory powers. • Bureau of Consumer Financial Protection and other consumer protections. • The Volcker Rule. NOT.

9. Regulation of insurance in the United States • 1865 case Paul v. Virginia: State regulation, because insurance is not commerce. • 1944 case U.S. v. Southeastern Underwriters: Reverses Paul v. Virginia. • 1945: McCarran-Fergusson Act: Federal government delegates insurance regulation to the states, but antitrust laws apply to insurance. • AIG debacle prompted federal regulation in Dodd-Frank.

10. A New Foundation: Original proposal by President Obama • Consolidation of regulatory agencies, elimination of national thrift charter, and new oversight council to evaluate systemic risk. • Comprehensive regulation of financial markets, increased transparency of derivatives (bringing them onto exchanges). • Consumer protection reforms including a new consumer protection agency and uniform standards for "plain vanilla" products as well as strengthened investor protection.

11. Original proposal by President Obama continued • Tools for financial crises, including a "resolution regime" complementing the existing Federal Deposit Insurance Corporation (FDIC) authority to allow for orderly winding down of bankrupt firms, and including a proposal that the Fed receives authorization from the Treasury for extensions of credit in "unusual or exigent circumstances”. • Various measures aimed at increasing international standards and cooperation, including in this section were proposals related to improved accounting and tightened regulation of credit rating agencies. • The Volcker Rule added to the proposal in January 2010.

12. The Volcker Rule • Prohibits a bank or institution that owns a bank from engaging in proprietary trading that isn't at the behest of its clients, and from owning or investing in a hedge fund or private equity fund. • Limited the liabilities that the largest banks could hold. • Volcker Rule was added as an amendment to financial regulatory bill, but Senate refused to add it. • The House-Senate conference brought the Volcker Rule back, but allowed banks to: invest in hedge funds or private equity funds (up to 3% of their Tier 1 capital), do proprietary trading in Treasury securities, bonds issued by Federal Government entities, such as FNMA and FHLMC, and municipal bonds.

13. The Act • The Act is categorized into sixteen titles and by one law firm's count, it requires that regulators create 243 rules, conduct 67 studies, and issue 22 periodic reports. • The Act changes the existing regulatory structure, such as creating new agencies (while merging and removing others) with the objectives being: streamlining the regulatory process, increasing oversight of specific institutions regarded as a systemic risk, amending the Federal Reserve Act, promoting transparency, and some additional.

14. New agencies created • Financial Stability Oversight Council • Office of Financial Research • Bureau of Consumer Financial Protection.

15. Title I: Financial Stability • Creates the Financial Stability Oversight Council and the Office of Financial Research. • Two new offices are attached to the Treasury Department, with the Treasury Secretary being Chair of the Council, and the Head of the Financial Research Office being a Presidential appointment with Senate confirmation.

16. Purposes of the Financial Stability Oversight Council • Identify the risks to the financial stability of the United States from both financial and non-financial organizations. • Promote market discipline, by eliminating expectations that the Government will shield them from losses in the event of failure. • Respond to emerging threats to the stability of the US financial system.

17. Membership of the Financial Stability Oversight Council • Secretary of the Treasury (chairs the Council) • Chairman of the Federal Reserve • Comptroller of the Currency • Director of the Bureau of Consumer Financial Protection • Chairperson of the U.S. Securities and Exchange Commission • Chairperson of the Federal Deposit Insurance Corporation • Chairperson of the Commodity Futures Trading Commission • Director of the Federal Housing Finance Agency • Chairman of the National Credit Union Administration Board • Plus one independent member (with insurance expertise), appointed by the President, with the advice and consent of the Senate, for a term of 6 years

18. Nonvoting members of the Financial Stability Oversight Council • Director of the Office of Financial Research (part of the Treasury Department and established in the Act) who is the Council's executive director • Director of the Federal Insurance Office (part of the Treasury Department and established in this Act) • One state insurance commissioner, to be designated by a selection process determined by the state insurance commissioners (2-year term) • One state banking supervisor, to be designated by a selection process determined by the state banking supervisors (2-year term) • One state securities commissioner (or officer performing like function) to be designated by a selection process determined by such state security commissioners (2-year term).

19. Resources of the Financial Stability Oversight Council • The Federal Advisory Committee Act, which limits the powers of advisory committees, does not apply to the Council. • The Council has an almost unlimited budget in that the Council may draw on virtually any resource of any department or agency of the Federal government. • An employee of the Federal Government detailed to the Council shall report to and be subject to oversight by the Council during the assignment to the Council, and shall be compensated by the department or agency from which the employee was detailed.

20. Authority of the Financial Stability Oversight Council • The Council has very broad powers to monitor, investigate and assess any risks to the US financial system. • The Council has the authority to collect information from any State or Federal financial regulatory agency, and may direct the Office of Financial Research to collect information from bank holding companies and nonbank financial companies. • Under specific circumstances, the Chairman of the Council (Secretary of the Treasury), with the concurrence of 2/3 voting members, may place nonbank financial companies or domestic subsidiaries of international banks under the supervision of the Federal Reserve if it appears that these companies could pose a threat to the financial stability of the U. S.

21. Financial Reporting to the Council The Council may require any bank or non-bank financial institution with assets over $50 billion to submit • certified reports as to the company’s financial condition • systems in place to monitor and control any risks • transactions with subsidiaries that are regulated banks • the extent to which any of the company's activities could have a potential disruptive impact on financial markets or the overall financial stability of the country

22. Office of Financial Research • Department within the Treasury. • Office is tasked with providing administrative, technical, budget analysis and other support services to the Council and its affiliated agencies. • Salaries in the Office do not have to follow standard government scale. • Office may request, from department or agency of the United States, "such services, funds, facilities, staff, and other support services as the Office may determine advisable.

23. Support for the Office • The Data Center, which collects, validates and maintains (and publishes some of) the data required to support the Council; which may be obtained from commercial data providers, publicly available data sources and the financial entities supervised by state and Federal agencies; and • The Research and Analysis Center, which conducts independent analysis of available information to identify financially destabilizing effects, and develops and maintains independent analytical capabilities and computing.

24. Title II: Orderly Liquidation Authority Liquidation authority • In General - FDIC and/or the Federal Reserve • Broker Dealers - SEC and/or the Federal Reserve • Insurance Companies – Federal Insurance Office and/or the Federal Reserve

25. More Title II • When a financial institution is placed into receivership under these provisions, within 24 hours the Secretary shall report to Congress, and within 60 days there shall be a report to the general public. • The report on the recommendation to place a financial company into receivership shall contain various details on the state of the company, the impact of its default on the company, and the proposed action.[

26. Orderly Liquidation Fund • The Orderly Liquidation Fund is to be an FDIC-managed fund, to be used by the FDIC in the event of a covered financial company's liquidation that is not covered by FDIC or SIPC. • The method of capitalization is by collecting risk-based assessment fees on any "eligible financial company" - which is defined as ”any bank holding company with total consolidated assets equal to or greater than $50 billion and any nonbank financial company supervised by the Board of Governors."

27. Orderly Liquidation Authority Panel • Established inside the United States Bankruptcy Court for the District of Delaware, the Panel evaluates the conclusion of the Secretary of the Treasury that a company is in (or in danger of) default. • The Panel consists of three bankruptcy judges drawn from the District of Delaware, all of whom are appointed by the Chief Judge of the United States Bankruptcy Court for the District of Delaware.

28. Orderly Liquidation Authority Panel • If the Panel concurs with the Secretary, the company in question is permitted to be placed into receivership. • If they do not concur, the Secretary has an opportunity to amend and refile his or her petition. • In the event that a Panel decision is appealed, the United States Court of Appeals for the Third Circuit has jurisdiction; in the event of further appeal, may be filed with the United States Supreme Court.

29. Title III - Transfer of Powers to the Comptroller, the FDIC, and the FED • Abolishing the Office of Thrift Supervision and transferring its power over the appropriate holding companies to the Federal Reserve, state savings associations to the FDIC, and other thrifts to the Office of the Comptroller of the Currency. The thrift charter is to remain, although weakened. • The amount of deposits insured by the FDIC and the National Credit Union Share Insurance Fund is permanently increased from $100,000 to $250,000. • Each of the financial regulatory agencies represented on the Council shall establish an Office of Minority and Women Inclusion.

30. Title IV - Regulation of Advisers to Hedge Funds and Others • Significant regulation of hedge funds, and other similar investment intermediaries for the first time, and is known severally as the "Private Fund Investment Advisers Registration Act of 2010”. • In general, it increases the reporting requirements of investment advisors, and limits the ability of these advisors to exclude information in reporting to the various Federal government agencies. However, there is an exemption in reporting for Venture Capital Fund Advisors, certain advisors with assets under management under $150 million, and family offices (as defined by the Commission).

31. Title IV - Regulation of Advisers to Hedge Funds and Others • The Act changes the definition of accredited investor, which means someone with personal or (joint with spouse) net worth over a 4-year period, that averages more than $1 million, to exclude the value of the person's residence from the calculation. • The Commission is allowed to adjust this value with time. The Act also provides that the SEC shall, every five years, adjust for the effects of inflation, that any factor used in rule or regulation be in multiples of $100,000.

32. Title V -- Insurance • Federal Insurance Office Act of 2010”, establishes within the Department of the Treasury the Federal Insurance Office.

33. Federal Insurance Office tasks • Monitoring all aspects of the insurance industry (except health insurance, some long-term care insurance, and crop insurance). • Monitoring the extent to which traditionally underserved communities and consumers, minorities, and low-and moderate-income persons have access to affordable insurance (except health insurance). • Making recommendations to the Financial Stability Oversight Council about insurers.

34. Federal Insurance Office tasks • Administering the Terrorism Insurance Program. • Coordinating international insurance matters. • Determining whether State insurance measure are preempted by covered agreements (states may have more stringent requirements). • Consulting with the States (including State insurance regulators) regarding insurance matters of national. • importance and prudential insurance matters of international importance.

35. Title VI – Improvements to Regulation • Introduces Volcker’s Rule, but not in full. • Limits banking entities to owning no more in a hedge fund or private equity fund than 3% of the total ownership interest.Total of all of the banking entity’s interests in hedge funds or private equity funds cannot exceed 3% of the Tier 1 capital of the banking entity.

36. Improvements to Regulation • The rule distinguishes transactions by banking entities from transactions by nonbank financial companies supervised by the Federal Reserve Board. • Regulators are required to impose upon institutions capital requirements that are "countercyclical, so that the amount of capital required to be maintained by a company increases in times of economic expansion and decreases in times of economic contraction.”

37. Title VII - Wall Street Transparency and Accountability • Regulation of over the counter swaps markets. • Requires that various derivatives known as swaps, which are traded over the counter be cleared through exchanges or clearinghouses. • Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) both regulate swaps under the Act, but the SEC has authority over "security-based swaps".

38. Title VII - Wall Street Transparency and Accountability • The regulators are required to consult with each other before implementing any rule-making or issuing orders regarding several different types of security swaps. • The Act repeals exemption from regulation for security-based swaps under the Gramm-Leach-Bliley Act.

39. Title VII - Wall Street Transparency and Accountability • The title provides that, "Except as provided otherwise, no Federal assistance may be provided to any swaps entity with respect to any swap, security-based swap, or other activity of the swaps entity.” • "Interagency Group" is constituted to the oversight of existing and prospective carbon markets to ensure an efficient, secure, and transparent carbon market, including oversight of spot markets and derivative markets.

40. Title VIII - Payment, Clearing and Settlement Supervision • Gives the Federal Reserve this task: to create uniform standards for the management of risks by systemically important financial organizations in their payment, clearing and settlement activities.

41. Title IX - Investor Protections and Improvements to the Regulation of Securities • To prevent regulatory capture within the SEC and increase the influence of investors, the Act creates an Office of the Investor Advocate, an Investor Advisory Committee composed of 12-22 members of whom serve 4-year terms, and an ombudsman appointed by the Office of the Investor Advocate. • The Investor Advisory Committee was actually created in 2009 and therefore predates the passage of the Act, but it is specifically authorized under the Act.

42. More on Title IX • SEC is specifically authorized to issue "point-of-sale disclosure" rules when retail investors purchase investment products or services; these disclosures include concise information on costs, risks, and conflicts of interest. • Subtitle A provides authority for the SEC to impose regulations requiring "fiduciary duty" by broker-dealers and investment advisers to their customers.

43. Title IX, Subtitle B • “Whistleblower bounty program” which is based upon a similar program established by the IRS in 2006; the program allows persons who provide information which leads to a successful SEC enforcement to receive 10 to 30% of the monetary sanctions over $1 million. • Allows the SEC to prohibit pre-dispute mandatory binding arbitration.

44. Title IX, Subtitle B • Exempts the SEC from disclosing information obtained pursuant to 17(b) of the Securities Exchange Act of 1934 or information "based upon or derived from" such information "obtained by the Commission for use in furtherance of the purposes of this title, including surveillance, risk assessments, or other regulatory and oversight activities" - meaning information derived from examinations.

45. Title IX, Subtitle C • Mandates the creation by the SEC of an Office of Credit Ratings (OCR) to provide oversight over nationally recognized statistical rating organizations (NRSRO) and enhanced regulation of such entities. • Grants authority to the SEC to temporarily suspend or permanently revoke the registration of an NRSRO with respect to a particular class or subclass of securities if after notice and hearing the NRSRO lacks the resources to produce credit ratings with integrity.

46. Title IX, Subtitle C • SEC prescribes rules with respect to credit rating procedures and methodologies. • OCR is required to conduct an examination of each NRSRO at least annually and shall produce a public inspection report. • SEC will require NRSROs to publicly disclose information on initial and revised credit ratings issued, including the credit rating methodology utilized and data relied on, to enable users to evaluate NRSROs.

47. Title IX, Subtitle C, NRSROs • NRSROs are required to establish, maintain, enforce and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings. • Submit to the OCR an annual internal control report. • Adhere to rules established by the Commission to prevent sales and marketing considerations from influencing the ratings issued by a NRSRO.

48. Title IX, Subtitle C, NRSROs • Policies and procedures with regard to certain employment transitions to avoid conflicts of interest, the processing of complaints regarding NRSRO noncompliance, and notification to users of identified significant errors are required. • Compensation of the compliance officer may not be linked to the financial performance of the NRSRO.

49. Title IX, Subtitle C, NRSROs • The duty to report to appropriate authorities credible allegations of unlawful conduct by issuers of securities. • The consideration of credible information about an issuer from sources other than the issuer or underwriter which is potentially significant to a rating decision. • The Act establishes corporate governance, organizational, and management of conflict of interest guidelines. A minimum of 2 independent directors is required.

50. Title IX, Subtitle D • Improvements to the Asset-Backed Securitization Process (for CMO, CDO, CBO, CDO of ABS, CDO of CDO). • Regulations for assets if residential in nature are jointly prescribed by the SEC, the Secretary of Housing and Urban Development, and the Federal Housing Finance Agency. • Otherwise by the Federal Banking agencies and the SEC.