On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (H.R.4173). The law features provisions to strengthen consumer and investor protection, mitigate systemic risk, improve corporate governance, enhance bank regulation, and outline new responsibilities of the Federal Reserve System and other federal regulators.
The final version is the result of a three-week conference to reconcile the Restoring Financial Stability Act of 2010 (S. 3217), approved by the Senate in May 2010,1 and the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173), approved by the House in December 2009.2 The conference text was largely based on the more recent Senate bill, but legislators merged in House provisions and a host of new amendments to create the most comprehensive and influential financial reform package since the Great Depression. The legislation leaves several hundred rules and studies to be completed by regulators over the next two years, further extending the impact of the law and the transformation of the financial industry’s regulatory landscape. House Financial Services Chairman Barney Frank (D-Mass.) is expected to clarify certain provisions in a technical corrections bill later in the year to help ease the implementation of the overhaul.
The following analysis highlights the most important provisions in the law, as well as relevant changes from previous versions.
The Financial Stability Act establishes the Financial Stability Oversight Council, which will have the responsibility to promote market discipline, coordinate with other regulators to identify and respond to threats to financial stability, and resolve gaps in regulation. The council will consist of representatives with voting rights from nine federal financial regulators and an independent insurance expert. The legislation also establishes a new Office of Financial Research within the Department of the Treasury, which will support the council’s efforts by coordinating the collection of data from bank holding companies (BHCs) and nonbank financial companies, conducting applied analysis and long-term research projects, and developing tools for risk measurement and monitoring.
The council will have the authority to place a systemically important financial institution under the supervision of the Federal Reserve. Nonbank institutions may be required to establish an intermediate holding company to be regulated by the Federal Reserve and may be required to divest holdings. The Federal Reserve, in consultation with the council, will tighten prudential standards for the large, interconnected BHCs and financial institutions it supervises. These firms will undergo annual stress tests and will be subject to credit exposure limits. Conferees added a House-passed provision that will require such institutions to maintain a leverage ratio of 15 to 1.
Conferees agreed to include an amendment that requires size- and risk-based capital requirements for BHCs and certain nonbank financial institutions to be at least as strong as regulations that apply to subsidiary banks. The amendment also exempts BHCs with less than $15 billion in assets from a general rule that excludes trust-preferred securities from tier 1 capital. Larger BHCs will have five years to phase out their use of trust-preferred securities as part of tier 1 capital.
Title II establishes an Orderly Liquidation Authority to effectively dissolve troubled financial firms that are not already covered by Federal Deposit Insurance Corporation (FDIC) receivership and for which bankruptcy proceedings would adversely affect financial stability. The FDIC will broadly model the framework of the new authority after the U.S. Bankruptcy Code, as well as the procedures it uses for receivership of federally insured banks (defined in the Federal Deposit Insurance Act). The Treasury, the FDIC, and the Federal Reserve will work together to identify the firms and present their case for orderly liquidation for judicial review. Conferees rejected the inclusion of Fannie Mae, Freddie Mac, and other governmental entities in the definition of financial companies eligible for the liquidation mechanism.
In an effort to protect taxpayers from bearing the costs of a failing financial institution, the legislation mandates the inclusion of a repayment plan for each liquidation proposal that does not rely on any public funds and directs losses to creditors, shareholders, and all parties responsible for the institution’s condition. The legislation allows the FDIC to help cover the costs of liquidation by issuing debt securities to the Treasury and by collecting from creditors that benefitted from the use of the Orderly Liquidation Authority instead of normal bankruptcy proceedings. The FDIC will also have the ability to recoup losses from the sale of company assets and from a claw-back provision that reclaims payments to creditors in excess of liquidation value. As a last resort, the FDIC may assess a risk-based fee on large financial companies. The legislation creates an Orderly Liquidation Fund (OLF) to offset the costs of the new Liquidation Authority, but conferees eliminated a plan from the House version to pre-fill the fund with $150 billion from risk-based assessments on large financial institutions.
The act prohibits the FDIC from directly bailing out financial institutions. It also bars the agency from taking equity interest in or becoming a shareholder of any financial company.
Title III of the act follows the previously passed Senate and House bills’ plan to abolish the Office of Thrift Supervision (OTS) and transfer its responsibilities to the Office of the Comptroller of the Currency (OCC), the FDIC, and the Federal Reserve. It keeps provisions from the House bill to preserve the thrift charter and to create the post of deputy comptroller to supervise thrifts for the OCC.
The Federal Reserve will supervise and regulate thrift holding companies and bank holding companies, along with applicable nonbank subsidiaries. The OCC will become the primary regulator for national banks and thrifts of all sizes. The FDIC will regulate all state-chartered thrifts and banks that are not members of the Federal Reserve System. These regulators will have the authority to assess fees on the financial entities they supervise to offset the cost of operations. In a last-minute change, conferees removed a risk-based fee for larger financial institutions to fund the act (see other plans for funding in the Pay It Back Act, Title XIII).
Title III also includes major changes to the Federal Deposit Insurance Act. Conferees agreed to permanently increase the limit on federal deposit insurance for banks, thrifts, and credit unions to $250,000, and made the change retroactive to January 1, 2008. The provision, which was not part of the original House or Senate bills, will benefit depositors of banks that failed before Congress temporarily raised the limit from $100,000 to $250,000 in October 2008. Additionally, the act eliminates the reserve ratio3 cap for the FDIC’s Deposit Insurance Fund (DIF) and increases the minimum reserve ratio from 1.15 percent to 1.35 percent of estimated insured deposits. Insured depository institutions with assets over $10 billion will be charged higher premiums to rebuild the DIF.4 Conferees adopted House language that replaced total deposits with average total assets as the assessment base for insured depository institutions, increasing the share of liability for larger banks with lower levels of domestic deposits.
In addition, conferees agreed to extend for two years most accounts under the Transaction Account Guaranty (TAG), a program started as part of the Temporary Liquidity Guarantee Program (TLGP) in 2008 to assist small businesses with operating cash balances in checking accounts. A House-approved provision to make it permanent was rejected. Both commercial banks and credit unions will have access to the unlimited federal guarantee for non-interest-bearing transaction accounts.
Title IV of the act, the Private Fund Investment Advisers Registration Act, follows the Senate-passed version closely. The provision requires hedge fund and private equity advisers with more than $150 million in assets to register with the Securities and Exchange Commission (SEC). Regulators will collect data — such as type and amount of assets held, use of leverage, counterparty credit risk exposure, trading and investment positions, and side arrangements — from registrants to evaluate systemic risk. The act extends the registration requirement to the class of “private advisers,” which were previously exempt in the Investment Advisers Act of 1940, Section 203(b). The act would not apply to family offices or advisers that counsel only venture capital funds.
Title V of the act creates the Office of National Insurance within the Department of the Treasury; this office will gather information on the insurance industry and monitor its systemic risks. It will have the power to suggest that an insurer be regulated by the Federal Reserve as a nonbank financial company, and the director will serve as an adviser to the Financial Stability Oversight Council. It will not have rule-writing authority but will help coordinate domestic and international insurance policies. In a compromise between the House and Senate versions, the Office of National Insurance will be required to notify the Committees on Financial Services and Ways and Means of the House and the Committees on Banking, Housing, and Urban Affairs and Finance of the Senate if it intends to preempt state law.
Title V also includes regulations to streamline surplus lines of insurance and reinsurance on the state level.
Title VI of the act, the Bank and Savings Association Holding Company and Depository Institutions Regulatory Improvements Act, enhances supervision and places new restrictions on financial institutions.
The act weakens language from a Senate amendment known as the Protect Our Recovery Through Oversight of Proprietary (PROP) Trading Act.5 The new provision directs regulators to prohibit insured depository institutions and their parent companies from proprietary trading and certain relationships with hedge funds and private equity funds. The act explicitly bans trades and relationships that involve a conflict of interest, expose the firm to too much risk, or pose a threat to financial stability, and provides a timeline for the divestiture of prohibited positions or relationships. However, the act allows a number of exemptions: institutions can trade on behalf of clients, to mitigate risk, and to enhance the safety of the institution or the financial system. Institutions can also continue to engage in transactions of government or government agency securities, small business investment companies, public welfare investments, and certain securities related to insurance companies. Conferees added a provision to allow de minimis investments of up to 3 percent of a bank’s tier 1 capital in hedge and private equity funds if the investment is less than 3 percent of the fund’s capital. Nonbank institutions are not subject to the same restrictions, but firms deemed systemically important by the Oversight Council that engage in proprietary trading or certain relationships with private funds will be required to abide by stricter capital regulations and other constraints determined by the Federal Reserve.
The act will strengthen supervision by requiring the Federal Reserve to examine nonbank subsidiaries with the same discretion as an examination of the parent company. It will also minimize regulatory arbitrage by requiring regulators to jointly approve a firm’s charter conversion. Additionally, grandfathered unitary savings and loan holding companies could be required to establish intermediate holding companies to ensure proper regulation of their financial activities. The Federal Reserve will be charged with designing countercyclical capital requirements, which will require firms to build their reserves while the economy is growing and lower required reserves during a downturn.
The act includes a study and moratorium on new applications and changes in control for credit card banks, industrial loan companies, and other types of limited-purpose banks.6 It bars any banking entity that serves directly or indirectly as an investment manager, adviser, organizer, or sponsor to a hedge fund or private equity fund from engaging in certain transactions with the fund, such as a loan or the purchase of assets from the fund. The act also tightens the restrictions described in Section 23A of the Federal Reserve Act by prohibiting derivative transactions with affiliates. The affected banking entities will be treated as a member bank and the related fund will be treated as an affiliate; transactions between the Â banking entities and related funds must be comparable to transactions by unaffiliated market participants, as described under Section 23B of the Federal Reserve Act.
In addition, the act includes concentration limits on banks’ positions, elimination of the elective investment BHC framework, constraints on the size of allowable mergers, the addition of credit exposure from derivative transactions to banks’ lending limits, and the repeal of the prohibition on payment of interest on demand deposits. Conferees approved a provision to prevent firms that underwrite asset-backed securities from also taking trade positions that are a conflict of interest.
Title VII of the act, the Wall Street Transparency and Accountability Act, gives more oversight of swaps to the Commodities Futures Trading Commission (CFTC) and the SEC. The act will require firms to trade most swaps through clearinghouses and on regulated public exchanges, as well as provide information on their activity in what had been an unregulated market. By imposing direct regulation on the products, instead of broader supervision at the entity level, the act essentially reverses the deregulation of over-the-counter derivatives from the Commodity Futures Modernization Act of 2000. It also preserves the historical responsibilities of the CFTC (responsible for commodities-based swaps) and the SEC (responsible for securities-based swaps). Firms and traders with high trade volume and customized swaps will be subject to stricter regulatory standards, including position limits, higher capital levels, and additional reporting requirements. Nonfinancial companies that use derivatives to hedge legitimate commercial risks, known as “end users,” will be exempt from the requirements.
Conferees rejected a Senate amendment to force commercial banks to spin off all swaps activities but included provisions that will require banks to shift a subset of derivatives to a separate entity. Under the new provision, banks will be able to continue to hedge risk by trading interest rate or foreign exchange swaps.
The act establishes new adviser conduct and registration rules for swap dealers and major swap participants and expressly prohibits federal assistance to certain swap entities.
Title VIII allows the Federal Reserve to issue rules that will regulate payment, clearing, and settlement activities among financial institutions determined systemically important by the Financial Stability Oversight Council. The SEC and CFTC will have regulatory authority over the market utilities in the sectors that they oversee (securities and commodities, respectively). A market utility is defined as an entity that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions; the Chicago Mercantile Exchange, for example, would continue to be regulated by the CFTC, unless it was ever deemed systemically important by the Oversight Council. The Federal Reserve will serve as a back-up examiner and enforcement authority for noncompliant financial institutions and as an emergency authority over a designated financial market utility if it poses a risk to financial stability.
Title IX of the act contains numerous provisions to simultaneously vet and enhance the SEC, as well as grant it more authority to protect investors, regulate securities, and improve corporate governance.
The act mandates studies of the SEC’s management and internal supervisory controls. It also creates new advocates for investors in the roles of an Investment Advisory Committee and the Office of Investor Advocate in the SEC.
In addition, the SEC will examine nationally recognized statistical ratings organizations (NRSROs) annually, require full disclosure of rating methodologies, increase liability for biased ratings, and prohibit certain activities with conflicts of interest. Conferees found a middle ground in allowing investors to sue NRSROs for “knowingly or recklessly” issuing a rating. A House proposal was tougher on the NRSROs, while precedent had been easier on the agencies. A new Office of Credit Ratings at the SEC will have the power to fine or deregister noncompliant NRSROs.
The act includes many provisions that direct the SEC to improve the corporate governance of the entities it supervises. For example, the SEC could grant shareholders proxy access to nominate directors or give them the opportunity to cast non-binding votes on pay for executives of companies they own. The SEC will also have the authority to offer rewards to whistle-blowers who report securities violations. Conferees agreed to give the SEC authority to write laws concerning fiduciary duties for brokers who give investment advice after the SEC completes a six-month study of the industry; a House proposal to implement the duties without a prior study was rejected. However, the act directly increases oversight and requires fiduciary duty of municipal advisers.
The legislation also requires issuers and originators of asset-backed debt to retain some of the credit risk they package or sell. A compromise reached in conference deliberations requires such parties to hold a 5 percent stake in their products. Mortgage lenders that offer lower-risk loans and avoid nonstandard features, such as negative amortization, interest-only payments, and balloon payments, will be exempt from the risk retention requirement as well as loans guaranteed by the Federal Housing Administration, the Department of Agriculture, and the Department of Veterans Affairs. Conferees also included a provision that allows regulators to consider exemptions for commercial mortgage-backed securities.
Title X, the Consumer Financial Protection Act, establishes an independent Bureau of Consumer Financial Protection that will regulate all providers — bank and nonbank — of consumer financial products and services, as well as offer public education and assistance programs. The bureau will have the authority to write and enforce rules to preserve access to fair, transparent, and competitive products and services in the consumer finance industry.
The bureau will be funded by and placed within the Federal Reserve, which will be prohibited from interfering with the bureau; the House language to create a stand-alone agency was rejected. The bureau’s director will be appointed by the President and confirmed by the Senate.
All consumer protection powers from seven other federal agencies will be transferred to the new bureau. Its purview will extend to credit, savings, payment, and other consumer financial products and services; it will not cover investment products, insurance products, or the auto industry. It will have the authority to supervise, in coordination with other prudential regulators, providers such as mortgage-related firms, credit card and student lenders, and banks and credit unions with over $10 billion in assets; other regulators will retain oversight of the activities of smaller banks. Automobile companies, other sellers of nonfinancial goods, real estate brokers, accountants, and other related financial service providers are exempt from bureau regulation. The bureau will not have the authority to set usury limits.
State laws and enforcement powers, unless inconsistent with federal laws, will be preserved. Conferees sided with Senate language to clarify state law preemption standards for national banks and subsidiaries. Federal regulation can preempt state consumer financial law on a case-by-case basis if the state law discriminates against national banks and if it violates the standard established by the 1996 U.S. Supreme Court case decision, Barnett Bank of Marion County, N.A., v. Nelson, Florida Insurance Commissioner, et al., 517 U.S. 25.7 However, the act does not allow federal law to preempt state law for subsidiaries or affiliates of national banks, which contradicts what the Supreme Court decided in Watters, Commissioner, Michigan Office of Insurance and Financial Services v. Wachovia Bank, N.A., et al8 in 2007. The act preserves the ability of state attorneys general and other state authorities to enforce laws against national banks.
In addition, the bureau will act as a consumer advocate and educator by researching the industry and responding to complaints about financial services and providers. It will also provide services related to increasing financial literacy.
Besides creating the consumer finance watchdog, Title X includes regulation on fees involved with payment card transactions. The act grants the Federal Reserve the authority to prescribe regulations regarding payment card network fees and interchange from electronic debit transactions to ensure that the fees are “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” Issuers with less than $10 billion in assets will be exempt. Currently, interchange fees are set by credit card networks, such as Visa and MasterCard. The act allows merchants to set minimum charges (up to $10) for the use of payment cards or to offer discounts for the use of alternative forms of payment but prohibits merchants from discriminating between issuers.
Title XI of the act identifies changes to governance and transparency at the Federal Reserve Board and throughout the Federal Reserve System. The legislation commissions the Government Accountability Office (GAO) to conduct a one-time audit of emergency loans and other actions during the financial crisis (since December 1, 2007) within a year of enactment. Conferees rejected a tougher House amendment to allow audits of monetary policy decisions, information that is still protected under the Federal Banking Agency Audit Act (enacted in 1978 as Public Law 95-320).
The act also eliminates the voting rights of commercial bank representatives in selecting presidents of regional Federal Reserve Banks. These leaders will be selected by directors that are representatives of the public, known as class B and C directors. Conferees rejected Senate language to make the president of the Federal Reserve Bank of New York a political appointee.
In addition, the act creates the position of vice chairman of supervision, which will be chosen by the President from the existing members of the Board of Governors of the Federal Reserve.
Title XI also alters the ways in which the Federal Reserve and the FDIC can respond to a liquidity crisis. The act mandates changes to the emergency lending policies described in Section 13(3) of the Federal Reserve Act and eliminates the Federal Reserve’s ability to lend to individual firms and insolvent entities. The Federal Reserve will retain the power to create broad programs and facilities to preserve liquidity but will need to get approval from the secretary of the Treasury first. It must also provide justification and details of the transactions to Congress. The act subjects the Federal Reserve to ongoing audits of future special credit facilities, discount window lending, and open market operations but allows a two-year lag before releasing identifying information.
The act also mandates that the FDIC and the secretary of the Treasury collaborate on new policies and procedures governing debt guarantee programs and that together they set the terms and conditions of future programs. If the Federal Reserve and the FDIC determine that emergency action is necessary to stabilize the economy (by two-thirds majority of each board), the FDIC will create programs to guarantee debt of solvent insured banks according to the new policies. Congress must approve the pre-established limit to the FDIC guarantees. The act includes a “fast track” plan for expedited congressional action in time-sensitive cases. The FDIC will assess fees on all participants of a debt guarantee program to offset its losses and costs, although it can borrow from the Treasury if necessary.
Title XII, the Improving Access to Mainstream Financial Institutions Act, authorizes the secretary of the Treasury to establish grants and cooperative agreements for financial products and services that are appropriate and accessible for underserved populations, including low-cost alternatives to payday loans. It allows the secretary of the Treasury to implement programs to enhance access to mainstream depository institutions and to establish loan-loss reserve funds.
Title XIII reduces Troubled Asset Relief Program (TARP) authorization from $700 billion to $475 billion and prohibits spending for new initiatives in the program. The savings from TARP and the increase in the DIF assessment from Title III will help offset the costs of the financial system overhaul. A $19 billion Financial Crisis Assessment Fund that was initially approved by the Conference Committee, but removed before the bill was presented to the House, called for the Financial Stability Oversight Council to impose a risk-based annual fee on financial companies with more than $50 billion in consolidated assets and financial companies that manage hedge funds with over $10 billion in managed assets.
The act also mandates that idle American Recovery and Reinvestment Act (ARRA) funds and proceeds from the sale of Fannie Mae, Freddie Mac, and Federal Home Loan Bank obligations purchased during the financial crisis go toward deficit reduction.
Title XIV, the Mortgage Reform and Anti-Predatory Lending Act, enhances regulation of residential and high-cost mortgages, including mortgage origination and servicing. It aims to protect consumers from unfair and deceptive practices while encouraging appropriate mortgage products.
The act directs the Federal Reserve to prescribe regulations barring steering incentives and offering unreasonable or deceptive mortgages to unqualified consumers. Residential mortgage originators will be required to verify and document that consumers can reasonably afford a mortgage, using a payment schedule that fully amortizes the loan over the term. They will be prohibited from charging prepayment penalties on most loans and from taking compensation that varies based on the terms of the loan, except the amount of the principal. Conferees agreed to include House language that exempts loans made or guaranteed by the Department of Housing and Urban Development, the Department of Veterans Affairs, the Department of Agriculture, and the Rural Housing Service.
The Expand and Preserve Home Ownership Through Counseling Act in Title XIV creates the Office of Housing Counseling within the Department of Housing and Urban Development. The new office will target traditionally underserved populations and address the entire process of homeownership, including the decision to purchase a home, issues arising during the period of ownership, and the sale or disposition of the home.
The act also places extra restrictions on the use of both high-cost and high-risk mortgages and sets new home appraisal standards. Although the act does not offer reforms for government-sponsored entities Fannie Mae and Freddie Mac, it acknowledges their problems and calls for future reform.
On June 15, the Board of Governors of the Federal Reserve issued a final rule amending Regulation Z to limit penalties that can be charged to credit card users. The rule caps late payment penalties at $25, unless the customer is a repeat offender. The penalty fee for a violation cannot exceed the dollar amount associated with the violation (e.g., the issuer cannot charge $25 if the customer is late making a payment for $20). The rule also bans inactivity fees and prevents issuers from charging multiple fees for a single violation. The rule was required by the Credit Card Accountability and Disclosure (CARD) Act of 2009 (Public Law No. 111-24) and becomes effective on August 22, 2010. For information on other rules issued in compliance with the Credit CARD Act, see Banking Legislation and Policy, Volume 29, Number 1.
On April 7, the SEC proposed changes to Regulation AB and other rules regarding the offering process, disclosure, and reporting for asset-backed securities (ABS) (75, Federal Register, pp. 23328-514). The proposals would strip the mandate to reference credit ratings for shelf registrations,9 require issuers to retain 5 percent of the securities they sell, and demand more transparency for shelf registrations and public offerings of asset-backed securities. The proposal also seeks to give investors more time to consider “transaction-specific information” by changing the filing deadlines for ABS offerings and requiring more information about the pooled assets within the securities.
On May 19, the U.S. Court of Appeals for the Ninth Circuit ruled that, under the Truth in Lending Act (TILA), credit card issuers need to settle billing disputes only with customers who meet the legal definition of “obligor” (Edwards v. Wells Fargo and Co., 9th Cir., No. 06-16892, 5/19/10). The court ruled that TILA does not require the issuers to contact or respond to requests from the person who actually made the disputed purchase if that person is not the obligor, such as a family member who is authorized to use a card linked to the account but who is not personally liable for the charges.