Dodd-Frank at 2: Summary - Dodd-Frank, Consumer Protection Act

As we come up on the second anniversary of the passage of the Dodd-Frank Act, construction of the new regulatory structure that Congress envisioned is well underway but far from completion. For example, 129 rules have been finalized, giving us a clearer picture of the Dodd-Frank regulatory framework, but another 137 rules, which contain many of the core Dodd-Frank reforms await completion. One might think, or hope, that there is some kind of economy of scale in rulemaking and that the 137 can be finished in short order. However, implementation may become more complex and difficult as the fall elections (and perhaps the results) cause Congress to re-engage with Dodd-Frank and as the courts become involved. For example, on July 10, 2011, Republicans in the House of Representatives began a series of six hearings leading up to the second anniversary, which will attack a variety of provisions in the statute.

In any event, virtually all financial institutions should look carefully at some of the specific efforts of the regulators over the last two years, since these are beginning to affect business planning and operations. The mechanisms for the oversight of systemically important banks and nonbank financial companies by the Financial Stability Oversight Council and the Federal Reserve Board are beginning to take shape. The basic construct of the resolution scheme for systemically important financial institutions has come together, and the first of the living wills have been submitted. However, we do not yet have clarity relating to the additional requirements that will apply to our SIFIs. We also have had some surprises. We knew that Basel III would be adopted in the United States, but many smaller banks had not anticipated that they would be subject to these requirements. Considerable progress has been made in addressing executive compensation and other governance matters. Less progress has been made in finalizing the rules relating to credit rating agencies. The regulatory framework affecting derivatives has taken shape, though important cross-border and international harmonization issues remain. As of this milestone, the most significant questions that remain to be answered by rulemaking relate to the mortgage market and the future of securitization in the United States.

With elections nearing, and market volatility persisting, it is not clear that answers will soon emerge. In the pages that follow, we summarize briefly the principal developments in several key areas. Here is our disclaimer: This is a summary, and only a very brief summary at that, and all of it is qualified in its entirety by reference to our more complete (and far longer) descriptions, analyses and reports.

FINANCIAL STABILITY REFORM (as of July 10, 2012)

Management, if not elimination, of systemic risk is perhaps the primary purpose of the Dodd-Frank Act (the "Act"). The Financial Stability Oversight Council (the "Council"), an interagency group with broad oversight of this risk and the authority to identify systemically important financial institutions and activities, and the Federal Reserve Board (the "Board"), the primary body for supervising these institutions and activities, have now begun their work in earnest. With the finalization of the Council's criteria for the designation of nonbank financial institutions as systemically important and with the publication of proposed enhanced prudential standards, we have some idea of how the Council and the Board will attempt to contain systemic risk.

From one perspective, every provision in the Act is aimed at the prevention of systemic risk and the rise of institutions that are too big to fail. On a practical level, however, the Council and the Board have principal responsibility. The Federal Deposit Insurance Corporation (the "FDIC") and the Office of the Comptroller of the Currency (the "OCC") also have important roles. Developments so far include:

Creation of the Council

The Council was formally organized shortly after the enactment of Dodd-Frank. It meets with some regularity, having convened just under 20 times since its creation in 2010. The constitutionality of the Council has recently been challenged in a lawsuit filed in the U.S. District Court for the District of Columbia, State National Bank of Big Spring, Texas v. Geithner, No. 1:12-cv-01032-esh ("Big Spring").
Voting members are primarily ex officio heads of the federal financial regulatory agencies. There are ten voting members, including the Secretary of the Treasury (Timothy Geithner), who serves as Chairman of the Council, the Chairman of the Federal Reserve Board (Ben Bernanke), the Chairman of the Securities and Exchange Commission (Mary Shapiro), the Chairman of the Commodity Futures Trading Commission (Gary Gensler), the Chairman of the National Credit Union Administration (Debbie Matz), and one independent member with insurance expertise (Roy Woodall). The other voting members include:
- The Comptroller of the Currency. Thomas J. Curry recently was confirmed as Comptroller. Previously, he was a member of the FDIC board and [Superintendent of Banking] in Massachusetts.
- The Chairperson of the FDIC. Martin J. Gruenberg is currently Acting Chairperson and serves on the Council. The President nominated Mr. Gruenberg as Chairperson, but he was confirmed as Acting Chairperson.
- The Director of the Consumer Financial Protection Bureau. Richard Cordray became Director through a recess appointment on January 4, 2012. This appointment will last until the Senate adjourns at the end of 2013. The constitutionality of the appointment recently was challenged in Big Spring.
- The Director of the Federal Housing Finance Agency (the "FHFA"). Edward DeMarco currently serves as Acting Director and represents the FHFA on the Council. Through an unusual provision in the FHFA's organic statute, the President may "designate" an Acting Director. Unlike a recess appointment, there is no time limit on a designated Acting Director. The President has not yet nominated a permanent Director.
The Council currently has four non-voting members, including the Director of the Federal Insurance Office (Michael McRaith), a state banking regulator (John P. Ducrest, Commissioner, Louisiana Office of Financial Institutions), a state insurance regulator (John Huff, Director, Missouri Department of Insurance, Financial Institutions, and Professional Registration), and a state securities regulator (David Massey, Deputy Securities Administrator, North Carolina Department of the Secretary of State, Securities Division). The Dodd-Frank Act calls for a fifth nonvoting member, the Director of the Office of Financial Research. Richard Berner has been nominated but not yet confirmed. Until there is a confirmed Director, the OFR will not be represented on the Council.
The Council has established several committees to handle its work, including separate committees for systemic risk, the designation of nonbank financial companies as systemically important, the nature of the heightened prudential standards that will apply to systemically important financial institutions, and review of resolution plans and divestiture orders.
The Council is required to conduct several studies. To date, it has published studies on four issues: prompt corrective action, haircuts on secured creditors in the liquidation of a systemically important institution, implementation of the Volcker Rule, and concentration limits on large financial institutions.

Office of Financial Research

The Office of Financial Research ("OFR") has three central functions: collecting and analyzing data for the Council, performing research, and developing tools for risk measurement and monitoring.
The OFR also is largely responsible for establishing a Legal Entity Identifier by which financial institutions would identify each of its entities and thereby enable regulators to better understand market exposures involving different entities. (The CFTC and the SEC have more limited roles in this area.)
The Treasury Department has established and staffed the OFR, and a Director, Richard Berner, has been nominated but not yet confirmed.
The OFR has proposed a methodology to standardize how parties to financial contracts are identified in data collected for the Council. The proposed rule has not been finalized.
The OFR has produced two working papers, one on systemic risk analytics, the other on best practices in risk management.

Systemic Risk Regulation

Systemic risk regulation extends to nonbank companies that are "predominantly engaged" in financial activities. The Board has proposed a definition of the term, based on either of two conditions: (i) 85 percent or more of a company's gross revenues in either of the previous two calendar years are derived from financial activities; or (ii) 85 percent or more of its consolidated assets in one of the previous two years are financial assets.
The Council has finalized the criteria for the designation of a nonbank financial company as systemically important. We understand that it expects to designate the first nonbank financial companies before the end of 2012. We discussed the standards in a paper published in May 2012, "Systemically Important Nonbank Financial Institutions: FSOC Approves Final Rule," available at http://www.mofo.com/files/Uploads/Images/120515-Systemically-Important-Nonbank-Financial-Institutions.pdf.
On June 12, 2012, the Board, together with the FDIC and the OCC, released three capital proposals that would apply to all banking organizations, including but not limited to those that are systemically risky, and finalized a market risk capital rule that applies to banking organizations subject to the Basel II advanced approaches to capital adequacy.
The Board and the FDIC also have released stress testing guidance or requirements for systemically important banking organizations and banks and for all banking organizations and banks with more than $10 billion in consolidated assets.
The Council and the Board also have authority to, respectively, identify and regulate financial market utilities ("FMUs") that are systemically important. On July 8, 2011, the Council finalized criteria for identifying these FMUs. The Board has proposed risk management standards and a requirement for advance notice by an FMU to the Board of material changes to the FMU's rules, procedures, or operations.
On January 5, 2012, the Board published the first broad set of proposed enhanced prudential standards for U.S.-based systemically important financial institutions ("SIFIs"). (A proposal for comparable standards for foreign banking organizations will be forthcoming.) The proposal would implement much of section 165, including capital and leverage requirements, liquidity, exposures to single counterparties, risk committees, stress testing, and early remediation. For a full discussion, please see our paper, "Enhanced Prudential Standards: The Federal Reserve's Proposal", available at http://www.mofo.com/files/Uploads/Images/120123-Enhanced-Prudential-Standards-The-Federal-Reserves-Proposal.pdf.
On December 1, 2011, the Board, the FDIC, and the OCC published a final rule on the annual capital planning process for bank holding companies with consolidated assets greater than $50 billion.
The Board and the FDIC completed rules on resolution planning for SIFIs. The FDIC also issued a comparable rule on resolution planning by insured depositary institutions ("IDIs") with more than $50 billion in consolidated assets. We discuss this planning process in greater detail in a user guide, available at http://www.mofo.com/files/Uploads/Images/110905-Living-Wills.pdf.
On July 18, 2011, the FDIC finalized rules for the Orderly Liquidation Authority in Title II of Dodd-Frank.
On June 28, 2011, the Board, the OCC, and the FDIC issued a final rule implementing in part the Collins Amendment (section 171), which requires that the capital requirements for bank holding companies be as stringent as the current capital requirements at the bank level. The final rule places a floor on the risk-based capital requirements that would apply to those bank holding companies that use the Basel II "advanced approaches" method of calculating risk-based capital.
On June 25, 2011, the Group of Governors and the Heads of Supervision—the group that oversees the Basel Committee on Banking Supervision— published proposed regulatory requirements for global systemically important banks. These standards will have no force of law in the United States but have informed and will continue to inform U.S. rulemaking.

RESOLUTION PLANNING (as of July 10, 2012)

One of the first elements of systemic risk regulation in the Dodd-Frank Act to see the light was Section 165(d), which calls for resolution planning, i.e., the preparation of "living wills." The purpose of the living will is to provide a plan under which, "in the event of material financial distress or failure," a Covered Company can be sold, broken up, or wound down quickly and effectively in a way that avoids or mitigates serious, adverse effects to U.S. financial stability. A living will serves at least three functions: (i) as a plan for how a large, troubled banking organization may restore itself to health without government assistance, (ii) as a road map for resolution activity by the Federal Deposit Insurance Corporation (the "FDIC") if it were to place the organization into receivership under Title II of Dodd-Frank, and (iii) as a guide for the Federal Reserve Board (the "Board") in its ongoing supervision of the organization.

On November 1, 2011, the Board and FDIC published a final rule requiring certain "Covered Companies" to submit a living will.¹ The FDIC earlier had adopted a similar rule for resolution planning by large insured depository institutions ("IDIs"). We discuss the elements of resolution planning in a user guide, available at http://www.mofo.com/files/Uploads/Images/110905-Living-Wills.pdf.

July 2, 2012, was the date on which the Board and the FDIC required nine U.S. and foreign banking organizations with $250 billion or more in nonbank assets (for foreign banking organizations, $250 billion or more in U.S. nonbanking assets) to file resolution plans. They have done so, and the public portions of these plans were released on July 3. We reviewed the plans in a recent bulletin, available at http://www.mofo.com/files/Uploads/Images/120705-Living-Wills-Public-Portions-Released.pdf.

Covered Companies²

Bank holding companies with consolidated assets of $50 billion or more, as determined based on the average of the company's four most recent Consolidated Financial Statements for Bank Holding Companies as reported on the Board's Form FR Y-9C.
Foreign banks or companies that are bank holding companies or are treated as bank holding companies under Section 8(a) of the International Banking Act of 1978 (each an "FBO") that have $50 billion or more in total consolidated assets, based on the FBO's most recent annual FR Y-7Q filings or the average of the four most recent quarterly, FR Y-7Q filings.
Nonbank financial companies supervised by the Board, as designated by the Financial Stability Oversight Council (the "Council").³
The Covered Company is the top-tier holding company in a multi-tiered holding company structure.
Separately, the FDIC published a final rule requiring IDIs with $50 billion or more in consolidated assets ("covered insured depository institutions" or "CIDIs") to submit a resolution plan under the Federal Deposit Insurance Act in the event of the CIDI's failure.⁴

Resolution Plan Deadlines

Covered Companies that, as of November 30, 2011, had $250 billion or more in total nonbank assets, or in the case of a Covered Company that is foreign based, such company's total U.S. nonbank assets, were required to file by July 2, 2012 ("Group 1"). The Board has discretion to move institutions from one group to another. We understand that at least one Group 1 company has been moved to Group 2, and at least one institution with total nonbank assets of less than $250 billion was transferred to Group 1.
Covered Companies that, as of November 30, 2011, had $100 billion or more in total nonbank assets, or in the case of a Covered Company that is foreign based, such company's total U.S. nonbank assets, must file by July 1, 2013 ("Group 2").
Remaining Covered Companies that do not belong to Group 1 or Group 2 must file by December 31, 2013 ("Group 3").
A company that becomes a Covered Company after November 30, 2011, must submit its resolution plan by the next July 1 following the date the company becomes a Covered Company, provided that July 1 is at least 270 days after the date the company becomes a Covered Company.
A Covered Company must file a living will annually on or before the anniversary date of the date of submission of its initial plan.
A Covered Company must also submit a notice identifying any event, occurrence, change in conditions or circumstances, or other change that results in, or could reasonably be foreseen to have, a material effect on the resolution plan of the Covered Company, no later than 45 days after the event.
The deadline for the submission of a bank-level plan required by the FDIC is the same as the deadline for its holding company. Five of the nine Covered Companies that were required to file on July 2, 2012, control U.S. bank subsidiaries; in four of these cases, the CIDI plan was combined with the Section 165(d) plan.

General Substantive Requirements for a Resolution Plan

The manner and extent to which any IDI affiliated with the company is adequately protected from risks arising from the activities of nonbank subsidiaries of the company.
Detailed descriptions of the ownership structure, assets, liabilities, and contractual obligations of the company.
Identification of the cross-guarantees tied to different securities.
Identification of major counterparties.
A process for determining to whom the collateral of the company is pledged.
Covered Companies in Group 3 may submit a "tailored" resolution plan, which would include all of the elements of a standard plan, but the scope of the tailored plan can be limited in certain respects.
The final rule on living wills sets forth eight required elements of a plan. The plans filed on July 2, 2012, however, contained 11 parts. Future filers should review the public portions of the July 2, 2012, plans to confirm the substance of their plans.
Resolution plans will be based in part on assumptions about the financial industry and the economy that will be provided by the FDIC and the Board. The assumptions used for the July 2, 2012, plans were relatively optimistic—e.g., a failure would be idiosyncratic and other financial institutions would not be in distress—but the regulators are likely to develop more-sophisticated and challenging assumptions in the future.

Review of a Resolution Plan

The Board and the FDIC will review resolution plans within 60 days of submission and will first determine whether the plans appear "informationally complete," in which case they will be accepted for further review.
If a resolution plan is jointly determined to be "informationally incomplete," the Board and the FDIC will require that the Covered Company resubmit an informationally complete plan within 30 days.
After accepting plans for further review, the Board and the FDIC will make a determination of whether the plan is "credible," taking into account variances among Covered Companies' core business lines, critical operations, foreign operations, capital structure, risk, complexity, financial activities (including the financial activities of their subsidiaries), size, and other relevant factors.
The credibility standard will not, however, be applied with respect to the initial submission. The Board and the Agency will apply it to all future submissions. The two agencies will, for example, begin to test the credibility of plans filed by the nine organizations that filed on July 2, 2012, only after those organizations have submitted their annual updates on July 1, 2013.
If the Board and the FDIC jointly determine that a resolution plan is not credible, a Covered Company must resubmit a revised plan within 90 days of receiving notice that its plan is deemed deficient.
Failure to remedy deficiencies could result in the imposition of a wide range of measures, including additional capital, leverage, or liquidity requirements and forced divestiture of assets or operations.
FDIC review of a bank-level plan will follow a similar process.

Related Resolution Planning Initiatives

Credit exposure reports, also required by Section 165(d) of the Dodd-Frank Act, were included in the proposed rule on resolution planning, but the Board and the FDIC have deferred final action on credit exposure reports until the Board has issued rules on credit exposure limits, as required by Section 165(e).
The Board has proposed regulations to limit a SIFI's credit exposures to third parties—including a ceiling on exposures to any one counterparty of 25 percent of total capital—which would take effect, at the earliest, on July 21, 2013.⁵
The Board and the FDIC, along with the Office of the Comptroller of the Currency (the "OCC"), issued interagency guidance on counterparty credit risk management on June 29, 2011.⁶
Section 165(i) of the Dodd-Frank Act requires that the Board conduct annual stress tests of all Covered Companies; Covered Companies must also conduct their own tests on a semiannual basis.⁷ Stress testing rules were included in the Board's recent proposal on enhanced prudential standards.
The Board, the FDIC and the OCC separately have adopted final rules on capital planning.
The December 31 deadline for the submission of annual plans by all but the very largest organizations (which filed on July 2, 2012, and will continue to submit annually on July 1) dovetails with stress testing and capital planning.
The Board may require changes to a living will based on stress test results or on data in credit exposure reports. Accordingly, preparation of a living will must be rolled into credit exposure reporting, capital planning, and stress testing.
Section 166 of the Dodd-Frank Act requires that the Board, in consultation with the Council and the FDIC, establish a series of specific remedial actions (e.g., more stringent prudential standards) as a Covered Company experiences increasing financial distress. Such rules were proposed as part of the enhanced prudential standards in January 2012.
The Orderly Liquidation Authority, created under Title II of the Dodd-Frank Act, authorizes the FDIC in certain limited cases to place financial companies into receivership.

AGENCIES AND AGENCY OVERSIGHT REFORM (as of July 10, 2012)

Regulatory failure—the legal inability or the unwillingness to regulate large sectors of the financial services industry and their lending and secondary market activities—was a major contributor to the financial crisis. In response, the Dodd-Frank Act created several new agencies or offices, eliminated the Office of Thrift Supervision (the "OTS"), and modified the jurisdiction of several existing agencies. The construction of the new framework has proceeded smoothly in some areas, less so in others, notably the Consumer Financial Protection Bureau (the "Bureau"). Many previously unregulated institutions will have to grow accustomed to a new federal regulator. Of course, the success and impact of the new framework will depend in large measure on the substance of new rules, and many rules remain a long way off.

Major Agency Changes

The Financial Stability Oversight Council (the "Council") has been established and, has met almost 20 times since its establishment. The constitutionality of the Council recently has been challenged in a lawsuit filed in the U.S. District Court for the District of Columbia, State National Bank of Big Spring, Texas v. Geithner, No. 1:12-cv-01032-esh ("Big Spring").
The Bureau has been established and a director, Richard Cordray, named through a recess appointment. The appointment will last until the Senate adjourns at the end of 2013. This appointment also has been challenged in Big Spring.
Treasury has established two required offices within the department: the Office of Financial Research ("OFR") and the Federal Insurance Office ("FIO"). In late December 2011, the President nominated Richard Berner as director of OFR. Senate confirmation is required. The Senate Banking Committee has approved the nomination, but the full Senate has yet to act. In March 2011, Secretary Geithner designated Michael T. McRaith director of the FIO; no Senate confirmation is required for this post.
The OFR is charged with collecting and analyzing data for the Council in order to identify systemically risky activities and institutions. This work began shortly after the enactment of Dodd- Frank, initially under the aegis of Treasury's domestic finance unit and later within the OFR. The OFR has begun one rulemaking, proposing a methodology for standardizing the identification of parties to financial contracts.
The Securities and Exchange Commission (the "Commission") has established the Office of Credit Ratings to oversee large credit rating agencies, as required by section 932 of Dodd-Frank, and named Thomas J. Butler as director.
The OTS was abolished on October 19, 2011.

Major Changes in Agency Oversight

Several types of financial institutions and certain financial activities will be subject to substantially new regulation.
Systemically important nonbank financial companies
- The Council has authority to designate these institutions, and the Board will regulate them once designated.
- The Council finalized its criteria and procedure for making such designations in April 2012.
- The Board has begun to propose rules, including enhanced prudential standards, addressing the regulation of systemic risk.
Thrift institutions—The supervisory and rulemaking authority of OTS over these institutions is transferred to the other three federal bank regulatory agencies.
- Board—Supervision of and rulemaking for all savings and loan holding companies. The Board has begun to announce the general supervisory principles it will apply.
- OCC—Supervision of all federally chartered savings associations and savings banks. OCC has rulemaking authority generally over all savings associations, whether federal or state chartered. The OCC has incorporated the regulations of the former OTS into its own and has completed the transition of the OTS oversight regime into its own.
- FDIC—Supervision of state-chartered savings associations. FDIC has no rulemaking authority over state-chartered thrifts.
Providers of consumer financial products— Rulemaking authority for essentially all federal statutes regulating consumer financial products has been transferred to the Bureau.
- The allocation of supervisory responsibilities is complicated, but two categories of providers will be governed in almost all respects by the Bureau.
  - Nonbank financial companies—These companies currently are unregulated with respect to their consumer businesses. Dodd-Frank grants supervisory, enforcement, and rulemaking authority over many (but not all) of these institutions to the Bureau. Until a director has been confirmed, the Bureau has indicated that it will not attempt to exercise its supervisory or enforcement authority over these companies.
  - Insured depository institutions ("IDIs") with more than $10 billion in total assets.
- Supervision of the consumer compliance obligations of these two types of institutions will be transferred from the current regulator—primarily the Board—to the Bureau. The Bureau has primary, but not exclusive, enforcement authority over these institutions.
- Supervision of IDIs with less than $10 billion in total assets will remain with the IDI's primary regulator, but the CFPB will have back-up supervision and enforcement authority.
Large hedge funds—The Commission has finalized a rule implementing the Dodd-Frank provision that requires hedge funds that manage over $100 million as investment advisers to register with the Commission in that capacity. Dodd-Frank repealed an exemption previously set forth in the Investment Advisers Act of 1940.
Mid-sized investment advisers—The Commission has finalized a rule implementing the provision of Dodd-Frank that transfers the supervision of investment advisers with between $25 and $100 million in assets under management from the Commission to state securities regulators.
Swap dealers and participants—The Commission and Commodity Futures Trading Commission ("CFTC") have proposed and are beginning to finalize a variety of rules addressing registration by and operations of swap dealers, major swap participants, and swap clearinghouses. Other agencies, including the Board and FDIC, have proposed margin and capital requirements for the entities that they regulate that are dealers or participants.
Clearing organizations—The CFTC has several rulemaking procedures in progress to implement several requirements of Dodd-Frank; none have yet been finalized.
FMUs—Those entities that are deemed systemically important by the Council will be regulated by the Board. On July 18, 2011, the Council finalized criteria for the designation of these entities as systemically important. The Board has proposed a rule establishing risk management standards and requiring such entities to provide advance notice of material changes to their rules, procedures or operations.

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Footnotes

1. 76 Fed. Reg. 76323 (Nov. 1, 2011).

2. The Board and the FDIC state in the final rule that they expect the regulation to apply to 124 companies, the vast majority of which are FBOs. See Cady North, Bloomberg Government Study: How Foreign Banks Are Regulated Under Dodd-Frank, July 4, 2011, at 19 (noting that of the 124 Covered Companies, an estimated 100 foreign banks will need to comply with Section 165(d)).

3. These companies are informally referred to as systemically important financial institutions or "SIFIs." The Council finalized its criteria and process for designating SIFIs in April 2012. 77 Fed. Reg. 21637 (Apr. 11, 2012). The Council is expected to designate the first SIFIs by the end of 2012. Ultimately, this group may include the largest insurance companies, asset managers, and hedge funds.

4. 77 Fed. Reg. 3075 (Jan. 23, 2012), to be codified in 12 C.F.R. § 360.10.

5. 77 Fed. Reg. 594 (Jan. 5, 2012).

6. See Interagency Counterparty Credit Risk Management Guidance, S&R Letter 11-10 (July 5, 2011). Note that this guidance covers all U.S. bank holding companies and banks.

7. Separately, the federal banking agencies and the U.S. Treasury proposed stress test guidance, which will be reflected in the regulation governing stress tests. See 76 Fed. Reg. 35072 (June 15, 2011).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

United States: Dodd-Frank at 2: Summary