On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Financial Reform Act, declaring the Financial Reform Act to contain "the strongest consumer financial protections in history." The President added that because of the Financial Reform Act "the American people will never again be asked to foot the bill for Wall Street's mistakes. There will be no more taxpayer-funded bailouts."

Overview

The Financial Reform Act is both comprehensive and expansive in its coverage of financial regulatory reform. In addition to the broad changes mandated by statute, the Financial Reform Act requires hundreds of regulatory rulemakings and scores of studies, whose impact will change the financial landscape for decades to come. The impact of many of the statutory provisions, and all of the regulatory changes and studies, will be phased in over a period of years.

While a number of reforms are aimed at banks and banking regulation, the new legislation will also have a direct impact on nonbank financial companies and their consumers. Notably, the
Financial Reform Act contemplates restricting proprietary trading and financial companies' sponsorship of, or investment in, hedge funds or private equity funds. From a consumer perspective, the legislation aims to protect borrowers from predatory lending practices and to increase lender transparency and accountability.

Most importantly, the Financial Reform Act seeks to bring stability to the U.S. economy by establishing the procedures to be followed in order to anticipate and solve future financial crises and by ensuring that the U.S. Congress plays a role in an open and transparent process.

Stabilization of the Financial System

General. The principal goal of the Financial Reform Act is to create mechanisms to stabilize the economy, to mitigate systemic risks, and to foresee future financial crises. One of the concerns arising from the handling of the recent financial crisis was the perception that the federal government was using financial tools at its disposal, but not in an open and coordinated fashion. Moreover, the federal government did not seem to have all the relevant financial information it needed, in part because many of the key players in the economy were largely unregulated, and regulators did not fully understand the magnitude of the risks that came to destabilize the economies of the United States and the world.

The Financial Stability Oversight Council. To bring some order to this problem, the
Financial Reform Act creates the Financial Stability Oversight Council with power to analyze the ongoing economy and to require regulation of sectors of the economy that were previously unregulated. The Council will have ten voting members and five nonvoting members:

The voting members of the Council are:

  • The Secretary of the Treasury, who will chair the Council;
  • The Chair of the Board of Governors of the Federal Reserve System;
  • The Comptroller of the Currency;
  • The Chair of the Securities and Exchange Commission;
  • The Chair of the Federal Deposit Insurance Corporation, or FDIC;
  • The Chair of the Commodity Futures Trading Commission;
  • The Director of the Federal Housing Finance Agency;
  • The Chair of the National Credit Union Administration Board;
  • The Director of the newly created Bureau of Consumer Financial Protection (discussed in greater detail in a separate Perkins Coie update); and
  • An independent insurance expert appointed by the President and confirmed by the Senate.

The nonvoting members of the Council are:

  • The director of the newly created Office of Financial Research (discussed below);
  • The director of the newly created Federal Insurance Office (discussed below);
  • A state insurance commissioner;
  • A state banking supervisor; and
  • A state securities commissioner.

The Council will meet at least once each quarter to identify and respond to emerging risks within the financial system. In general, the Council will act by a majority of the voting members.

The Council has a mandate to identify risks to U.S. financial stability. To that end, it must gather information, encourage the sharing of data among agencies, and identify gaps in financial regulation.

In addition to its oversight activities, the Council has the authority to:

  • recommend enhanced prudential standards to the Federal Reserve regarding risk-based capital, leverage, liquidity, risk management and other requirements for financial companies and institutions as they grow in complexity and size; and
  • designate, by a two-thirds vote (including the affirmative vote of the Secretary of the Treasury), a nonbank financial company as "systemically important" and, therefore, to be regulated by the Federal Reserve, if the Council determines that the company's ongoing activities or material financial distress could pose a risk to financial stability. This provision was included to enable the Federal Reserve to manage those large, unregulated financial companies whose internal difficulties brought the U.S. economy to the precipice.

Definition of Nonbank Financial Company. What is a "nonbank financial company"? The Financial Reform Act defines the term as meaning any company, other than a bank holding company or a company that is treated as a bank holding company, that is "predominantly engaged in financial activities." The term "predominantly engaged in financial activities" generally means that 85% or more of the company's consolidated annual gross revenues are attributable to activities that are "financial in nature," such as securities underwriting, dealing and market-making, insurance activities, and merchant banking. The Financial Reform Act excludes certain entities from the definition of a nonbank financial company, including U.S. security exchanges, derivative clearing organizations, and farm credit institutions. The Financial Reform Act charges the Federal Reserve with promulgating regulations to determine if a company is predominantly engaged in financial activities.

"Hotel California" Provision. During the recent financial crisis, a number of nonbank financial companies acquired bank subsidiaries to become bank holding companies, thereby becoming subject to Federal Reserve regulation, but also making them eligible for funding under the Troubled Asset Relief Program, or TARP. As the crisis passed, several of these companies sought to return the TARP funding, divest themselves of their banking subsidiaries, and return to their unregulated status. In an effort to maintain Federal Reserve control over these companies, the
Financial Reform Act provides that bank holding companies with $50 billion or more in assets as of January 1, 2010 that received TARP funds will not be able to avoid Federal Reserve supervision by divesting themselves of their bank subsidiaries and ceasing to be bank holding companies. This limitation on the impact of "de-banking" has been called the "Hotel California" provision, in reference to the popular song by the Eagles ("You can check out any time you like, but you can never leave").

Office of Financial Research. The Financial Reform Act creates the Office of Financial Research, which will be housed in the Department of the Treasury and staffed by qualified experts. The Office, as the data collection agency for the Council, will assemble financial data and conduct economic analyses in an effort to identify and monitor emerging risks to the economy. The Council will make this information public through periodic reports and testimony to Congress. The Office of Financial Research will have the authority to issue regulations regarding data collection and may issue subpoenas to financial companies in order to obtain the information necessary to its functioning.

Federal Insurance Office. The Financial Reform Act also creates the Federal Insurance Office, although its activities and goals are not well defined in the Financial Reform Act. It has no regulatory responsibility, but it will enable the Department of the Treasury, where the Office will be located, to create new expertise in insurance regulation. It will gather information about the insurance industry, submit reports and testimony to Congress about the insurance industry, and generally monitor the industry for systemic risk. While it does have some substantive powers in the area of international trade and insurance, the creation of the Federal Insurance Office may be most important as a harbinger of a greater future federal role in the regulation of insurance.

Reports on Credit Exposure. In a further effort to stabilize the financial system and maintain its stability, bank holding companies with $50 billion or more in assets and nonbank financial companies supervised by the Federal Reserve will be required to provide periodic reports on their credit exposure to other financial institutions and other entities' credit exposure to them. In addition, these institutions will be required to limit their aggregate credit exposure to any unaffiliated entity to 25% of its capital stock and surplus; however, this provision will take effect no earlier than three years from enactment. These institutions will also be required to provide advance notice to the Federal Reserve of any acquisition of direct or indirect ownership or control of a company conducting financial activities and with consolidated assets exceeding $10 billion.

Stress Tests. The Financial Reform Act seeks to provide more data to avoid future financial crises by determining if regulated financial entities are sufficiently capitalized. The Federal Reserve will conduct annual stress tests of regulated institutions to ensure that they have the capital, on a consolidated basis, necessary to absorb any potential losses. These government-implemented stress tests will be in addition to self-administered semiannual stress tests (or self-administered annual stress tests for bank holding companies with between $10 and $50 billion in assets). If the Council determines through the stress tests that any institution poses a threat to financial stability, the Federal Reserve will require the institution to maintain a debt-to-equity ratio of no more than 15‑to‑1 and to take off-balance sheet activities into account when determining the institution's compliance with the capital requirement.

The Volcker Rule

General. The "Volcker Rule," named for former Federal Reserve Chairman Paul A. Volcker, attempts to address problems arising from the repeal of the Glass-Steagall Act in 1999. Under Glass-Steagall, there was a legal division between commercial banks, which accepted deposits and many personal and commercial loans, and investment banks, which underwrote and traded securities. Over the years, the lines between these two types of banking were blurring, and Congress acted in 1999 to remove the impediments to commercial banks' engaging in investment banking activities.

The banking regulatory system was established to protect the assets of commercial banks in order to provide assurances of stability to their depositors and borrowers. Investment banks, without the government protections available to commercial banks, had more freedom of action and far fewer worries about compliance with regulations. With the repeal of Glass-Steagall, however, the commercial banks engaged in more speculative activity, while maintaining government protections, and the investment banks began to compete for depositors and loans in a less regulated environment.

Limitations on Proprietary Trading and Investments in Hedge Funds. The Volcker Rule, which goes into effect two years after enactment, attempts to reestablish the pre-1999 separation by limiting the ability of commercial banks to engage in proprietary trading (that is, investing the bank's own funds) or to sponsor hedge funds. The Financial Reform Act prohibits a banking entity (defined as an "insured depository institution") from engaging in proprietary trading, or investing in or sponsoring hedge funds and private equity funds, and limits the relationships a banking entity may have with such funds.

The drafters of the Financial Reform Act included a compromise to permit a commercial bank to make an investment in a hedge fund or private equity fund as long as the bank's investments in all such funds do not exceed 3% of the bank's Tier 1 capital, and the bank's investment in the fund is reduced to not more than 3% of the total ownership of the fund within one year of the fund's creation. Nonbank financial companies regulated by the Federal Reserve will be allowed to engage in such activities, but with additional capital requirements and quantitative limits.

Bank Shutdown and Orderly Liquidation

General. During the recent financial crisis, as financial institutions faced the prospects of insolvency, the only alternative solutions that emerged were government assistance or bankruptcy. Bankruptcy was considered to be a draconian method of closing down a large financial institution, which would have negative economic repercussions throughout the entire financial system. Taxpayer-funded bailouts of the troubled entities seemed to be the only viable alternative. The drafters of the Financial Reform Act were charged with creating a more efficient method of closing down troubled institutions and avoiding the use of taxpayer money.

Shutdown Plans. Few institutions had considered what actions they would take in the event of a deepening financial crisis. To avoid this uncertainty, the Financial Reform Act requires financial institutions with $50 billion or more in assets and nonbank financial companies supervised by the Federal Reserve to periodically submit plans for their rapid and orderly shutdown in the event of material financial distress or failure. Institutions that fail to submit acceptable plans will be subject to higher capital requirements and certain restrictions on their activities.

Liquidation by the FDIC. In addition to planning for the rapid and orderly shutdown of financial institutions, the Financial Reform Act authorizes the FDIC, acting in the capacity of a receiver, to liquidate failed financial companies. The FDIC may seize, break up and wind down failing financial institutions and may also remove responsible parties within management and/or the board of directors of the failing companies. The FDIC will act as receiver, however, only if the Secretary of the Treasury, upon a recommendation from the Board of Governors of the Federal Reserve and the FDIC Board of Directors:

  • determines that the financial company is in default or in danger of default, its failure would have adverse effects on financial stability, and there is no viable private sector alternative to avoid such default; and
  • has received either the acquiescence or consent of the financial company's board of directors to the FDIC's receivership or an order from the U.S. District Court for the District of Columbia authorizing the receivership.

Repayment of Government Advances. The FDIC may borrow funds from the Treasury for the cost of an orderly liquidation. To ensure that taxpayers will not bear the cost of such liquidations, the FDIC may only borrow the amount of funds to liquidate the company that it expects to be repaid from the liquidated assets of the company or from assessments on the financial sector.

If repayment falls short through the process of orderly liquidation, the government will seek repayment first, through the clawback of payment to creditors exceeding liquidation value, and then, from assessments charged to large financial institutions with more than $50 billion in assets, with the higher-risk companies paying more, based on a risk matrix and assessment.

Payments to Executives and Directors. Although the Financial Reform Act does not limit compensation payable to senior banking executives and directors, it does affect the payment rights of those individuals in an orderly liquidation by subordinating their claims for wages, salaries or commissions in liquidation to those of general unsecured creditors. Thus, only claims of shareholders and other equity holders will have a lower priority right of payment.

Changes in the Regulatory Landscape

Elimination of the Office of Thrift Supervision. The Financial Reform Act provides for the eventual elimination of the Office of Thrift Supervision. Supervision of all federal savings associations, including those with federal thrift charters, will be transferred to the Office of the Comptroller of the Currency. Supervision of savings and loan holding companies and their nondepository institution subsidiaries will be transferred to the Federal Reserve. Supervision of all state savings associations will be transferred to the FDIC. These transfers of responsibilities will take place one year after enactment, subject to certain permitted extensions of up to six additional months. The Office of Thrift Supervision will be eliminated 90 days after the completion of the transfers.

Preemption of Certain State Consumer Financial Laws. Additionally, the Office of the Comptroller of the Currency may, in certain circumstances, preempt state consumer financial laws on a case-by-case basis if it finds that the law "prevents or significantly interferes with" the exercise by a national bank of its powers. Preemption will only be effective after prescribed notice and comment procedures are followed.

Emergency Lending by the Federal Reserve

General. The drafters of the Financial Reform Act wanted to authorize the continued provision of liquidity to financial markets during times of financial crisis, while at the same time providing more openness to the process. Members of Congress watched in astonishment as the FDIC and the Federal Reserve provided massive funding to troubled entities, without any input or oversight from Congress. The Financial Reform Act seeks to bring a balance to this process by limiting the ability of the Federal Reserve to provide lending assistance to a single entity unless it is part of a broad-based program.

New Procedures for Federal Reserve Lending. The Financial Reform Act alters the Federal Reserve's emergency lending authority under Section 13(3) of the Federal Reserve Act by prohibiting the Federal Reserve from lending to individual institutions. Instead, the Secretary of the Treasury will be required to approve any lending, and the lending program must be broad-based and apply to a nonfailing institution. The Federal Reserve will also be required to report to Congress to justify the use of this authority and describe the material terms of all Section 13(3) emergency lending, discount window lending and open market transactions. Furthermore, the Government Accountability Office, the audit, evaluation, and investigative arm of Congress, will conduct a one-time audit of the Section 13(3) emergency lending that took place during the financial crisis and will have the authority to conduct future audits of Section 13(3) emergency lending, discount window lending and open market transactions.

Bank Holding Companies and Their Nonbank Subsidiaries

The Financial Reform Act requires the Federal Reserve to examine and regulate nonbank subsidiaries of bank holding companies that engage in activities the bank could perform, such as mortgage lending, on the same schedule and in the same manner as with bank examinations.

Enhanced Capital Standards

In an attempt to enhance the capital structure of U.S. bank holding companies, the
Financial Reform Act (in a portion of the Financial Reform Act known as the "Collins Amendment") imposes capital standards on holding companies that are currently applicable to U.S. insured depository institutions. Under the Financial Reform Act's new capital standards, for example, trust preferred securities, an increasingly used hybrid security consisting of a preferred stock issued by an affiliated special trust and a debt security issued by the institution, will no longer be deemed Tier 1 capital (which is, in general, the core capital of an institution, consisting of common stock, retained earnings and other similar equity); provided, however, that these new rules will be subject to certain phase-in requirements and to exemptions for certain smaller depository institutions.

Mortgage Reform

Limitations on Predatory Lending Practices. Among the provisions related to consumer financial protection are those aimed at mortgage reform and the curbing of predatory lending practices. Perhaps the most significant of these reforms is the establishment of new minimum underwriting standards for residential mortgages, including a requirement that lenders reasonably determine a borrower's ability to repay loans by verifying the borrowers' credit history, current obligations, employment status and income at the time a loan is made.

Regulation of Mortgage Originators and Improper Steering Incentives. The
Financial Reform Act requires the registration of mortgage originators and prohibits certain steering incentives that tend to induce predatory lending practices, such as the existing practices of imposing prepayment penalties on borrowers or compensating mortgage originators based on the terms of loans they originate other than their principal amounts. Lenders will be subject to heightened disclosure obligations under certain mortgages, including providing the maximum possible payment on a variable rate mortgage, warning consumers that their payments may vary based on interest rate changes and disclosing the date on which that rate may be adjusted. Lenders who do not comply with these new standards will be held financially accountable for as much as three years' worth of interest payments and attorneys' fees, if applicable. Additionally, defenses to foreclosure will be available to borrowers if their lenders are noncompliant with these obligations.

Demand Deposit Accounts

The Financial Reform Act repeals the prohibition on the payment by insured depository institutions of interest on demand deposit accounts, such as most checking accounts.

Federal Deposit Insurance Corporation Reforms

Permanent Increase in Maximum Account Insurance. As the FDIC was forced to close banks during the financial crisis, it noted that much of the instability was caused by the withdrawal by depositors of funds from troubled banks in excess of the amount insured by the FDIC. In an attempt to stabilize these deposits, the standard insurance amount was temporarily increased in October 2008 to $250,000 per depositor, per insured bank. This increase is set to expire on December 31, 2013 (after the FDIC already extended it once). On January 1, 2014, therefore, the standard insurance amount was scheduled to return to $100,000 per depositor, per insured bank for all deposit accounts except certain retirement accounts, which would have remained at $250,000 per depositor, per insured bank.

The Financial Reform Act permanently increases the standard maximum federal deposit insurance coverage for banks, thrifts and credit unions to $250,000. Investors in longer-term certificates of deposit that would have matured after the original December 2013 expiration date will now be protected by the increased insurance. The change is retroactive to January 1, 2008, so depositors who lost money at the banks that failed before the limit was originally raised in October 2008 will be reimbursed for money they were unable to recover at the time.

Increase in Insurance Available for Non-Interest-Bearing Accounts. While the temporary FDIC program to provide unlimited insurance on all non-interest-bearing demand transaction accounts will expire on December 31, 2010, it will be replaced by a similar program that will continue in effect until January 1, 2013.

Program to Guarantee Obligations of Solvent Depository Institutions. Congress was concerned about the unilateral ability of the FDIC to provide large sums of money to distressed companies. While the FDIC will now be able to create a widely available program to guarantee obligations of solvent financial institutions, the guarantee will only be instituted after a number of requirements are met, including the determination by a two-thirds majority of the Federal Reserve Board and the FDIC Board that a threat to financial stability is present; and the approval by the Secretary of the Treasury of the terms and conditions of the guarantee and the overall cap. In addition, a joint resolution of Congress (adopted on an expedited basis according to procedures set forth in the Financial Reform Act) must approve the maximum amount of debt that can be guaranteed.

Revised Method of Assessing Insurance Fees. The FDIC is charged with amending its regulations regarding the assessment for federal deposit insurance by basing the charges on assets and equity, instead of U.S. account deposits. This shift would have the effect of shifting the burden of assessments toward larger institutions that have significant assets and operations outside the United States. The minimum reserve ratio for the federal deposit insurance fund will increase from 1.15% to 1.35% (but the FDIC is instructed to offset the effect of this increase on institutions with less than $10 billion in assets).

Additional Information

This Update is only intended to provide a summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. You can read the full text of the final legislation, as enacted, at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.