Dodd-Frank: content, purpose, implementation status, and issues.
Introduction and summary
As financial regulation evolved over the past 80 years, it became
common to introduce new legislation with the claim that “this is
the most significant regulatory reform since the Great Depression and
the Banking Act of 1933.” On July 21, 2010, following the 2008-09
financial crisis, President Barack Obama signed into law the Dodd-Frank
Wall Street Reform and Consumer Protection Act (hereafter Dodd-Frank).
In the view of many in the industry, Dodd-Frank became the new standard
against which all future reforms would be compared. (1) The stated goals
of the act were to provide for financial regulatory reform, to protect
consumers and investors, to put an end to too-big-to-fail, to regulate
the over-the-counter (OTC) derivatives markets, to prevent another
financial crisis, and for other purposes. The act has far-reaching
implications for industry stability and how financial services firms
will conduct business in the future.
Implementation of Dodd-Frank requires the development of some 250
new regulatory rules and various mandated studies. (2) There is also the
need to introduce and staff a number of new entities (bureaus, offices,
and councils) with responsibility to study, evaluate, and promote
consumer protection and financial stability. Additionally, there is a
mandate for regulators to identify and increase regulatory scrutiny of
systemically important institutions. As a result, macroprudential
regulation (aimed at mitigating risk to the financial system as a whole)
will play a much more important role than it has in the past (see
Bernanke, 2011). Two years into the implementation of the act, much has
been done, but much remains to be done.
The act continues to be debated in the political, business, and
public arenas. Were the right lessons learned from the recent crisis?
Were the appropriate reforms introduced in the new regulations? (3) Did
the act go far enough or too far? Were the regulators given too much
discretion in implementing the act? How burdensome are the new
regulations and how will the intermediation process be affected? Will
financial innovation be affected? Might regulatory reform induce some
current financial activities to shift toward the less-regulated shadow
financial sector? (4) Are banks finding ways to effectively avoid or
cushion the impact of the new rules?
In this special issue of Economic Perspectives, we, and the authors
of the accompanying articles, discuss and evaluate the Dodd-Frank Act
from a number of perspectives. In this introductory article, we
summarize the major components of the act addressing prudential
regulation, particularly those aspects that are highlighted in the
accompanying articles. We also discuss the economics behind many of the
reforms considered. This is not an attempt to cover every aspect of the
act–as with any legislation, there are certain issues amended to the
legislation late in the drafting process that are well outside the realm
of financial regulation: The authors of the accompanying articles in
this issue are: a scholar who has been actively involved in critiquing
the new regulation, regulators who are responsible for implementing some
of the more important aspects of the reform, and a financial policy
expert working with a banking trade association.
Matthew Richardson (2012), Charles E. Simon Professor of Applied
Economics at New York University, provides a general evaluation of
Dodd-Frank, highlighting many beneficial aspects of the reforms–these
include efforts to measure and regulate systemic risk; expansion of the
regulatory reach to nonbank, systemically important financial
institutions (SIFIs); and efforts to introduce a new resolution process
for SIFIs. He also addresses what he terms missed opportunities in the
regulatory reform effort and the potential for adverse, unintended
Martin Gruenberg (2012), acting chairman of the Federal Deposit
Insurance Corporation (FDIC), discusses the new powers given to the FDIC
in Dodd-Frank to resolve select institutions deemed to be systemically
important. Prior to Dodd-Frank, the FDIC’s resolution powers were
limited to insured depository institutions. Holding companies or nonbank
financial companies could only be resolved through the bankruptcy
process. Gruenberg discusses the process by which the FDIC can use its
new authority to effectively resolve SIFIs.
Wayne Abernathy (2012), executive vice president at the American
Bankers Association, discusses the process by which the new regulations
have been developed and implemented. Many of the act’s original
deadlines have been missed. Abernathy questions whether the process has
gone as smoothly as suggested by financial regulators. However, he
acknowledges the magnitude of the task and suggests that some
modifications to the act may be necessary if its original intent is to
be realized. He also raises some concern about the competitive impact
across classes of banks–e.g., money center versus community banks.
Mark Van Der Weide (2012), senior associate director of supervision
and regulation at the Board of Governors of the Federal Reserve System,
discusses the Federal Reserve’s efforts to mitigate threats to
financial stability. Much of the effort has been directed at identifying
and quantifying SIFIs. What criteria should be considered? What weights
should be applied to the criteria? Once institutions have been
categorized, the regulatory agencies must then decide how to calibrate
the regulatory apparatus to best address the systemic concerns.
Finally, Scott O’Malia (2012), commissioner of the Commodity
Futures Trading Commission (CFTC), discusses how the CFTC has been
implementing its responsibilities under the act. He raises concerns
about whether the commission is keeping the market adequately informed
about developments. Additionally, he expresses concern about the
commission’s ability to keep up with industry developments and to
leverage technology to support its enhanced regulatory role. He proposes
some adjustments to the existing implementation process.
In this article, we briefly discuss aspects of the Dodd-Frank Act
that are covered by the guest authors in this issue. In particular, we
discuss efforts to enhance financial stability, improve the failure
resolution process, and regulate the over-the-counter derivatives
market. We also outline the purpose of the reforms and the tools
available to regulators to achieve the desired outcomes.
There had been numerous proposals for regulatory reform in recent
years, but most of these proposals differed significantly from
Dodd-Frank. Most recent proposed reforms were more concerned with
restructuring the regulatory agencies than altering prudential
regulation and allowable financial activities. For example, the U.S.
Department of the Treasury (2008) proposed the phasing out of the thrift
charter, the transitioning of thrifts toward a bank charter, and the
elimination of the Office of Thrift Supervision (OTS). (6) It also
recommended a federal regulator for insurance companies. However, there
were few proposed changes to product powers or prudential regulation.
Dodd-Frank also differed from reforms actually put in place over
the previous 30 years in that it reversed the deregulatory trend that
started in the early 1980s. For example, bank and bank holding company
product powers had been expanded with the 1980 Monetary Control Act, the
1982 Garry-St. Germain Act, and the 1999 Gramm-Leach-Bliley Act. The
1980 and 1982 acts also eased deposit pricing restrictions on the
industry. Limitations to geographic expansion were lifted with the 1994
Interstate Banking and Branching Efficiency Act (the Riegle-Neal Act)
and numerous state laws aimed at increasing banks’ ability to
operate across state borders.
Another way in which Dodd-Frank differed from other recent
regulatory reforms was in the flexibility it gave regulators. This
approach contrasts significantly with the FDIC Improvement Act of 1991,
for example, which was enacted at a time when Congress was frustrated
with bank regulators because of the large number of recent bank failures
and resulting large losses to the bank insurance fund–see Kane (1989a,
1989b), Benston and Kaufman (1994), and Young (1993). By contrast, many
parts of the Dodd-Frank Act lack specificity as to how they are to be
implemented, giving regulators significant discretionary authority to
develop and implement rules (Casey, 2011). However, in many cases,
Dodd-Frank imposed deadlines by which reforms need to be in place or
studies need to be completed. This places significant pressure on
regulators to meet the deadlines and implement the reforms while
considering the potential regulatory burden that might be placed on the
industry, as well as any adverse impact that burden may have on the
industry’s ability to carry out its role in markets.
Perhaps the most important objective of Dodd-Frank is to ensure a
safe and stable financial system. Toward that goal, the act shifts from
exclusively concentrating on microprudential regulation, which focuses
on risk at individual institutions, to include macroprudential
regulation, which focuses on overall market stability and systemic risk.
During the financial crisis, it became obvious that the assumption that
the financial system as a whole could be kept safe by regulating
individual institutions was unsound. A purely microprudential approach
ignores interconnections and externalities, whereby the actions of a
single financial institution can induce broader spillover effects that
adversely affect general market conditions, other financial
institutions, and ultimately the economy as a whole. In contrast,
macroprudential regulatory approaches attempt to manage overall
financial system risk. (7) Ideally, macroprudential tools can be used to
induce financial institutions to internalize the costs of their actions
on society, including externalities where costs are generated and
shifted to others. (8) With the increased reliance on macroprudential
regulation, there was also a realization that regulators need to
anticipate forthcoming industry problems.
These challenges were addressed in title I of Dodd-Frank, which
created the Financial Stability Oversight Council (the Council) and the
Office of Financial Research (OFR), which is housed in the U.S. Treasury
Department. In addition, title I provides the Federal Reserve with
additional authority to manage the systemic risk posed by SIFIs. (9)
The Council is structured as a consultative group of financial
regulators. Its role is to identify risks that pose a threat to the
stability of the financial system, promote market discipline, and
respond to emerging threats. To accomplish this, the Council has the
authority to make recommendations about appropriate macroprudential
regulation, to collect information about market activities, and, perhaps
most importantly, to designate systemically important institutions or
activities that will come under the oversight of the Federal Reserve as
the systemic risk regulator. (10) The consultative format of the Council
allows the individual agencies to continue to handle the substantive
supervision of their industry-specific institutions, but also to share
insights and keep the other agencies aware of developments across the
financial industry. By design, this consultative format avoids the
creation of another regulatory bureaucracy, but brings the key
regulatory agencies together in a formal way to contribute to public
The Council consists often voting members and five nonvoting
members, combining the expertise of federal and state regulators and an
insurance expert appointed by the President.
The voting members are as follows:
* Secretary of the Treasury, who serves as the chairman of the
* Chairman of the Board of Governors of the Federal Reserve System;
* Comptroller, Office of the Comptroller of the Currency;
* Director of the Bureau of Consumer Financial Protection;
* Chairman of the Securities and Exchange Commission;
* Chairman of the Federal Deposit Insurance Corporation;
* Chairman of the Commodity Futures Trading Commission;
* Director of the Federal Housing Finance Agency;
* Chairman of the National Credit Union Administration Board; and
* An independent member with insurance expertise, appointed by the
President and confirmed by the Senate for a six-year term.
The nonvoting members, who serve in an advisory capacity, are:
* Director of the Office of Financial Research;
* Director of the Federal Insurance Office;
* A state insurance commissioner designated by the state insurance
* A state banking supervisor designated by the state banking
* A state securities commissioner (or officer) designated by the
state securities commissioners.
The Council’s success will hinge on its ability to maintain a
comprehensive view of the financial system. Given the vast and complex
nature of the financial system, this is a monumental task. The Council
has the authority to request data and information from a number of
sources, including the member agencies, financial institutions (if the
information is not readily available from primary regulators), and the
new OFR. The breadth and quality of this information will be critical in
helping the Council to meet its objective of anticipating threats to
financial stability, such as emerging asset bubbles. The OFR could play
an integral role in this process as it collects, organizes, and analyzes
financial data in its role of supporting the Council and its member
agencies. In addition, the Council’s member agencies could also
conduct more targeted analysis aimed at their particular industry
Perhaps most importantly, the Council can also designate a nonbank
institution as systemically important if the material distress or
failure of the institution would pose a risk to financial stability. In
making these decisions, the Council will consider the nonbank
SIFI’s size, leverage, liquidity profile, interconnectedness, mix
of activities, and importance as a source of credit and liquidity to the
financial system. To facilitate the designation process, the Council can
request data and information from the firm in question, the firm’s
primary regulator, and the OFR. The Council may also ask the Federal
Reserve to conduct examinations of the financial institution to
facilitate the designation process. If, after the evaluation processes,
the company is designated as systemically important, it will be subject
to supervision by the Federal Reserve and enhanced prudential standards.
The Council can also make recommendations to the Federal Reserve
regarding the form that the enhanced prudential standards should take.
These standards must be more stringent than those applicable to other
nonbank financial companies with consolidated assets less than $50
billion. In addition, the standards and requirements are likely to
increase in stringency with the size of the company’s systemic
footprint. The enhanced prudential standards might apply to any or all
of the following:
* Risk-based capital requirements,
* Leverage limits,
* Liquidity requirements,
* Resolution plan and credit exposure reports,
* Concentration and credit exposure limits,
* Contingent capital requirements,
* Enhanced public disclosures,
* Short-term debt limits, or
* Overall risk-management requirements.
In addition to recommendations concerning non-bank SIFIs, the
Council may also recommend that the Federal Reserve apply enhanced
prudential standards to institutions designated by the Council as
financial market utilities (FMUs)–that is, institutions primarily
involved in payment, clearing, or settlement activities that facilitate
the completion of financial transactions. Again, the concern is that
problems at these institutions could have systemic implications for the
effectiveness of the broader financial system. Title VIII of the act
requires the Federal Reserve to develop risk-management standards,
incorporating relevant international standards, for the operations of
these systemically important FMUs with respect to credit, liquidity,
settlement, operational, and legal risk. In fact, the designation of
these systemically important FMUs has proceeded more quickly than has
the designation of nonbank SIFIs. In July, the Council designated eight
FMUs as systemically important and subject to Federal Reserve oversight.
The Council may issue similar recommendations for nonbank SIFIs and
bank holding companies that are not designated as FMUs if the
institutions take part in payment, cleating, and settlement activities.
For example, the Council could make recommendations to impose
restrictions on banks that act as agents in the tri-party repo market.
Furthermore, the Council may provide recommendations to primary
regulators to apply new or more stringent regulation to the activities
and practices undertaken by financial institutions, even if these
financial institutions have not been designated as SIFIs. Such
recommendations can also be applied to specific financial instruments
that are used or sold by these institutions. These recommendations may
be made if a specific practice, activity, or financial instrument could
create or increase the risk of significant liquidity, credit, or other
problems in the financial markets.
Finally, if the Federal Reserve determines that a nonbank SIFI or a
bank holding company with consolidated assets greater than $50 billion
poses a threat to the financial stability of the U.S., upon an
affirmative vote from the Council, it can impose restrictions on the
activities of these institutions. The tools available to the Federal
Reserve to mitigate such risks include:
* Limiting the ability of the company to merge with, acquire,
consolidate with, or otherwise become affiliated with another company;
* Restricting the ability of the company to offer a
financial product or products;
* Requiring the company to terminate one or more activities;
* Imposing conditions on the manner in which the company conducts
* Requiring the company to sell or otherwise transfer assets or
off-balance-sheet items to unaffiliated entities.
Arguably, many institutions and specific areas of the financial
system were not subject to adequate supervision and regulation prior to
the financial crisis. Possible examples include operating units of
insurance giant AIG and global investment bank Lehman Brothers, the OTC
derivatives markets, and consumer mortgage lending. The new oversight
structure and systemic designation processes mandated under Dodd-Frank
are an effort to better capture and regulate institutions and activities
that can threaten the stability of the financial system.
Orderly liquidation authority
Since the failure, and subsequent rescue, of Continental Illinois
National Bank in 1984, there has been a general outcry against the use
of a too-big-to-fail policy and the resulting means by which large,
complex financial institutions were resolved–typically with government
support. (12) The general argument against such policies–which result
in an implicit government guarantee–is that they reduce market
discipline and result in moral hazard, allowing systemically important
firms to take on excessive risk. In addition, these firms obtain a
comparative advantage in the marketplace as a result of their perceived
too-big-to fail status, which lowers the risk premiums on their debt
instruments (deposits, senior debt, and subordinated debt). (13) From a
political perspective, the practice of preferential treatment for any
company goes against the philosophical underpinnings of a capitalist
society. Moreover, in times of financial crisis, the financial industry
appears to be favored by the government. It might seem reasonable,
therefore, to argue that financial firms, like other firms, should be
resolved through the standard bankruptcy process. However, when Lehman
Brothers failed, was not bailed out, and filed for bankruptcy in 2008,
the consequences for the financial markets were severe, putting further
strain on an already stressed system. For policymakers, this experience
underscored the need to develop a more efficient resolution process for
financial institutions that would reduce the risk of market disruption
without making taxpayers accountable for the resolution costs.
U.S. law, like that in most other major jurisdictions, provides for
alternative liquidation (Chapter 7) and rehabilitation (Chapter 11)
procedures upon bankruptcy. However, the interconnected nature of the
financial system gives rise to the need for an alternative failure
resolution process for financial firms. For example, the existing
bankruptcy process provides special treatment for “qualified
financial contracts.” These contracts–particularly repurchase
agreements and derivatives–are insulated from typical bankruptcy
provisions that would prevent creditors from terminating their contracts
or seizing and selling collateral. Therefore, particular creditors of
the failing financial firm are able to terminate, accelerate, or net
contracts, as well as acquire and sell collateral associated with these
contracts to close out their positions. These creditors avoid the
bankruptcy process while other creditors are prevented from closing out
their positions and must enter the process as a general or senior
creditor, depending on their contractual priority.
These “safe harbor provisions” for qualified financial
contracts have created concerns about potential adverse spillover
effects, overutilization of qualified contracts, and inconsistent or
inequitable treatment of creditors. The safe harbor provisions, and the
resulting rush to close out positions or obtain access to collateral,
could lead to significant disruption in financial markets as parties
move quickly to replace the contracts or sell collateral into what may
be very illiquid markets. It has been argued that this could lead to
runs on short-term instruments, which systemically important financial
firms would be holding in sufficient quantities, and fire sales into
unstable markets. (14) That is, it is argued that there could be adverse
The orderly liquidation authority in Dodd-Frank is intended for
troubled institutions that are considered systemically important. When
firms enter the bankruptcy process, the objective is to maximize the
value for creditors and create an orderly process for distributing that
value in order of priority. However, with a systemically important firm,
an optimal resolution process also needs to account for the potential
impact on parties other than the creditors of the firm–that is, the
spillover effects on other financial sector participants and the overall
economy. These are the externalities discussed earlier.
To avoid potential disruptions resulting from resolving a
systemically important firm through the bankruptcy courts, title II of
Dodd-Frank spells out the role of the FDIC, in certain limited cases, as
the orderly liquidation authority for institutions deemed to be
systemically important. (15) In that process, the safe harbor provisions
are eliminated and the FDIC manages the resolution process. The use of
such authority, however, is expected to be extraordinary and only when
the stability of the whole U.S. financial system is in jeopardy. In most
cases, the standard bankruptcy process will continue to apply.
To initiate the orderly liquidation process, the Secretary of the
Treasury will decide if the financial company is in default or in danger
of default, the company is systemically important, and it would be in
the interest of the stakeholders of the financial company to enter into
the orderly resolution process. The Secretary may initiate the process
and recommend that the FDIC be made receiver of the troubled company.
Depending on the type of financial institution, others on the Council
may make a similar recommendation.
Dodd-Frank, however, imposes significant restrictions on the
resolution process. First, the management and board of directors that
were responsible for the failure of the firms must be removed from the
organization. Second, the priority of claims in the resolution process
should be adhered to in allocating firm losses–that is, equity holders
will not receive anything until all the other creditors, including the
FDIC, have been repaid according to their priority. Third, the FDIC will
not take an equity position with the failing firm. Finally, no taxpayer
funds are to be used to prevent the firm from being liquidated. Instead,
the industry, perhaps through special assessments, will incur any losses
from the resolution process.
An important element of the new resolution process is the
requirement that SIFIs provide supervisors with a document indicating
how they could most efficiently be resolved should they encounter
financial problems–the so-called living will (see Avgouleas, Goodhart,
and Schoenmaker, 2010; Bemanke, 2010). (16) One of the major problems
with resolving a large financial institution is the complex
interconnectedness of the various elements of the organization.
Affiliates and subsidiaries may be legally structured in a manner to
achieve certain corporate objectives such as tax avoidance or regulatory
arbitrage that may make the resolution process more difficult. With a
living will in place, regulators can work with the SIFIs to restructure
the organization and avoid these difficulties should resolution become
necessary. (17) Generally, the living wills are intended to provide the
resolution authority with critical information on the firm’s
organizational structure to aid in the resolution process. The first
submission of living wills for banks with assets greater than $125
billion was in July 2012.
Based on Dodd-Frank, the FDIC has put in place plans to accomplish
the twin goals of eliminating too-big-to-fail and taxpayer-funded
bailouts. In the orderly resolution process, the FDIC will act as
receiver and the failing firm will be removed from the bankruptcy
Over-the-counter derivative markets
Title VII of Dodd-Frank establishes a framework for the regulation
of previously unregulated OTC derivatives. Even before the financial
crisis, there were concerns that the OTC derivatives market represented
a risk to the financial system, because it lacked the oversight and risk
management tools typically associated with clearinghouse and exchange
arrangements (see Born, 1998). The legislation brings the swap market
under a joint SEC-CFTC regulatory regime to improve transparency,
governance, and regulatory oversight. Broadly speaking, the legislation
imposes new requirements for the instruments (swaps and security-based
swaps (19)), the market participants (swap dealers and major swap
participants), and the facilities on which the trades will be executed
and cleared (designated contract markets, swap execution facilities, and
derivatives clearing organizations). The regulatory responsibilities are
split between the SEC and the CFTC (the joint regulators). The SEC will
regulate security-based swaps, and the CFTC will regulate other swaps
(i.e., all other transactions defined as swaps that are not security
based). Forward contracts on commodities that are guaranteed for
physical delivery are exempt from the definition of a swap. Foreign
exchange swaps and foreign exchange forwards have also been exempted
from the definition of a swap. (20)
OTC swaps are typically customized bilateral contracts negotiated
between counterparties that sometimes can be traded directly to other
market participants. A swap is an agreement between counterparties to
exchange the cash flows of two distinct reference items. Often, one of
the reference items is fixed and one is floating. Swaps can be based on
various interest rates, exchange rates, currencies, commodities,
securities, indexes, and other reference items. Buyers of OTC swaps are
exposed to liquidity risk–the inability to sell an asset when
necessary–and counterparty risk–the possibility that the seller will
default on the contract’s obligations. Interest rate swaps make up
the largest segment of the swaps market by notional value of contracts
outstanding, approximately $400 trillion as of December 2011. (21)
Another type of swap, a credit default swap (CDS), was a
significant factor in the financial crisis of 2008. (22) These
instruments were originally designed to provide lenders and market
participants with a method to hedge (insure) against the credit risk of
a particular company, institution, or industry. The buyer of a CDS pays
a prenegotiated fixed premium (a percentage of the notional value) to
the seller for the life of the contract in return for a guarantee that
the seller will make a payment (the difference between notional and
market value) if a prespecified credit event occurs on the reference
security. If the buyer of the CDS owned the reference security, the CDS
would be a hedge against losses on that security. If the buyer of the
CDS did not own the reference security, the CDS would be a speculative
short in the form of a naked CDS contract. (23) In either case, the
seller takes a long position on the reference security, collecting
premiums in exchange for providing credit protection to the buyer. The
market for CDS (and the synthetic securities derived from pools of CDS)
was initially concentrated in corporate credit, meaning that the
underlying reference securities were typically corporate loans or bonds.
However, the market expanded into consumer and commercial credit as CDS
contracts were written on residential/commercial mortgage-backed
securities and consumer/commercial asset-backed securities, or tranches
of these securities.
When asset prices deteriorated leading into the financial crisis,
problems in the OTC derivatives market became apparent. Information on
prices, quantities, and firm-specific exposures was limited. In
addition, the lack of central counterparty clearing house (CCP)
arrangements increased the complexity and uncertainty around
counterparty risks. This lack of transparency intensified the withdrawal
of liquidity during the crisis, because financial institutions were
reluctant to enter into lending or OTC derivative contracts without the
ability to properly assess their counterparty’s risk profile. In
addition, many financial institutions owned CDS and other credit
derivatives as hedges against their exposure to structured assets or to
other financial institutions. Given the pre-Dodd-Frank regulatory
regime, certain institutions (such as AIG) sold large amounts of credit
protection in the form of CDS and other types of credit derivatives. As
margin calls and payments were triggered, the insuring institutions were
unable to fulfill their obligations and there was no CCP to cover
payments to the owners of the credit protection. In contrast,
approximately 50 percent of the global OTC interest rate swap market is
cleared by an independent CCP, the SwapClear service of LCH.Clearnet.
This market functioned relatively well during the crisis, even when
Lehman Brothers failed with a $9 trillion portfolio. The risk-management
procedures performed as planned and the collateral that Lehman held
covered all defaults, and the portfolio was successfully unwound and
auctioned off by the CCP (see LCH.Clearnet, 2008).
As a result of Dodd-Frank, the joint regulators will have the power
to determine which types of swaps will have to be cleared through a CCP
and which swaps will be exempt from such clearing requirements. The
joint regulators will also determine the appropriate margin and
collateral requirements for swap transactions cleared on CCPs, taking
into account systemic risk considerations. These requirements are
powerful tools to control risk levels in the system. If one of the
entities involved in a nonexempt swap transaction is a nonfinancial
commercial end-user, then the trade is exempt from any clearing
requirement. CCPs that clear any non-security-based swaps (for example,
interest rate swaps) must register with the CFTC as a derivatives
clearing organization (DCO) and will be subject to reporting,
recordkeeping, and operational guidelines. (24) In addition, many DCOs
will also register as swap data repositories and perform the functions
prescribed in Dodd-Frank, which include making data and information on
market participants’ open swap positions readily available to
regulators. (25) The goal is for all swaps that are mandated to be
cleared centrally to be executed as standardized products on a
designated contract market (e.g., CME Group) or a newly created
swap-execution facility, both of which will be required to follow
reporting, recordkeeping, and operational guidelines set by the joint
regulators. These execution requirements are intended to provide market
participants and regulators with more transparent price and volume data.
Any entity that is substantially involved in making a market for
swaps will be designated as a swap dealer (SD) and any nondealer
substantially involved in trading swaps will be designated as a major
swap participant (MSP). In general, if an entity is a commercial
enterprise using swaps to hedge its activities, it will be exempt from
these definitions. Both SDs and MSPs must register as such and will be
subject to reporting, recordkeeping, and operational guidelines of the
joint regulators, even if the entity is a bank or bank holding company.
If the SD or MSP does not have a prudential regulator, the joint
regulators can impose capital requirements and will impose margin
requirements for noncleared swap transactions. Otherwise, the prudential
regulators will impose these requirements. However, the joint regulators
can prescribe rules that limit the activities of nonbank SDs and MSPs,
even if these entities have prudential regulators. These rules may
include position limits and limitations on the involvement with certain
types of swaps.
The goal of title VII is to enable the CFTC and the SEC to regulate
their markets comprehensively. The legislation imposes new restrictions
and requirements on the instruments, market participants, and trading
platforms. The implementation process is very difficult but of critical
importance, especially given the enormous size and importance of the OTC
derivatives market to the financial system as a whole.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer
Protection Act became law. The purpose of this article has been to set
the stage for this special issue of Economic Perspectives, which
provides a variety of perspectives on the challenges related to
implementing the act. The treatment is not comprehensive. We have chosen
to focus on specific aspects of the reform and their likely impact. We
have not addressed two controversial aspects of Dodd-Frank–the
introduction of the Consumer Financial Protection Bureau (see
Cadwalader, Wickersham & Taft LLP, 2012) and the proposed limits on
banks, and their affiliates, engaging in proprietary trading for their
own account (the so-called Volcker rule; see Duffle, 2012).
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“Living wills as a catalyst for action,” Duisenberg School of
Finance, DSF policy paper, No. 4, May.
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Improvement Act,” in Reforming Financial Institutions and Markets
in the United States, George Kaufman (ed.), Boston: Kluwer Academic
Bernanke, Ben, 2011, “Implementing a macroprudential approach
to supervision and regulation,” in Implementing Dodd-Frank:
Progress to Date and Recommendations for the Future, proceedings of the
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(1) More details and the full text of the act are available at
(2) A number of law firms and consulting firms provide periodic
updates as to the status of Dodd-Frank implementation. See, for example,
Davis Polk & Wardwell LLP (2012).
(3) See, for example, Financial Crisis Inquiry Commission (2011),
which is accompanied by dissents, including that of Peter J. Wallison
(available at http://fcic-statie.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_wallison_dissent.pdf).
(4) See Duffle (2012).
(5) In the case of Dodd-Frank, this includes issues such as
“disclosures relating to conflict minerals originating in the
Democratic Republic of the Congo,” and “reporting requirements
regarding coal or other mine safety.'”
(6) Under Dodd-Frank, chartered thrifts will be supervised by the
national bank regulators and the OTS has been eliminated.
(7) One of the first to stress this need was Borio (2003). For a
more thorough discussion of macroprudential regulation, see Hanson,
Kashyap, and Stein (2011).
(8) Pollution is the classic example of a negative externality,
where the polluting firm imposes costs on others that are not accounted
for in the production process and in determining prices and quantities
of outputs. Regulation should induce the polluters to internalize the
cost they are imposing on others. Systemic risk is the externality
addressed in Dodd-Frank.
(9) The other regulators will also be involved in the regulation of
SIFIs through their role in the Council and the continuation of their
previous regulatory authorities.
(10) Bank holding companies with assets greater than $50 billion
are defined as SIFIs in the act.
(11) The list is of designated FMUs is included in FSOC (2012),
Appendix A, available at
(12) For more on Continental Illinois and means to address the
too-big-to-fail issue, see Wall and Peterson (1990), Evanoff and Wall
(2001), Evanoff, Jagtiani, and Nakata (2011), Bliss and Kaufman (2011),
and Brewer and Jagtiani (2012).
(13) The literature on this topic is quite extensive. See, for
example, Flannery and Sorescu (1996), Evanoff and Wall (2002), DeYoung
et al. (2001), and Kwast et al. (1999).
(14) Some argue that instead of the new orderly liquidation
authority, the existing bankruptcy code should be utilized for financial
firm failures (Skeel, 2012) or that the code should be modified to
better handle systemic financial firm failures (Scott, 2012). For a
discussion of the advantages and disadvantages of using the bankruptcy
code to resolve systemically important firms, see Bliss and Kaufman
(2011) and Board of Governors (2012). For a discussion of the problems
associated with safe harbor provisions, see Skeel and Jackson (2012).
(15) The decision to use the orderly liquidation authority would be
made on a case-by-case basis. Bank holding company and nonbank SIFIs
would qualify for consideration by the authorities to enter the orderly
resolution process. The status of designated FMUs is currently unclear.
(16) It has been suggested that FMUs also be required to develop
living wills, but this has yet to be decided.
(17) Indeed, one of the recommendations in the 2012 FSOC annual
report was to use information from the living wills to simplify
financial firms’ organizational structure. See FSOC (2012).
(18) Some remain skeptical of whether the law will succeed in
making too-big-to-fail a thing of the past and getting taxpayers off the
hook–for example, see Wilmarth (2011).
(19) Security-based swaps are broadly defined as swaps based on a
single security, or a loan, or a narrow-based group, or an index of
securities, or events relating to a single issuer or issuers of
securities in a narrow-based security index.
(20) This was decided by the Secretary of the Treasury, by
authority granted in Dodd-Frank. See
(21) See table 19 in www.bis.org/statistics/otcder/dt1920a.pdf
(22) Such contracts are typically associated with AIG, leading up
to their rescue during the crisis. However the issue with the AIG
contracts may have had more to do with the collateralization “hair
trigger” and the sudden need to meet these calls.
(23) In the case of naked CDS, the notional amount of the contracts
can become greater than the notional amount of the assets on which the
contracts are written.
(24) CCPs that only clear security-based swaps are not subject to
the same requirements.
(25) See www.cftc.gov/ucm/groups/public/@newsroom/documents/file/sdr_qa.pdf.
Douglas D. Evanoff is a vice president and senior research advisor
for banking and financial institutions and William E Moeller is a senior
associate economist in the Economic Research Department of the Federal
Reserve Bank of Chicago.
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