Can The Dodd-Frank Act Tackle the ‘Too Big To Fail’ Issue?

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As Dodd-Frank Law celebrated its fifth anniversary on 21st July 2015, the Fed got tougher on the big banks.

“The Federal Reserve sent a message to the largest U.S. financial firms: Staying big is going to cost you.”

The central bank urged the eight largest banks in the country to retain an additional capital against any future losses. Similar regulatory reforms have been initiated through the Dodd-Frank Act across big banks ever since the financial collapse in 2008. The Dodd-Frank Wall Street Reform and Consumer Protection Act or simply known as “Dodd-Frank” was passed as a law by the Obama administration in 2010 so that events similar to 2008 are not repeated. The Act gave regulators the power to control the risky financial activities of large banks and address the ‘too big to fail’ (TBTF) issue. The TBTF status allowed large financial firms and big banks to be bailed out during the 2008 crisis because the firms were largely interconnected and the systemic risk arising from their failure could lead to a bigger damage to the economy. Bailing them out was considered the only option by the financial authorities.

After the 2008 financial crisis, many new policies were introduced to simplify the supervision and regulation of large banks. The Dodd-Frank Act introduced regulations like higher capital requirements, aggressive stress testing, restrictions of speculative activities and internal controls to name a few, to closely administer the big banks. This was done so that they are self-reliant in case of any future financial crisis and no support is required through government bailouts. After seven years of the financial collapse and five years of the Dodd-Frank, the TBTF issue remains questionable and vague to many. Dodd- Frank aimed to address the too big to fail problem by separating their risky activities (Volcker Rule), making derivative trading more transparent and imposing stricter capital controls on large banks. The intention behind this was clearly not to eliminate the TBTF problem but ensure that large firms do no pose systemic risk like they did in 2008.

The Volcker Rule

Section 619, the ‘Volcker Rule’ was recommended as a part of the Dodd-Frank Act and passed by the Senate on May 20, 2010 to simplify the supervision of big banks. The Volcker Rule restricts the ways big banks invest by regulating their trading in risky transactions. In other words, the rule prohibits “banking entities” to invest customer deposits in speculative investments through “proprietary trading”. But proprietary trading was not really the root cause for the 2008 financial crisis so introducing Volcker rule might be a futile attempt to address a problem that never existed. Other than this, cross-border issues remain huge and problematic since banks are more globally connected. The Federal Reserve has given banks two more years to meet the requirements of the Volcker Rule by July 21, 2016. The estimates by the Office of the Comptroller of the Currency show that even though the ‘Volcker Rule’ will be expensive and may cost banks $541 million a year, it will make them more efficient and safe from any future crisis. However, these benefits will be “difficult to quantify.” The bottom issue is that if a big bank fails, it will still be a risk to the financial system, irrespective of it being a retail or an investment bank. 

Stricter Capital Regulations

Besides ‘Volcker Rule’ under the Dodd-Frank Act, new capital rules were also introduced resolve the ‘too big to fail’ problem. Strict capital rules are usually applied so that a big bank can sustain itself during an event of a crisis and does not require any bailouts. In December 2014, the Federal Reserve increased the capital requirements for 8 largest banks in the US. Janet L. Yellen, the Fed’s chairwoman said the proposed rule

“would encourage such firms to reduce their systemic footprint and lessen the threat that their failure could pose to overall financial stability.” 

JPMorgan, State Street, Goldman Sachs Morgan Stanley, Bank of New York Mellon, Bank of America, Wells Fargo and Citigroup will have to fully comply by these new regulations by the beginning of 2019. In addition to this, stringent norms under Basel III also require world’s biggest banks to hold at least, twice as much loss-absorbing capital as smaller ones.

However, such rules do not fully address the TBTF issue since they focus on strengthening the big banks, if they meet the capital requirements, rather than allowing them to shrink. The Fed’s rule is aimed more towards those large firms that need short term borrowings to keep them away from failing during a financial crisis.” Norbert and Ligon highlighted the fact that even though these capital requirements provided a cushion to big banks for any future financial crisis, they were filled with “arbitrary measures of risk.” Higher capital requirements would lead to higher costs that could then be passed on to the customers and eventually only shareholders would profit from the high-risk earnings. 

Risk from Derivatives

The absence of regulation played a major part in worsening the 2008 crisis as the derivatives were traded in over the counter i.e. they were not subject to regulation. The Dodd- Frank aimed to move derivatives to public stock exchanges and clearinghouses so that the associated risks could be easily monitored with more transparency in their operations. The Commodity Futures Trading Commission (CFTC) was assigned with the implementation of these new reforms and has so far achieved partial success in implementing the Dodd Frank Title VII- the section that deals with derivatives. But much of the implementation remains incomplete due to lack of governance and coordination between global legislators and regulators. Besides this, the cross international transactions for derivatives still appear unregulated. The big banks also appear bigger with huge exposure to derivatives. JPMorgan Chase, Citibank, Goldman Sachs, Bank of America, Morgan Stanley and Wells Fargo continued to face credit risk exposure to derivatives, which is ‘28 times greater than their total assets’ making markets more complex.

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While driving the derivatives to clearinghouses might have been successful in reducing credit risk and increasing information on type and volume of trade, but it’s the sheer lack of coordination amongst regulators that is delaying the entire reform process.

A Final Thought on The Dodd-Frank and ‘Too Big To Fail’

Clearly, the TBTF problem continues to exist with megabanks continuing to threaten the future economy. Thomas Hoenig, the vice chairman of the Federal Deposit Insurance Corporation (FDIC), found that assets of the four largest U.S. banks amounted to 97 percent of the country’s gross domestic product in 2012. Besides being complex and lengthy, Dodd Frank is also burdened with high compliance costs and delayed implementation. If Dodd- Frank wants to seriously address the TBTF issue, it needs to implement all its rules on big banks without any further interruption.

The Dodd-Frank Act 2010 addresses the biggest financial disaster in eight decades (since the Great Depression in 1930s) and it may take some time to show its influence. While success of the Dodd-Frank is under scrutiny, the TBTF problem remains unaddressed. Even though some parts of Dodd-Frank law may be successful in reducing the systemic risk, a bigger part of the Dodd-Frank Act, that could potentially be effective, has taken way too much time to be implemented.

Post 2008, the US banks have not only become ‘healthier and stronger’ but also ‘bigger and more interconnected.’ Even after five years of its introduction, Dodd-Frank still remains incomplete with roughly 40 percent of 400 proposed rules waiting to be finalized. Ever since the introduction of Dodd-Frank Act, banks have been delaying many important rules in the Act with regulators missing crucial deadlines. Dodd-Frank remains an unfinished business since its regulators have so far missed deadlines on 79 rules. For Dodd-Frank to work its magic it would need to be enforced on time and considered beyond political and financial interests, but for it to be termed ‘infallible’, we would have to wait for another crisis.

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