The legislative barometer has been signaling change for months and the monumental Dodd-Frank Wall Street Reform and Consumer Protection Act is now very close to becoming law.
This legislation will impact many aspects of financial institutions' business and will alter the way many institutions interact with their corporate and retail customers, analysts, regulators and shareholders. As new rules and rulemaking bodies are established, there will be a constant management challenge for every type of bank, with each potentially facing a different set of implications depending on its business mix and organizational structure.
Perhaps the biggest impact will come from the formation of a financial stability council, with systemic oversight.
A new category of "systemically important" institutions will be created, and it will likely include banks as well as nonbanks. Firms in this group will face new information and reporting provisions, although it will be some time before we know precisely what they are. The law's text tells us some, and others are extensions of existing regulatory techniques. For example, stress testing appears to be becoming a routine examination technique. In some cases, the scenarios being developed for so-called reverse stress tests are improving management thinking about an institution's business mix and the adequacy of its contingent liquidity plans.
But the regulator probably will request information not currently generated by banks and other significant firms. It's a good bet the regulator will continually shift its demands as it monitors different aspects of risk in the financial system; firms will probably need to adopt more dynamic information provision capabilities. In addition, the making and maintaining of "living wills" as part of a new focus on resolution represents a further set of costs and practical issues.
Regulators, most notably the Senior Supervisors Group, have cited the complexity of the industry's technological infrastructure as a hindrance in identifying and measuring risk within the system. In response to closer regulatory scrutiny as well as their own risk management requirements, banks continue to grapple with the need to extract meaningful data from a plethora of legacy and other systems.
The challenges are significant. If experience is a guide, the data and reporting requirements will probably take quite some time to be implemented and be phased in over a period of several years. The requirements figure to be burdensome, expensive and permanent. Participants in the financial services industry will, however, have opportunities to provide meaningful input and to use the dialogue with regulators to develop their own cost-effective compliance strategies.
It may be tempting for those outside this group — those just below the systemically important group — to assume that they can continue with business as usual, that the new law will not directly affect them in this respect. But it's doubtful this will be the case. These firms run the risk that a change in the systemic environment could be deemed sufficient by the regulator to pull them up into the list of systemically important firms. It is conceivable that as the new regulator gears up it might impose new reporting requirements specifically to monitor these almost-there-but-not-quite firms for signs of increasing riskiness. Markets are dynamic and so will be the evolving information needs of the systemic regulator.
Here's something else to keep in mind: Some of the broader effects of the law will be subtle and will only become evident as further flesh gets added to today's legal bones based on directives and practices that are bound to emerge.
It is helpful to keep regulatory reform in context. What will really drive earnings in financial services for the next 15 years? How the U.S. and global economy performs could be at least as important as new rules. Still, it's no exaggeration to say that the Dodd-Frank Act will lead to a realignment that will test financial firms in fundamental ways. Moreover, the regulatory storm will rumble on globally. Only with time will it become clear how the consequences of U.S. domestic reforms will compare with those of proposed changes elsewhere. The thunder will be audible for many months, even as financial firms get down to the business of adjusting to the U.S. law.