Will Dodd-Frank Drive the Financial Industry Overseas?
WASHINGTON — In the battle over Dodd-Frank implementation, large U.S. banks may do well to remember the story of the boy who cried wolf.
For years, banks and Wall Street have argued that over-regulation will drive the financial services industry overseas, a claim that has rung hollow as such a scenario has so far failed to materialize.
But many observers are now saying the regulatory reform law, by adding significant requirements on domestic banks not faced by European and other international financial firms, may finally be a tipping point.
They point to several provisons of Dodd-Frank, including the Volcker Rule, "push-out" requirements for certain derivatives activities, ongoing stress tests, and additional capital requirements.
"The real concern is the layering on of Dodd-Frank, and the fact that it imposes a whole set of burdens that don't apply universally," said Greg Lyons, a partner at Debevoise & Plimpton LLP. "If you go back to the beginning to the Group of 20 nations meeting, there was this underlying theme of it's got to be uniform, international rules, and that changed when Dodd-Frank passed."
To some, the threat is more rhetorical than real. Speaking at a hearing last month, Rep. Barney Frank, the lead Democrat on the House Financial Services Committee, noted that European banks make similar claims to their regulators in the hopes for lighter treatment. He feared that if American and European banks were successful, it would result in a "net lowering" of standards.
"We are told that we won't have a level playing field here, if we are too tough," said Frank. "In all the years I have heard people complain about the unlevel playing field, I have never heard of an instance in which anybody was at the top of the unlevel playing field. We have a constantly declining playing field in which everybody is at that the bottom and no one has ever been on top."
Karen Shaw Petrou, a managing partner at Federal Financial Analytics, argues there is a conflict inherent in the Dodd-Frank law. Large U.S. firms are effectively penalized for being "too big to fail," but simultaneously face a new resolution regime designed to signal to the market that they will not be protected by the government.
"That's fundamentally asymmetric," said Petrou. "You're dammed for the sin of being too-big-to-fail and simultaneously taxed by your counterparties because you could fail."
Bankers complain that such regulations under Dodd-Frank have hindered a stronger economic recovery, kept capital on the sidelines as rules have been slow to implement, and that tightened standards applicable only to the U.S. will put them at a disadvantage.
As a result, the financial services industry has spent more than $50 million lobbying to erode new regulations, while lawmakers have introduced more than two dozen pieces of legislation to weaken provisions in the law.
The Obama administration has sought to make the argument that tougher rules would encourage better investor confidence, and thus draw more business into the U.S. But that promising prognosis is too early of a call to make.
"That's an open question," said Petrou. "If Secretary Geithner is right then the competitiveness implications will at least be reduced. If he isn't, they won't."
Regulators are also worried that international regulators may not follow the U.S. lead when it comes to financial reform.
"Unless we have international consistency, we will not have a level playing field, we'll have opportunities for regulatory arbitrage and the entire reform process will not be effective," said Federal Reserve Board Chairman Ben Bernanke, at the Financial Stability Oversight Council on July 18.
U.S. firms are particularly concerned about the Volcker Rule, named after the former Federal Reserve Chairman Paul Volcker, which places a ban on proprietary trading and limits investments in hedge funds and private equity funds. So far, other nations have not followed suit with a similar restriction, while U.S. regulators have given little indication of how they plan to implement the provision. (They must do so by October.)
One of the areas still left in the dark is the task of defining the precise boundaries of the provision. Hal Scott, a professor at Harvard Law School, has argued that by defining proprietary trading in a narrow fashion could help to preserve U.S. competitiveness.
Jaret Seiberg, a financial services policy analyst at MF Global's Washington Research Group, said that is especially true when it comes to market making for fixed-income products.
"If we have very tough restrictions on proprietary trading that essentially restrain market making then institutions without those restrictions will be more competitive in the money marking space and will capture more of that business," said Seiberg.
Another sore spot for banks: the derivatives push out, one of the most complex undertakings by Dodd-Frank. Under the law, banking companies must "push out" certain derivatives activities into non-bank affiliates subject to additional rules or in certain cases divest those activities altogether.
No counterpart in Europe or Asia have proposed similar regulations, fueling fears it could hurt U.S. banks' competitiveness.
"If we are going to have all of these margin rules and the rest of the world doesn't, where is that business going to go?" said Seiberg. "It's going to go where there aren't the same levels of margin requirements."
Some observers said the end result will be to grow the so-called "shadow" banking system, rather than regulate it. "Is the economy as a whole better off having those kinds of operations engaged by entities wholly outside of the framework?" said Lyons. "It's a fair question."
There is also a concern over the requirements for annual stress tests by the Fed, which will determine whether a bank can pay dividends or participate in any share repurchases. Other banks outside of the U.S. may face stress tests but are not required to submit their annual capital plans, for approval, at the start of the year.
"Where we seem to be going in the United States — it's almost as if we have a policy of saying, 'Because we are so concerned about our inability to supervise banks as well as we would like to we're going to impose high capital adequacy requirements on banks,'" said Ernest Patrikis, a lawyer at White & Case LLP. A practice, he says, "that opts for regulation over supervision; rigid numbers over qualitative work."
Many view the U.S. as racing too far ahead of the rest of the world.
"The world is not moving in lock step," Oliver Ireland, a partner at Morrison & Foerster. "People have to recognize, and I think people do recognize, that to the extent that people aspire to be major financial centers be it in the U.S., or E.U., or in Asia, when you wind up with a climate that is more conducive to business; businesses are going to migrate there."
Bankers also worry they will face higher penalties for being considered systemically important than overseas companies. Although international regulators have agreed to a capital surcharge of between 1% to 2.5%, Dodd-Frank gives domestic agencies leeway to go further. (The Fed is expected to put out a proposal by the end of the summer).
U.S. banks also face a resolution regime under the Dodd-Frank, including requirements to file living wills that detail how they could be dismantled in a crisis. But European countries right now are continuing to prop up many banks and have not moved forward with resolution plans.
This week the Financial Stability Board, along with the Basel Committee on Banking Supervision released a paper discussing cross-border resolution, but said there was more work left to be done.
"It seems to me that all three of those things have a significant potential to put U.S. financial institutions at a competitive disadvantage to foreign financial institutions," said Ireland. "How big that disadvantage is, of course, dependent on what the foreign jurisdictions do."
For now, there seems to be no signs of a mass exodus of banks leaving the U.S.
"The U.S. market is still important and vibrant enough," said Lyons. "From a regulatory perspective, I would imagine that U.S. bank regulators would not look favorably upon somebody saying, 'We're going to move our headquarters to some other country to reduce our capital requirements, but by the way we still want access to the U.S. market.'"
But, like so many concerns aired by the financial services industry, it's very difficult to know for certain just how U.S. banks could be affected competitively in the long run.
"Financial markets are just too disrupted," said Petrou. "I do not think you can make any normative assumptions about the impact of all of these rules under current market circumstances."