Nearly a year after passage of the landmark Dodd-Frank Wall Street Reform Act, the battle over the future of financial regulation in the United States continues in the lobbies of Washington. Major provisions of the law, most notably those connected with the $600 trillion derivatives market, have yet to be finalized. Meanwhile, regulators are moving at what seems like a snail’s pace to come into compliance with the new rules as they fight their own internal battles.
While moves to kill parts of the law look to be a long shot with the Democrats still in control of the Senate and the Presidency, efforts to further delay implementation of certain provisions could ultimately be successful. This delay could give Wall Street the breathing room it needs to regroup and possibly snuff out parts of the act they don’t particularly care for.
The Dodd-Frank Act, named for now former Senator Christopher Dodd of Connecticut and Representative Barney Frank of Massachusetts, touched on nearly every corner of the financial system, tightening oversight in areas thought to be responsible for the financial crisis. Banks reluctantly supported most of the provisions in the Act, but they drew a clear line at supporting moves to reform the lucrative derivatives market. Wall Street had minted money in this opaque corner of the market for years, reaping fat margins brokering bespoke and complicated deals outside the view of regulators. But a lack of transparency and counterparty credit risk was seen as one of the major contributors to the financial crisis.
Dodd-Frank called for most derivative contracts to go through a central clearing exchange, with prices to be reported to the market and adequate collateral collected to prevent a firm from taking on too much risk. But while this would arguably make the market safer, and prevent another AIG-like disaster, it also would wipe out the fat margins that the banks have enjoyed for years trading in this opaque market, potentially costing them billions of dollars in future revenue.
The banks at risk of losing the most are those with massive swap trading operations, namely JP Morgan (JPM) and Goldman Sachs (GS). Jamie Dimon, JP Morgan’s chief executive officer, has been critical of Washington’s meddling into the derivatives market, saying that the new rules would “stifle economic growth.” Speaking on a quarterly earnings conference call last year, Dimon noted that the new rules could cost the bank several hundred million dollars to $2 billion in lost revenue each year.
The whole situation becomes more complicated now that the Republicans have control the House. They are worried that parts of Dodd-Frank, especially the new derivatives rules, could hurt the competitiveness of U.S. banks, as well as the economic recovery.
So they’re taking their time. “There is no need to rush and meet arbitrary deadlines when the rest of the world is at least 18 months behind the United States,” Representative Spencer Bachus, the Republican from Alabama and chairman of the House Financial Services Committee, said last month in a public statement.
But Democrats see the need to rush. An 18-month delay would push the implementation phase past the crucial 2012 election where the Republicans could potentially retake control of the Senate and the Presidency. This would give the Republicans real power to alter and kill parts of Dodd-Frank before they ever go into force. However, analysts see the Republicans actions so far as mostly symbolic since they lack the votes in the Senate to force any real changes to the law.
“All of it is just political wrangling, most of it will go nowhere” says Kevin McPartland, an analyst at the Tabb Group. “Everybody is just trying to make a stand and put their position on the record, but in the end it’s not really going to have any impact.”
But this has gone beyond partisan ranker at this point. Shortly after the House voted along party lines to delay implementation of the derivatives section, New York Democratic Senators Chuck Schumer and Kirsten Gillibrand, along with all 16 Democratic House members from New York, issued a letter to regulators expressing their concern over the implementation of the new derivatives rules.
A competitive disadvantage
Like the Republicans, the New York Democratic members were concerned that the new rules would put U.S. banks at a competitive disadvantage to their non-U.S. counterparts, most notably Deutsche Bank and Barclays, as they would not have to adhere to the strict new rules governing derivatives when dealing with non-U.S. clients. They want U.S. banks to therefore be exempt from the new rules when they deal with non-U.S. clients.
It is of course no surprise why the New York members broke ranks, since the state is Wall Street’s home turf. But it is still unclear what this little uprising will accomplish. After all, allowing U.S. banks to avoid regulatory oversight when dealing with foreign clients could still threaten the safety and soundness of the U.S. economy. Take the case of AIG (AIG), which nearly crippled the entire financial system in 2008 over derivatives. The majority of counterparties to AIG’s toxic credit default swaps that the U.S. government bailed out were foreign banks — to the tune of $57.8 billion.
But if Republicans and the New York Democrats aren’t able to delay Dodd-Frank from coming into force, then regulators stand a good chance of doing that on their own. It turns out that the regulators aren’t ready to implement all the new rules and regulations that come with the Act by the mandated July 21st deadline. In fact, they are probably going to miss it by a mile. The Commodity Futures Trading Commission, headed by former Goldman Sachs executive Gary Gensler, has been dragging its heels when it comes to implementing the dozens of new rules associated with the Act. The agency seems to be overloaded with thousands of public comments it has received on the new rules, a large majority of which are from the banks. But politics may serve to slow down the regulators even further.
“The Republicans will never be able to get any legislation changes through, but they are hoping to get the House Republicans to hold out against adequate funding of the regulators,” Barney Frank, co-author of the Dodd-Frank Act and the ranking Democrat on the House Financial Services Committee, told Fortune. “And it is easier to deny an agency funding than change the legislation that creates it.”
For years the CFTC has been operating with a limited budget. But with even more responsibilities it is being asked to do more with less. The agency requested through the White House $304 million for its budget this year as it gets ready to implement and begin enforcing the new rules. The Republicans, who are in control of the powerful appropriations committee, earmarked just $202 million for the agency this year and just $172 million for 2012.
“Appropriations is the only area where the Republicans have strength,” Rep. Frank says. “The President can’t force [House Republicans] to vote more money – you can stop bad things with a veto but you can’t use the veto to force good things.”
It is unclear how this reduction in budget will slow down the implementation of the new derivatives rules. It could take several more months to get the agency ready. What is clear is that it will reduce the effectiveness of the agency in policing the Street — if the rules ever come into force.
“I think if funding stays as low as it is the implementation period will be longer,” McPartland says. “To get prepared for the new derivative rules each of the large banks are spending between $200 and $300 million, which is more than the CFTC’s entire budget – that inequality almost speaks for itself.”
For the moment Wall Street is preparing for the worst and hoping for the best when it comes to the new derivatives rules. Most banks have already taken steps to comply with parts of the Act even though the implementation date of the new rules remains up in the air. But if Wall Street gets its way, all that preparation will have gone to waste as the new rules end up on the cutting room floor. That is one loss that the banks would most likely be very happy to absorb.
