Dodd-Frank Failures Bolster Case for Revamp

In the span of the past several weeks, we have seen regulators created by the Dodd-Frank Act lose two important court decisions over their processes while a third looming ruling could take another swipe at the Consumer Financial Protection Bureau's authority. Meanwhile, several big banks failed yet again to meet a Dodd-Frank standard meant to eliminate "too big to fail."

Nearly six years after Dodd-Frank's passage, can anyone honestly say that this law is working?

The setbacks in the post-crisis legislative reforms include questions over regulators' adherence to administrative law, as well as the statutory bounds of the CFPB's authority. The legal tangling underlines this point: With many of the law's requirements simply too complicated to implement, evidence is mounting that those practical difficulties have led agencies to disregard legal norms as they try to fulfill their missions.

First, a federal judge threw out the determination by the Financial Stability Oversight Council — created by Dodd-Frank — that MetLife was a "systemically important financial institution," or SIFI. Judge Rosemary Collyer chided the FSOC for "fundamental violations of established administrative law" and ruled that the final determination of SIFI status for MetLife was "arbitrary and capricious" without even considering the substantive arguments.

Collyer's decision was a sweet victory for the insurer, but it does not provide redress for the significant financial costs incurred by MetLife in shutting down much of its retail operation in the face of its SIFI designation. More importantly, because the court did not even examine the substantive arguments by MetLife against the SIFI designation — focusing instead on FSOC's departure from its own guidance about the SIFI process — the decision is unlikely to affect the negative bias of regulators against nonbank financial institutions.

The FSOC's reasoning with respect to MetLife makes little sense to those familiar with the insurance industry. The 2008 financial crisis was essentially about a run on liquidity, a cascade of investor fear that created a systemic event. Somehow, the FSOC came to the conclusion that a life insurance company could pose a systemic threat to the financial system, this even though insurers have few significant short-term liquidity needs. Insurers tend to be over-capitalized and are net providers of liquidity to the markets through investment activities, yet the federal regulators who sit on the FSOC somehow missed these key business model distinctions.

Next we have the failure of a number of large banks to gain regulatory approval for the "living wills" that are mandated by Dodd-Frank. A living will is essentially a roadmap for winding down a large bank in the event of a bankruptcy.

The living will provision was just one component of the law aiming to protect the system from the failure of a large firm. Banks drawing up the resolution plans must credibly prove their structures are simple enough that they could be unwound through a traditional bankruptcy without causing systemic chaos and without regulatory intervention.

This is now the second time many of the banks received poor grades. Under the law, the Federal Deposit Insurance Corp. and Federal Reserve Board can ultimately force banks with subpar plans to increase capital or divest assets to become easier to unwind. But the banks' progress so far — as well as the regulators' delay in providing feedback and vague guidance on what makes a good plan — does not inspire confidence.

Reading Dodd-Frank, you might get the impression that Congress really expects regulators to break up a large failed bank, but that is incorrect. The other component aiming to limit the effect of a firm's collapse is the authority for the FDIC to take over a failed bank or nonbank financial institution until the financial crisis has passed. This power arguably would have prevented the failure of Lehman Brothers and Bear Stearns.

The key flaw in the Dodd-Frank law when it comes to living wills and the enhanced resolution authority is that the regulators themselves, not the banks, should be the ones developing the resolution plans. The notion that this process should be conducted by the banks is highly suspect. Trying to guess, in advance, how a bank resolution process might proceed is an entirely speculative exercise.

U.S. banks have long been required to provide detailed information about their affiliated companies to federal regulators. Also, it may surprise readers of American Banker to learn that were a bank taken over by the FDIC under its expanded resolution authority, the receiver would not be required to use the living will to guide it actions. The living will process as it stands today seems to be a terrible waste of time and money.

But the biggest questions about the Dodd-Frank reforms relate to the CFPB, which is arguably the progressive heart of the law. The bureau's latest setback was an April ruling by Judge Richard Leon of the U.S. District Court for the District of Columbia blocking the agency's investigation of an accreditor of for-profit colleges. Leon said the CFPB's pursuit of the company was "well outside" its authority.

The CFPB also is under attack for its targeting of the nonbank mortgage firm PHH Corp., which has appealed its $109 million CFPB fine to the U.S. Court of Appeals for the D.C. Circuit. As in the case of the FSOC decision with respect to MetLife, the process used by the CFPB is as much an issue as the underlying facts in the litigation. But the PHH case also scrutinizes the constitutionality of the bureau's authority under Dodd-Frank, specifically the conditions by which a sitting president can remove a CFPB director.

"The president and the Congress have no control over this agency," Ted Olson, the former solicitor general who is representing PHH, argued before the court.

Sadly, the CFPB has chosen to use substantial fines and enforcement actions as its primary regulatory tools — rather than rulemaking subject to public notice and comment — which has greatly antagonized the industry.

And as with the previous examples, the logic used by Congress in crafting the objectives of the Dodd-Frank law for the CFPB seem to be at fault. Even though these disputes may be decided not on the merits of the statute, judges increasingly see the processes carried out by regulators emboldened by the 2010 law as "arbitrary and capricious."

The legal setbacks are ultimately a failure of a law that has proven too unwieldy to implement. Before the next financial crisis, Dodd-Frank is badly in need of review and revision.

Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency.