One Year Later: Where Dodd-Frank is Falling Behind

Second of two parts

WASHINGTON — Facing an aggressive implementation schedule for the Dodd-Frank Act, regulators made some progress on key issues, but left some of the biggest ticket items lagging behind.

A year after its passage, regulators have not identified which financial institutions are considered systemically important, a critical decision that allows supervisors to more closely regulate them. They have also delayed rules designed to make derivatives trades more transparent, failed to fully set up a new agency designed to collect important data on large financial firms and stalled on a ban on proprietary trading.

"I don't see progress. There's been a lot of talk," former Sen. Ted Kaufman, D-Del., said of the law's implementation overall.

How quickly regulators can pick up the pace will be a determining factor in the success — or failure — of the regulatory reform law.

Office of Financial Research
When Congress was writing legislation last year to overhaul U.S. financial regulation, one of the problems that lawmakers sought to remedy was that regulators lacked important industry data.

For example, as AIG was hurtling into the abyss in 2008, financial regulators did not have access to its credit default swaps book, which might have revealed the insurer's precarious situation.

Lawmakers sought to fix that problem by establishing a new data-collection and research office within the Department of the Treasury.

As a result, the Office of Financial Research now has the authority, backed by subpoena power, to collect certain data that financial firms have previously kept secret. It can then share that data with other agencies, which can use it to monitor stability in the financial markets.

The office has substantial autonomy, and it is supposed to be led by a director who will serve a six-year term and is subject to Senate confirmation. But nearly a year after the law's passage, the Obama administration has yet to tap someone for the post.

At a Senate hearing in May, Deputy Treasury Secretary Neal Wolin sought to emphasize the progress that has been made in staffing the new office, including the hiring of former Morgan Stanley chief economist Richard Berner to help build the OFR. Asked about timing of a nomination for the office's director, Wolin said, "I expect the president will make a nomination for that important job soon."

Wolin's response drew a rebuke from Sen. Mark Warner, D-Va. "We need a nominee," Warner said.

Nine weeks later, the post remains vacant.

Treasury officials argue they are making great strides setting up the agency. Yet unlike the Consumer Financial Protection Bureau, which did not have a nominee to lead it until the White House named former Ohio Attorney General Richard Cordray over the weekend, observers question the administration's commitment to the financial-research office.

Some note that the administration never pushed for the research office. Instead, it was the brainchild of Sen. Jack Reed, the No. 2 on the Senate Banking Committee, who successfully added it to the reform bill.b

But observers view the office as a critical way to gain data on systemic threats and say the administration needs to move faster in setting it up. Nominating a director is critical, many say.

"You can't expect any of these agencies to function without a director," said Karen Shaw Petrou of Federal Financial Analytics.

Systemic identifications
Dodd-Frank addresses the problem of "too big to fail" financial institutions in part by asking regulators to identify large, interconnected institutions whose failure would pose a threat to financial stability, and then subjecting them to heightened supervision.

But despite giving that job to the Financial Stability Oversight Council, a newly established umbrella organization made up of all the financial regulators, precious little headway has been made.

In January, FSOC issued a proposal on the topic, but it mostly mimicked the law's admittedly vague criteria for identifying systemic risk without providing any real details. The law states that FSOC should consider factors such as the firm's size, scope, scale, concentration, and interconnectedness.

Even Sheila Bair, the then-chairman of the Federal Deposit Insurance Corp. and a member of the council, was critical of the lack of detail.

"This lack of specificity and certainty in the designation process is itself a burden on the industry and an impediment to prompt and effective implementation of the designation process," Bair said in written testimony to Congress on May 12. "The sooner we develop and publish these metrics, the sooner this needless uncertainty can be resolved."

The uncertainty is causing consternation on Wall Street, where firms would like to take steps to avoid being classified as systemically significant. Right now they don't feel like they have enough information.

"We're still just speculating who's going to be pulled in," said Mark Calabria, a former Republican staffer on the Senate Banking Committee who is now director of financial regulation studies at the Cato Institute.

Behind the scenes, regulators are at odds over the designation of nonbanks, raising questions about when they will release a new plan. The FDIC favors selecting institutions from a broader pool to screen them for a possible systemic determination and plan for a hypothetical resolution. The Fed, meanwhile, wants to keep the category narrower so it can focus on institutions that truly pose a threat to the economy.

Volcker Rule
Named after former Fed Chairman Paul Volcker, the Volcker Rule is designed to accomplish two major things.

First, it prohibits banks from engaging in proprietary trading. Secondly, it places restrictions on the ability of banks to own hedge funds and private equity funds.

In January, the Financial Stability Oversight Council released a 79-page study on the Volcker Rule. The study was intended to inform the rulemaking process, but it left a lot of questions to the regulators, who now have until October to adopt regulations that will implement the Volcker Rule.

As of today, however, regulators have yet to release a proposal, and banks are engaging in an intense behind-the-scenes lobbying effort in order to narrow the Volcker Rule's impact.

One key question is how proprietary trading will be defined. Some of the large Wall Street banks have begun to spin off activity that will clearly count as proprietary trading — for example, Morgan Stanley stated in January that it planned to spin off its proprietary trading desk by the end of 2012 — but there remain a lot of gray areas.

"Until we see what the regulators have done, it will be hard to know how effectively the banks have tackled this issue," said Amy Friend, who served as chief counsel at the Senate Banking Committee during the debate over Dodd-Frank and is now a managing director at Promontory Financial Group.

Derivatives Reform
Perhaps the most complex aspect of the reform law, the vast market of derivatives presents an enormous challenge to regulators.

Prior to Dodd-Frank, derivatives were mostly traded over the counter, rather than on exchanges, and without a requirement for centralized clearing.

As a result, derivatives markets have been criticized for lacking transparency and for adding risk to the financial system. The reform law seeks to change all of that.

Much of the implementation work falls to the Commodity Futures Trading Commission, which has around 700 employees and has seen its responsibilities expand substantially. Between July and September 2011 alone, the CFTC is supposed to complete 42 statutory rulemakings, according to the law firm Davis Polk.

Under the circumstances, it is perhaps no surprise that the agency last month decided to delay implementation of certain rules until December. And there have been other snags.

House Republicans are seeking to reduce the CFTC's budget by about 15% at a time when the agency says that it needs to add hundreds of staffers to carry out its new responsibilities.

The CFTC has also been facing intense lobbying from financial firms. In some cases, firms are hoping to influence the rulemaking in a way that provides them an advantage, since the new derivatives rules create big opportunities to make money. In other cases, firms are hoping to weaken the new rules by arguing that lots of derivatives trading will otherwise migrate to Europe, where the rules are currently more lax.

Furthermore, in April the Treasury Department proposed to exempt foreign exchange swaps, which can be used to hedge exposure to or speculate in different currencies, from the law's requirements for exchange trading and central clearing. Treasury argued that such rules could disrupt the market and have serious economic consequences.

Despite all of these challenges, reform advocates praise the effort that the CFTC is making, saying it is difficult for the agency to complete the rules within the timeline that was mandated for them.

"I think they've done heroic work," said Michael Greenberger, a University of Maryland law professor and former official at the CFTC during the Clinton Administration.

Risk Retention
One of the key lessons that legislators drew from the financial crisis is that mortgage originators need to have some skin in the game. If originators can easily offload all of the risk of default to the next link in the securitization chain, they have no incentive to care about whether the loan will actually be repaid.

To address this concern, the 2010 reform law includes a requirement that mortgage lenders retain at least 5% of each borrower's credit risk. But the law also contains an important caveat. It states that "qualified residential mortgages" are exempt from the risk retention requirement. And it leaves it to the regulators to define a qualified residential mortgage.

The question now is whether the 5% risk retention standard will become an industry norm, with the qualified residential mortgage as a relatively rare exception to the rule, or vice versa.

In March, regulators issued a proposal that would define a qualified residential mortgage as one with at least a 20% down payment. They also proposed other criteria, including debt-to-income limitations.

The intent was clearly to create a narrow slice of the mortgage pie, with relatively few borrowers qualifying for QRM loans.

But industry players and consumer groups have rebelled, arguing the 20% requirements is too stringent and will drive up the cost of borrowing for anyone with a smaller downpayment. The industry has won substantial support from both Republicans and Democrats in Congress; more than 320 lawmakers have signed onto letters calling on regulators to at least consider relaxing the 20% plan.

While the risk retention proposal was supposed to be finished within a year, that is now highly unlikely.

Regulators agreed to delay a comment deadline to Aug. 1 from June 10, and must still sort through those responses before crafting a final rule. As a result, risk retention is likely to be stalled for some time.

"I can't really think of a rule so far that has gotten that amount of pushback," Calabria said.