Dodd-Frank Act: An Overview for Community Banks
Trying to understand the whole of H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act, is tough. The Act is long, complex and if you are focusing directly on the credit crisis, the Act is not particularly intuitive. Much of the Act has only a tangential relationship to the core purpose of the bill, preventing a reoccurrence of the credit crisis. Here is a brief, title by title summary to help, and along the way, I will point out the more important sections for community bankers.
I. Financial Stability – addresses the core purpose of the bill by creating a new oversight regulator, the Financial Stability Oversight Council. This council of regulators will monitor the financial system for "systemic risk" and will determine which entities pose significant systemic risk. Generally speaking, it will make recommendations to regulators for the implementation of the increased risk standards, also known as prudential regulation, to be applied to bank-holding companies with total consolidated assets of $50 billion or more and to designated nonbanks.
For community banks, a key provision is the exemption for banks of less than $50 million in assets from a provision that excludes from Tier I capital calculations trust preferred securities. The Federal Reserve's policy on small bank holding companies was also preserved. The Act also grandfathers trust preferred securities issued before May 19, 2010 by bank holding companies with less than $15 billion in total assets.
II. Orderly Liquidation Authority – again, a core purpose title. It establishes a framework for the liquidation by the Federal Deposit Insurance Corporation ("FDIC") of large institutions that pose systemic risk. The Treasury supplies liquidity for the liquidation that must be paid back in 60 months.
III. Enhancing Financial Institution Safety and Soundness –merges the Office of Thrift Supervision (“OTS”) into the Office of the Comptroller of the Currency ("OOC"). The OTS regulatory responsibilities will be spread among other regulators. The Federal Reserve will regulate savings and loan holding companies, the OCC will regulate federal savings associations, and the FDIC will regulate State savings associations. The transfer of functions is to occur on the date one year from the date of enactment but may be extended for up to eighteen months from the date of enactment. The regulators are required to issue regulations for the entities that are newly under their regulatory umbrella no later than the date of the transfer of the functions. Ninety days after the transfer, the OTS will go out of existence and its employees will become employees of the OCC or the FDIC.
For community banks, a key provision in this title changes in the assessment base for deposit insurance. Before, the base was domestic deposits less tangible equity. Now, the base is average consolidated total assets minus average tangible equity. The result is that larger financial institutions, which have more non-deposit assets, will pay a greater percentage of the aggregate insurance assessment and smaller banks will pay less than they would have, perhaps as much as $4.5 billion less over the next three years.
Another key provision for community banks is the permanent increase in FDIC deposit insurance per depositor from $100,000 to $250,000, and the extension of the unlimited deposit coverage for non-interest bearing transaction accounts for two years. HR 4173 also increases the minimum reserve ratio for the Deposit Insurance Fund from 1.15 percent to 1.35 percent, but exempts institutions with assets of less than $10 billion from the cost of the increase.
IV. Regulation of Advisers to Hedge Funds and Others – requires most advisors to “private funds” register with the SEC. “Private funds” are defined to cover most private equity funds, hedge funds, and venture capital funds.
A key provision of interest to community banks is a change in the definition of “accredited investor”: for the next five years, the net worth calculation for determining an accredited investor is $1 million excluding the value of a primary residence. Previously, there was no such exclusion. After five years, the Securities and Exchange Commission is required to adjust the $1 million threshold for inflation. The change was effective when the Act was effective. On July 23rd, the SEC answered questions concerning how the indebtedness secured by the primary residence should be treated, indicating that such indebtedness should be deducted from an investor’s net worth while any equity in the primary residence is excluded. Community banks engaged in capital raising activities must amend the definition of “accredited investor” to conform.
V. Insurance – establishes the Federal Insurance Office, housed in the Office of the Treasury. It is to review the insurance industry and study for Congress the federal regulation of insurance.
VI. Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions – This title implements the so-called modified Volcker Rule. The rule limits the ability of certain bank and bank-related entities to engage in proprietary trading or investing in hedge funds and private equity funds to 3 percent of the entity’s Tier 1 capital, among other restrictions. "Proprietary trading" is defined to include the purchase or sale of any security, any derivative, any contract for the sale of a commodity for future delivery, or option on such instrument.
For community banks, the key provisions in this title are: a moratorium on deposit insurance applications for three years for new credit card banks, industrial loan companies and trust banks owned by commercial companies, the expansion of the definition of affiliate transactions to cover certain kinds of security transactions such as repurchase agreement, derivative transaction and securities borrowing; and the codification of the source of strength doctrine, the long-time view of the Federal Reserve that a holding company should serve as a source of financial strength for its subsidiary banks.
VII. Regulation of Over-the-Counter Swaps Markets – imposes exchange trading for derivatives contracts and imposes new capital and margin requirements and various reporting obligations on Over The Counter swap dealers and major OTC swap participants.
For community banks, the most important provision in this title levels the competitive playing field by prohibiting the Federal Reserve or the FDIC from providing assistance to insured depository institutions involved in the swaps markets, with certain exceptions.
VIII. Payment, Clearing, and Settlement Supervision – allows for a systemic approach to certain financial market payment, payment, clearing and settlement systems. Designation as systemically important will require two-thirds of the Financial Stability Oversight Council.
IX. Investor Protections and Improvements to the Regulation of Securities – has a number of provisions intended to protect investors, including for example: risk retention requirements for certain asset-backed securities; reforms to regulation of credit rating agencies; establishing an Investor Advisory Committee and an Office of Investor Advocate, and requiring the SEC to study whether a fiduciary duty standard of care for broker-dealers providing personalized investment advice to a retail customer should be created.
For community banks, the most important section of this Title establishes a number of changes to corporate governance procedures for public companies that ultimately, and perhaps quickly, will become the "best practices" (if not the expected practices) for all corporations large and small. The most important of these are: proxy access requirements for shareholders; disclosures about the failure to separate the role of the chair of board and chief executive officer; shareholder voting on executive compensation; the establishment of an independent compensation committee; executive compensation disclosures and clawbanks. In addition, the Federal Reserve is required to issue regulations regarding incentive-based pay practices within nine months of the effective date of the Act; these regulations will apply to institutions with more than $1 billion in assets.
For small, publicly held community banks, an important provision in this title is an amendment to the Sarbanes-Oxley Act to permanently exempt non-accelerated filers from section 404(b) of the Act.
X. Bureau of Consumer Financial Protection – This is probably the most important title in HR 4173 for community banks. It will alter in dramatic fashion the way consumer credit is regulated, moving from framework of the federal regulation of disclosure and the state law regulation of fairness and suitability, to an overall, nationwide federal suitability framework. It establishes the Bureau of Consumer Financial Protection, an independent entity housed with the Federal Reserve in order to provide a source of funding (initially $500 million) and gives the Bureau the authority to prohibit practices that it finds to be “unfair,” “deceptive,” or “abusive” in addition to requiring certain disclosures. The words “unfair” and “deceptive” appear to reference and incorporate similar words in the enabling legislation of the Federal Trade Commission and some state consumer legislation. The “abusive” addition to this grant of regulatory scope is new and it is likely that defining the meaning of this term in this context will produce additional regulation and litigation. The Bureau may also prohibit consumer mandatory arbitration provisions and it will oversee the mortgage reform and enforcement provisions of Title XVI of the Act that are described below.
For community banks, in addition to creation of the Bureau, this Title also contains a number of other important provisions. For example, it limits interchange fees for debit card transactions (including those involved with certain prepaid card products) to an amount established as reasonable under regulations to be issued by the Federal Reserve. Cards issued by banks with less that $10 billion in assets are exempt from this requirement although this exemption has been criticized as being ineffective because small banks will have to match the rates being offered by their larger competitors. Some community banks have estimated that this provision could mean hundreds of thousands of dollars of lost revenue.
Another key change for community banks is the Act’s treatment of preemption. Essentially, the Act will undo recent court decisions and OCC guidance that expanded the application of preemption to subsidiaries of national banks. The standard for the preemption of state law is to return to the one enunciated in a well-known court decision, Barnet Bank v. Nelson: “irreconcilable conflict” and “stand as an obstacle to the accomplishment” of the purpose of the federal law. The Act also codified the result in a recent U.S. Supreme Court decision that the visitorial powers provisions of the National Bank Act do not limit the authority of state attorneys general to bring actions against national banks to enforce state consumer protection laws.
XI. Federal Reserve System Revisions gives the Government Accountability Office authority to conduct a one-time audit of the Federal Reserves emergency lending during the credit crisis and gives the GAO other auditing responsibilities over the Federal Reserve. The tile also tightens the conditions under which the Fed may provide emergency assistance to institutions and authorizes the FDIC to guarantee debts of banks and bank holding companies.
XII. Improving Access to Mainstream Financial Institutions – is intended to provide alternatives to payday loans. This title is intended to encourage low-and moderate-income individuals to create accounts in insured depository institutions and it creates a program to provide low-cost loans of $2,500 or less.
XIII. Pay It Back Act – is a largely technical section dealing with previous programs for emergency assistance to insured financial institutions. It reduces decreases the TARP funds authorized by under the Emergency Economic Stabilization Act of 2008 (the so-called TARP funds) from $700 billion to $475 billion.
XIV Mortgage Reform and Anti-Predatory Lending Act – is another important provision for community banks. It places new regulations on mortgage originators and imposes new disclosure requirements and appraisal reforms, the most important of which are: the creation of a mortgage originator duty of care, the establishment of certain underwriting requirements so that at the time of origination the consumer has a reasonable ability to repay the loan; the creation of document requirements intended to eliminate "no document" and "low document" loans, the prohibition of steering incentives for mortgage originators; a prohibition on yield spread premiums, and prepayment penalties in many cases; and a provision that allows borrowers to assert as a foreclosure defense a contention that the lender violated the anti-steering restrictions or the reasonable repayment requirements.
XV. Miscellaneous Provisions – contains a number of provisions that have little to do with the credit crisis and more to do with finding a vehicle for passage of what is usually called special interest legislation. For example, this Title restricts U.S. from funding certain loans to heavily indebted countries and declares that a trade of conflict minerals from the Congo is helping to finance conflict. This title also articulates disclosure requirements for companies operating mines, and requires that any mining company that is a public company to include in its annual report all payments made to foreign governments or the Federal Government for development of oil, natural gas, or minerals.
For community banks, the key to immediate future is watching the regulatory implementation of HR 4173. There are tens, if not hundreds, of new regulatory initiatives arising from the Act. Although most should have little impact on community banks, some will be critical. The most critical ones for community banks will be those concerning capital requirements and consumer lending.
