In an effort to reinstate regulatory order after the 2008 financial market crisis, the 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Barack Obama on July 21, 2010. The Act attempts to restrict the actions of financial firms, including banks, through larger capital, registration, data and reporting requirements. The legislation also created new regulatory bodies with broad supervisory powers and increased the responsibilities of some existing regulatory agencies.
Yet, one year after the bill’s signing, the full scope of its implications still isn’t clear. Many of the terms in Dodd-Frank were either undefined or left for regulators to discern, and some provisions of the legislation were not yet at the implementation stage. “We have participated in several industry forums and working groups to try to better understand the trends and the impact to our clients,” says Jean Sheridan, head of financial regulatory reform management at Northern Trust, Chicago.
What is clear, Sheridan notes, is that a series of ongoing changes is likely to impact institutional investors and plan sponsors in the form of new reporting and margin requirements, and higher costs are likely.
Addressing Systemic Risk
Many point to Lehman Brothers’ $600 billion bankruptcy in 2008 as the first domino to fall in the financial crisis, noting that the firm’s size and interconnectedness with other financial institutions illustrates the danger of large yet undercapitalized institutions. The idea that an institution is “too big to fail,” meaning that its financial collapse would likely result in the failure of other systemically important financial institutions (SIFIs), is one of the chief issues that Dodd-Frank attempts to rectify.
Dodd-Frank tasks a new regulatory body, the Financial Stability Oversight Council (FSOC), with examining financial and nonfinancial institutions, which could include insurance companies, hedge funds and private equity firms. The FSOC, in turn, could require these institutions to register with the Securities and Exchange Commission (SEC).
There are several potential implications for larger hedge funds, endowments and pension funds. The SIFI designation could result in restrictions on leverage, increase capital set-aside requirements and affect relationships with counterparties as well as raise margin requirements for pension funds, endowments or hedge funds not considered SIFIs.
Money Market Funds Targeted
Lehman’s bankruptcy had another immediate impact: It caused the share price of the Reserve Primary Fund — one of the oldest and largest money market funds (MMFs) — to fall below $1, or “break-the-buck.”
According to the SEC, the Reserve Primary Fund held $785 million in Lehman-issued securities. The fund became illiquid when it was unable to meet requests for redemptions from institutional investors. Fear of a liquidity crisis prompted bank runs on Reserve and other money market funds, and resulted in the Treasury offering a temporary guarantee of retail and institutional funds that had not exclusively invested in municipal and government debt. In addition, the Federal Reserve offered hundreds of millions in loans to the funds via its discount window.
Provisions in Dodd-Frank charge the President’s Working Group and SEC with reviewing rules on the net asset value (NAV) of money market funds, potentially allowing for floating rather than fixed net asset values, private emergency liquidity facilities, mandatory redemptions-in-kind and insurance for MMFs.
Derivatives Legislation and Institutional Investors
An issue Dodd-Frank repeatedly revisits is the amount of capital reserves firms keep on the books at any given time and the interconnectedness of large investors. According to Lehman’s final annual report, at the time of its failure in 2008 the firm had an estimated $738 billion exposure to the over-the-counter (OTC) derivatives or “swaps” market, which is predominantly composed of privately negotiated interest-rate-related instruments. Separately, American International Group, Inc. (AIG) also had built a huge portfolio of OTC derivatives; the government later bailed out AIG for more than $85 billion.
U.S. regulators decided the proliferation of such large-scale risk could no longer be allowed; and so new regulation, in the form of Titles VII and VIII of the Dodd-Frank Act, set in motion the requirement to centrally clear all OTC derivatives trades with the goal of increasing transparency and mitigating counterparty risk. These areas of the Dodd-Frank Act are particularly relevant for institutional investors.
The Act gives primary authority to the Commodity Futures Trading Commission (CFTC) and the SEC to regulate the swaps market, although various banking regulators will retain substantial authority over banks.
The legislation requires that certain swaps be traded on exchanges, be centrally cleared and publicly reported. It also requires the registration of both swaps dealers and large end-users and requires the establishment of new swap market mechanisms. It authorizes the regulators to establish a comprehensive regulatory system applicable to these registrations. (For a deeper at look at how proposed OTC derivatives changes are likely to affect institutional investors, see “OTC Derivatives Regulations a Mixed Bag for Investors.”)
Northern Trust has been preparing clients for regulatory changes by holding webinars, notifying them of pertinent dates and providing insights into related trends.
“Our derivatives people are very focused on what is going on in the industry, and are always available to clients if there are specific questions,” Sheridan says. Behind the scenes, Northern Trust has been testing the technology involved with central clearing to make sure the firm is ready to comply with the changes.
Understanding the Changes
With many of the regulations expected to be finalized in the second half of 2011, Sheridan says Northern Trust will continue to work to prepare itself and its clients for implementation. Additional changes affecting institutional investors will come indirectly by way of new regulatory requirements on their investment managers and advisors, which could include registration and regulation of hedge fund and private equity firms, regulation of incentive compensation structures and some divestment by banks of alternative asset management units.
However, she says Northern Trust continues to make good progress. “Certain aspects of the Act will provide greater protection to our clients and the industry as a whole. We are working hard so that we can continue to be at the forefront of regulations that impact our business and our clients so that we can assist them to do the same,” Sheridan says.