Financial Reform: The Devil Is in the Details

By Winthrop N. Brown of Milbank, Tweed, Hadley & McCloy LLP

Since it became clear that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 would be enacted, much has been written about how attention now turns to the regulators for the issuance of more than 200 separate sets of regulations that are mandated by the new law.

On Friday, the day after the bill passed, Bank of America ( BAC) warned that the financial overhaul legislation could cost it as much as $4.3 billion a year in lost revenue, plus a one-time charge of $7 billion to $10 billion.

Although other major banks reporting earnings on Friday, including J.P. Morgan Chase ( JPM) and Citigroup ( C) did not disclose details of how the bill would affect them, Bank of America's pronouncement was interpreted as an indicator that banks with significant exposure to the U.S. consumer market will face larger-than-expected costs from financial regulation.

In the wake of these predictions and concerns among key players in the financial industry, we are told by the press to brace for "an army of lawyers and lobbyists" which, having partly had its way with Congress, is now about to descend on the dozen-or-so agencies that will be issuing regulations implementing the Act. The implication is that, once again, and behind closed doors, key decision-makers will have their arms twisted by hired guns to undo the tough restraints that the Act imposed on the financial industry.

In fact, the process that is about to unfold is remarkably open, substantive and fair to all parties. For the most part, the agencies concerned are staffed with smart, knowledgeable and dedicated civil servants who have every incentive to carry out Congress's intent. (They testify regularly on the Hill and do not want to be criticized in public for failing to carry through on the Act's requirements.)

Opposite the agency staff will be arrayed a number of key industry trade associations and consumer interest groups that will do their best to shape the regulatory outcome in the interests of their members. These groups will depend heavily on talented in-house lawyers and policy types who have years of experience in how regulations can affect their members. They may call on outside law firms for help in preparing their comments on proposals, but the positions they adopt will be carefully crafted internally by representatives of their members.

In virtually all cases, the process will begin publicly with the publication of a proposed regulation. Well before the proposal is published, the staff of many agencies will be willing to meet in person with interested parties. These meetings are disclosed to the public and for the most part only serve to reinforce the position later taken by these parties in their written comments on the proposal.

When published, the proposed regulation will be preceded by a "preamble" explaining what factors and authority the agency considered in issuing the proposals. Written comments will be solicited from the public by a deadline and, once received, will typically be posted on the agency's website. The merits of these comments will be carefully reviewed, catalogued by issue, debated internally, and weighed against opposing positions. They may be discussed with the staff of other agencies and with Congressional staff.

They will then be then described in internal memoranda prepared for the members of the agency's governing body before a decision on a final rule is made. The comments and the agency's reaction to them will be summarized in the preamble to the final rule when it is published. Almost always, some modifications are made to the rule to reflect the comments.

As a lawyer who has practiced in this regulatory area for many years, I have two reactions to the process that is about to unfold. First, all participants should take comfort from the way in which the financial regulatory agencies will carry out their responsibilities. To a remarkable degree, the positions of interested parties are genuinely solicited, and are thoroughly considered and deliberated.

The rationale adopted by the agency is largely disclosed. Parties may not get the result that they want but, in my experience, they rightly believe that they will get a fair hearing and may well be able to change some minds. Trade associations and consumer groups would not dedicate the resources they do to participate in the process if they had not seen how it can make a difference.

Second, the system needs the energetic participation of individual institutions and their trade associations such as the American Bankers Association, the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association to ensure that the regulations that will be adopted reflect the views of the financial industry. In particular, it needs input on the actual way the financial industry functions.

For all their talent and good intentions, many of the staff members at the various financial regulatory agencies have little or no actual experience in the financial industry. The largest contribution that a participant can make to the process is often to dissuade an agency from adopting a requirement that simply does not reflect how its business is conducted.

Four matters in the Act pose the greatest risk that regulations will not accurately reflect the market. These matters are, first, two elements of the so-called Volcker rule -- the prohibition on proprietary trading and the prohibition on investments by bank holding companies and their subsidiaries in hedge and private equity funds. These prohibitions are designed to prevent banking institutions from engaging in risky activities, but could have the effect of limiting perfectly safe exposures.

A third matter is the collection of issues raised by the Act's move to regulate the swap market to decrease counterparty risk and increase disclosure. These issues include the definition of swap dealer, the posting of margin by end-users and the degree to which swap activities should be "pushed out" of a bank to a nonbank affiliate. The fourth is the risk-retention rule that requires "securitizers" to retain skin-in-the-game in connection with their securitizations and collateralized debt obligations by continuing to hold a portion of these offerings on their own balance sheets.

In each of these areas, the markets at issue are technically sophisticated and the politics are highly charged. The agencies are about to lay the groundwork for financial regulation for the next several decades; once set, the rules will be difficult to amend.

The industry needs to ensure that its views are heard and that, at the very least, any new restrictions are imposed based on a thorough understanding of how their members actually conduct business. Not even the press should begrudge them that effort.

Winthrop Brown is a partner in the Washington DC office of Milbank, Tweed, Hadley & McCloy LLP. His practice focuses on the regulation of financial institutions, including U.S. and foreign commercial and investment banks, bank holding companies and managers of private investment funds.

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