Where There’s Smoke There’s FireThe Burning Issues in the

Dodd-Frank Regulatory Reform Act

November 19, 2010C. Bruce Crum

Gregg B. EichnerRusty N. LaForge

Robert T. Luttrell, IIIJ. Barrett Ellis

New Agencies

• Office of Thrift Supervision (stand alone)

Eliminated Agencies

□ Bureau of Consumer Financial Protection (“independent” within the Fed)□ Financial Stability Oversight Council (stand alone)□ Federal Insurance Office (Treasury)□ New Offices of Minority and Women Inclusion (banking and securities regulators)□ Investor Advisory Committee (stand alone; to advise SEC)□ Office of Investor Advocate (SEC)□ Office of Credit Ratings (SEC)□ Credit Rating Agency Board (SEC)□ Office of Financial Literacy□ Office of Financial Research (Treasury)□ Office of Housing Counseling (HUD)□ Office of Fair Lending and Equal Opportunity (Fed)□ Office of Financial Protection for Older Americans (Fed)

Selected New Agencies

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Rules for Regulators

Financial Stability Oversight Council (FSOC)

• Newly created agency responsible for systemic risk• Provide recommendations for capital and leverage requirements• Prevent systemic risk from threatening the financial system• 10 voting members

– Treasury Secretary, Fed Reserve Chairman, Comptroller of the Currency, CFPB, SEC, FDIC, CFTC, FHFA, NCUA, independent member named by the President

• 5 non-voting members– OFR, FIO, state banking regulator, insurance regulator, securities regulator

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Financial Stability Oversight Council (FSOC)

The Federal Reserve• Consumer protection

– Will house the new Bureau of Consumer Financial Protection• Systemic regulation

– Will work closely with new Financial Stability Oversight Council to set tougher standards for disclosure, capital and liquidity that will apply to banks as well as non-bank financial companies

• Transparency– Fed will have to disclose counterparties and information of 13(3) and discount window lending and

open market transactions, with specified time delays• Limits on Fed’s Section 13(3) Emergency Lending Authority

– Treasury must approve any lending program– Emergency lending to “individual” entities prohibited (Bear Sterns, AIG)– Collateral must be sufficient to protect taxpayers from losses

• Limits on debt guarantees– To prevent bank runs, the FDIC can guarantee debt of solvent, insured banks after meeting onerous

approval requirements from the Fed, FDIC, Treasury, the President and Congress• Supervision

– The Fed will keep its existing bank supervisory powers of both large and small banks– Creates a Vice Chairman for Supervision, member of the Board of Governors of the Fed designated

by the President, who will develop policy recommendations

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Bank Supervision• Eliminates

– OTS• Keeps

– Fed, FDIC, OCC• Creates

– FSOC

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Bank Supervision (cont)

• Clear and streamlined supervision– OTS abolished, with authority transferred to OCC; thrift charter preserved– Elimination of regulatory overlap (less arbitrage on regulatory supervision)– Clearer lines of responsibility among regulators on supervision

• Charter conversions– Banks cannot convert charter to avoid an enforcement action (unless both the

old regulator and new regulator do not object)

• Volcker rule– Prohibition on proprietary trading and restrictions on investments in hedge

funds and private equity funds

• Stronger lending limits– Credit exposure from derivatives transactions included in banks’ lending limits

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Bank Supervision (cont)

• Supervision of Holding Company Subsidiaries– Requires the Fed to examine non-bank subsidiaries that are engaged

in activities that the subsidiary bank can do on the same schedule and in the same manner as bank exams

• Interest on Business Checking– Authorizes banks to pay interest on business checking accounts,

effective one year from the date of enactment

• Dual Banking System– Preserved; state banking system that governs most community banks

will continue to exist

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Rules for Banks

Enhanced Prudential Standards

• Discourage excessive growth and complexity– Financial Stability Oversight Council to make recommendations for increasingly strict rules for companies that grow in size and

complexity• Volker Rule

– Prohibits proprietary trading and restricts investments in hedge funds and private equity funds• Risk-Based Capital Requirements

– Establishes a floor for capital that cannot be lower than the standards in effect today• Stricter Leverage Limits and Liquidity Requirements

– Financial Stability Oversight Council can impose 15:1 debt-to-equity ratio on systemically important companies to mitigate threats to stability

• Stress Tests– For systemically important companies requires stress tests to be conducted by the Fed but does not specify frequency– Bank and thrift holding companies with $10 billion or more in assets must conduct annual stress tests

• Concentration Limits– Credit exposures of systemically important companies to non-affiliates cannot exceed 25% of capital stock and surplus

• Resolution Plans (Living Wills) and Credit Exposure Reporting for Systemically Important Companies• Risk Committees

– Required for systemically important, publicly traded non-bank financial companies, as well as publicly traded bank holding companies, with total consolidated assets > $10B

Enhanced prudential standards for systemically important financial companies and interconnected bank holding companies

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Bank Capital• Trust Preferred (TruPS) and hybrid securities excluded from Tier 1 capital

– For banks with assets < $15B as of December 31, 2009, existing TruPS grandfathered

– TARP preferred issuances grandfathered, regardless of the size of the institution

• Minimum capital and leverage ratios– Establishes a floor for capital that cannot be lower than the standards in effect

today– Must include off-balance sheet activities in calculating new capital

requirements – Must address risks relating to derivatives, securitized products, financial

guarantees, securities borrowing and lending, repos, concentrations in assets where values are model-driven

– New capital requirements to be countercyclical

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Bank Capital (cont)

Banks with assets < $500M exempt

Regulatory capital deductions

(e.g. hybrid exclusions from Tier 1)

Leverage ratios and risk-based capital ratios

Banks with assets> $15B

□ Phased in from Jan 1, 2013 to Jan 1, 2016

□ No impact for first 2 years

□ Incremental phase-in 1/3rd per year starting Jan 1, 2013

□Effective when new requirements are implemented within the next 18 months

Banks with assets < $15B

□ Grandfathered (effectively) □Effective when new requirements are implemented within the next 18 months 12

Timing and Applicability of “Collins Amendment” Capital Requirements

OTC Derivatives: Overview• Comprehensive set of new rules to reduce counterparty risk and increase transparency• While the Dodd-Frank Act establishes the broad outline of regulation, most of the details will

be determined by the regulators (CFTC and SEC) in the months ahead• Provides for federal regulation of the derivatives markets.• Requires most derivatives trades to go through a clearinghouse and be exchange-traded and

also would require regulators to impose more stringent capital and margin requirements on those derivatives not required to be traded on an exchange.

• There are limited exemptions from these expanded regulations for certain commercial end users of derivatives

– Banks that engage in swaps with their customers in connection with providing loans will not trigger the definition of “swaps dealer,” which carries a host of regulatory burdens, nor will banks that use swaps to hedge their own interest rate risk. A de minimums provision will exempt banks and other entities that use swaps infrequently.

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□ Important Distinctions Capital and margin requirements: Between dealers/major swap participants and end

users Central clearing by end users: Between financial and non-financial companies

Securitization• Risk Retention (“skin in the game”)

– Lenders required to hold at least a 5% stake in the asset-backed debt they structure and sell

– Regulators will have flexibility to tailor risk-retention rules to specific products– Retained credit risk may not be hedged– 5% will not be a first loss piece; rather it must be a “vertical slice”

• Exemptions– Qualified residential mortgage carveout

• All of the assets that collateralize the ABS must be qualified residential mortgages• Federal banking agencies, the SEC, the Secretary of HUD and the Director of the FHFA to jointly

define the term “qualified residential mortgage”– Loans guaranteed by the Federal Housing Administration, U.S. Department of

Agriculture, and U.S. Department of Veterans Affairs• Disclosure

– Requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets

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Interstate Branching• Removes the Riegle-Neal provisions that allowed states to restrict de novo

interstate branching (effective immediately)– National or state banks from any state will be allowed to branch into any other

state as if they were chartered in that state• State statutes including a prohibition against interstate branching through

de novo establishment will become moot and will need to be revised• Eliminates the required “opt-in” election by each state to permit interstate

branching through de novo branches. – A majority of states did not opt-in– In those states, for example Kansas, the acquisition of either an existing bank

or a branch of a bank in that state was the price of admission

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Interstate Branching (cont)

• Reasons for this proposed change– The legislation initially proposed by the Treasury represents a leveling

of the interstate branch playing field between commercial banks and federal thrifts, which have had the authority to branch nationwide since 1992

– News reports have tagged this new nationwide de novo branching authority as a “Big Gift for Big Banks.” The provision was introduced in the House bill by a congressman from North Carolina, a state which a very big bank calls home

– Theory that certain regulators would be pleased to have more competition in some states to help pare down the excessive number of community banks

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Interstate Branching (cont)

• The removal of the Riegle-Neal “opt-in” barrier to de novo interstate branching in many states may dash the hopes of banks to sell for high multiples as the price of admission

• It also will likely eliminate the variety of ways banks found to enter other states without doing a whole bank acquisition and merger– These included buying shell charter skeleton banks from two merging

banks for premiums that have exceeded $1 million

– Structuring a branch acquisition so as to strip most all of the unwanted assets and deposits at closing as well as then relocating and closing the acquired branch

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Rules for Consumers

Bureau of Consumer Financial Protection

• Independent authority created with broad sweeping powers within the Federal Reserve, with the specific mandate of consumer protection on financial products

• Independent head, budget and rule writing authority– Established within the Federal Reserve (i.e., not an independent agency)– Director appointed by the President and confirmed by the Senate– Dedicated budget paid by the Federal Reserve System– Authority to write rules for consumer protections governing all financial

institutions – banks and non-banks – offering consumer financial products or services

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Bureau of Consumer Financial Protection (cont)

• Accountability and authority– Consolidates responsibilities previously held by various bank regulators,

making one office accountable for consumer protections– Fed cannot prevent Consumer Bureau from issuing a rule– Financial Stability Oversight Council, by a 2/3 vote, can overturn a Bureau rule– State attorneys-general empowered to enforce certain rules issued by the

Bureau– Authority to examine and enforce regulations

• Scope– Banks with assets > $10B, all mortgage-related businesses, payday lenders,

student lenders, large non-bank financials– Exemptions include auto dealers, real estate brokers, accountants and lawyers,

and insurance– No authority over SEC registered and CFTC registered persons

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Other Consumer Protections• Interchange fees (Durbin amendment)

– Fed has authority to limit interchange, or “swipe” fees, that merchants pay for debit card transactions

– Fed to ensure fees are “reasonable and proportional”– Retailers can offer discounts based on form of payment and refuse

credit cards for purchases under $10– Merchants will be permitted to route debit card transactions on more

than one network

• Credit score– Gives consumers free access to their credit score if their score

negatively affects them in a financial transaction or a hiring decision

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Other Consumer Protections (cont)

• Mortgage reform– Institutions must ensure borrowers can repay loans they are sold– Prohibits incentives that encourage lenders to steer borrowers into more

costly loans– Prohibits pre-payment penalties– Establishes penalties for irresponsible lending– Expands protections for high-cost mortgages– Requires additional disclosures for consumers on mortgages, including

requiring disclosure of maximum a consumer could pay on a variable rate mortgage

– Establishes an Office of Housing Counseling within HUD to boost homeownership and rental housing counseling

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FDIC Deposit Insurance• Change to assessment base

– Changes the assessment base from domestic deposits to assets (minus tangible equity)– Will save community banks $4.5B over the next 3 years– Among top priorities in financial reform

• Increase in reserve ratio to fund Dodd-Frank Act– Increases reserve ratio from 1.15 to 1.35 with a target date of 9/30/20– Added to replace, in part, the $19B “bank tax”, which was added to the bill in the closing hours of

consideration– Banks under $10B will be held harmless from premium increases as a result of this provision, just as

they were carved out from the “bank tax”• Increase in deposit insurance

– Permanently increases the maximum amount of deposit insurance for banks, thrifts and credit unions to $250,000 per depositor

• Increase made retroactive to Jan 1, 2008– Offsets the implicit guarantee enjoyed by too-big-to-fail banks and keep deposits in small

communities– FDIC will insure the full amount of qualifying “noninterest bearing transaction accounts” for 2 years

beginning December 31, 2010

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Timing and Implementation

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Detailed Implementation Timeline

Topic Timing Considerations

Bureau of Consumer Financial Protection

□ In general, changes become effective on “transfer date”, which will be 6 – 18 months from date of enactment (possible extension up to 24 months from enactment)

□ Regulators must agree and specify “transfer date” within 60 days of enactment

Interchange fees □ Interchange fees provision will take effect 1 year after enactment

□ Fed has 9 months to gather data and set debit card interchange fees

Leverage and capital requirements

□ Fed must impose leverage and capital requirements within 18 months of enactment

□ Trust preferred phase-out: In general will be phased in from Jan 1, 2013 to Jan 1, 2016

OTS elimination □ OTS abolished 90 days after transfer date

Interest on business checking

□ Effective 1 year from the date of the enactment25

Pressure on Bank Profitability

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Pressure on Bank Profitability

Provisions in Dodd-Frank Act that will reduce bank profitability

□Bureau of Consumer Financial Protection

□Volcker RuleRestrictions on risky but historically profitable activities

□Higher capital requirementsResulting in lower ROE

□Less derivative trading revenues$40B globally in 2009

□Less securitization revenue

□ Interchange fee limits will reduce credit card profitability

□ Higher compliance costs Arising from implementation of new

disclosure, reporting, compliance and governance standards

□ Potential assessments To cover costs of unwinding failing firms

□ Funding of dozens of new government studies

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Bank regulators and the new Consumer Financial Protection Bureau will likely exert sharp downward pressure on a full range of consumer-facing fee businesses

Pressure on Bank Profitability

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Bank OverdraftFees

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Credit Card Interchange Fees

Source: Center of Responsible Learning, FDIC, New York Times: Your Money (2010)

• Checking accounts costly to provide– Processing costs– Technology costs– Costs of providing convenient access– Staff costs– Legal and compliance costs– Fraud costs– Capital costs and FDIC insurance

• Congressional action is limiting sources of revenue that support low-cost checking– It takes many low-balance, high-overhead accounts to fund loans– Debit card interchange had become a stable source of revenue offsetting some

of the account costs– Multiple service relationships help offset costs of deposit accounts

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Pressure on Bank Profitability

Pressure on Bank Profitability

• Excerpts From Bank of America 8-K Filing Made Friday, July 16, 2010Impact of Durbin Amendment• We estimate that our debit card revenue for 2010 will be approximately $2.9 billion.

Although subject to final rule making over the next year, we estimate that the decrease in annualized revenue before mitigation could be as much as $1.8 billion to $2.3 billion starting in the third quarter of 2011.

• The estimated shortfall in revenue would impact the carrying value of the $22B of goodwill currently included in the Global Card Services segment. Utilizing these revenue estimates, the estimated impairment of goodwill to be reported in 3Q10 would potentially be in the range of $7B to $10B. The amount of impairment recorded in 3Q10 will be after consideration of the value of mitigation initiatives applicable to Global Card Services that exist at that time.

Pressure on Bank Profitability• Excerpts From Bank of America 8-K Filing Made Friday, July 16, 2010

Commentary on Regulatory Reform• CARD Act

– Total 2010 expected interest and fees impact, net of mitigation, to be roughly $1B after-tax

• Regulation E / Overdraft policy changes– Previously disclosed 2010 impact $1 B after-tax, before any mitigation

• 4Q10 total service charges expected to reduce to roughly $2B pre-tax

• Dodd/Frank Bill– Uncertainties remain as hundreds of rules need to be written by multiple regulators– Impacts to businesses and clients are uncertain– Impacts will be phased in over many different timeframes– Mitigations for potential impacts are under assessment

The High Cost of Reform School

The High Cost of Reform School

The High Cost of Reform School

Pressure on Bank Profitability

And BofA’s Strategy To Address Cost Of Regulatory Reform

“We are looking at different ways that customers can provide us value for the value we provide,” bank spokesman Robert Stickler said. “That can be the way they interact with us, how much businesses they bring us, and if all else fails it can be a monthly fee. That’s the strategy.”

One branch manager summed up many of the moves as an end to “selling for free.”

Wall Street JournalJuly 16, 2010

Pressure on Bank Profitability• Conclusion

– Transaction accounts are expensive to provide– Banks have been able to offset costs and offer free or very low cost

transaction accounts because of other revenue– As restrictions are added reducing interchange, overdraft and other

sources of income banks must reexamine features and pricing of accounts

– No business can be viable unless revenues exceed costs– Congressional action is driving these services back to the days when

monthly fees, direct deposit requirements and restrictions on the number of transactions were the norm

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