Dodd-Frank 2.0: The Clinton Program for Financial Regulation

October 22, 2015

On October 8, 2015, the presidential campaign for former Secretary of State Hillary Clinton released the candidate’s prescriptions for further regulation of the U.S. financial sector. Rather than seeking to "reform the reform," the Clinton Program would go farther than Dodd-Frank, including borrowing a number of ideas from Europe.

Although in part a political document, the proposals clearly constitute serious policy as well. They demonstrate that five years of Dodd-Frank have not extinguished critical policy debates, especially on the Too Big to Fail (TBTF) issue.

Another debate that has not been extinguished concerns the appropriate calibration of regulation. The Factsheet setting forth the Clinton Program argues that raising American income levels requires strong, long-term growth, for which the additional reforms are necessary.[1] The connection between regulation and growth has also been noted by certain critics of the Dodd-Frank Act, who have argued that refining aspects of the legislation would lead to improvements in labor force participation and household incomes.

With a Republican regulatory reform measure already drafted by Senate Banking Committee Chairman Richard Shelby (the Shelby Bill),[2] and some of Secretary Clinton’s challengers advocating even stronger measures, the coming months have the potential to allow for a candid discussion of the connection between the extent of U.S. financial regulation and Americans’ income levels, as well as the appropriate resting place of the regulatory pendulum for the next five years.

I. Dodd-Frank Strengthened with a European Finish

Just as the Dodd-Frank Act sought to fill in certain gaps in existing U.S. financial regulation, the Clinton Program would not only defend Dodd-Frank as it currently exists, but it would impose new requirements, with a conscious goal of "tackl[ing] excessive risk wherever it appears."[3] For such excessive risk, the Clinton course of treatment would rely principally on the following remedies:

Borrowing from a number of European countries,[4] Secretary Clinton would impose a graduated "risk fee" on what she perceives as "the largest financial institutions." The fee would be based on a company’s liabilities, excluding insured deposits and certain insurance policy reserves. The fee rate would scale higher for firms with greater amounts of debt and riskier short-term forms of debt; funds raised from the fee would go to general revenue.

The risk fee would be imposed on banking institutions with more than $50 billion in assets, including foreign bank U.S. intermediate holding companies of that asset size,[5] and systemically significant nonbanks. Unlike the Shelby Bill, which would greatly increase the asset threshold for systemically important banks,[6] the Clinton Program accepts Dodd-Frank’s equation of $50 billion in total consolidated assets with systemic significance – even though that threshold is more an accident of the legislative process than anything else.[7]

Also borrowed from Europe,[8] Secretary Clinton would impose a "high-frequency trading tax" targeted at what she perceives as the most abusive high-frequency trading strategies – those involving excessive levels of order cancellations. Secretary Clinton views such strategies as making U.S. markets less stable and less fair.
Continuing in this internationalist mode, Secretary Clinton would "enhance international cooperation to curb excessive risk-taking," particularly in the areas of capital requirements, collateral and margin requirements for securities financing and derivative transactions, and bank resolution. Presumably the current practice whereby American regulatory practices are significantly informed by the pronouncements of the Financial Stability Board (FSB) would continue, and perhaps U.S. regulation would become even more driven by the FSB’s agenda.
As President, Secretary Clinton would pursue legislation to enhance the ability of U.S. regulators to reorganize, downsize or break apart large financial firms on the ground that they were not being managed effectively. This legislation would supplement existing authority under Dodd-Frank’s resolution plan and Kanjorksi Amendment provisions.[9] In addition, Secretary Clinton pledged to appoint regulators who would make use of all such available bank "break up" authorities – and therefore FDIC Vice Chairman’s Thomas Hoenig would find more support for his position on Too Big to Fail.[10]
The Clinton Program would increase regulatory authority over the so-called "shadow banking" sector, targeting repurchase agreements, broker-dealers, hedge funds, private equity funds, money market funds and "exchange-traded products." This would entail greater disclosure, collateral and margin requirements for repurchase agreements, greater leverage restrictions and liquidity requirements for broker-dealers, more reporting by hedge funds and private equity funds, among other suggestions. Secretary Clinton would also give more power to the Financial Stability Oversight Council (FSOC), the government entity responsible under Dodd-Frank for monitoring and making recommendations on the risks of shadow banking.[11]
Secretary Clinton would seek to reinstate the now-repealed "swaps push out" provision contained in the Lincoln Amendment to Dodd-Frank, thus forcing banking organizations to move many significant derivative activities to nonbank affiliates.
Secretary Clinton would remove the exception to the Volcker Rule that permits banking entities to invest up to 3 percent of their Tier 1 capital in bank-sponsored hedge funds that engage in proprietary trading. Stating that "[t]he Dodd-Frank Act’s Volcker Rule put into practice a straightforward and common-sense principle: banks shouldn’t be allowed to make risk and speculative trading bets with taxpayer-backed money," her Factsheet claimed that this exception for bank asset management activities was a "damaging loophole."

II. Enforcement Powers Strengthened Beyond the Obama Approach

In addition to regulatory enhancements, the Clinton Program would seek to take bank enforcement powers to new levels. Contending that, since the Financial Crisis, both corporations and individuals responsible for wrongdoing "too often . . . [got] off without sufficient penalty," Secretary Clinton would seek to increase sanctions for both. With respect to individuals, the Clinton Program would:

Continue in the recently announced policy direction of emphasizing individual accountability when prosecuting financial wrongdoing.[12]
Mandate that fines for major corporate wrongdoing be paid out of the incentive-based compensation of culpable employees, their supervisors and relevant senior executives, and empower regulators to require that senior executives leave their jobs when particularly egregious misconduct takes place under their supervision. (Bank regulators currently do have the power to remove senior executives, and sometimes do, usually through pressure on bank boards; presumably, Secretary Clinton believes the power has not been exercised enough.)
Extend industry ban prohibitions so that "serious crimes under securities, commodities, consumer, and banking laws would result in employment bars across the entire financial services industry," not just the industry the malefactor was working in.
Extend the criminal statute of limitations for major financial fraud to 10 years.
Introduce legislation to reverse the Second Circuit’s holding in United States v. Newman,[13] and thus make insider trading cases under the federal securities laws easier to prosecute.

Corporations would not fare much better. Under the Clinton Program, the Department of Justice would be required to establish guidelines for the use of deferred prosecution agreements and non-prosecution agreements, and the use of those agreements would be curtailed. In instances of egregious wrongdoing, firms would be required to admit wrongdoing and the underlying facts of the matter. Secretary Clinton also stated her support for the Truth in Settlements Act introduced by Elizabeth Warren, and, conversely, her opposition to SEC waivers for recidivist bank issuers. Finally, Secretary Clinton would increase funding for the Department of Justice, SEC, and CFTC, and introduce legislation providing that SEC and CFTC funding be independent of the appropriations process, like funding for the bank regulators.

In some instances, Secretary Clinton’s enforcement proposals mimic existing practices, but when considered as a whole, it is fair to say that they would advance beyond the Obama Administration’s current practices.

III. No Reinstatement of Glass-Steagall

Secretary Clinton did draw a line on one issue – unlike Senator Sanders and former Governor O’Malley, she would not seek to cure the TBTF issue by reinstating those provisions of the Glass-Steagall Act that the Gramm-Leach-Bliley Act repealed. Universal banks would therefore not be required to divest their securities underwriting and dealing subsidiaries, but, as described above, individual banks could be subject to government-mandated divestiture orders if they were not sufficiently well managed, and all banks would be required to "push out" many of their derivative activities to separately capitalized affiliates.

* * * * *

As noted, the Clinton Program would effectively place a European-style overlay over Dodd-Frank. It is therefore quite ironic that contemporaneously with the release of the Clinton Program, there was considerable evidence of Europeans’ softening their approach to financial regulation.

Four days after the release of Secretary Clinton’s recommendations, Frédéric Oudéa, the president of the European Banking Federation and chief executive officer of Société Générale, noted the formidable competition that U.S. banks were now providing in European markets, and warned against "counterproductive steps" that certain European countries were considering, including a financial transactions tax, that would give U.S. banks more advantages.[14] He argued that as a result of bolstered capital cushions and a European bank resolution mechanism, Europe’s banking sector had become safer, and additional regulation could result in European companies being forced to become reliant on non-European banks for debt financing, capital markets advice, and hedging solutions.[15]

Two days after Mr. Oudéa’s article, an American former senior bank executive was reported to be the choice to lead one of the U.K.’s most important universal banks. And a few days later, regulators implementing the United Kingdom’ bank ring-fencing scheme – which requires a "push out" of investment banking operations from retail banks similar to the Lincoln Amendment derivatives "push out" that Secretary Clinton wishes to reimpose – chose less onerous alternatives on questions relating to dividend payments and the responsibility of senior management for wrongdoing.[16]

The message from Europe, therefore, seems to be one of dissatisfaction with "tackl[ing] excessive risk wherever it appears," as Secretary Clinton would purport to do, on the grounds that doing so leads to stagnation in the financial markets and the economy as a whole. And indeed a similar message came from Asia on October 13th, when Nobuchika Mori, Commissioner of Japan’s Financial Services Agency, stated in a speech entitled "Rethinking Regulatory Reforms" that "the [G-20] leaders intend to move from the case of adding new regulation to that of implementing it, but the factories manufacturing new regulation are still operating at their full capacity."[17] Commissioner Mori added: "[F]inancial stability is not a goal in itself. It is a means to ensure sustainable growth."

With this in mind, it seems reasonable to pose certain questions about the Clinton Program.

On the subject of risk, isn’t Dodd-Frank already having significant de-risking effects?

One of the four nonbank financial companies designated as "systemically significant" by the FSOC has embarked on a radical downsizing, and has announced it will be seeking de-designation in the first quarter of 2016.
Trading revenues in fixed income, currencies and commodities (FICC trading) have dropped in 17 of the past 22 quarters, on an industry-wide basis, and pressured earnings at traditional investment banks in the third quarter of 2015.
In a recent survey by Ernst & Young, global banks noted continued reluctance by investors to accept lower returns on equity, despite the reduction in risk brought about by the higher capital and liquidity buffers of Dodd-Frank, Basel III and analogous non-U.S. reforms. This has led, on an industrywide basis, to significant re-evaluations of business lines.[18]

Should policymakers first seek to account for the cumulative effects of post-Financial Crisis regulation, some of which has still not even been proposed?

Large banking organizations have been hit with a series of new regulatory requirements and enhanced standards over the last 5 years – Volcker, Basel III, enhanced standards, living wills, LCR, SIFI-surcharge, DFAST, CCAR – and more are on the way (with some not even proposed) – margin requirements for uncleared swaps, early remediation requirements, SCCL, NSFR, TLAC.
Because it is impossible currently to determine how all of these attacks on, and buffers against, the type of risk taking that brought on the Financial Crisis will work together, U.S. and international regulators have wisely staggered the effective dates of these rules and standards, so that banks have at least some time to evaluate the overall effects on their business plans.
With the work of Dodd-Frank still unfinished – but clearly having the effects of contracting global banking – should there be at least a "pause," if not a "rethinking," before a new course of taxes, costs and FSB-derived-acronyms is served to the banking industry?

If one is committing to internationalism, how does this square with increasing obligations on the U.S. operations of foreign banks, which are already subject to discriminatory treatment under the Federal Reserve’s implementation of Dodd-Frank?

Monsieur Oudéa noted that U.S. banks were strengthening their position at home in part due to "regulation that makes it more difficult for foreign players to operate in the US."[19] By this he is referring to the unprecedented "Intermediate Holding Company" (IHC) requirement imposed on foreign banks with $50 billion or more in total U.S. nonbranch assets under the Federal Reserve’s Section 165 rule.
The IHC requirement is a significant departure from the principles of national treatment and equality of competitive opportunity that had animated foreign bank regulation for years. And yet the Clinton Program would add to this by subjecting foreign bank IHCs to its proposed bank levy, and maintaining the $50 billion asset threshold for this levy, even though that threshold bears no relation whatsoever to systemic importance.
One may ask, therefore, whether continuing to increase the burdens on foreign banks operating in the United States will lead to reciprocal discriminatory treatment of U.S. banks operating abroad, thus limiting the ability of U.S. banks to diversify their businesses and stifling opportunities for revenue growth.

Given the record of nonbank financial regulation under Dodd-Frank, would it perhaps make more sense to keep business activities in the already regulated space through appropriately calibrated bank regulation, rather than increasing the scope of nonbank regulation?

In some ways, the Dodd-Frank Act could also be called the "Shadow Banking Protection Act of 2010," given how the nonbanking financial sector has grown in the last five years, as regulated banks get out of historical businesses with low returns on equity or high compliance costs. The Clinton Program is therefore correct to identify shadow banking as a principal area of concern in the years to come.
Notwithstanding this trend, the FSOC, the government entity entrusted by Dodd-Frank with identifying trends in shadow banking, has taken very limited actions. It has designated four Nonbank SIFIs, three of which are large insurance companies subject to extensive state regulation.
The FSOC has designated no financial activities as raising systemic risk, even though activities regulation was also comprehended by Title I of Dodd-Frank and would arguably provide a more targeted approach to shadow banking. The efforts of the Office of Financial Research in analyzing the asset management industry met with heavy criticism, including from the SEC, the independent agency with the most expertise on that industry.[20]
It is clear that the new costs associated with the Clinton Program would accelerate the movement of certain businesses out of U.S.-regulated banking institutions, to be picked up by nonbanks. But those institutions raise their own risk issues, especially those operating beyond the purview of U.S. regulation.
Perhaps here too at least a regulatory "pause," if not a rethink, might allow for a more prudent allocation of activities between a sector with a long history of regulation and one where regulation is essentially starting anew.

Given the scope of the Factsheet setting forth the Clinton Program, one can expect that there will be detailed responses to questions like these as the 2016 election approaches. It is quite clear, moreover, that the issue of financial sector regulation will be as important in this election cycle as in 2008 and 2012, with the likely effects of the outcome on bank business models rapidly becoming apparent.

[1] Factsheet, " Hillary Clinton: Wall Street Should Work for Main Street," October 8, 2015 (Clinton Factsheet), available at https://www.hillaryclinton.com/p/briefing/factsheets/2015/10/08/wall-street-work-for-main-street/.

[2] Financial Regulatory Improvement Act of 2015, available at http://www.banking.senate.gov/public/.

[3] Clinton Factsheet (emphasis added).

[4] Examples may be found from (alphabetically) Austria and Belgium to Sweden and the United Kingdom.

[5] Clinton Factsheet, Note xiii.

[6] Under the Shelby Bill, the total asset threshold would increase to $500 billion for banking institutions as a general matter, although the Federal Reserve and FSOC would retain the power to designate banking institutions with between $50 billion and $500 billion in total assets as systemic on a case-by-case basis.

[7] The $50 billion threshold derives from Senator Dodd’s failed attempt to limit Federal Reserve oversight of state member banks to the largest such institutions. It then was accepted as a replacement for the language in the House version of Dodd-Frank, which stated that enhanced prudential standards would apply to "large interconnected bank holding companies" in addition to nonbank financial companies designated by the FSOC. Every nonbank financial company that the FSOC has designated to date had more than $500 billion in total assets at the time of its designation.

[8] Italy, for example, has implemented such a tax, although its economy has not been a model of recovery.

[9] Under Section 165 of Dodd-Frank, the Federal Reserve and FDIC may order bank holding companies whose living wills have been found deficient to divest assets, if the deficiencies have not been appropriately remedied. The Kanjorksi Amendment, Section 121, permits the Federal Reserve to order systemic firms to divest assets if it determines that the firm poses a "grave threat" to financial stability and other remedies are inadequate.

[10] See, e.g., Joshua Zumbrun, "Hoenig Says U.S. Should Break Up Big Financial Firms," Bloomberg, February 23, 2011.

[11] Dodd-Frank Act, Section 120.

[12] See Gibson Dunn & Crutcher LLP Client Alert, DOJ’s Newest Policy Pronouncement: the Hunt for Corporate Executives (September 11, 2015), available at: http://www.gibsondunn.com/publications/Pages/Yates-Memo–DOJ-New-Posture-on-Prosecutions-of-Individuals–Consequences-for-Companies.aspx.

[13] 77 F.3d 438 (2d Cir. 2014). See Gibson Dunn & Crutcher LLP Client Alert, United States v. Newman: Second Circuit Ruling Portends Choppier Waters for Insider Trading Charges Against Downstream Tippees (December 15, 2014), available at: http://www.gibsondunn.com/publications/pages/US-v-Newman–Second-Circuit-Ruling-Portends-Choppier-Waters–Insider-Trading-Charges-Against-Downstream-Tippees.aspx.

[14] Frédéric Oudéa, "Europe Needs Homegrown Bulge Bracket Banks," Financial Times (October 12, 2015). Monsieur Oudéa’s contentions about the resurgence of U.S. investment banks in Europe are supported by numerous recent articles in the financial press.

[15] Id.

[16] Caroline Binham and Emma Dunkley, "Banks Win Fresh Concession on Ringfencing Rules," Financial Times (October 15, 2015).

[17] Blake-Evans Pritchard, "JFSA’s Mori Warns on Over-Regulation of Banks, Risk (October 13, 2015) (emphasis added).

[18] Ernst & Young LLP, 2015 Risk Management Survey of Major Financial Institutions (October 2015).

[19] Frédéric Oudéa, "Europe Needs Homegrown Bulge Bracket Banks," Financial Times (October 12, 2015).

[20] Andrew Ackerman & Ryan Tracy, "SEC Fights Turf War Over Asset Managers," The Wall Street Journal (January 28, 2014).

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