Abstract
The Dodd-Frank Act (DFA), which was first proposed in fall of 2009, is expected to bring a paradigm shift in the state of
the regulatory environment of financial institutions. It will require transforming current IT systems which are supporting
regulatory compliance into more reliable compliance tracking systems and in-turn adding more value to the business.
While the act will complete two years in July 2012, it is still in an evolving stage and how it ultimately pans out is something
which remains to be seen. This paper will cover DFA’s context, proposed changes and impact on the financial services
industry from a business and IT perspective.
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Dodd-Frank Act: Impact on Business and IT
Lack of regulatory oversight, neglected visible warnings, poorly understood toxic instruments, size of financial institutions and their interconnectedness were some of the reasons for the financial catastrophe in 2007-08. With the US being the biggest source as well as victim of this crisis, the need to bring strong changes in the US regulatory system was quite evident. The Dodd–Frank Wall Street Reform and Consumer Protection Act (DFA) aims to bring in sweeping changes in the US regulatory system.
While DFA aims to bring in structural changes to a lot of areas, it will have a strong impact on IT systems as well. We believe that data management, regulatory reporting and trading platform changes are likely to be the major areas where IT systems will be impacted. This paper discusses the impact on some of the IT systems in the financial services industry.
DFA’s major objectives are to prevent a repeat of events like the credit crisis, remove the myth of “too big to fail” and avoid bail-outs from taxpayers money. Key highlights of DFA’s proposal which aim to transform the regulatory structure are:
• Protect American consumers from abusive financial services practices. • End the “too big to fail” bail-out concept to ensure that taxpayers don’t bear
the brunt of the failure of large financial institutions.
• Create advance warning systems so that the entire financial system is well prepared to deal with future crisis.
• Bring more transparency in derivatives and exotic instrument markets ensuring that these instruments, which was one of the major reasons for the credit crisis, don’t create havoc again.
• Increase accountability of credit rating agencies as these ratings play a major role in investment decisions for debt instruments.
• Provide shareholders a say in executive remuneration so that top executives’ decision making is aligned with the long term interest of the financial institution (FI) rather than making personal gains.
DFA’s main objective is to protect the American financial system and its various stakeholders. The act will need FIs to develop and adopt a new organizational culture which has its foundation laid on the principles of customer and investor protection. Certain proposed changes under DFA, like pricing of different products or value proposition to the customers, will impact the financial performance of FIs. Hence, FIs will need to transform their business strategy so that the impact of proposed changes on their financial performance is minimal. In the DFA regime, FIs will also need to improve their risk and compliance capabilities such as developing a comprehensive risk reporting framework including real-time reporting or developing a robust stress testing mechanism across different scenarios. With the act cutting out certain revenue streams for FIs and putting an additional cost burden of complying with new regulatory requirements, FIs will need to be more efficient in their cost management. FIs will need to be quick in their response to the changing regime. They will require setting up a regulatory response team managing coordination amongst the firm’s different businesses and help in implementing the regulatory compliance program.
Major Sections of DFA
DFA has been categorized into sixteen different acts. All these titles, collectively, aim to bring more clarity in the role and responsibilities of the regulators, do away with the ambiguity in existing regulations and empower the regulators. In order to do so, the act mandates many changes to the activities of financial institutions and banks. The figure below showcases the major areas that will be impacted by the act.
DFA’s Impact on Business and IT
DFA aims to bring about a complete overhaul in the existing financial system and impacts different Lines of Business in the financial services industry. The following table highlights the impact of DFA in certain lines of business and the impact on the corresponding IT systems.
Business Lines (Impacting Acts) Business Impact IT Impact
Commercial / Consumer Lending (Title XIV – Mortgage Reform and Anti-Predatory Lending Act1
Title VI - Improvements to regulation of bank and savings Association holding companies and depository institutions2,
Volcker’s Rule)
• Requirement for stricter origination and underwriting leading to the need for better documentation.
• Increased focus on standardizing data collection for underwriting.
• Restriction on mortgage originators to lend only to those borrowers who are likely to repay their loans.
• Stricter residential mortgage organization standards which must be met while lending. • Capital restrictions on investments will impact
proprietary trading which will in-turn surely have revenue impacts on banks.
• Existing systems will have to adapt to new rules and regulations especially regarding mortgage lending. • Latest regulations will put more focus on stress
testing.
• Higher requirements for documentation with more stringent loan tracking and borrower performance tracking.
• Increased focus on internal quality checks leading to increased testing requirements for existing systems. • Greater regulatory reporting with regards to lending
activities, loan monitoring and investments.
Investment Banking (Title VI - Improvements to regulation of bank and savings Association holding companies and depository institutions, Volcker’s Rule)
• Volcker’s Rule places restrictions on proprietary trading and certain M&A activities.
• Stricter restrictions on securitization business will result in lower transaction volumes of securitized instruments.
• Factoring / implementing rules within existing systems to prevent prohibited trades.
• Increased focus on testing to ensure prohibited transactions are avoided.
• Greater amount of regulatory reporting.
Wealth Management and Investment Advisory
(Title IV – Regulation of Advisers to Hedge Funds and Others3 Title IX - Investor Protections and
• Increased reporting requirements of investment advisors.
• Limit the ability of financial / wealth advisors to exclude information while reporting to various federal government agencies.
• Implement stricter pre-trade compliance checks, more system enforced restrictions and post-trade compliance reporting.
• Incorporate new regulations into processes and business rules of online transaction processing systems.
Clarifying Federal Regulator Powers and Responsibilities
Mandating Changes to Financial Firm Activities
Capital Markets Related Provisions
Created the Financial Stability
Oversight Council Prohibit Proprietery Trading (Volcker Rule) Creation of Clearing Houses for Swaps Altered Federal Banking Regulation
and Supervision Stringent Norms for Securitization Reform of Credit Rating Agencies Curtailed Federal Reserve’s Emergency
Credit Lending Abilities Registration of Investment Advisor to be More Stringent Consumer Protection Provisions are Mandated Created the Orderly Liquidation
Business Lines (Impacting Acts) Business Impact IT Impact
Hedge Funds and Private Equity (PE) Funds
(Title IV- Regulation of Advisers to Hedge Funds and Others)
• Hedge funds and PE funds will need to register themselves with the Securities and Exchange Commission (SEC).
• Banks can’t provide more than 3% of the fund’s capital or invest more than 3% of their Tier 1 capital which will lead to an impact on fund raising for hedge funds and PEs.
• DFA puts a restriction on the ability of banks to bail out a fund in which they are invested. Thus, banks will have to be more prudent while investing which will lead to relatively riskier funds being forced out of the market.
• With the registration of hedge funds and PE funds becoming mandatory, these institutions will need to set up their own compliance offices and systems. • Increased requirement for record keeping
and reporting of assets under management, counterparty credit risk exposure, valuation methodologies and practices, types of assets held and trading practices.
Securities Trading (Title VII – Wall Street Transparency and Accountability5)
• SEC and Commodity Futures Trading Commission (CFTC) to regulate over-the-counter (OTC) derivatives to prevent excessive risk-taking. • Central clearing for OTC derivatives and exchange
trading for swaps will become mandatory (except for a few deviations as provided in the act). • DFA proposes a role for both regulators and
clearing houses to determine which transactions should be cleared.
• Need for data collection and publication through clearing houses or Swap Data Repositories (SDRs) to improve market transparency, monitoring and response from a regulatory perspective.
• DFA empowers regulators with the authority to impose capital and margin requirements on Swap Dealers (SDs) and Major Swap Participants (MSPs) instead of the users.
• Introduction of a new trading platform - SWAP Execution Facility (SEF).
• Other participant trading platforms will need to adapt to central clearing and exchanged trading. • Real-time and pre-decided period-based reporting
for public, regulators and market supervision while following the guidelines for dada dissemination.
1 Title XIV—Mortgage Reform and Anti-Predatory Lending Act, Dodd-Frank Wall Street Reform and Consumer Protection Act – June 2010, Page 773,
2 Title VI—Improvements To Regulation Of Bank And Savings Association Holding Companies And Depository Institutions, Dodd-Frank Wall Street Reform and Consumer Protection Act – June 2010, Page 226
3 Title IV—Regulation of Advisers to Hedge Funds and Others, Dodd-Frank Wall Street Reform and Consumer Protection Act – June 2010, Page 199
4 Title IX—Investor Protections and Improvements to the Regulation of Securities, Dodd-Frank Wall Street Reform and Consumer Protection Act – June 2010, Page 870 5 Title VII—Wall Street Transparency and Accountability, Dodd-Frank Wall Street Reform and Consumer Protection Act – June 2010, Page 271
DFA’s Progress Report
As of April 2012, the count of DFA’s total required rulemakings stood at 398. However, DFA’s progress has been sluggish with the rulemaking activities running way behind schedule. 221 of DFA’s rulemaking requirements should have been finalized but only 73 (33%) of the rulemaking requirements could reach the finalization stage while 148 (67%) of the rulemaking requirements missed this deadline.
Further, only 108 (27%) of the total rulemaking requirements have been finalized whereas 144 (36.2%) rulemaking requirements have not even been proposed. The figure below displays DFA’s progress.
What it means for IT Outsourcing
31.91% 5.28% 27.14% 4.77% 30.90% 31.91% 5.28% 27.14% 4.77% 30.90%
DFA Rulemaking Progress by the End of April 2012
Missed Deadlines, Proposed Missed Deadlines, Not Proposed Finalized
Future Deadlines, Proposed Future Deadlines, Not Proposed
More IT investments across different lines of business
DFA proposes stricter norms for lines of business spread across the financial services industry. This will not only require more investment in modifying existing IT systems but also building new IT systems and integrating them with existing platforms. In order to comply with new regulations, financial institutions will need to increase investments towards IT.
Efficient cost management may result in greater outsourcing
With DFA affecting the revenues across different streams (e.g. proprietary trading, OTC derivatives, changes in securitization) and rising costs (of risk management, compliance, reporting, switching to new platforms), the pressure on cost savings and efficiency will increase. This will push securities firms to rely more on business process outsourcing (BPO) and information technology outsourcing (ITO).
Changes in service delivery processes
DFA will also have an impact on the firms’ attitude towards IT services. It will influence the way concepts such as application service provider (ASP)-based delivery, software-as-a-service (SaaS) and cloud computing are viewed. During the last few years, there has been a clear trend in the
1. A closer look: The Dodd–Frank Wall Street Reform and Consumer Protection Act, Impact on Information Technology and Data, PwC, October 2010
2. A closer look: The Dodd–Frank Wall Street Reform and Consumer Protection Act, Impact on SWAP Data Reporting, PwC, October 2010
3. The Implications of Landmark US Reg. Reform Act, The Dodd–Frank Wall Street Reform and Consumer Protection Act, Deutsche Bank, July 2010
4. The Dodd-Frank Wall Street reform and consumer protection act, or Dodd-frank act, represents the most comprehensive financial regulatory reform measures taken since the great depression, Morrison & Foerster
5. Summary: Restoring American Financial Stability, Senate Committee on Banking, Housing, and Urban Affairs, Chairman Chris Dodd (D-CT)
6. Technology Implications and Costs of Dodd-Frank on Financial Markets, TABB Group, March 2011
7. REGULATORY REFORM SUMMIT 2011 DODD-FRANK IMPACT ANALYSIS, Barclays Capital, July 2011
8. US Regulatory Reform in Securities and Investments: The Dodd-Frank Act and Its Implications, November 2010, Tower Group
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About the Authors
Vibhash Prakash AwasthiVibhash is a Lead Risk Consultant within the Risk and Compliance practice of FSI [Financial Services and Insurance]. He has rich experience in Credit Ratings, Investment Banking and Basel II implementation. Vibhash earned his Post Graduate Diploma in Management from Indian Institute of Management, Calcutta (IIM-C). He can be reached at [email protected].
Hemant Shashikant Dandegaonkar
Hemant SD is an Principal Consultant within the Risk and Compliance practice of FSI [Financial Services and Insurance] responsible for development of the practice, research and PoV creation, supporting proposals, and other practice PMO activities. He has worked in the banking domain extensively in the areas like Basel-II, euro compliance and Y2K compliance. He is co-inventor for a patent on Program Maintainability Index of Software applications in JAVA and COBOL. He can be contacted at [email protected].
Abhishek Prasad Mokal
Abhishek Prasad Mokal is an Associate Consultant within the Risk and Compliance Practice of FSI [Financial Services and Insurance]. He is finance major with CFA, Level 1 and has worked in the Retail Banking domain in the areas of Account Management and Mortgages. He can be contacted at [email protected].
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