Challenges in making rules under the Dodd Frank Act, 2010

The Dodd-Frank Act is very ambitious in its scope and expects all agencies charged with banking regulation to come up with specific rules within 18 months (or so) in their respective domains so as to actually implement the DFA across the financial services spectrum. This is (far) easier said than done and regulatory agencies need significant resources to be able to do a good job in this area. Let us see some of the things that precede rule-making at individual agency level:

1.       Subject matter expertise: All the agencies have accumulated vast expertise in their respective domains but DFA covers new territories not charted by any agency thus far. They include Hedge Funds, Capital Adequacy, Consumer Protection, Segregation (Volcker) and so forth. The industry has spent billions of dollars and employed an army of Ph Ds to come up with very sophisticated IP and to understand these issues to a level that you can write a regulation around it will take a lot of learning for the agencies. In general, I believe a good regulation does not need to correspond one-to-one with industry practices but writing a new regulation in an hitherto unregulated (or lightly regulated) area is a different cup of tea.

2.       Defining the terms: Each industry has its jargon and I guess financial services is the leader in this arena. From “give me some balance sheet” to “dark pools” and from “family offices” to “Hedge Funds” there are terms galore and everyone understands what they mean but when you talk of basing a law on these terms, you need a precise definition to ensure that the Regulated Entities are clearly identified and the regulations do not end up offering regulatory arbitrage. I will not be surprised if the terms to be defined run into thousands and this amounts to virtually building an industry lexicon and will be a humongous task.

3.       Resources: Obviously, these are not the times to fund major government initiatives. Already, the DFA sets in motion activities that need huge funding support (consumer protection, education, orderly liquidation fund, insurance council and more). And the DFA rule-making process (we are still not talking about enforcement, just rule-making) is causing agency heads to raise their hands in despair. The Chairman of the SEC, in a recent study by Boston Consulting Group, said the following “We are currently understaffed by about 400 and need a total of 800 staff to cope up with the DFA”. Union rules, poor communication with self-reg (read FINRA) institutions were cited as some of the challenges. Read this in conjunction with 1 above and you realize that even if budgets were to be available, you are not going to find people of the required caliber in the required numbers quickly.

4.       Internal Training: Consumer education et al are great things to do but the regulators across the board will require significant training and collaboration with other centers of expertise within the government. It is fair to say that every examiner of every agency does not understand the nuances of all the complex swaps and derivatives and hedge funds and dark pools to a level that he or she can actually go ahead and examine it to assure regulatory compliance. We expect legal issues to come up as entities will fight fiercely to maintain the confidentiality of their intellectual property in trading strategy models and formulae and even if they were to be overcome, to have the domain and technology expertise to reverse-engineer those to an extent that you can verify if they break any laws. The Fed Agencies will need to collaborate in innovative ways with universities and specialized agencies not only in the United States but globally to really create the capability needed to implement DFA in a meaningful way.

5.       Plugging the holes: In the meanwhile, the new Pokemon Institute reports shows the goings-on in the data theft and breach world. They surveyed 51 organizations from 15 industries (including financial services) and say that the cost of data breach repairs continue to climb and the average cost of doing so across surveyed entities in 2010 was $ 7.2 million. They, of course, do not include the costs that are not immediately visible in monetary terms such as reputation, client walking away to a competitor etc and we all know that those costs eventually extract a far

These are huge challenges and it will test the mettle of the government from the President to the Fed and all the agencies to take the well-meaning DFA to a state of a comprehensive and enforceable law. All this is not to say that it is not good or anything of that sort. In spite of all the issues and challenges, this step is pioneering and if successful, will establish a bench-mark for regulating the financial services industry of the future. America leads the world in financial services and it must lead in financial services regulation too but it will take a lot more than good intentions to make it work.