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Regulatory intelligence

Deregulation in US financial services

Navigating Trump-era priorities from within industry and government

At the beginning of each year, and certainly each new president’s administration, we find ourselves engaged in discussions of how the regulatory landscape in Washington, D.C. will impact businesses in the US .

This is the state in which we find ourselves now.

In Congress, the Financial CHOICE Act proposes to repeal a number of the Dodd-Frank Act requirements that were either in effect or close to being finalized.

The most notable CHOICE Act provision is a so-called regulatory “off ramp,” which would free an institution from regulatory scrutiny if it holds 10 percent of its assets in reserve to cover potential losses – regardless of the bank’s size or the complexity of its business.

The new one-size-fits-all regulation would make compliance simpler and less costly, supporters say. But Dodd-Frank backers and regulators doubt whether the 10 percent reserve cushion would be large enough to prevent another crisis should some of the largest US banks fail.

On the executive side, a presidential executive order issued by President Trump on January 30, 2017, calls for executive departments and agencies to identify two existing regulations to be repealed for every new one proposed.

While the “Two-for-Every One” order does not apply to independent agencies like the Securities and Exchange Commission (SEC), the Federal Reserve and most bank regulators, a bill passed by the House on January 12, 2017 may still restrict the SEC’s rulemaking ability if passed by the Senate and signed into law.

Specifically, the SEC Regulatory Accountability Act would require the SEC to identify the problem a proposed rule is designed to address and ensure its benefits outweigh the costs.

President Trump aimed to dismantle even more financial regulations with the issuance of additional executive orders on April 21.

These executive orders will prompt a review of the significant tax regulations issued in 2016 and 2017 that are overly complex and, as his order states, “impose an undue financial burden” on taxpayers. The order is more likely to target corporate taxes than individual returns.

The order also calls for a review of the Treasury Secretary’s obligation to use orderly liquidation authority to bail out insolvent financial institutions, reigniting the debate over a key provision of the Dodd-Frank Act.

The SEC on its own has proposed amendments to various rules to reduce the burdens placed on smaller issuers, such as proposed amendments to the definition of “smaller reporting company,” that would make scaled disclosure requirements available to a wider array of issuers.

Businesses expect big benefits

Banks and other financial companies, expecting big benefits from Republican-led deregulation, spent record amounts on lobbying in the last election cycle, according to an advocacy group report released in March.

The Financial sector spent $2 billion on political activity from the beginning of 2015 to the end of 2016, including $1.2 billion in campaign contributions – more than twice the amount given by any other business sector, according to the study from Americans for Financial Reform.

Goldman Sachs released an investment analysis saying that large US banks stand to profit significantly from the kind of financial deregulation expected from the Trump administration and a Republican Congress.

As much as $218 billion in excess capital could be returned to shareholders or reinvested in the banks themselves if all the deregulation the industry is seeking comes about.

Still, even though President Trump has called for significant bank deregulation from both the agencies and via a congressional rewrite of the 2010 Dodd-Frank financial deregulation law, there will be pushback from Democrats and others. Even Goldman Sachs conceded in its review that it was unlikely that all Dodd-Frank-era regulation would be undone.

Doing away with Dodd-Frank completely would be impossible without convincing Senate moderates. And getting rid of the majority or all of it would be costly for industry participants – at least for some time – because institutions have carefully crafted their policies, procedures, technology and expertise to many of the law’s prescriptions.

Some of those changes have actually improved business, according to a study by the consulting firm Accenture. Almost three-quarters of the 132 business executives surveyed by the firm said: “Dodd-Frank will increase their company’s profitability over the lifetime of the program.”

Some burdens attending regulatory rollback

Although regulated industries are not ones to normally whine at the prospect of regulatory rollback, doing a 180-degree reversal can be costly and arduous, especially when they have already designed policies, procedures and system infrastructure around meeting the burdens of an expected rule – one that seemed almost certain last year.

The US Department of Labor (DOL)’s Fiduciary Rule is a case in point.

The Fiduciary Rule requires all who provide retirement investment advice to plans and Individual Retirement Accounts to abide by a fiduciary standard – putting their clients’ best interest before their own profits. Brokers, rather than adhering to the best-interest standard required of registered investment advisers, now adhere to a national standard that their sales must be suitable for their clients.

The DOL has taken steps to delay its implementation of the Fiduciary Rule, offering temporary relief from enforcement of the measure from April 10 to June 9, 2017, although the industry has pressed newly sworn-in DOL Secretary Alexander Acosta for even more time.

In addition, although the national Fiduciary Rule in its current state may be in jeopardy, many brokerage firms have already announced new compensation and sales policies, and competitive forces have already driven fees and commissions lower industry-wide.

The rule’s mandates of lower fees, additional disclosure and removal of conflicts of interest in retail investment advice are likely irreversible at this point.

Furthermore, the significant investments made by some firms in an effort to comply with the new rules, along with already announced changes to fee structures and sales practices, may also make it difficult for them to change or reverse course.

Over the past few years, the SEC has published rules requiring advisers and funds to make sweeping changes to their compliance programs and operations more generally, such as liquidity risk management rules and a revamping of the money market industry regarding disclosures and oversight in this subsector.

The liquidity rules are a likely target for elimination, given the high cost attributed to their implementation and compliance oversight.

As with the Fiduciary Rule, however, since this liquidity rule was adopted in October 2016 and many funds are actively complying, rolling back operations and revising policies and procedures is not without substantial cost, albeit leading to a likely savings over the long term.

Changing direction at federal agencies

Acting SEC Chair Michael Piwowar appears ready to make changes at the SEC; in a February speech, he argued for possible changes to the definition of accredited investor.

Piwowar said the accredited investor rule has produced what he calls a large group of “forgotten investors” unable to benefit from potential opportunities such as unregistered securities, hedge funds and other private investment openings.

His criticism of the rule is something that actually follows on the heels of an Obama-era initiative designed, post- financial crisis, to make the SEC more capital-friendly by encouraging the funding of small businesses by easing many securities regulations via the Jumpstart Our Business Startups Act (JOBS Act).

Piwowar has pushed that cause further by stating his desire to ease restrictions on raising funds via private securities offerings so more investors can access them.

The potential risk to investors could be high, which the agency must appreciate, given that its January list of 2017 examination priorities notes that it would pay close attention to abuses directed at investors – particularly elderly and other “vulnerable” investors – and that it would allocate more resources to examine private fund advisers.

The agency will be looking at the myriad rules that affect different parts of the industry, and make some cuts purely based on complexity and their high costs to businesses.

One act of simplifying, clarifying and removing duplicative filing requirements occurred at the end of 2016 and pertained to three Financial Industry Regulatory Authority (FINRA) rules governing communications with the public.

The consolidation of these rules was welcomed by investor interests and industry participants alike, since they will not lessen investor protection and may provide a modicum of relief to compliance departments.

Examples include rules to regulate mutual fund use of derivatives and rules requiring funds to adopt enhanced- risk management measures, which remains a proposal after the agency failed to get a quorum of commissioners to vote on it in December.

In addition, some easing of disclosure rules and other requirements in the initial public offering sector could happen under its new chairman, Jay Clayton. He is expected to move swiftly to start smoothing the path for businesses seeking to raise money. One such step would be to ease rules governing how companies can “test the waters” by talking to potential investors ahead of an initial public offering (IPO). That helps companies decide whether to proceed and gives them some idea of where to go for funding, before they spend hundreds of thousands of dollars on paperwork.

The regulator might spur what are known as mini-IPOs under “Regulation A,” or offerings up to $50 million. The SEC could do so by raising the threshold to entice more companies to go public through such a fast-track process. This would create more work for those at the SEC, but a big profit potential for the investment bankers and lawyers working on such deals.

Enforcement priorities

Investigations and enforcement actions are high-cost items to the government and (as critics of such enforcement activity would say) when not adequately targeted or circumscribed, they are also bad for business.

But even those who would push back on some of the top-dollar fines in certain areas and the focus on “broken windows” – an enforcement policy punishing minor as well as major breaches of the securities laws, embraced by former SEC Chair Mary Jo White – would agree that enforcement is necessary.

As Piwowar has stated, when a company clearly discloses in its corporate filings that it faces the risk of being hit with a penalty, it is on notice that paying a fine is a fact of being regulated.

What he does not countenance – and other agency heads may follow suit in so reasoning – are penalties that improperly impact the “forgotten investor” by penalizing them twice. That is, once with respect to the corporate- harming conduct and a second time through imposition of the penalty.

The aforementioned Financial CHOICE Act also touches on enforcements and reining them in. It instructs federal regulators to consider proportionality to determine sanctions, since it is common for other US federal regulators, regulators in international jurisdictions, or even one or more state regulators to all bring suit against a corporate bad actor.

The cost of compliance

It is difficult to measure the overall cost of complying with regulations, considering the many parts of the federal, state and local government entities issuing them. Plus, some best practices that companies follow emanate from sources other than formal regulations – like enforcement decisions or efforts to match the practices of one’s competitors.

Again, other jurisdictions and their regulatory imperatives affect global business practices as some of these businesses will adopt uniform practices that can withstand the strictest of regulatory obligations they face in their various business locations and thereby go beyond the letter of the law in others.

One example of this is the collection of rules known as the Markets in Financial Instruments Directive (MiFID), the second iteration of which (MiFID II), is poised to take effect in January 2018 in the European Union.

MiFID II is a wide-ranging piece of legislation affecting investment intermediaries that provide services to clients around shares, bonds, units in collective investment schemes and derivatives, and it will affect firms around the world that deal either directly or indirectly with Europe. Many US firms are changing their policies and procedures on a global basis to ensure compliance.

Looking beyond such large, global firms, studies have shown that the cost of regulatory compliance disproportionately affects smaller firms.

This is noticeable in the debate about the Fiduciary Rule, as some of the most vocal critics of it have been the small and midsized business community – more so than the largest firms.

Regulations have costs – to implement, track, enforce, test and document adherence to. They also have benefits – the cleaner air we breathe, safer air travel and fewer dangerous, little-understood products being mass-marketed in the financial services industry. The costs and benefits have to be quantified in any true study of the cost of compliance.

The costs associated with disclosure-related provisions have been largely monetized because of the requirements of the Paperwork Reduction Act, but the costs associated with provisions that change how the markets are regulated are generally not monetized.

The main regulatory agencies in the financial services arena – such as the Federal Reserve, Consumer Financial Protection Bureau, SEC and Commodity Futures Trading Commission – are independent under the law, and existing executive orders generally do not require independent agencies to submit their regulations for review or to engage in analysis of costs and benefits.

The dearth of compliance cost-benefit data in regulatory arenas (other than the environmental one, where such data is more abundant) is a continued obstacle to efficiency.

A serious consideration of costs and benefits is a useful gauge for ensuring that regulations actually improve outcomes for the intended beneficiaries that outweigh the costs (staffing, technology, time, etc.) associated with implementing and monitoring adherence.

A number of professions make their living promulgating and enforcing consumer, financial national security and environmental protections or by helping businesses and individuals manage the burdens that more regulations inevitably create (from compliance professionals to lawyers to auditors), but plenty of small and even midsized business owners will tell you how hard it is to operate their businesses in the US, thanks to regulatory complexity.

In the meantime, this is not the time to take the eyes off the road and become lax in anticipation of less regulation, as it is the first time many on Wall Street and in government positions have worked in any environment other than an actively growing one.

The new landscape in the near term will require careful attention to the regulations that are being maintained (presumably there is good reason for their retention); which policies and operations must change to adjust to the new landscape; where money, manpower and technology could be redeployed; and whether any unintended outcomes resulting from deregulation require prompt attention.

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