Washington regulatory update

May 11, 2011

"A wise and frugal government, which shall leave men free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned - this is the sum of good government." Thomas Jefferson

"Bill Gates is a very rich man today... and do you want to know why? The answer is one word: versions." Dave Barry

Federal Reserve Chairman Ben Bernanke on Macroprudential Approach to Supervision and Regulation

On May 5th, Federal Reserve (Fed) Chairman Ben Bernanke presented a thoughtful presentation on Macroprudential Supervision and Regulation at the Chicago Fed's Annual Conference on Bank Structure and Competition. The Chairman noted that a central element of Dodd-Frank is its requirement that the Fed and other regulators adopt a so-called "macroprudential approach" to supplements traditional supervision and regulation on individual firms or markets, "with explicit consideration of threats to the stability of the financial system as a whole." The ultimate goal of macroprudential supervision is "to minimize the risks of financial disruption that are sufficiently severe to inflict significant damage on the broader economy." However, the Chairman took pains to point out that a macroprudential approach to oversight "does not avoid the need for careful microprudential regulation and supervision." He noted that the oversight of individual institutions serves many purposes beyond the enhancement of systemic stability, including protection of the deposit insurance fund, detection of money laundering and the prevention of unlawful discrimination or abusive lending practices. At the end of the day, the Chairman emphasized that microprudential oversight provides the "knowledge base" on which a more systemic approach must be built; regulators cannot understand what is going on in the system as a whole without a clear view of developments within key firms and markets. "Without a strong microprudential framework to underpin them, macroprudential policies would be ineffective," said Chairman Bernanke.

While proclaiming macroprudential supervision to be a "major innovation," the Chairman nonetheless admitted that "it also poses considerable conceptual and operational challenges to implementation." He then went on to describe the Fed's approaches to date to implementing macroprudential oversight. The critical first element is a system for monitoring evolving risks to financial stability -- the primary role and responsibility of the Financial Stability Oversight Council (FSOC). He confirmed that FSOC monitoring efforts are "well under way" with working groups established for specific sectors or aspects of the financial system. These working groups make regular presentations to the FSOC. But in words that will no doubt be appreciated by the regulated community, the Chairman stated it was in no one's interest to impose "ineffective or burdensome rules that lead to excessive increases in costs or unnecessary restrictions on the supply of credit."

To better manage its new macroprudential oversight authority, the Fed has created the "LISCC" -- the Large Institution Supervision Coordinating Committee, as a large multidisciplinary working group to oversee supervision of large institutions. A similar structure is to be formed to supervise Financial Market Utilities. As practical examples of macroprudential supervision, the Chairman referred to the recent Comprehensive Capital Analysis and Review of the 19 largest bank holding companies as an example of a horizontal assessment with a macroprudential approach.

Lastly worth noting was the Chairman's explanation that the most stringent margin requirements for uncleared swaps would apply to derivatives contracts between swap dealers and other major swaps market participants "as such arrangements could otherwise involve a risk of "default chains" in which distress at one major firm could cascade throughout the market.

Systemic Risk -- Congress Weighs In and the SEC to Hold a Roundtable on Money-Market Funds and Systemic Risk

On May 12, 2011, Chairman Tim Johnson announced the Senate Banking Committee will hold a hearing on Dodd-Frank implementation of monitoring systemic risk and promoting financial stability. Witnesses will include the heads of the financial regulatory agencies and Neil Wolin, Deputy Secretary of the Treasury. The Chairman, Rep. Randy Neugebauer (R-TX) and Ranking Member Michael Capuano (D-MA) of the of the Subcommittee on Oversight and Investigations of the House Financial Services Committee also sent a letter to the FSOC on May 4, 2011 requesting the FSOC to resubmit its proposed rule on designating certain nonbank financial institutions as systemically important financial institutions (SIFIs) for another "round of notice and comment and include in the revised proposal a more detailed description of the decision-making criteria and material that are contemplated for the final rule." Absent providing such criteria, the legislators asked the FSOC to explain how it will provide an opportunity for potentially-affected firms to comment effectively. In the course of his letter, the legislators noted the "FSOC staff has internally circulated a memorandum providing very specific potential metrics for making the SIFI designation."

On Tuesday, May 10, 2011, the SEC will host a roundtable discussion on money market funds and systemic risk. The objective is to solicit views and discussion of options for mitigating systemic risks associated with money-market funds. The Agenda includes a discussion on the potential for money-market funds to pose a systemic risk to broader financial markets followed by a discussion of four mitigating options raised in the President's Working Group Report, including (i) Floating NAV vs. Bank regulation and (ii) Hybrid approaches to regulation -- (a) Private liquidity bank, (b) mandatory reserve and capital requirements, and (c) Liquidity fees.

It is worth noting that Fed Chairman Bernanke in his remarks summarized above, noted that while the powers of the FSOC itself were limited one of its key roles was fostering coordination among the agencies. He cited the case of money-market mutual funds as an example of such cooperative work. Chairman Bernanke emphasized that "the stability of money market mutual funds -- which suffered dramatic runs that worsened funding conditions at the height of the crisis -- is clearly a systemic issue, not just an industry issue. He endorsed the fact that the SEC is appropriately taking the lead in investigating whether further steps are necessary. Chairman Bernanke also indicated that under the aegis of FSOC, the SEC has consulted with other agencies, including the Federal Reserve, which have provided their own analyses and perspectives. In particular, interagency consultation has helped clarify the potential systemic implications of instability in the money market mutual fund industry. The Federal Reserve will be among the agencies participating in the SEC roundtable, as other representatives of FSOC and representatives from the private sector as will sponsors of a number of major funds and public-interest and academic participants.

CFTC Reopens and Extends Comment Periods for a Host of Dodd-Frank Rulemakings

In a Federal Register Notice of May 4, 2011, the Commodity Futures Trading Commission (CFTC) stated that the regulatory requirements that it had proposed to implement the derivatives title of Dodd-Frank had presented "a substantially complete mosaic of the Commission's proposed regulatory framework for swaps under the Dodd-Frank Act." In light of this mosaic, the CFTC is reopening or extending comment periods of many of its regulatory proposals with an additional period for public comment. In particular, the CFTC is seeking more information -- especially quantitative, on the costs and benefits of the proposed rules.

The Federal Register Notice includes a list of thirty-two different affected rulemakings -- some of whose comment periods have been closed for several months. For those rulemakings whose comment period had closed by May 4th, the comment period is reopened until June 3, 2011. For those rule-makings whose comment period closes during the extended comment period, the comment period is also extended until June 3, 2011. If the original comment period extends beyond June 3, 2011, that will be the last date for comment on such rulemaking.

Joint CFTC-SEC Staff Roundtable on Implementation Phasing for Final Rules for Swaps and Security-Based Swaps under Title VII of Dodd-Frank

The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) staffs held a two-day public roundtable on May 2 and 3, 2011 to discuss the schedule for implementing final rules for swaps and security-based swaps under Dodd-Frank. The CFTC staff presented a series of questions aimed at eliciting public comment and input regarding how to phase the implementation of new rules.


In the view of CFTC Staff, the Act gives the CFTC and SEC certain flexibility to set effective dates and a schedule for compliance with rules implementing Title VII, which involves oversight of swaps and security-based swaps. This authority may be used so that market participants have time to develop policies, procedures, systems, and infrastructure needed to comply with the new regulatory requirements. The order in which the CFTC finalizes the rules does not determine the order in which the rules become effective or the applicable compliance dates.

The staff believes that the CFTC has the ability to phase implementation of the new requirements based on factors such as: the type of swap, including by asset class; the type of market participants that engage in such trades; the speed with which market infrastructures can meet the new requirements; and whether registered market infrastructures or participants might be required to have policies and procedures in place ahead of compliance with such policies and procedures by non-registrants.


The CFTC staff described a number of concepts it is considering in framing recommendations to implement and phase the effective dates of final rules for swaps. In general, these concepts favor a logical, systematic approach to phasing-in rules; some concepts presented included the following:
  • For market infrastructures, e.g., clearing entities, trading platforms, and data repositories, new policies, procedures, and rulebooks must be completed before compliance with those policies, procedures, and rulebooks by market participants could be required.
  • Open access requirements to both clearinghouses and swap execution facilities must provide for client clearing and access at the same time for all participants who wish to use the platform.
  • Non-financial end users have different characteristics than those of financial entities. Consequently, it may be appropriate to provide more time for any new regulatory requirements that may apply to transactions with non-financial end users
  • The Act specifies a number of different requirements for transaction compliance. Among these requirements are (i) the clearing requirement; (ii) the trading requirement; (iii) real-time public reporting; (iv) reporting data to a data repository; (v) swap dealer and major swap participant requirements, such as documentation, confirmation, valuation, and margining; and (vi) compliance with any applicable position limits. Each of these transaction compliance requirements could have different approaches to phased implementation of effective dates depending on the specific requirements of the rules.
  • With respect to transaction compliance, interdependence of one rule with another must be considered. . For instance, it may be appropriate for the definitions of swap dealer and major swap participant to be final before the business conduct requirements for those entities become effective.
  • The statute provides for some natural sequencing. A clearing requirement cannot go into effect until the CFTC conducts a 90-day review process of the swap or group, category, type, or class of swaps. Additionally, there can be no trading requirement prior to the Commission’s determination that a swap is required to be cleared, a trading platform(s) has listed the swap for trading, and the CFTC has determined that the swap is made available for trading.
  • A rule’s effective date may have to take into account the time and resources needed to achieve the needed technology connectivity.
  • For some asset classes, a certain amount of market infrastructure may already be in place and market participants may have already developed procedures that could be adapted to comply with the new Dodd-Frank regulatory requirements. Other asset classes may not be as far along. This suggests that implementation of effective dates for some rules could differ by asset class.

The Consumer Financial Protection Bureau -- the Never-Ending Story Takes Some New Turns

As rumors continue to circulate that the Administration will propose Professor Elizabeth Warren as the first Director of the CFPB, the House Financial Services Subcommittee on Financial Institutions and Consumer Credit on May 4, 2011 passed three bills that would significantly alter the shape and scope of the CFPB. Two of the bills center on the leadership of the CFPB. One would replace the position of Director with a five-member commission, while another would keep any authority from moving to the agency if its leadership is not in place in time for its July 21st start date. Another would scale back the agency’s rule-making ability, allowing the FSOC to reject any CFPB rule with a majority vote. The current language of the Dodd-Frank Act would require the Council to come up with a two-thirds vote. The full House Financial Services Committee is set to vote on - and will most likely pass - this legislation on May 12th.

Meanwhile, on May 5, 2011, 44 Republican Senators led by Senate Banking Committee Ranking Member Richard Shelby (R-AL) sent a letter to President Obama "demanding" changes to the CFPB before nominating someone to lead the bureau. The letter, drafted by enough Senators to block a vote on a potential nominee, articulated many of the points reflected in the related House legislation discussed above. Further, the Senate letter directed that funding for CFPB be subject to congressional scrutiny.

In light of these developments it becomes increasingly likely that the Obama Administration may appoint Professor Warren as Director through a recess appointment -- Congressman Barney Frank, Ranking Minority Member of the House Financial Services Committee, suggested as much in remarks quoted in the press last week. A recess appointment would temporarily circumvent the Senate confirmation process, but such a move, particularly for a post that has been and continues to be controversial, could hold longer-term political costs for the CFPB in the future. A "recess appointment" must be made when the Senate is not in session, but the appointment would expire at the end of the current Congress, requiring a re-nomination and confirmation.

SEC Seeks Public Comment on Short Sale Disclosure

Under Section 417 of Dodd-Frank the SEC’s Division of Risk, Strategy, and Financial Innovation is required to conduct studies of the feasibility, benefits, and costs of (A) requiring reporting in real time, publicly or, in the alternative, only to the SEC and the Financial Industry Regulatory Authority (FINRA), short sale positions in publicly listed securities, and (B) conducting a voluntary pilot program in which public companies could agree to have sales of their shares marked "long,"short," or "market maker short," and purchases of their shares marked "buy" or "buy-to-cover," and reported as such in real time through the Consolidated Tape. (The term Consolidated Tape refers to the current reporting systems for transactions in all exchange-listed stocks and ETFs.)

In the Division’s estimation, data made public by certain self-regulatory organizations (SROs) indicate that orders marked "short" under current regulations account for nearly 50% of listed equity share volume. Short selling involves a sale of a security that the seller does not own or a sale that is consummated by the delivery of a security borrowed by, or for the account of, the seller. Typically, the short seller later closes out the position by purchasing equivalent securities on the open market and returning the security to the lender. In general, short selling is used to profit from an expected downward price movement, to provide liquidity in response to unanticipated demand, or to hedge the risk of an economic long position in the same security or in a related security.

To better inform the study required by Section 417, the SEC, on behalf of the Division, seeks comment on both the existing uses of short selling in securities markets and the adequacy or inadequacy of currently available information regarding short sales, as well as comment on the likely effect of these possible future reporting regimes on the securities markets, including their feasibility, benefits, and costs. The SEC is required to submit a report on the results of these studies to Congress no later than July 21, 2011. All interested parties are invited to submit their views, in writing. Empirical evidence relevant to any part of the Division’s study is expressly requested.

Regulation Z Proposal Implementing Dodd Frank Ability to Repay Provisions

The FRB issued proposed amendments to Regulation Z (implementing regulation for the Truth in Lending Act or TILA) requiring creditors to evaluate a consumer's ability to repay a mortgage loan and establishes minimum underwriting criteria. The proposal was issued in response to Dodd-Frank provisions prohibiting creditors from issuing mortgage loans without evaluating a consumer's repayment ability. The provisions are substantially similar to repayment ability standards issued by the FRB in July 2008 under the Home Ownership and Protection Act (HOEPA). The proposed repayment ability requirements would apply to all consumer purpose mortgage loans (except for home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans) unlike the Board's 2008 HOEPA rule which only applies to higher cost mortgage loans or those secured by a borrower's principal dwelling.

The proposal provides creditor's with four methods for complying with the repayment ability requirement:

General Ability-to-Repay Standard

A creditor can meet the general ability-to-repay standard by considering and verifying the following eight underwriting factors:
  • Income or assets relied upon in making the ability-to-repay determination;
  • Current employment status;
  • The monthly payment on the mortgage;
  • The monthly payment on any simultaneous mortgage;
  • The monthly payment for mortgage-related obligations;
  • Current debt obligations;
  • The monthly debt-to-income ratio, or residual income; and
  • Credit history; and
Underwriting the payment for an adjustable-rate mortgage based on the fully indexed rate.

Qualified Mortgage

A creditor can originate a "qualified mortgage," which provides special protection from liability. The FRB is soliciting comment on two alternative definitions of a qualified mortgage.

Alternative 1 would operate as a legal safe harbor and define a qualified mortgage as a mortgage for which:
  • The loan does not contain negative amortization, interest-only payments, or a balloon payment, or a loan term exceeding 30 years;
  • The total points and fees do not exceed 3% of the total loan amount;
  • The income or assets relied upon in making the ability-to-repay determination are considered and verified; and
  • The underwriting of the mortgage (1) is based on the maximum interest rate that may apply in the first five years, (2) uses a payment scheduled that fully amortizes the loan over the loan term, and (3) takes into account any mortgage-related obligations.
Alternative 2 would provide a rebuttable presumption of compliance and would define a qualified mortgage as including the criteria listed under Alternative 1 as well as additional underwriting requirements from the general ability-to-repay standard. Thus, under Alternative 2, the creditor would also have to consider and verify:
  • The consumer’s employment status;
  • The monthly payment for any simultaneous mortgage;
  • The consumer’s current debt obligations;
  • The monthly debt-to-income ratio or residual income; and
  • The consumer’s credit history.

Balloon-Payment Qualified Mortgage

A creditor operating predominantly in rural or underserved areas can originate a balloon payment qualified mortgage. This option is meant to preserve access to credit for consumers located in areas where creditors may originate balloon loans to hedge against interest rate risk for loans held in portfolio. Under this option, a creditor can make a balloon-payment qualified mortgage with a loan term of five years or more by:
  • Complying with the requirements for a qualified mortgage; and
  • Underwriting the mortgage based on the scheduled payment, except for the balloon payment.

Refinancing of a Non-Standard Mortgage

A creditor can refinance a "non-standard mortgage" with risky features into a more stable "standard mortgage." This option is meant to preserve consumers’ access to streamlined refinancings that materially lower their payments.

Under this option, a creditor complies by:
  • Refinancing the consumer into a standard mortgage that has limits on loan fees and that does not contain certain features such as negative amortization, interest-only payments, or a balloon payment;
  • Considering and verifying the underwriting factors listed in the general ability-to-repay standard, except the requirement to consider and verify the consumer’s income or assets; and
  • Underwriting the standard mortgage based on the maximum interest rate that can apply in the first five years.
The proposal also implements prepayment penalty limitations, lengthens record retention requirements for repayment ability and prepayment penalty requirements, and prohibits creditors from bypassing rules by structuring credit as open ended. Rulemaking authority for the TILA will transfer to the Consumer Financial Protection Bureau (CFPB) on July 21, 2011. The Fed has solicited comments on the proposed rule until July 22, 2011; therefore, the rulemaking will be finalized by the Consumer Financial Protection Bureau (which assumes regulatory responsibility for Regulation Z on July 21, 2011).