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Sen. Dodd Concerned About Global Regulatory Arbitrage, Particularly in Derivatives Area

By Jim Hamilton

In recent remarks at an Atlantic Council forum, Senate Banking Committee Chair Christopher Dodd said that the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act is only the beginning of a process that will include regulations and international harmonization. Noting that the Act incorporates the understanding of the global interconnectedness of financial services, Senator Dodd said in crafting the legislation Congress followed the G-20 principles on financial regulatory reform almost to the letter. Indeed, the model for the legislation is the G-20 agenda for financial reform based on enunciated principles. More broadly, in Dodd-Frank, Congress was creating the 21st century architecture for financial services regulation that could become a global model.

The Chair also noted that harmonization of principles internationally is important. The Act had four central goals that harmonized with G-20 principles. First, the Act sought to regulate the shadow banking system and OTC derivatives. Second, the Act sets up a Financial Stability Oversight Council to monitor systemic risk to the financial system, creating a multiple set of eyes in an effort to get out in front of problems. Third, the Act sets up a liquidation authority to end taxpayer bailouts of large financial institutions and end too big to fail. An insolvent highly interconnected company that puts the financial system at risk will pay a price. While conceding that the resolution path may need some tinkering, Senator Dodd said that it preferable to the bankrupty process, which is not well equipped to handle the liquidation of a complex globally interconnected financial institution. Fourth, the Act enhances consumer protection in an effort to restore trust and confidence to the financial system. The Act accommodates both consumer and prudential interests when it comes to financial institutions.

The Act attempted to minimize regulatory arbitrage, noted Senator Dodd, but we must also avoid sovereign arbitrage and a race to the bottom. Derivatives regulation is one area where we could have race to bottom, he cautioned, as legislation erects a responsible regulatory structure without strangling creativity and innovation. Exotic derivatives instruments must have as much transparency as possible. He noted that the EU has not been inclined to have mandatory exchanges for derivatives, while Dodd-Frank essentially has that concept. Noting that mandatory exchanges for derivatives makes sense, Senator Dodd would like to see the EU follow that model. But conceded that the derivatives area is one that could run wild on you with regulatory arbitrage, so we need commonality here.

Meeting the challenge of avoiding regulatory arbitrage and harmonizing financial regulation globally must be an ongoing process, said the senator. In that spirit, he recommended formalizing a permanent process at the G-20 so that regulatory principals can meet regularly, he suggested as frequently as quarterly, to discuss regulatory harmonization. This is critical, he emphasized.

The Act works on the premise that we will still need credit rating agencies. For one thing, it is hard for small public companies to do the due diligence. Senator Franken came u with what Senator Dodd called a ``wheel of fortune approach?? random selection of rating agencies and you spin a wheel and randomly get a rating agency. Senator Dodd did not know how that approach would work. Companies are different. Thus, the Act directs the SEC to do study and if the Commission can?t come up with a better idea, the SEC will do the Franken approach. Senator Dodd hopes they come up with better idea. This is an SEC study, but with goal to come back with something that makes sense

He assumes and expects that there will be a technical corrections bill because of the size of Dodd-Frank, but not necessarily in the 111th Congress.

With regard to the Basel III new capital rules, Senator Dodd praised the Collins provisions in Dodd-Frank dealing with adequate capital and leverage. People are rightly concerned about the issues of inadequate capitalization and leverage. It is an issue, he said, but not the only issue, on whether a financial institution poses a systemic risk. He noted that Senator Richard Shelby, Banking Committee Ranking Member, is very concerned about capital standards, so there is a common interest in adequate capital standards. An ongoing permanent dialogue is needed in this area as well, said Mr. Dodd.

Full post as published by Jim Hamilton's World of Securities Regulation on August 05, 2010 (boomark / email).