It has been well publicized that on July 21, 2010, President Obama signed into law the 2,319 page Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), to respond to the financial crisis and the Great Recession of 2008. Without a doubt, the Act offers the most robust change to the U.S. financial regulatory system since the Great Depression. By way of comparison, the Federal Reserve Act (1913) was 31 pages, the Glass-Steagall Act (1933) was 37 pages, the Interstate Banking Efficiency Act (1994) was 61 pages, the Gramm-Leach-Billey Act (1999) was 145 pages, and the Sarbanes-Oxley Act (2002) was 66 pages. Despite the breath and scope of the Act, the specific details and implementation of many of the key provisions are left to be determined in the coming months and years by various regulatory agencies (the Act contains over 240 rule making efforts and nearly 70 studies to be completed by 11 regulatory agencies). Moreover, many commercial borrowers are wondering how these changes may affect their ability to finance their companies.  

The Act will impact not only the largest financial institutions, but also regional and community banks, and non-bank financial companies. A primary goal of the Act is to address risky lending practices, which some believe was at the core of the financial crisis. This article summarizes and briefly analyzes key provisions of the Act which may have the most direct impact on commercial lending, and identifies the agencies tasked with regulating those provisions.

I. Capital Reserves (Collins Amendment)

Summary: Section 171 of the Act, known as the Collins Amendment, limits the capital that may be used by depository institutions for regulatory purposes. The limitations include restricting the types of instruments that may be used for regulatory purposes. Section 112 of the Act tasks the newly created Financial Stability Oversight Council with recommending to the Federal Reserve new standards for risk – based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures, and general risk management for large lenders including banks and non-bank financial companies supervised by the Federal Reserve. The Act will incorporate new capital standards which are now being reviewed on a global scale by the Basel Committee on Banking Supervision (which includes federal banking agencies). The new Basel standard is widely expected to include higher overall capital reserve requirements and further limitations on assets which may be counted toward capital.  

Impact: The Collins Amendment may, at least in the short term, diminish the amount of credit available due to the higher capital reserve requirements on covered institutions.  

II. Credit Risk Retention Requirement for Asset Based Securities  

Summary: The Act requires lenders to retain a certain portion of credit risk in connection with the issuance of asset based securities (“ABS”). ABS is broadly defined to include a fixed income or other security collateralized by any type of self-liquidating financial asset (such as a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the security holder to receive payments that depend primarily on the cash flow from the asset. Under the Act, an issuer of an ABS must retain five percent (5%) of the credit risk for such issue, and is prohibited from hedging or transferring the credit risk. Presumably since the lenders/issuers will now have ‘skin in the game’, documentation for individual loans that make up such securities, as well as the quality of appraisals (and market assumptions made for appraisals), will be much higher and more heavily scrutinized. One exemption from the retention requirement will be for “qualified residential mortgages” which will include residential mortgages deemed to be the lowest risk of default by regulators (the exact definition of “qualified residential mortgages” will be determined by the regulators over the next year). The specific risk retention requirements are to be determined by the Office of the Comptroller of the Currency, the FDIC, the SEC, and the Federal Reserve.  

Impact: Commercial lending standards likely will be increased along with increased scrutiny of appraisals, assumptions and due diligence. Consequently, financial covenants may be stricter, and loan documentation would reflect far more conservative terms such as increased loan-to-value requirements and decreased debt service coverage ratios.  

III. Reform Regulation of Credit Rating Agencies

Summary: The Act addresses an aspect of the financial crisis which is considered by many in Congress to be a major problem in the structured financial products market. The Act encompasses credit ratings agencies, which previously were covered under the Rating Agency Act, thought the creation of the Office of Credit Ratings (OCR) within the Securities and Exchange Commission (SEC). The goal of the OCR is to promote greater transparency and reduction of conflicts of interest among credit ratings agencies. At the conclusion of a two year study period, the SEC is to make a determination of the process by which ABS issues will be matched with credit ratings agencies. At a minimum, credit ratings agencies will be required to disclose more information including any assumptions underlying the ratings, methodology, use of any third parties for due diligence, and ratings track records.  

In addition, the SEC will be required to examine all Nationally Recognized Statistical Ratings Organizations (“NRSRO” – which includes each of the major credit ratings agencies) at least once per year and publicize its findings. NRSROs will also be required to submit an annual report to the SEC with an assessment of its internal controls structure governing the NRSRO’s issuance of credit ratings. The SEC will have the power to suspend or revoke the registration of NRSROs if it determines that the internal controls are lacking. Moreover, the Act gives ABS investors a private right of action against NRSROs for a “knowing or reckless” failure to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk or to obtain reasonable verification of such factual elements.  

Impact: The ABS market was effectively frozen during the financial crisis. It is now slowly coming back, although it is unlikely to increase at any significant pace at least in the foreseeable future. Many hope the higher standards for NRSROs will cause the market to return in a sustainable manner which will likely be significantly smaller in size than the peaks reached prior to the financial crisis. As a result, the impact of these reforms will likely diminish the availability of credit.  

IV. The Volcker Rule

Summary: A highly publicized provision in the Act is the so-called “Volcker Rule”, which is named after Paul Volcker, the former chairman of the Federal Reserve and current head of the President’s Economic Recovery Advisory Board. The Volcker Rule, with few exceptions, would bar banks from owning, investing, or sponsoring hedge funds, private equity funds, or proprietary trading operations for their own profit. The Act broadly defines ‘banking entity’ to include (i) insured depository institutions (i.e., banks, thrifts, credit card banks, industrial banks, but excluding certain limited purpose trust companies), (ii) any company that controls an insured depository institution (i.e., bank holding companies, savings and loans holding companies, and any company that directly or indirectly controls a nonbank bank, such as an industrial loan company or a credit card bank, including private equity firms and industrial firms such as General Electric, that control industrial loan companies or federal savings banks); (iii) any company that is treated as a bank holding company under the International Banking Act (i.e., foreign banks that have U.S. branch, agency, commercial lending affiliate, and any company that directly or indirectly controls such a bank) and (iv) any “affiliate” or “subsidiary” of any of these entities. The Act creates a new section 13 to the Bank Holding Company Act which generally prohibits a banking entity from engaging in proprietary trading or acquiring any equity, partnership, or other ownership interest in or sponsor a hedge fund or private equity fund. As with much of the Act, the Volcker Rule is subject to further study and recommendations by the relevant regulators [WHO?], and may take anywhere from one to two years for enactment.  

Impact: The prohibition of covered banking entities from participating in private equity and hedge funds may decrease the number and size of private funds in the near term, which obviously could decrease the availability of private debt and equity. On the other hand, the elimination of those investment options for banks and non-bank lenders may result in increased credit availability to traditional commercial borrowers.  

V. “Too big to Fail” - Creation of Financial Stability and Oversight Council

Summary: In an effort to protect the economy against the ‘too big to fail’ dilemma that faced regulators in the financial crisis, the Act has created the Federal Stability Oversight Council (“FSOC”), which is tasked to monitor systemic risk and make recommendations to regulators. The FSOC is to have 10 voting members and 5 non-voting members from government agencies including the Federal Reserve, the Comptroller of the Currency, the Consumer Financial Protection Bureau, the SEC, the FDIC, the CFTC, and other regulators (including state regulators), and will be chaired by the U.S. Treasury Secretary. While the FSOC will have vast responsibility to oversee the financial system, focusing particularly on gaps in the regulatory framework and emerging systemic risks, it will have limited enforcement authority and must rely upon recommendations to other agencies/regulators for any necessary enforcement actions.  

Additionally, the Act enables regulators to deal with failing banks and covered institutions, “in a manner that mitigates such risks and minimizes moral hazard.” Once a financial institution is deemed to be in financial distress by at least a two-thirds vote of the board of directors of the FDIC, the Treasury, and the Federal Reserve, the FDIC is given authority to manage the unwinding of the financial institution in a manner that minimizes the systemic risk to the broader markets and economy. The costs associated with liquidation will be covered by fees imposed on financial firms with assets over $50 billion. To assist the FDIC, large banks and complex financial institutions are required to periodically submit orderly liquidation plans.  

Impact: The ‘too big to fail’ provisions of the Act will likely not have a significant impact in the foreseeable future on the availability of credit, however, the cost of compliance with these provisions will likely be passed on to borrowers.