Dodd Frank Act and the Consumer Affect on Banks

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1 A Point of View Dodd Frank Act: Partner your way to Compliance With the passage of the Dodd Frank Act, banks and financial institutions are grappling with a highly restrictive environment and burgeoning compliance costs. Looking at the cost pressures, it is imperative for institutions to partner with a pyramid of specialized service partners rather than creating the entire structure in-house and consequently, negatively impact their balance sheets. Our proposed model perceives execution partners at the base, competency partners in the middle and strategy partners at the top of the partnership pyramid. Introduction If the Glass-Steagall Act was the dragon they managed to bury, Mr. Dodd and Mr. Frank have definitely brought it back. The Banking and Financial Services (BFS) industry seems to have completed a full circle with the Glass-Steagall, then Gramm-Leach-Bliley and now the Dodd-Frank act. The financial crisis of 2008 was followed by the worst economic downturn since the 1930s. As the crisis unfurled, the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July According to the bill s subtitle, the intention of the legislation is the oft quoted to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end too big to fail, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. Implementation of Dodd-Frank Act: Rethink, Revamp Compliance Financial institutions are actively trying to adapt to the new regulatory environment which has evolved with the passage of the Dodd-Frank Act. That said, implementing the Dodd-Frank Act is not easy, either for the regulators or for the institutions under their purview. Major constraints to successful implementation include the ever evolving regulations, fragmented technology and data architecture, and resource constraints. All these factors can drag the implementation beyond prescribed timelines and escalate associated costs. Even large Bank Holding Companies (BHCs) are struggling to conform to the standards set by Fed on capital planning and related compliance activities. Compliance does not come cheap Various studies indicate that Dodd Frank implementations will cost the institutions, on an average, at least $50 million, depending on factors such as the institute s Assets Under Management (AUM), revenue, and size and complexity of operations. The costs can be broadly attributed to the expansion of the compliance function, restructuring of legal entities, development of new systems and tools and building new capabilities. CCAR regulation could be a case in point. CCAR: Fed Assessment 2013 Some areas where large BHCs continue to fall short of industry leading practices in Capital Planning Not being able to show how all their risks are accounted for in their capital planning processes Using stress scenarios and modeling techniques that do not address the particular vulnerabilities of the BHCs business model and activities Generating projections for some components of loss, revenue, or expenses using approaches that are not robust, transparent, and/or repeatable Having capital policies that do not clearly articulate a BHC s capital goals and targets and do not provide an analysis of how these goals and targets were determined Having capital policies not comprehensive or detailed enough to provide clear guidance about how the BHC would respond to changes in its capital position due to different economic circumstances Having less-than-robust governance or controls around the capital planning processes, including fundamental riskidentification, -measurement, and - management practices BHCs continue to face challenges with MIS. Many BHCs have systems that are antiquated and/or siloed and not fully compatible, requiring substantial human intervention to reconcile across systems Source: The Federal Reserve, Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice, August 2013

2 Comprehensive Capital Analysis and Review (CCAR): A Case in Point CCAR (mandated by Section 165 of the Dodd-Frank Act) incorporates post stress evaluation of BHCs capital adequacy, internal capital adequacy assessment processes, and viability assessment of their capital plans. The Fed also assesses BHCs strategies for addressing proposed revisions to the regulatory capital framework agreed under Basel III and the Dodd-Frank Act (DFA). Modeling and Reporting Requirements CCAR mandates significant modeling and stress testing requirements. Various models need to be built to project net income and stressed capital while creating a capital plan. These models include loss projection models for loans held in the accrual loan portfolio, loss projection models for losses from changes in fair value on loans, Pre-Provision Net Revenue (PPNR) components projection models and Capital Ratio Projection model among others. The schedules that incorporate the Capital Plan, FR-Y-14A, use data from FR Y-14Q and FR Y-14M schedules as the primary input. These projections need to be done on a quarterly basis over the nine-quarter planning horizon, beginning with the fourth quarter of the current calendar year. Cost Impact of CCAR CCAR compliance can therefore turn out to be a costly affair for the BHCs. Not all institutions have adequate capabilities in terms of building analytical models for stress testing, or sufficient resources to meet the huge documentation and reporting requirements. The existing data, systems and IT infrastructure may not have the capabilities required to handle the highly detailed reporting and reconciliation requirements. Significant investments will be required in areas such as manpower, capability building and IT infrastructure. From the manpower perspective, primary estimates suggest that some big banks are spending almost 29-30,000 hours per annum on CCAR compliance. Compliance Costs and Working Partnerships Considering the compliance costs in terms of technology and people and skills upgrades, it is imperative that complying institutions explore low cost options, outsourcing the compliance function to the extent possible. Partnership Pyramid Outsourcing activities related to regulatory compliance, however, is a balancing act. Organizations need to ensure a tight grip on strategically important data and decisions while achieving cost efficiencies through outsourcing. Figure 1 presents a pyramid of activities that banks may consider outsourcing and partnerships they may seek to execute those activities. Strategic consultants appear at the peak of the pyramid, skill based consultants in the middle and program implementation partners at the base. Strategic consultancy partners: Industry Experience, Thought Leadership and Relationships Skilled Consultancy partners: Systems, Legal, Accounts, Process, Quantitative Modeling Program Implementation partners: Skills like reporting, documentation, record keeping, coordination and maintenance activities Figure 1: Partnership Pyramid 2

3 Strategic Consultancy Figure 1 shows the partnership pyramid with strategic consultants at the tip. Strategy consultants are recognized for their deep industry experience and wide industry network. Strategy consultants have an in depth understanding of the financial markets, various interrelationships within the financial ecosystem and can guide financial institutions in avoiding hurdles in regulatory compliance. They offer thought leadership and help financial institutions frame policies, strategic business plans and define roadmaps for implementing the policies. Skilled Consultancy Forming the middle of the pyramid are skill based consultants. They could be corporate attorneys (interpreting the bold and fine print of various regulations), data and systems architects (understanding and integrating various systems to align the data with reporting requirements), process engineers (to establish efficient governance, controls and checks), and quantitative modelers (to satisfy the huge stress testing requirements). They are essentially domain specialists either thought leaders in their respective domains or industry practitioners applying their knowledge in the regulatory context. Program Implementation At the base of the partnership pyramid are execution partners with skillsets to routinely deliver all the predefined processes using existing systems and frameworks. Another major faculty is program management. CCAR compliance requires participation from almost all the functions within banks such as Treasury, Financial Planning and Analysis (FP&A), Risk Management, Technology and all lines of business as also the Chief Executive Office. Coordinating communication as well as data flow between the various stakeholders is a huge task in itself, requiring significant investments in terms of cost, time and effort. Metrics to identify activities that can be outsourced: Identifying and outsourcing compliance related activities requires in depth analysis of various activities involved in achieving compliance and determine their outsourcability. This analysis helps to identify the kind of outsourcing partners an institution needs to work with. Figure 2 highlights some of the metrics that can be used for the purpose. They include process attributes that help determine the portability of the processes, skillset requirements and regulatory constraints, if any. Process attributes Technical portability Process maturity, stability and process definition Process risk profile Possibility of process automation Requirement regarding proximity to the Outsourcing institution Specialized skillsets Specialized skillsets involved Specific certifications / licenses Regulatory constraints Cannot be done outside the institution Cannot be done outside the geography Figure 2: Outsourcability Metrics 3

4 Conclusion In summary, looking at the onslaught of regulations and aggressive timelines regulators have chalked out for compliance, it has become imperative for financial institutions to look for various partnering / outsourcing options. Developing all the skills in house will prove to be expensive, time consuming and not always efficient, especially for a cost function like compliance. Some institutions might eventually prefer to transition to an in-house compliance unit, but given the demands of the regulation, this may not be feasible in the immediate future About the author Varsha Khare Varsha leads the CCAR and Regulatory Compliance offerings space within the Analytics and Insights Practice (Banking and Financial Services) at Tata Consultancy Services. Varsha is a Ph.D. in Economics from the University of Mumbai and has over 12 years of experience in the Banking and Capital Markets sectors. 4

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