By Emil Kranz, VTM Analyst at Prevalent, Inc.
The newly proposed Dodd-Frank rewrite, which is currently part of the $21 billion funding bill being deliberated by the Senate, would cause a shakeup in the riskiness of third-party relationships with banks and financial services organizations which have less than $500 billion of assets on their books, causing companies to have to reevaluate their risk profiles.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted to tighten the regulations imposed on Financial Institutions following the 2008 financial crisis. The major issues addressed within Dodd Frank were: increase capital reserve requirements, creation of the Consumer Financial Protection Bureau (CFPB), and increased transparency in derivative trading.
The proposed Dodd-Frank rewrite looks to change two of the three major issues that the original Dodd-Frank addressed, leaving derivative trading alone. In terms of capital requirements, the rewrite is looking to lower the capital reserve requirements for those organizations who have less than $500 billion of assets on their books. This new “too big to fail” threshold is 10 times that of the current $50 billion threshold. The main argument for this change is that main street and regional banks are being treated like larger Wall Street Banks, which is “unfair.” Along with the lowering of capital reserve requirements, the rewrite looks to allow organizations to provide potentially riskier loans, just as long as those loans remain on their books as opposed to being traded through CDOs.
How does this affect the third-party risk environment?
With lower capital reserves comes a higher chance of financial instability and therefore failure. The Dodd-Frank rewrite, while giving the possibility for greater revenue generation for banks, also increases the risk of bank failure. A primary concern with the rewrite is that no provision is made for providing additional regulatory oversight on how the additional capital will be used. Although the rewrite forces banks to keep all loans on their books, there is no regulatory sanctions regarding the type or riskiness of the loans a bank may write. By forcing banks to keep all written loans on their books, as opposed to trading them through CDOs, the risk of interconnected banks leading to an economic collapse is greatly reduced. However, while decreasing the risk of overly interconnected banks, the rewrite doesn’t address the risk associated to each individual bank.
Inspecting the rewrite on an individual bank level, it lacks necessary regulatory oversight. Lower capital reserves mean that a bank has less of a safety net in the event of an economic downturn. The issue with allowing banks to hold lower levels of capital on hand is that the economy is filled with uncertainty. With the current economic situation in Greece, as well as the currency issues facing Asia and other, countless economic issues, the risk of an organization defaulting on a loan is nearly impossible to calculate accurately.
With this level of uncertainty, comes an increased risk of default, which in turn creates a greater risk of loss for the bank. This potential for loss, paired with the lower capital reserve requirements, leads to an increased risk of bank failure. The changes in capital reserve requirements directly increases the potential for loss and therefore makes additional monitoring of all banks, and reassessments of their risk profiles a necessary part of third-party risk assessment for these institutions.