DODD - FRANK BILL IS NO GLASS - STEAGAL / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

Dodd-Frank bill is no Glass-Steagall

By Aline van Duyn and Francesco Guerrera

Last updated: June 27 2010 19:41

New direction: financial institutions face a maze of prohibitions and exemptions that will have different effects on different companies

Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up.”

That is how the Library of Congress described the run-up to the Glass-Steagall Act of 1933, which revolutionised the US financial sector for six decades by separating investment and wholesale banking.

Nearly 80 years later – with Glass-Steagall long repealed – the backdrop to the latest overhaul of financial regulation was similar to those Depression-era days. The outcome, however, is markedly different.

The financial crisis of 2007-09 left a trail of congressional hearings and accusations against banks of conflicts of interest and, even, fraud. But the Dodd-Frank bill that came out of a 20-hour horse-trading session on Friday morning is no Glass-Steagall.

Instead of the “formidable barrier” set up in the 1930s, present-day financial institutions – banks but also hedge funds, private equity groups, insurers and exchanges – have to navigate a maze of prohibitions and exemptions that will have different effects on ­different companies.

One outcome is broad and almost certain: large financial groups whose failure would put the whole system at risk will have to cut back on risk and set aside more capital than before the crisis.

Just how much capital is a question US and international regulators will have to answer in the ­coming months as a final agreement on new standards takes shape. “This is a big deal,” said Richard Spillenkothen, a former director of banking supervision at the Federal Reserve who is now with Deloitte &  Touche. “Regulators have a lot of authority to set much stricter capital standards”.

Securities houses – a sector that saw two of its members, Lehman Brothers and Bear Stearns, collapse during the turmoil – will bear the brunt of the regulatory crackdown.

As a result of the ­“Volcker rule”, named for its backer Paul Volcker, the former chairman of the ­Federal Reserve, Goldman Sachs and Morgan Stanley will have to stop trading on their own accounts and cut back on investment in hedge funds and private equity over the next five years or so. They will also have to ensure that their dealings with clients are not plagued by conflicts of interest, which could have profound implications for their business models.

Large commercial banks such as JPMorgan Chase, Citigroup and Bank of America fared better. Although a much-feared requirement to spin off some of their derivatives units remained in the legislation, it was diluted. Banks will be allowed to retain the bulk of their derivatives units – including interest rate swaps, foreign exchange instruments and investment-grade credit default swaps. Derivatives based on equities, commodities and “junk” CDSs, however, will have to be placed in a separate subsidiary with higher capital requirements, although the exact details will still need to be mapped out.

Betsy Graseck at Morgan Stanley estimates the rule will require the “Big Three” derivatives houses – JPMorgan, BofA and Citi – to spin off about 30 per cent of their derivatives-trading businesses. “The outcome is better than expected as banks will be able to retain a significant portion of their swaps business,” she wrote to clients.

Nevertheless, there will be dramatic change to the $615,000bn over-the-counter derivatives business, which grew in the years leading up to the crisis into one of the largest sectors of the global financial markets. It developed as a private market, with contracts struck directly between Wall Street dealers, and trading also taking place behind closed doors. Those direct connections are now seen as a source of systemic risk.

Now, efforts will accelerate to shift OTC derivatives into the public eye, although most new rules will apply only to new contracts, not existing ones. Swaps will have to be standardised, cleared and traded on electronic platforms as they come under explicit regulatory oversight. Those contracts that do not fit these criteria are likely to be subject to higher capital charges.

Creating this new structure offers potential new business to technology companies, exchanges, clearing houses and interbroker dealers. “Those that can benefit are certainly exchanges because they have the clearing houses,” said Richard Repetto, analyst at Sandler O’Neill. “This is all incremental new business.” He expects the interdealer brokers to capture new trading: “Their platforms stand to gain a lot of volume.”

In the coming months there will be an almighty tussle as regulators – mainly the Commodity Futures Trading Commission and the Securities and Exchange Commission – devise detailed rules to flesh out and back the 2,000 pages of new laws. Those details could yet determine which groups come out on top, and also the cost of derivatives and investing.

“There is something for everyone to be focused on – no one [in financial ­markets] can say: it does not apply to me,” said Luke Zubrod, director at Chatham Financial, an advisory firm.

Additional reporting by Tom Braithwaite

Copyright The Financial Times Limited