The Dodd Frank Wall Street Reform and Consumer Protection Act is just one of the many challenges facing the banking industry in Cayman today. While most banks are focusing on the Foreign Account Tax Compliance Act and the implementation of the Basel Accord, they should also be aware of Dodd Frank, particularly when they are already in the process of changing their systems, says Dara Keough, partner at KPMG in Cayman.
“I know a lot of banks that are changing the systems for FATCA and Basel 2. But they need to be aware of what is coming around the corner in terms of Dodd Frank so that they can make their systems flexible enough for those changes as well,” says Keough.
The flexibility is important because the shape the legislation is going to take will be largely defined by the rules and regulations. Only about 30 per cent of the Dodd Frank rules have been written so far and there is still a lot more that can happen in terms of new regulations affecting banks in Cayman, because it is such a complex set of regulations, says Keough.
Much of the foreseeable impact will be indirect rather than direct.
Depending on the type of operations that a foreign bank maintains in the US it will be affected by Dodd Frank in different ways.
If a foreign bank is or owns an FDIC insured bank in the US it will be heavily impacted through increased supervision by the FDIC, the Federal Reserve and if it offers consumer products, also the Consumer Financial Protection Bureau.
With the appointment of Richard Cordray as new head of the CFPB in January, the Bureau can now write rules around enforcement and supervise institutions from a consumer protection perspective, says Jim Low, a partner with KPMG in New York.
From a banking perspective Dodd Frank is predominantly concerned with the issue of systemic risk and concentrates most regulatory initiatives on strategically important financial institutions, defined as bank holding companies with total worldwide consolidated assets of $50 billion or more.
Under Dodd Frank these banks will face more stringent prudential standards, such as risk-based capital requirements, leverage limits, liquidity requirements and concentration limits. SIFIs will be expected to establish risk committees and draft living wills outlining how their operations can be reorganised rapidly in case they become insolvent.
Another important aspect of Dodd Frank for banks is the Volcker rule which prohibits proprietary trading and investing in or sponsoring of hedge funds and private equity funds by banks.
“What is most interesting about the Volcker rule is if you are subject to the Volcker rule, you will need to have a compliance programme in place to show and demonstrate to the regulators that you are actually complying with the Volcker rule which will be subject to independent process,” says Low.
This will require complex processes and a costly infrastructure. Even though most of the 7,900 FDIC banks in the US will fall under an exemption, they will still need to have some kind of compliance programme in place.
Whether and how far foreign banks are impacted by Dodd Frank is still not clear. According to Low the principal of extraterritoriality is the big question that is currently being debated.
Cayman banks, which generally do not have subsidiaries in the US or sell products to US consumers, are most likely to be impacted via their connectivity with US financial institutions, specifically in the trading of derivatives commonly used to hedge interest rate, commodity and foreign exchange risk, says Low.
“Banks will have to try to understand how Title VII [of the Act] applies and impacts them from an extraterritoriality perspective.”
Title VII, also called the Wall Street Transparency and Accountability Act of 2010, regulates the over the counter derivatives market, which has an estimated size of $600 trillion, and requires that swaps are cleared through exchanges and clearinghouses.
This will impact the global pricing of these derivatives and also mean that Cayman banks by entering into a trade with a dealer in the US will be subject to dealer trading reporting, capital and margin requirements and supervision by the Commodities Futures Trade Commission and the SEC.
“What you could see is that the end user the Cayman Islands bank is going to have to put a lot more capital going forward as a result of the rules of the SEC or the CFTC depending on the nature of the trade, ie if it is a swap or a security,” says Low.
He suspects, as a result of Dodd Frank, it could become more profitable for Cayman Islands banks to trade with a dealer in London or elsewhere in the world rather than the US.
For large multinational organisations with operations in the US, Europe and Asia this can already be observed, Low says. As these banks already follow the concept of subsidiarisation, an effort to make individual parts of a banking group more resilient and to reduce intra-company contagion risk, individual operations are increasingly treated on a standalone basis.
“They are trying to isolate their operations in the US, in the UK and Asia. They almost want to have dealers within their organisation within the region so they can minimise their connectivity back to the US.”
Banks therefore have to examine their trades to understand what the cost of the OTC derivative regulations is going to be.
Repeal of Regulation Q
Another area of Dodd Frank that has already impacted banking in the Cayman Islands is the repeal of Regulation Q which until June 2011 did not allow banks to pay interest on commercial checking account balances.
As a result of the ban offshore cash management structures in the Cayman Islands developed, which allowed commercial banking customers to gain overnight interest income on their account balances.
These relatively costly Eurodollar sweep structures are made increasingly redundant as US banks now have the ability to pay interest on business checking accounts held onshore in the United States.
Low believes the repeal of Regulation Q was motivated by the objective of helping regional bank network in the US, which may only have domestic operations and it will come down to the cost of creating structures in the Cayman Islands and the ability to establish a deposit base in the US.
Keeping it flexible
For Cayman banks it is therefore important to analyse the cost impact of the regulation of OTC derivatives trading by Dodd Frank and the nature of their connectivity with US banks.
Any banking system changes necessitated by other regulations such as FATCA or Basel 2 should ensure sufficient flexibility to avoid having to alter the infrastructure on a larger scale once new rules based on Dodd Frank have been formulated.
“The biggest thing the banks are thinking about right now is when changing the system how to keep the systems flexible to accommodate future changes in regulation that may be coming through,” says Keough.
Although banks may be more concerned with other regulatory initiatives, due to the extended rule making phase of Dodd Frank, at the very least they should keep apprised with the rule making process and its implications for compliance, concludes Low.