The Costs of The Dodd-Frank Act

As companies begin to add up the cost of compliance with the Dodd-Frank Act, some are feeling the effects of what might be called slow-motion sticker shock.

As the rules required by the legislation have slowly rolled out, the financial effect is becoming clearer and by nearly all estimates the mounting costs far surpass most early assessments of the expense of Dodd-Frank, especially for companies in the financial services industry.

“Bankers are just realizing how significant the new credit card rules, the new rules on mortgages, and the actions of the Consumer Financial Protection Bureau will have on their business,” says Lynne Barr, partner in the financial institutions group and chair of the banking and consumer financial services practices with the law firm Goodwin Procter. “It's pretty staggering.”

Barr adds that while she isn't trying to minimize the damage wrought by the recession, nor the abuses that led up to it, “what Congress tends to do is to over-react.” The result may be that some of the intended remedies cause their own harm.

A 2012 report by Standard & Poor's estimates that Dodd-Frank could reduce pretax earnings of the eight largest U.S. banks by $22 to $34 billion annually, up from a 2010 estimate of $19.5 to $26 billion. The largest chunks of the increase come from a new way of calculating the banks' contribution to the Federal Deposit Insurance Corp.'s Deposit Insurance Fund, as well as a stricter interpretation of the Volcker Rule's limits on proprietary investments and trading than was initially envisioned, the S&P report notes.

Standard & Poor's estimated that the rule alone could collectively cost the 10 largest U.S. banks as much as $10 billion annually.

Dodd-Frank's effect is beginning to be felt by community bankers as well, says Chris Cole, senior vice president and senior regulatory counsel with the Independent Community Bankers of America. As recently as a year ago, many community bankers would have said the costs of Dodd-Frank weren't too bad, Cole notes.

That changed when the CFPB issued rules relating to mortgage loans last year. “They've brought the cost of compliance way up for community banks,” Cole says. For instance, mortgage lenders now must verify eight underwriting factors when issuing qualified mortgages; these loans offer lenders some protection from lawsuits, should borrowers later run into problems meeting their obligations.

That's not to say that Cole sees no value in Dodd-Frank. “You now have the government looking more seriously at how the big banks are managed.”

Not Just Financials

While many of the provisions in Dodd-Frank are aimed at financial institutions, some cut across other industries. That's the case with several sections of Title VII of the Act, “Wall Street Transparency and Accountability,” which imposes new oversight and regulations on over-the-counter derivative transactions. Most manufacturers use derivatives to hedge transactions involving commodities, interest rates, or foreign currencies—not to speculate. They still may be affected by, for example, by a proposed requirement that derivatives users post margins on their transactions.

A 2012 letter from the Coalition for Derivatives End-Users to the FDIC, the Federal Reserve, and other regulators states that placing a margin requirement of 3 percent on the S&P 500 companies could reduce capital spending by between $5.1 and $6.7 billion. “Companies need to have the money sitting aside,” for the margin requirement, says Carolyn Lee, senior director of tax policy with the National Association of Manufacturers. 

NAM is working with legislators to remove end-users from the proposed requirements. The Coalition's letter to regulators points out that “the text, structure, legislative history, and purpose of the Dodd-Frank Act all evidence that Congress did not intend for end-users to be subject to margin requirements.” However, some regulators disagree about the intent of the statutes, Lee notes.

Overall, the private sector will spend more than 24 million hours each year complying with the first 224 (out of 400) rules established by Dodd-Frank, according to the Dodd-Frank Burden Tracker, a creation of the House Committee on Financial Services. That compares to an initial estimate of about 20 million hours.

“The benefits at this stage are very speculative. We're not in an economic environment where the benefits have become apparent.”

—William Mayer,

Partner,

Goodwin Procter

Ultimately, Dodd-Frank's effect likely will extend beyond the expense side of businesses' ledgers and hit their top lines, as well. That's because the regulations may influence the decisions executives make about the businesses they'll pursue.

These less visible costs, typically resulting from changes in companies' behavior can be more significant than the costs of, say, legal fees or IT investments that companies incur in order to comply with the new rules. “The directly visible stuff is just the tip of the iceberg,” says Jim Angel, associate professor at Georgetown University specializing in the structure and regulation of financial markets. More significantly, companies may avoid certain product lines because they don't want to run afoul of a new rule. Overall economic costs rise “if you have less competition in certain areas and if firms don't compete where they have a competitive advantage,” Angel says.

These repercussions may mean the law ultimately fails to achieve its goals of protecting consumers and fostering a safer financial system. Cole notes that if the number of banks making mortgages declines, consumers may pay more for their loans or have a harder time finding them.  

                   ABOUT THIS SERIES

Compliance Week's exclusive four-part series on the Dodd-Frank Act will take a look at the state of rulemaking to carry out the 2010 landmark reform law. We'll explore how well some of the law's components are working and if it has had the intended effect of improving corporate governance and creating stability in the banking sector, along with what it is costing companies to comply and what's still to be done to finish rulemaking on the law.

Part 1: The Dodd-Frank Act: Where Are We Now, Feb. 4Part 2: How the Dodd-Frank Act Is Changing Corporate Governance, Feb. 11Part 3: The Costs of the Dodd-Frank Act, Feb. 19Part 4: Dodd-Frank Act Still a Work in Progress, Feb. 25

Costs vs. Benefits

Additionally, some requirements appear likely to impose significant costs for questionable benefits. One is the pay-ratio rule contained in Section 953 of Dodd-Frank. The provision requires listed companies to calculate the pay of its chief executive officer as a ratio to that of its median employee. “This is something that will again pose a huge cost burden,” says Lee of NAM. Along with the task of assembling the data—enormous in itself—companies need to comply with data privacy laws that can vary from country to country.

Even those within the SEC have questions about the cost of the rule compared to its benefits. “The pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little,” said SEC Commissioner Daniel Gallagher in a statement. “There are no—count them, zero—benefits that our staff have been able to discern.” 

Similarly, the conflict minerals rules of the law also likely will boost costs for little benefit, Angel says. “Clearly, there are horrific human rights abuses taking place in the Congo.” However, making all public companies, including those with no business activity in the Congo, audit their supply chains—again a costly undertaking—is among the rules that are “totally useless,” Angel says. 

Indeed several legal challenges to Dodd-Frank Act provisions are based on the idea that the regulatory agencies writing the rules didn't perform the required work to calculate the cost of compliance versus the benefits to the financial system.

DODD-FRANK'S EFFECT ON BANK EARNINGS

The following chart from S&P shows the estimated effect the Dodd-Frank Act will have on aggregate large bank earnings.

Source: Standard & Poor's.

At the same time, it's important to note that some expenses often attributed to Dodd-Frank probably would have happened anyway in the aftermath of the financial crisis. For instance, while Dodd-Frank imposes higher capital standards for financial institutions, “banks likely increased their capital levels, to some extent, in response to market forces after the crisis,” a 2013 report, “Financial Regulatory Reform: Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act” by the Government Accounting Office points out.

And some tension between economic growth and safety is inevitable. “There's an inherent trade-off,” notes John Fisher, lead analyst with the GAO. While boosting safety buffers within the financial system—through higher bank capital requirements, for instance—may lower growth, it also reduces the risk of a financial crisis. That's important, as estimates of the cost of the recent financial crisis range from several trillion dollars to more than $10 trillion, the GAO report notes.

In addition, some of the funds companies are spending on the Dodd-Frank Act have more to do with lobbying regulators as the rules are promulgated than with actually complying with them. A Sunlight Foundation analysis from earlier this year showed that representatives from financial institutions show up in the regulators' meetings logs for at least 2,118 meetings during the first three years of Dodd-Frank's implementation—an average of almost 14 each week.

Perhaps the most critical question about the costs imposed by Dodd-Frank is whether they are likely to help avert another crisis. The verdict on this also remains to be seen. William Mayer, partner in and co-chair of the financial services group with Goodwin Procter, points out that many of the regulations have yet to be fully implemented and the country hasn't yet faced another significant economic downturn. “The benefits at this stage are very speculative. We're not in an economic environment where the benefits have become apparent.”