Dodd-Frank for Foreign Banks kpmg.com

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1 FINANCIAL SERVICES Dodd-Frank for Foreign Banks kpmg.com

2 1 Dodd-Frank for Foreign Banks Taking a stand... Financial headlines in the US, and around the globe, were dominated throughout the spring and early summer with blow by blow accounts of the evolving proposals for US financial reform. Amid much fanfare, and to the surprise of some, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), named for its House and Senate sponsors respectively, was finally signed into law on 21 July The horse trading which preceded its final passage, not to mention its breathtaking final length (more than 2300 pages) has left many a financial sector professional understandably confused as to what has been agreed, who is affected, and when the changes will happen. While many of the proposals are targeted at specifics of the US financial services sector and its structural idiosyncrasies, a number of the core principles in the Dodd-Frank Act mirror proposals in the wider international regulatory landscape. Will the competitiveness of US Banks really be undermined, as critics allege? There will be challenges. However, the largest cross-border banks are already re-positioning their businesses - and their breadth will help them to maximise opportunities for growth in strategic areas even in this new, more restrictive environment. Smaller, domestically focussed banks may suffer under the weight of new rules. But consolidation as a result could leave the mid-tier sector leaner and more responsive to consumer needs. Ultimately, the impact of Dodd-Frank will have to be assessed in the context of wider global regulatory initiatives which are changing the financial sector landscape in every jurisdiction. The evolving shape of Dodd-Frank as it emerges from regulatory studies will sound familiar to those watching developments across the Atlantic. What Dodd- Frank says The breadth of the rulemaking means that the precise impact on any given firm will vary significantly depending upon the nature, size and location of its business. But across the industry financial institutions are gearing up for a substantial rise in capital and compliance costs. We have polled the views and insights of our firms global regulatory specialists to set out a broad overview of the key impacts and how these might differ between domestic and foreign financial institutions with US operations. Despite its length, the Dodd-Frank Act is focussed on three broad outcomes: limiting risk in the financial system, increasing consumer protections and regulating the unregulated. Overall, this bill which was expected to cripple the big investment institutions that were perceived to be the most significant contributors to the US financial crisis, is so far reaching in its final scope that there are significant changes for all institutions. Consumer focussed institutions could also see their business environment change substantially, potentially driving a significant shakeout amongst the smaller or weaker players. Many aspects of the Dodd-Frank Act are guidance or proposals in outline form only, and proposed implementation timetables on some areas stretch out to five years after allowances are made for studies commissioned, detailed rule makings and transition arrangements. Nonetheless, we believe there are four overarching areas of change which are likely to have a significant impact on all or parts of the US financial sector, and we outline these below. Systemically important Given the focus of legislators on reducing overall risk in the financial system, there is unsurprisingly, significant text devoted to oversight of systemically important institutions. Critically, the Dodd-Frank Act creates a Financial Stability Oversight Council (FSOC) charged with identifying and responding to emerging risks in the financial system as a whole. Working through the Fed, which gains power to act as the primary regulator of all depository institution holding companies and non-bank financial companies classed as systemically important, the FSOC can take steps to impose additional capital, leverage, liquidity, risk management and other requirements on institutions believed to pose a risk to the financial system. In addition, the FSOC, on a two-thirds vote, can force the break up or restrict the growth of large institutions if there is deemed to be a risk to financial stability. Defining systemically important institutions has been left to regulators, but will affect banks with more than US$50bn in assets and other significant non-bank institutions (based on the nature, scope, size, scale, concentration and interconnectedness of their mix of activities.

3 Dodd-Frank for Foreign Banks 2 Increased oversight and new requirements levied on systemic institutions are supplemented with new resolution authorities for the Fed and FDIC designed to ensure an orderly wind down where systemic institutions run into trouble despite new regulations and oversight. Alongside pending FDIC and Fed requirements, the Dodd-Frank Act requires large, complex financial companies to periodically submit plans for their rapid and orderly shutdown ( living wills ) should the company fail. Failure to submit acceptable plans could attract higher capital requirements, restrictions on growth and forced reduction in business complexity. Oversight of systemic institutions and cross-border crisis management is a key topic for the November meeting of the G20 leaders in Seoul. EU and International regulatory bodies have already issued consultations with more detailed proposals expected before year end. Many of the potentially systemic institutions in the US have substantial international businesses and may be subject to similar systemic supervision in other jurisdictions. In both the EU and the US, being designated as systemic could result in increased supervisory intrusion, requirements to maintain living wills, higher capital and liquidity standards, and the potential to see limits imposed on business activity and expansion. Systemic institutions must demonstrate rigorous governance and risk management standards to avoid additional regulatory censure, and can expect to spend more time and effort managing regulatory relations both nationally and internationally. Capital and liquidity The Dodd-Frank Act echoes international regulatory pronouncements by calling for all financial institutions to hold more, and better quality, capital. As elsewhere in the globe, regulators have the ability to set higher capital and liquidity standards for larger and/or complex organisations and activities. The principle of focussing on high quality (ie common equity and retained earnings) capital, setting additional counter cyclical capital requirements, and putting perceived riskier activities (such as equity swaps) in separately capitalised entities are also included. The Collins Amendment, added late in the Senate legislative process, establishes current higher capital standards as a floor for future capital requirements for large bank holding companies and systemically important non-banks, and disqualifies Trust Preferred Securities from Tier 1 capital a significant issue for many thrift organisations as well as foreign banks who have set up subsidiaries to issue TRUPS as part of their capital strategy. All of these measures will ultimately result in higher capital costs of doing business for most financial institutions. New proposals from the Basel Committee of Banking Supervisors finalised on 12 September set a benchmark which the G20 governments, including the US, are expected to converge with. Financial institutions have already started the process of reassessing business activities to baseline their viability and attractiveness in the context of higher capital and liquidity costs.

4 3 Dodd-Frank for Foreign Banks The timing, and detail of implementation for final capital and liquidity rules will, however, leave significant scope for variation between nations in the short and possibly longer term, which will result in additional costs, but potential opportunities, for large cross-border institutions who can flex their operations to advantage. Trading Financial institutions with trading activities will see significant changes in the nature and shape of the marketplace for traded instruments. Though many wholesale provisions were watered down from the original strident proposals covered extensively in the press, significant changes remain. Many of these, however, are subject to studies by regulators in advance of detailed rule making, and therefore their final shape may not be realised for many years to come. Volcker Rule The so called Volcker Rule (named after the former Fed Chairman Paul Volcker who set out the original proposals) was included in the final Act. It restricts bank entities (defined as an insured depository institution, any company that controls it and any of its affiliates or subsidiaries) from proprietary trading and limits investment in, and sponsorship of, hedge funds and private equity funds. However, concessions were made, and the final wording exempts trades undertaken for hedging purposes or to facilitate client needs, as well as de minimis investments (3 percent of Tier 1 capital and up to 3 percent investment in each individual private equity fund, hedge fund and certain real estate funds). A study has been commissioned to define what constitutes proprietary versus other trading, which may yet result in a more flexible implementation. A lead time of up to five years gives banks time to either pare back or divest of investments, and many larger banks have already begun this process. The ruling applies to all US domiciled banks on their worldwide activities, but does not apply to foreign banks on trades booked in foreign jurisdictions with foreign counterparts. Other jurisdictions have largely ruled out the possibility of an outright ban on proprietary trading by banks (though the UK s Independent Banking Commission is considering a ban as part of its review of the UK banking sector). Top US traders may opt (or be forced) to leave in search of alternative employment in hedge funds or set up new investment boutiques which would shift, but not eliminate, more risky activity out of the regulated sector. US proposals could therefore give some advantage to foreign banks which could attract high profile traders, and avoid the cost of separately capitalised entities to engage in proprietary activity, though a narrow final definition of proprietary trading may limit the impact on all but a small number of US institutions. OTC Derivatives and Swaps Push Out Under the Dodd-Frank Act, federal regulators for the first time have official oversight of the OTC derivatives market, and as such significant increases in reporting and record keeping requirements are included to facilitate supervision and market transparency. Regulators, in coordination with central counterparties, will have the right to review individual and/or groups of trades to determine whether or not they should be eligible for clearing. Regulators will also have the ability to set margin and collateral requirements for non-cleared trades reducing counterparty risk but further increasing the costs of trading and possibly dis-incentivising trades perceived as risky. In a crucial concession, the original proposals to push out all swaps dealing business from banks to separately capitalised subsidiaries was significantly tempered, with core swaps activities such as interest rate and FX swaps (which account for approximately 80 percent of the market) exempt from the provision. The final wording of the Act results in a substantial shake up of the market for OTC derivatives in the US and in many respects the principles mirror draft changes in the EU OTC derivatives market. Significant players in both markets are likely to see earnings reduced as a result of proposals to increase capital for risky activities, and increased margin and collateral requirements associated with these trades. Plans to enforce standardisation to enable the majority of derivatives to be cleared through central counterparties and traded on exchanges will increase transparency and reduce the breadth of counterparty risk. But risk instead may concentrate within central counterparties - so their governance, operations and risk management should be carefully scrutinised. The rules have been designed to minimise the impact on commercial end users, who are largely exempt from new rules around clearing and collateral, and may benefit from lower fees. But large speculative trading may prove uneconomic in light of the additional capital, margin and collateral burdens proposed. Investor Protection The SEC must undertake a study and make recommendations to revise standards of care for broker-dealers, investment advisers and persons associated with them when dealing with retail customers. Critical to determining the final impact is the eventual definition of retail. Many local government investors are concerned that significant increases in fiduciary duty could restrict their access to financial products now routinely used to manage local funds.

5 Dodd-Frank for Foreign Banks 4 Consumer Protection A substantial portion of the legislation is aimed at protecting consumers and investors. The creation of an independent Bureau of Consumer Financial Protection (CFPB), housed within the Fed, is considered a landmark part of the Act. The CFPB becomes a single point for customer protection, though other agencies retain day to day supervisory powers. It will be able to write, examine and enforce regulations on products ranging from home loans to credit cards for banks and credit unions with total assets greater than US$10bn, all mortgage related business, and other non-bank lenders. In addition, Dodd-Frank (alongside other concurrent legislative initiatives) makes significant changes to consumer finance and the core banking products which constitute the consumer financial space. Reviews are underway to look at the pricing structure for core products including debit and credit cards, checking accounts, overdrafts and mortgages. In most cases, the fees which banks can charge in relation to these products and services are likely to reduce. Additional disclosures and more rigorous underwriting standards may reduce credit availability, but drive development of significantly simplified credit offerings for underserved consumer markets. Other changes to note The Dodd-Frank Act touches on a number of other changes to the marketplace and many of these will also have significant, if more discrete, impacts on the sector. Other areas of change include the investment management market, where mandatory registration of investment advisers and additional reporting requirements will force greater transparency (and cost) on the sector. Proposals to strengthen shareholder say over executive compensation through nonbinding votes and to potentially nominate members to the Board of Directors reinforce a general effort to give more power to shareholders to call management to account. As in the EU, credit ratings agencies will be subject to greater scrutiny and liability, and financial institutions will be less able to rely on ratings as the sole source to justify risk assessments on relevant assets. The securitisation market which had underpinned the massive growth in consumer lending in the run up to the crisis was granted a partial reprieve from proposals to require that issuers retain a 5 percent stake in any issues, with a study looking at the potential impacts. The current wording in Dodd- Frank requires additional disclosures about the underlying instruments, but exempts issues related to qualifying loans (eg government backed loans) where strong underwriting standards are demonstrated. These rules, however, differ from proposals already tabled by the FDIC and SEC which have wider (and differing) criteria for risk retention. Domestic financial institutions will be hit hard by these changes, some of which are retrospective, with smaller and mid size banks less well placed to reduce costs or diversify business in order to recoup lost margins. Large banks, which run major lending and payments operations, may see a significant hit to margins as a result of reduced interchange fees, additional costs to enhance and in some cases revise underwriting standards, and higher capital costs as a result of restrictions on securitisations. Many believe final rules on interchange fees will not be as harsh as originally thought, and rules allowing interest on checking accounts may increase costs but offer opportunities for responsive banks to bolster customer retention. Banks are already looking to process and technology improvements to help strip out operational costs, and reviewing product portfolios to determine what recalibration could enhance returns in this new environment.

6 5 Dodd-Frank for Foreign Banks What Dodd- Frank means The Dodd-Frank Act leaves significant scope for regulators to refine its provisions. The SEC, CFTC, Fed and FDIC are already leading substantial studies and consultations. Many industry participants hope that a measured and thorough approach gives industry participants an opportunity to push for practical final rules and limit the potential for significant unanticipated consequences. US regulatory bodies must work together to produce a coherent, effective set of rules. As the UK s FSA found when it merged itself together from its predecessors, there will be inevitable teething problems as supervisory bodies find their feet with their changed roles and responsibilities. No market participants have an interest in significantly undermining the competitiveness of the US financial industry. But there remains a political and regulatory commitment to fundamental change to bring banking back to a focus on core banking businesses and sound risk management.

7 Dodd-Frank for Foreign Banks 6 Summary implications Retail Therapy New rules will impact existing products and processes business models which yielded attractive margins in the pre-crisis market may no longer be viable. Loosened rules around interstate branching, and rising costs and supervision due to new regulation, will invariably result in winners and losers. Weaker banks continue to shut their doors or fall to stronger peers. Larger institutions with the scale to reduce operating costs and invest in infrastructure and risk management can benefit. But the regulators will keep a vigilant eye to ensure consolidation does not go too far. Significant for SIFIs Large, cross border banks may see a significant change to their business relative to the pre-crisis position. But for many, additional reporting to regulators, and additional capital and liquidity requirements, is already part of day to day business. Changes may therefore be more incremental than upheaval. However, enhancing systems, processes and strategies to embed new requirements and deliver new reporting on a systematic basis may require a substantial and considered investment. Traders downtrodden? Those banks with limited wholesale activities may see a more limited impact on their business than consumer banks and the systemic universal banks. Changes to the OTC derivatives market could impose the most substantial change, with increased costs due to additional capital, collateral and reporting requirements compounded by a reduction in margins as a result of exchange trading, prompting many banks to refocus efforts on investment banking services and fee based offerings. Cross-border convergence or divergence? Foreign banks, already used to complying with Basel II and gearing up to address pending EU changes may find themselves at an advantage in their ability to respond speedily to final US requirements by building on work already in progress but there remains a significant risk that, at least in the short term, the detail of EU and US rules may differ adding significantly to the compliance burden. Finally The timing of these changes will stretch out over a period of many years, but a majority of the changes will be finalised and ready for implementation within the next two years, which gives many banks little time to prepare for the scale of change proposed. Across the board, the increase in new regulation will drive significant increases in information requirements from regulators both in direct reporting, and indirectly to evidence more rigorous risk management. Many institutions are already viewing Dodd-Frank as the final impetus to tackle unwieldy technology platforms knitted together by work arounds and spreadsheets. Investment in data infrastructure is an opportunity for banks to access better data, underpin better risk management, better strategic decision making, and better operational efficiency. Flexibility, rationalisation, and simplicity are key to building a new information infrastructure which can rapidly provide an aggregated view of the business, adapt to changing internal and external requirements and ultimately underpin opportunities to grow and win in a changed financial sector landscape. Our global network of firms give us a global perspective on evolving regulatory change and what it can mean for your business. We are working with banks across the globe, cutting across the complexity of regulatory change; helping them to assess the potential impact on their businesses, build a coherent strategy for adapting to change and positioning for growth in an environment where uncertainty is increasingly part of the landscape.

8 Contact us Giles Williams Leader, Financial Services Risk and Regulatory Centre of Excellence, EMA region KPMG in the UK T: + 44 (0) E: giles.williams@kpmg.co.uk David Sayer Global Head of Retail Banking KPMG in the UK T: + 44 (0) E: david.sayer@kpmg.co.uk Nigel Harman Head of Banking KPMG in the UK T: + 44 (0) E: nigel.harman@kpmg.co.uk fsregulation@kpmg.co.uk The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation KPMG International Cooperative ( KPMG International ), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in the United Kingdom. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. Designed and produced by KPMG LLP (UK) s Design Services Publication name: Dodd-Frank for Foreign Banks Publication number: RRD Publication date: October 2010