From Wall Street to Main Street: The Legal and M k t I t f Fi i l R f E d U f Market Impact of Financial Reform on End-Users of Financial Services

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Bob Graves, Jonathan Ching (New York), Al Rota (Dallas), Joel Telpner (New York)

The Impact of Financial The Impact of Financial Reform on the Bank Credit Market: The Rise of Shadow Bank Market 2 0Shadow Bank Market 2.0

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What is the Shadow Bank Market?What is the Shadow Bank Market?

Simply stated, the provision of traditional banking services by nonbanks such as money market funds,

f fhedge funds, private equity funds, consumer and commercial finance companies, and specialty investment vehicles and funds

Many nonbanks and nonbank products are subject to regulation, some to extensive regulation, but none i bj t t l ti b kis subject to regulation as a bank

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Shadow Bank Market 1 0Shadow Bank Market 1.0

Consisted of nontraditional finance techniques and Consisted of nontraditional finance techniques and products such as ABCP, CMBS, RMBS, CLOs and CDOs

Companies and banks funded portions of their operations through nontraditional and often unregulated productsunregulated products

Lower funding costs; theoretically more efficient financial market

Many aspects shut down or severely curtailed by financial crisis and subsequent financial reform

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Shadow Bank Market 1 0Shadow Bank Market 1.0

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Financial Crisis and Its AftermathFinancial Crisis and Its Aftermath

Dodd-Frank and Other Financial Reform Legislation Dodd-Frank: 2300 pages, but most substance left to

l tregulators Some regulations complete, but most regulations remain to

be adopted Far-reaching consequences, both intended and unintended

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Volcker Rule

Restricts covered banking entities from making speculative investments with firm money but includes an exemption for tradesinvestments with firm money, but includes an exemption for trades to hedge risk No proprietary trading, ownership interest in hedge/PE fund, or

sponsorship of hedge/FE fundp p g CFTC proposes comment that commodity pools should not

necessarily be covered banking entities FDIC, FRS, OCC, SEC Core Volcker Rule (CFTC separate)

Rule in proposed phase; comment period is closed No firm date for completion; proposed effective date is July 21,

2012 (but press reports suggest September 2012) Will be administered by FRS, FDIC, SEC, OCC, CFTC

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Volcker Rule, cont . . .

FRS is responsible for conformance oversightFRS l d id th t d b ki titi ill h FRS released guidance that covered banking entities will have at least until July 21, 2014 to comply with Volcker Rule

CFTC issued proposed rule separately 17 CFR Part 75 17 CFR Part 75 Question 218.1 asks: Is the use of [the] definition of

commodity pools [in the definition of a covered fund] too broad? For example, will this definition potentially pull in p , p y padditional pools that may be outside the intent of the proposed regulations?

CFTC rule in proposed phase; comment period is closed

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Lincoln Amendment

Section 716 of the Dodd-Frank ActS h t l | A ti b il t l Swaps push-out rule | Anti-bailout rule Prohibits Federal assistance to any swaps entity with respect

to any swap, security-based swap, or other activity of the swaps entityswaps entity

Prohibits banking institutions in the U.S. from registering as swap dealers U.S. banks may deal in interest rate and currency swapsy y p

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Lincoln Amendment, cont . . .

Section 716 would force derivatives activities out of banks and potentially into less regulated entities or into foreign firmspotentially into less regulated entities or into foreign firms . . . [which] would increase, rather than reduce risk to the financial system Federal Reserve Chairman Ben Bernanke, May 2010, y

Would become effective July 16, 2013 Lincoln Amendment is under attack in Congress

H.R. 1838: Direct repeal of the Lincoln Amendmentp Reported by the House Financial Services Committee H.

Rept. 112-476, Part I.

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Collins Amendment

Section 171 of the Dodd-Frank ActFDIC OCC FRS FDIC, OCC, FRS 75 FR 82317

Final rule amending risk-based capital adequacy standardsE t bli h i k b d it l fl f i d Establishes a risk-based capital floor for insured depository institutions, bank and thrift holding companies, and systemically important nonbanks

12 CFR Parts 325 208 225 and 312 CFR Parts 325, 208, 225, and 3 Proposed revisions to risk-based capital guidelines related

to market risk capital rules; comment period is closed

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Collins Amendment, cont . . .

Reliance on Basel III is impermissible under Dodd-Frank requirements for debt and securitization positions becauserequirements for debt and securitization positions because Basel III relies on credit ratings

Requirements must be at least as stringent as Basel III [W]e note that increased capital and liquidity standards for depository [ ]e ote t at c eased cap ta a d qu d ty sta da ds o depos to y

institutions and insurance companies are likely to increase the returns to shadow banking activity . . . The reform effort has done little to address tendency for large institutional cash pools to form outside the banking system. Thus, we expect shadow banking to be a significant part of the y , p g g pfinancial system, though almost certainly in a different form, for the foreseeable future Federal Reserve Bank of New York, Staff Report on Shadow

Banking February 2012Banking, February 2012

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Skin in the Game - Securitization Risk Retention

15 U.S.C. 78o-11, as added by Section 941 of Dodd-FrankFi t t i 5% ( h d d) i k f ABS i Firms must retain 5% (un-hedged) risk of ABS issuances

Various methods to hold risk are permitted (vertically, horizontally, L-shaped, synthetically/equivalent risk)

Exemptions & protections Exemptions & protections Qualified Residential Mortgages Federally insured or guaranteed residential, multifamily, and

health care mortgage assetshealth care mortgage assets Re-securitization transactions in which credit risk must was

retained in the original issuance There can be no tranches or stripping of principal or pp g p p

interest

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit Skin in the Game cont . . .

ABS collateralized by assets that are (or ABS where the payment of principal and interest is) fully insured orpayment of principal and interest is) fully insured or guaranteed by the U.S. or a U.S. Agency

Securitizations collateralized solely by assets sold, held, insured or guaranteed by the Farm Credit Administrationg y

ABS securitized by any municipality exempt from registration under Securities Act of 1933

Certain foreign related transactions Commercial mortgages, commercial loans and auto loans may be

exempt if they meet yet to be determined underwriting standards Rule in proposed phase; comment period has been extended to

A t 1 2012August 1, 2012

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Significant Regulatory Developments Significant Regulatory Developments Affecting End-Users of Credit BCFPConsumer Protection

Well discuss in detail later.

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R lti (U ?)I t d d Resulting (Un?)Intended Consequence: Shadow Consequence: Shadow Bank Market 2.0

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Why Shadow Bank Market 2 0?Why Shadow Bank Market 2.0? Traditional banks and bank products may be unable

fully to meet needs and demands of end usersfully to meet needs and demands of end-users because: Substantial consolidation in banking industry g y

predating financial crisis Increased banking regulation and compliance

cost will result in even greater consolidation tocost will result in even greater consolidation to achieve economies of scale

Enhanced regulation and compliance cost will g preduce margins on traditional banking activities, leading many banks to eliminate or curtail business linesbusiness lines

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Why Shadow Bank Market 2 0?Why Shadow Bank Market 2.0?

Nonbanks and other lightly or nonregulated entities well-suited to fill vacuum Short-term: higher costs of funding, but likely will move

closer to parity with banks Less bureaucratic; more nimble; more willing to take credit

risk and consider alternative financing structures Relatively free of governmental and public oversight and

constraint

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What Will Shadow Bank Market 2 0 Look What Will Shadow Bank Market 2.0 Look Like? Far greater number of market participants, with nonbanks

playing an increasingly significant role Smaller sized institutions to avoid designation as systemically Smaller-sized institutions to avoid designation as systemically

important No one-stop shoppingspecialized service providers will

perform customized financial servicesperform customized financial services Banks will continue to play significant role, particularly in

syndication and distributionB k ill f tilit f ti ( h t) Banks will perform utility functions (e.g., cash management)

Ultimately, a broader and less centralized market

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What Will Shadow Bank Market 2 0 Look What Will Shadow Bank Market 2.0 Look Like? Continual growth in nonbank lending Continual growth in nonbank lending

25.0%$3,000

NonbankShareofSyndicatedLoans

19.0%

21.0%

23.0%

$2,000

$2,500

Trendlineindicate steadynonbankgainsinmarketshareTrend lineindicates steadynonbankgains inmarket

11.0%

13.0%

15.0%

17.0%

$1,000

$1,500

5.0%

7.0%

9.0%

$0

$500

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Total SyndicatedLoans (Bil l ions) Nonbanks Total Committed (Bil l ions) Nonbanks Share(%)

Source:BoardofGovernors oftheFederalReserveSystem,theFederalDepositInsuranceCorporation,andtheOffficeoftheComptrolleroftheCurrency

What Will Shadow Bank Market 2 0 Look What Will Shadow Bank Market 2.0 Look Like? Nonbanks are not only holding distressed credits Nonbanks are not only holding distressed credits

70.0%$450.0

NonbankShareofClassified SyndicatedLoans Meaningful divergence

50.0%

60.0%

$300.0

$350.0

$400.0

20.0%

30.0%

40.0%

$150.0

$200.0

$250.0

0.0%

10.0%

$0.0

$50.0

$100.0

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Total Classified(Bil lions) NonbanksShare(%)ofTotal Classified Nonbanks Total Classifedas Share(%)ofNonbanks Total Commitments

Source:BoardofGovernors oftheFederalReserveSystem,theFederalDepositInsuranceCorporation,andtheOffficeoftheComptrolleroftheCurrency

DERIVATIVES REGULATION DERIVATIVES REGULATION UNDER DODD-FRANKUNDER DODD FRANK

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The New Dodd-Frank WorldThe New Dodd-Frank World

New regulatory framework for swaps New regulatory framework for swaps New authority for the CFTC and the SEC Amendments to the Commodity Exchange Acty g Swaps regulated under Dodd-Frank Market participants regulated under Dodd-Frank OTC world is shrinking

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What is Covered? Most derivatives that were deregulated in 2000 will

now be defined: swaps regulated by CFTC

includes interest rate, currency, foreign exchange credit equity commodity weatherexchange, credit, equity, commodity, weather, energy, metal, agricultural and index swaps

excludes exchange-traded futures, contracts f th l f diti f f t d lifor the sale of commodities for future delivery, physically-settled forwards and exchange-traded options on currencies

FX swaps and forwards to be carved out by Treasury

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What is Covered?

Important non-swap categories also covered: security based swaps regulated by the SEC security-based swaps regulated by the SEC

includes swaps based on a narrow-based security index, a single security or loan (e.g., single-name credit default swaps)

mixed swaps jointly regulated by CFTC & SEC

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Swap Definitions Trigger Swap Definitions Trigger Other Requirements Effective date of the product definitions triggers:

dealer/major participant registration position limits for initial spot months position limits for initial spot months registration of SDRs becomes mandatory reporting of pre-enactment swaps (60 days after an

SDR becomes registered) is required data and real time reporting requirements

Product definitions rule expected to be considered in Product definitions rule expected to be considered in June and published in the Federal Register in early July

Market is anticipating effective date in early Sept.

Expected Timeline for ImplementationExpected Timeline for Implementation

June 2012 process for review of swaps for mandatory clearing begins (90 day process)

Sept 2012 Phasing of mandatory clearing begins; end-user exception will be defined.

Oct 2012 Customer clearing documentation rules Oct 2012 Customer clearing documentation rules expected to be finalized.

Nov 2012 Cleared and uncleared margin rules gexpected to be finalized.

Dec 2012 Mandatory compliance deadline for initial group of customersinitial group of customers.

Who is Covered? New Defined Entities Under Dodd-Frank Swap dealer:

Holds itself out as dealer, makes a market, regularly enters into swaps as ordinary course of businessp y

Major swap participant: Maintains a substantial position in swaps but not

th i d lotherwise a swap dealer outstanding swaps create substantial exposure that

could have adverse effects on U.S. financial stability any financial entity that is highly leveraged relative

to the amount of capital such entity holds

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What Requirements are Imposed on SDs and MSPs?

R i t ti d bj t t i ti Registration and subject to examinations Recordkeeping and reporting Business conduct standards Business conduct standards Disclosure obligations including valuations Compliance requirementsp q Risk management Capital and margin

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The Clearing Exception and End UsersThe Clearing Exception and End Users

Non financial entities that enter into swaps to hedge or mitigate commercial risk can avoid clearing.

The scope of the exception and the means by which exception is available await final rules

What about margin? What about margin? Are there other carve-outs from clearing?

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Goodbye to the OTC World? Mandatory Clearing is the New Reality

Whi h ? Which swaps? Many but not all Ongoing CFTC and SEC role Ongoing CFTC and SEC role Clearing houses have their say Process for reviewing swaps begins this monthg p g

Factors include: Notional exposures Trading liquidity Risk management

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Trading SwapsTrading Swaps

All th t i d t b l d l All swaps that are required to be cleared are also required to be traded on a regulated exchange or a swap execution facility (SEF) unless no exchange or SEF is willing to list the swap

CFTC and SEC proposed rules have inconsistenciesinconsistencies

At least 18 firms are currently developing SEF offeringsg

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Customer Clearing Documentation

All subject to final rules and development of market practices Futures and Options Agreement OTC Clearing Addendum OTC Clearing Addendum Clearinghouse Rules Execution AgreementExecution Agreement Tri-lateral Annex to Execution Agreement Cross-product netting agreement ISDA Master Agreement Control/Custody Agreement for IA segregation

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Margin and Capital Requirements

Margin requirementsA l l d d Apply to cleared trades

Apply to trades among SDs and MSPs May apply to uncleared trades May apply to uncleared trades

The proposed rules of CFTC and of Prudential Regulators are inconsistentg

Level of margin? To be determined Capital requirements

Apply to SDs and MSPs Level to be determined by applicable regulator

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Position LimitsPosition Limits

CFTC bli h d Fi l R l 18 N 2011 CFTC published Final Rule on 18 Nov 2011 Phase one: Spot-month position limits effective sixty

days following effectiveness of a final rule definingdays following effectiveness of a final rule defining the term "swap" under the Dodd-Frank

Phase two: Non-spot-month position limits will not b i l t d til th CFTC h i dbe implemented until the CFTC has received one year of swap open interest data regarding the relevant contracts, probably not until sometime in p y2013 or later

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Dodd-Frank and Dodd Frank and Consumer Protection

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D dd F k I t C E d UDodd-Franks Impact on Consumer End-Users Consumer Financial Protection Bureau (CFPB) created

to act as single regulator for consumer financial protection Focus on the consumer rather than type of entity Consolidation of rule-writing and enforcementConsolidation of rule writing and enforcement

Granted supervisory and examination authority over certain bank and non-bank entities Previously unsupervised entities will now be subject to

review depending on multiple factors Enforcement focused entityy

Stated agenda is to use enforcement rather than additional rule making

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D dd F k I t C E d U Dodd-Franks Impact on Consumer End-Users (cont) CFPBs supervision and examination powers will changeCFPB s supervision and examination powers will change

equation for consumers and certain nonbank entities providing consumer financial products and services.

Expected results of new supervision are: Expected results of new supervision are: Increased compliance costs

Costs passed to consumerp Inability to pass costs due to competition

Withdrawal from certain products or servicesI ti (?) Innovation(?)

Expect certain consumers to see an increase in cost and decrease in availability of certain consumer financial yproducts and services

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C lid tiConsolidation CFPB took over multiple responsibilities from the OCC,

FDIC, Federal Reserve, and FTC. Primary rule-maker and enforcement entity for:

1 Truth in Lending Act1. Truth in Lending Act2. Equal Credit Opportunity Act3. Fair Credit Reporting Act4. Fair Debt Collection Practices Act5. Real Estate Settlement Procedures Act6 Home Mortgage Disclosure Act6. Home Mortgage Disclosure Act7. The Credit CARD Act8. Electronic Funds Transfer Act

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What entities are now supervised?What entities are now supervised? Dodd-Frank granted the CFPB supervisory authority

over certain nonbanks:over certain nonbanks: Mortgage lenders, servicers, originators, and

brokers; Loan modification or foreclosure relief services; Payday, title, small loan lenders; and Private education lenders and servicersPrivate education lenders and servicers

CFPB has authority regardless of the size of the companies in these markets

Supervision program started for these entities in January 2012

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What entities may be supervised?What entities may be supervised? Dodd-Frank granted the CFPB supervisory authority

over nonbanks in certain consumer financial marketsover nonbanks in certain consumer financial markets CFPB is required to identify such markets and to

define larger participants in each CFPBs July 2011 Request for Comment identified 6

potential markets:1. Debt collection2. Consumer Reporting3. Consumer credit and related activities4. Money transmitting, check cashing and related

activities5. Prepaid cardsp6. Debt relief services

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What entities may be supervised? (contd)What entities may be supervised? (cont d) CFPBs February 2012 Proposed Rule for Debt

Collection and Consumer Reporting Markets:Collection and Consumer Reporting Markets: Defined annual receipts test for each market:

$10 million for debt collection (63% of market) $7 million for consumer reporting (94% of market)

Annual receipts must result from covered activity Unclear what impact this proposed rule will have on Unclear what impact this proposed rule will have on

other identified markets No time frame for additional larger participant rules

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What entities may be supervised? (contd)What entities may be supervised? (cont d) Debt collectors*

Credit reporting agencies* Credit reporting agencies* Retailers

Exemptionp Prepaid cards Financing

Ch k hi Check cashing Online payment companies (e.g., PayPal) Mobile payment systemsMobile payment systems Bill payment processors

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What does an examination entail?What does an examination entail? Routine, Target, or Horizontal examinations.

Focus is risk of harm to consumers Focus is risk of harm to consumers. Generally, CFPB will:

Request documents and other information prior to q ponsite examination;

Conduct onsite observation, employee interviews, and examination of additional document/information;and examination of additional document/information;

Reach preliminary conclusions regarding compliance management and statutory/regulatory compliance;

Communicate preliminary conclusions and seek cooperation in correcting issues; and

Finalize examination report to supervised entity.p p y

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What does an examination entail?What does an examination entail? (cont) CFPBs examination generally focuses on issues withinCFPB s examination generally focuses on issues within

its enforcement power: Unfair, deceptive, and abusive acts or practices

Vi l i f d fi l Violation of enumerated consumer finance laws Disclosure requirements Document retention requirementsDocument retention requirements Effective policies and procedures to avoid

violationS i id Service providers Policies and procedures to ensure service providers

do not violate consumer finance laws

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What is the CFPBs enforcement power?What is the CFPB s enforcement power? Authority to enforce:

Rules and regulations of all consumer financial laws;Rules and regulations of all consumer financial laws; Its own rules and regulations; and Unfair, deceptive and abusive acts or practices

Bureau may: Conduct investigations and hearings; Issue subpoenas and cease and desist orders; and Issue subpoenas and cease and desist orders; and Initiate lawsuits for damages, rescission, or civil

penalties Civil Penalties are defined:

First Tier = $5,000/day for violation Second Tier (reckless) = $25 000/day Second Tier (reckless) = $25,000/day Third Tier (knowing) = $1M/day

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Wh t f i b i ti ?What are unfair or abusive practices? Bureau may promulgate and enforce rules prohibiting unfair,

deceptive or abusive acts or practicesdeceptive, or abusive acts or practices Act defines unfair or abusive:

1. unfair if act is likely to cause (a) a substantial unavoidable injury to consumers that(a) a substantial, unavoidable injury to consumers that (b) is not outweighed by countervailing benefits to consumers or to competition; and

2. abusive if act (a) materially interferes with a consumers ability to understand a financial product or service or (b) takes unreasonable advantage of a consumer in certain respects.

Financial Stability Oversight Council may set aside any Bureau rule that threatens safety and soundness or stability of financial system.

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Bob GravesJones Day

Practice Leader, Banking & Finance P ti

Jonathan ChingJones Day

Of Counsel, Banking & Finance P tiPractice

Chicago, IL312.269.4356

rjgraves@jonesday.com

PracticeNew York, NY212.326.7829

jching@jonesday.com

Al RotaJones Day

Joel TelpnerJones Dayy

Partner, Financial Institutions Litigation & Regulation Practice

Dallas, TX(214) 969 3698

yPartner, Banking & Finance Practice

New York, NY212.326.3663

jstelpner@jonesday com

The views expressed in this presentation are those of the speakers and

(214) 969-3698ajrota@jonesday.com

jstelpner@jonesday.com

do not reflect the opinions of Jones Day or its clients.

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