How Investment Banking Rules Changed after the Financial Crisis

By Matt Krantz, Robert R. Johnson

Securities laws continue to evolve, and investment bankers need to keep up. In July 2010, President Obama signed into law the omnibus Dodd–Frank legislation. The law is still morphing and has expanded to 9,000-plus pages in length, affecting nearly every aspect of the financial markets. It continues to be subject to intense lobbying efforts by the investment banking industry and will undoubtedly be in flux for years to come.

The ultimate outcomes of many aspects of the law are unknown, but for investment banks some of the most important provisions and proposed provisions of the legislation include the following:

  • Increased transparency in the derivatives markets: Many firms, including investment banks, take huge positions in the derivatives markets. A derivative security — like an option or swap — is simply a security whose value depends on (is derived) by the value of another security. For instance, the value of a call option or put option on a share of stock depends upon the price of that share of stock.

    The problem with many complex derivatives — like credit default swaps — are that these holdings are both difficult to value and difficult to find information on. The problem is that many of the transactions in the derivatives market do not take place on organized exchanges where prices and volume levels are disclosed, but they take place over the counter or in private negotiations between the buyer and seller.

    Thus, there is limited transparency in these markets concerning both the pricing and the volume of the positions. The failure of Lehman Brothers and the dire financial situation faced by American International Group (AIG) was largely attributed to positions each firm had in derivatives security markets, particularly in credit default swaps.

  • Increased capital requirements: One of the most important provisions of the Dodd–Frank legislation involves increasing the capital (or equity) requirements of banks, effectively lowering the amount of leverage (borrowing) that investment banks can utilize in their operations.

    Many investment banking firms got into trouble during the crisis — and ultimately were bailed out by taxpayers — because these firms were so highly indebted that when some of their proprietary trading bets went against them, the losses were magnified and they didn’t have the funds available to absorb the losses.

    By increasing the amount of firm equity relative to borrowing of investment banks, the intention of the legislation is to create a more stable and secure banking system.

  • Limitations of proprietary trading: This area is still under intense negotiation and review, but one of the most contentious areas of the Dodd–Frank legislation involves limitations on proprietary trading by investment banking firms. The so-called Volcker Rule (named after former Federal Reserve Chairman Paul Volcker) would restrict banking firms from making speculative investments on their own account, only allowing them to trade on behalf of customers.

    The investment banking industry is fighting this provision because proprietary trading has traditionally been a profit center for investment banks. Investment banks won’t give up this revenue stream without a fight.

  • More intense scrutiny and reform of the credit-rating agencies: Credit-rating agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings provide ratings on a variety of financial securities — from government bonds to corporate bonds and mortgage-backed securities. These ratings are meant to provide investors with a sense of the likelihood that an issuer will default on a particular security.

    Rating agencies played a central role in the recent financial crisis, as many securities — particularly mortgage-backed securities — that had been given very high or the highest credit quality ratings defaulted as homeowners defaulted on their residential mortgages.

    Investment banks are major users of the services of these rating agencies, because it’s much easier to sell highly rated securities to investors because the buyers believe them to be relatively safe. Investment banking firms are the lifeblood of these rating agencies, because investment banks pay the rating agencies to rate the securities.

    There is an obvious conflict of interest with issuer-paid ratings — investment banks want high ratings for the securities they’re putting together, and rating agencies want the continued business of these investment banks. High ratings make both parties happy but can mislead investors who rely on these ratings as part of their investment decision-making process. The Dodd–Frank legislation provides for increased scrutiny of credit-rating agencies.

  • Risk retention of asset-backed securities: One of the most criticized practices of some investment banking firms that came out of the recent financial crisis was that firms put together securities (primarily mortgage-backed securities) of questionable quality and sold them to clients.

    In fact, what has been dubbed “the greatest trade ever” was when hedge-fund manager John Paulson effectively short-sold the U.S. housing market through a series of trades that several investment banks helped him engineer. Clients of the investment banking firm were on the other side of these trades.

    The Dodd–Frank legislation addresses this issue by mandating that a firm that puts these securities together retain at least 5 percent of the credit risk of those assets. In other words, investment banks are required to have some “skin in the game,” and if the value of these securities goes south, the investment banking firm will suffer similarly to the client who purchased the assets.

  • Executive compensation: One of the raging debates in business today involves the level of executive compensation, particularly within the financial services industry. Many people were outraged with the salary and bonus packages provided to executives from firms in the financial services arena that received government bailouts.

    Although not placing any dollar restrictions on salary and bonuses of executives, the Dodd–Frank legislation requires that companies must include a resolution in their proxy statements approving the compensation of top executives. It also requires that firms disclose certain statistics regarding executive pay, for instance, the ratio of CEO pay to median employee compensation. Requiring more disclosure will increase the scrutiny on executive pay packages.