A significant source of new regulation is the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law on July 21, 2010. The law aims to address deficiencies in financial-sector regulation that led to the 2008 financial crisis and bank bailout. Dodd-Frank is a relatively ambitious undertaking, targeting almost every aspect of banking.

However, government agencies need to devise rules to carry out the law’s provisions. Some Dodd-Frank provisions are under study, and resistance to new regulations and political considerations have delayed the rule-making process. It probably will be several years before Dodd-Frank is fully in place and its ramifications are known.

Among the most important provisions of Dodd-Frank is the setting up of a mechanism by which the government can wind down troubled financial institutions. The goal is for the government to avoid bailing out banks, as it did in late 2008. The government hopes to dispel the notion that it might again come to the assistance of the largest, systemically important financial institutions viewed in the past as ‘’too big to fail’’.

As part of this effort, banks are being asked to submit to regulators living wills, or hypothetical blue prints describing how they might be dismantled by the FDIC, should they become insolvent. Big banks like Bank of America (BAC - Free Bank of America Stock Report) and JPMorgan Chase & Co. (JPM - Free JPMorgan Chase Stock Report) are required to submit the first versions of the living wills by mid-2012; smaller banks, at a later date. Although the FDIC and the Federal Reserve have set rules for the living wills, there’s still a lot of discussion about what information needs to be included in the plans. Obviously, the wind-down mechanism won’t be tested unless a large institution actually fails.

Another part of the Dodd-Frank law calls for establishing a Consumer Financial Protection Bureau (CFPB). Abusive mortgage lending practices in the past, including inadequate disclosure of the terms and costs of a loan, led to the creation of the agency. The CFPB is already at work. It recently devised a model for a simpler credit card agreement that outlines the features and costs of a card product without unneeded legal jargon. But at this writing, the CFPB still lacks a chief, as Congress has not confirmed the Administration’s choice for the agency’s top job. Until the CFPB has a director, the agency’s rule-making powers are limited. The CFPB is vastly unpopular with banks, who fear the rules that it eventually issues will be costly.

Meanwhile, a provision of Dodd-Frank, dubbed the Volker rule after former Federal Reserve chairman Paul Volker, would limit federally-insured banks’ ability to use their own capital to engage in risky trading, which had a hand in precipitating the 2008 financial crisis. The rule would also restrict banks’ investments in hedge funds and private equity funds.  The proposal is expected to be implemented in July, 2012. A recent draft of the Volker rule has been criticized on the one hand, as too complex and as limiting banks’ competitiveness overseas, and on the other hand, as too easy for banks to circumvent. 

In all, implementing the Dodd-Frank law, including initiatives such as more closely regulating derivatives investments and setting capital guidelines for large, interconnected financial institutions, will take a lot more work over the next few years. Bank revenues are already under pressure owing to limitations on credit card, overdraft, and debit card fees put in place in the past two years, and additional regulations may depress revenues further.

But the banks are also having a hard time planning for the future, given the uncertainty as to how the many provisions of Dodd-Frank will eventually be implemented.  The uncertainty no doubt is contributing to bank stocks’ continued underperformance. Clearing up the confusion should be a plus for the industry and bank equities. Moreover, extending some of the above reforms to insurers and other nonbank financial companies that compete with banks ought to lead to a more level playing field in the financial services sector.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.