Jacobs Dodd Frank&Basel3 July12 7 15 12 V16

Dodd-Frank and Basel III: Post-Financial Crisis Developments and New

Expectations in Regulatory Capital

Michael Jacobs, Ph.D., CFASenior Manager

Deloitte and Touche LLP Governance, Regulatory and Risk Strategies / Enterprise Risk Service

July 2012

Important Disclaimer: The views expressed herein are those of the author and do not necessarily represent the views of Deloitte & Touche LLP

Outline• Motivation: The Financial Crisis and “Too Big to Fail”• Frank-Dodd and Implications for Financial Institutions

– History– Summary– Critique

• Basel III Supervisory Expectations and Guidance• Overview of Basel III New Capital & Liquidity Standards

– Key Elements– Implementation Issues– Critique

Motivation: The Financial Crisis and “Too Big to Fail”

• Reproduced from: Inanoglu, H., Jacobs, Jr., M., and Robin Sickles, 2010 (July), Analyzing bank efficiency: Are “too-big-to-fail” banks efficient?, forthcoming in the Journal of Efficiency

Figure 3: Average Ratio of Total Charge-offs to Total Value of Loans for Top 50 Banks as of 4Q09

(Call Report Data 1984-2009)

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

19840331

19841231

19850930

19860630

19870331

19871231

19880930

19890630

19900331

19901231

19910930

19920630

19930331

19931231

19940930

19950630

19960331

19961231

19970930

19980630

19990331

19991231

20000930

20010630

20020331

20021231

20030930

20040630

20050331

20051231

20060930

20070630

20080331

20081231

20090930

• Bank losses in the recent financial crisis exceed levels observed in recent history!

• This illustrates the inherent limitations of backward looking models – we must anticipate risk

Motivation: The Financial Crisis and “Too Big to Fail” (cont’d.)

• Reproduced from: Inanoglu, H., Jacobs, Jr., M., and Robin Sickles, 2010 (July), Analyzing bank efficiency: Are “too-big-to-fail” banks efficient?, forthcoming in the Journal of Efficiency

• Across several econometric models, we find evidence that the average the efficiency of the largest banks has decreased over time, as the financial sector in the U.S. has grown10 20 30 40 50 60 70 80 90 100

0.5

0.55

0.6

0.65

0.7

0.75

0.8

0.85

0.9

0.95

1

Time

Eff

icie

ncy

Averaged efficiencies from each estimator

FIX

RNDHT

PSS1

PSS2W

PSS2G

PSS3BC

BIE

Frank-Dodd & Implications for Financial Institutions: History

• The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) is perhaps the most ambitious and far-reaching overhaul of financial regulation since the 1930s

• The Banking Act of 1933 (“Glass-Steagall”), designed to prevent against financial panics that occurred since the mid-19th century, had been largely undone by the dawn of the financial crisis circa 2004

• Intent of Glass-Steagall was to prevent bank runs & provide an orderly resolution of troubled banks before they failed

• Established the Federal Deposit Insurance Corporation (FDIC) to protect retail depositors & ring-fenced banks’ permissible activities – Commercial lending, government bonds & general-obligation municipals– Riskier capital markets activity to be spun off into investment banks

.


• It has been argued that overall Glass-Steagall reflected a sound economic approach to regulation:– Identify the market failure: collective outcome of individual economic agents does not

lead to socially efficient outcomes (depositor runs)– Address market failure through a government intervention (insuring retail depositors

against losses)– Recognize & contain the direct & indirect costs of intervention through upfront

premiums for deposit insurance, restricting investment banking activities & “prompt corrective action” (early & orderly distress resolution)

• Easy regulatory era starting in the 1970s allowed a “shadow banking system” (money market funds, investment banks, derivatives & securitization markets) to evolve – Both opaque & highly leveraged, reflected regulatory arbitrage, the opportunity & propensity of

the financial sector to adopt organizational forms / innovations that would circumvent the regulatory apparatus designed to contain bank risk-taking

• This is considered the beginning of the end for of Glass-Seagall


• By mid-2004s large complex financial institutions (LCFIs) were seeking massive capital flows into the U.S. & U.K. by short-term borrowing financed at historically low interest rates

• They began to manufacture huge quantities of “tail risk”: i.e., small likelihood but catastrophic outcomes – Key example: senior, AAA rated tranches of subprime-backed mortgages that

would fail only if there was a secular collapse in the housing• A credit boom was fueled as LCFIs were willing buy loans from

originating lenders, distribute or hold after repackaging them – In 2008 over 20% of the US mortgage-backed exposure was guaranteed by “non-

agencies” (the private sector )• Unlike traditional securitization in which the AAA-tranches get placed

with institutional investors, in a significant measure these were originated and retained by banks


• Net result was that balance sheets at LCFIs grew 2-fold in the 2004 to 2007 period

• LCFIs (plus Fannie, Freddie-Mac & AIG) had taken a highly undercapitalized one-way bet on the housing market

• While these institutions seemed individually safe, collectively they were vulnerable: as the housing market crashed in 2007, the tail risk materialized & LCFIs crashed too

• Table 1: Distribution of the United States real-estate exposures, source – Lehman Brothers Fixed Income Report, June 2008

Frank-Dodd & Implications for Financial Institutions: Summary

• The first big banks to fail were in the shadow banking world were initially propped up by Fed assistance• Strains in the interbank markets & inherently poor quality of the underlying housing bets even in

commercial bank portfolios meant that in the fall of 2008 some banks had to fail• A panic ensued internationally making it clear that the entire global banking system was imperiled &

needed taxpayer funds• In the aftermath of this governments and regulators looked for ways to prevent or render less likely its

recurrence • Led first to a bill from the House of Representatives & then from the Senate, combined into the Dodd-

Frank Act • The critical task of Dodd-Frank Act viewed as addressing the increasing propensity of the financial sector to

put the entire system at risk & eventually bailed out at taxpayer expense


Highlights of the Dodd-Frank Act are:•Identifying & regulating systemic risk: set up a Council that can deem non-bank financial firms as systemically important, regulate them & as a last resort break them up

– Also establishes an Office under the Treasury to collect, analyze and disseminate relevant information for anticipating future crises

•Proposing an end to “too-big-to-fail”: requires funeral plans & orderly liquidation procedures for unwinding of systemically important institutions

– Rules out taxpayer funding of wind-downs instead requiring management of failing institutions be dismissed & costs be borne by shareholders, creditors, and if required ex post levies on surviving large financial firms

•Expands the responsibility & authority of the Fed: authority over all systemic institutions & responsibility for financial stability•Restricts discretionary regulatory interventions: prevent or limit emergency federal assistance to single non-bank institutions


• Reinstate a limited form of the “Volcker rule”: limit bank holding company investments in proprietary trading activities (hedge funds, private equity) & prohibits bailing out these investments

• Regulation & transparency of derivatives: central clearing of standardized & regulation of OTC complex ones, transparency of all & separation of non-vanilla positions into well-capitalized subsidiaries, with exceptions for commercial hedging uses

• Introduces a range of reforms for mortgage lending practices, hedge fund disclosure, conflict resolution at rating agencies, skin-in-the-game requirement for securitization, risk-taking by money market funds & shareholder say on pay and governance

• And perhaps its most popular reform, albeit secondary to the financial crisis, creates a Bureau of Consumer Financial Protection, that will write rules governing consumer financial services and products offered by banks and non-banks

Frank-Dodd & Implications for Financial Institutions: Critique

• It is highly encouraging that the purpose is explicitly aimed at developing tools to deal with systemically important institutions

• Strives to give regulators authority & tools to deal with this risk– Requirement of funeral plans to unwind LCFIs should help demystify their organizational structure & resolution challenges when they fail

• If enforced well, it could serve as a “tax” on complexity, another market failure in that private far exceed the social gains

• But the final language is a highly diluted version of the original Volcker Rule proposal limiting LCFI’s proprietary trading – Volcker Rule provides a more direct restriction on complexity & would help simplify their resolution – Also addresses moral hazard: direct guarantees to banks are meant to support payment / settlement systems & ensure robust lending– But the bank holding company structure effectively lower the costs for more cyclical and riskier functions (proprietary investments),

where there are thriving markets and commercial banking presence is not critical

Frank-Dodd & Implications for Financial Institutions: Critique

• Another positive feature is comprehensive overhaul of derivatives markets to promote transparency & avoid market failures when large derivatives dealer fails (e.g., Bear Stearns)– Transparency of prices, volumes and exposures to regulators & public enables better pricing & assessing of counterparty in bilateral

contracts• The Act also pushes for greater transparency by making systemic non-bank firms subject to scrutiny by the Fed & SEC• But the Act requires over 225 new financial rules across 11 federal agencies with little attempt at regulatory

consolidation– The financial sector will have to live with great uncertainty left unresolved until various regulators (Fed, SEC, CFTC) details the

implementation• Economically sound & robust regulation: weaknesses remain

– Implicit government guarantees persist in some & escalate in other areas– Capital allocation may migrate to these pockets & newer ones may arise– Implementation of the Act and future regulation may guard against this danger, but that remains to be seen

Basel III Supervisory Expectations and Guidance

• Objective of the reform package is to improve banking sector’s ability to absorb shocks arising from financial/economic stress & reducing risk of spillover to the real economy

• Aims to improve risk management, governance & strengthen banks’ transparency / disclosures including efforts to strengthen the resolution of systemically significant cross-border banks

• Reforms are part of the global initiatives to strengthen the financial regulatory system endorsed by the Financial Stability Board (FSB) and the G20 Leaders

• Supervisors attribute the severity of the financial crisis to banks building up excessive leverage & erosion of level/quality of capital base along with insufficient liquidity buffers

• System therefore was not able to absorb the resulting systemic trading & credit losses nor cope with reintermediation of large off-balance sheet exposures built up in shadow bank system

Basel III Supervisory Expectations and Guidance (cont’d.)

• Weaknesses in the banking sector were transmitted to the rest of the financial system & real economy resulting in massive contraction of liquidity & credit availability

• Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing the taxpayer to large losses

• The effect on banks, financial systems and economies at the epicentre of the crisis was immediate; however, the crisis also spread to a wider circle of countries around the globe. – For these countries the transmission channels were less direct, resulting from a

severe contraction in global liquidity, cross border credit availability and demand for exports

• Scope & speed with which the crisis was transmitted around the globe implies all countries raise the resilience of banking sectors to internal & external shocks


• To address the market failures revealed by the crisis BCBS introduced a number of fundamental reforms to the international regulatory framework to strengthen bank-level regulation to help raise the resilience of individual institutions to stress

• The reforms also have a macroprudential focus, addressing system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time

• Clearly these two micro and macroprudential approaches to supervision are interrelated, as greater resilience at the individual bank level reduces the risk of system wide shocks

• Building on the agreements reached at the 6 September 2009 meeting of the BCBS’s governing body, the key elements of the proposals were issued for consultation at the end of 2009


• First, the quality, consistency, and transparency of the capital base will be raised to ensure that large, internationally active banks are in a better position to absorb losses on both a going concern and gone concern basis – For example, under the previous BCBS standard, banks could hold as little as

2% common equity to risk-based assets• Second, the risk coverage of the capital framework will be

strengthened– In addition to the trading book & securitization reforms announced in 7-09,

strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos & securities financing activities

– Enhancements will strengthen the resilience of individual institutions & reduce the risk that shocks are transmitted from one institution to the next through the derivatives & financing channel

– The strengthened counterparty capital requirements also will increase incentives to move OTC derivatives to central clearinghouses


• Third, introduced a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review & calibration– This will help contain the build up of excessive leverage in the banking system,

introduce additional safeguards against attempts to game the risk based requirements & help address model risk

– To ensure comparability details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting

– Ratio will be calibrated so that it serves as a credible supplementary measure to the risk based requirements, taking into account the forthcoming changes to the Basel II framework

• Fourth, measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress – Countercyclical capital framework contributes to a more stable banking system,

which will help dampen vs. amplify economic & financial shocks – Promote forward looking provisioning based on expected losses that reflect

actual losses transparently & is less procyclical than incurred loss


• Fifth, a global minimum liquidity standard for internationally active banks: a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio– Framework also includes a common set of monitoring metrics to assist in

identifying & analysing liquidity risk trends at bank & system wide level– Standards and monitoring metrics complement BCBS “Principles for Sound

Liquidity Risk Management and Supervision” issued 9-08• BCBS is reviewing the need for additional capital, liquidity or other

supervisory measures to reduce the externalities created by systemically important institutions

• Market pressure has already forced the banking system to raise the level and quality of the capital and liquidity base – The proposed changes will ensure that these gains are maintained over the

long run, resulting in a banking sector that is less leveraged, less procyclical and more resilient to system wide stress


• BCBS conducted a comprehensive impact assessment of the enhanced capital and liquidity standards in the first half of 2010

• Based upon the conclusion that the effect on the global banking system would be favorable, BCBS reviewed & finalized the regulatory minimum level of capital in the second half of 2010

• Taking into account the reforms proposed, BCBS asserts that an appropriately calibrated total level and quality of capital has been achieved, considering all the elements of the reform

• The fully calibrated set of standards was developed by the end of 2010 to be phased in as financial/economic conditions improve with the aim of implementation by end-2012

• Within this context BCBS also will consider appropriate transition and grandfathering arrangements & believes these measures will promote a better balance between financial innovation, economic efficiency & sustainable long run growth

Overview of Basel III New Capital & Liquidity Standards

• The capital standards & new capital buffers will require banks to hold more & higher quality of capital than under current Basel II

• The new leverage & liquidity ratios introduce a non-risk based measure to supplement the risk-based minimum capital requirements (aka, leverage ratio) & measures to ensure that adequate funding is maintained in case of crisis

• Basel III proposes many new capital, leverage & liquidity standards to strengthen the regulation, supervision & risk management of the banking sector

Overview of Basel III New Capital & Liquidity Standards (cont’d.)

• Alongside higher capital requirement & increased capital ratios, Basel III introduces new liquidity & leverage ratios

• Also counterparty credit risk & market risk enhancements for the trading book (new capital requirements for Credit Value Adjustment, Wrong Way Risk, Stressed Value-at-Risk and Incremental Risk)

Basel III Capital & Liquidity Standards: Key Elements

• New regulations raise the quality, consistency & transparency of the capital base and strengthen the risk coverage of the capital framework

• Basel III strengthens the three Basel II pillars, especially Pillar 1 with enhanced minimum capital and liquidity requirements

What are the key elements of the new regulations?• Higher minimum Tier 1 capital requirement

– Tier 1 Capital Ratio: increases from 4% to 6%– The ratio will be set at 4.5% from 1 January 2013, 5.5% from 1 January 2014

and 6% from 1 January 2015– Predominance of common equity will now reach 82.3% of Tier 1 capital,

inclusive of capital conservation buffer• New Capital Conservation Buffer

– Used to absorb losses during periods of financial and economic stress

Basel III Capital & Liquidity Standards: Key Elements (cont’d.)

What are the key elements of the new regulations?•New Capital Conservation Buffer (continued)

– Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirement to 7%

• 4.5% common equity requirement and the 2.5% capital conservation buffer– The capital conservation buffer must be met exclusively with common equity– Banks that do not maintain the capital conservation buffer will face restrictions

on payouts of dividends, share buybacks and bonuses•New Countercyclical Capital Buffer

– A countercyclical buffer within a range of 0% - 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances

– When in effect, this is an extension to the conservation buffer


What are the key elements of the new regulations?•Liquidity Standards

– Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are available for one month survival in case of a stress scenario.

• Introduced 1 January 2015– Net Stable Funding Ratio (NSFR): to promote resiliency over longer-term time

horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis

– Additional liquidity monitoring metrics focused on maturity mismatch, concentration of funding and available unencumbered assets


What are the key elements of the new regulations?•Leverage Ratio

– A supplemental 3% non-risk based leverage ratio which serves as a backstop to the measures outlined above

– Parallel run between 2013-2017; migration to Pillar 1 from 2018•Minimum Total Capital Ratio

– Remains at 8%– The addition of the capital conservation buffer increases the total amount of

capital a bank must hold to 10.5% of risk-weighted assets, of which 8.5% must be Tier 1 capital

– Tier 2 capital instruments will be harmonized– Tier 3 capital will be phased out

Basel III Capital & Liquidity Standards: Implementation

• The Basel Committee has outlined phase-in arrangements

• Specific implementation timelines for individual countries, both members and non-members of the Basel Committee on Banking Supervision, may vary

Basel III Capital & Liquidity Standards: Implementation(cont’d.)

• The new Basel III regulations will affect all banks, however the severity of the impact may differ across types and size of banks

• Most impacted by increases in quantity & quality of capital, liquidity & leverage ratios, new Pillar 2 & capital preservation

• Most sophisticated banks affected by the amended treatment of counterparty credit risk, more robust market risk framework and to some extent, the amended treatment of securitizations

• Systemic Important Financial Institutions (SIFIs) may have to cope with higher capital requirements or be subject to at least additional supervision– Rules for SIFIs were defined by the Basel Committee in 2011

• The U.S. has stated on numerous occasions that they will move to Basel III – probably all US banks required to meet Basel III– But smaller institutions may have their capital requirements reduced


• US specific rules are to be clarified in 2012 and Basel III should take effect in early 2013

• Many institutions in several countries including the U.S. are not Basel II compliant, but their regulatory authorities have indicated that they will eventually move to a Basel III framework

• This creates an interesting situation because Basel II is the building block for Basel III – therefore, if implement a Basel II solution before Basel III, should ensure that solution is flexible

• Data infrastructure implemented should be able to easily accommodate a granular level of data to support both assets & liabilities for calculation of regulatory capital & liquidity ratios

• A vended solution needs a clear product roadmap that allows migration from Basel II to III system including regulatory capital calculation engines and regulatory reports


• As capital requirements are increasing the solution should optimize regulatory capital calculations to not hold an excess

• If able to bypass Basel II and implement Basel III then planning to update/replace existing Basel I systems quickly as possible

• In implementing Basel II systems, data is the most challenging & time consuming steps: should be considered early– Having granular level data has been identified as one of the biggest business

benefits from Basel II• While implementing an advanced approach can result in lower

capital requirements beneficial from a return of capital perspective, this benefit is not guaranteed

• Probably more institutions will leverage the advanced approach as a result of the higher capital requirements, which will likely make it more attractive from a capital reduction perspective


• With increased capital requirements, allocating capital efficiently & maximizing risk based returns becomes more important ever

• Should evaluate risk and banking systems to determine if newer systems and processes can help you reduce operating costs, increase return on risk & more effective capital allocation

• National regulators may increase the quality and quantity of data included in their national regulatory reports, especially around liquidity and leverage ratios

• Existing capital adequacy reports will also be updated: Such additional information will also have to be reported to the market via enhancing the current bank Pillar 3 disclosures

Basel III Capital & Liquidity Standards: Critique

• Basel III is in its finalized form only since September 2010, so it is too early to tell whether it will be effective in practice, but critics have already begun to voice their opinions

• Obvious criticism surrounds the high level of capital it requires banks to hold & the suppressive impact it will have on lending– E.g., if a bank has $100 of capital, under Basel II it could lend up to $1250 of

risk-weighted loans (8% minimum capital level under Basel II)– When Basel III is fully implemented that same $100 could represent up to 13%

of risk-weighted assets implies the bank can lend up to $770• A reduction in lending will inhibit economic growth: in the form of

higher capital requirements, Basel III is effectively restricting banks from sponsoring a robust and healthy economy

• Counterargument is that the leverage & liquidity requirements result in healthier banks that can better withstand downturns and less financial contagion, but then again at what cost?

Basel III Capital & Liquidity Standards: Critique (continued)

• A macro-prudential tool should be concerned with & address systemic risk contributions of financial firms, but the Basel rules are focused instead on individual risk of financial firms

• Reducing the individual risk of financial firms can in principle augment systemic risk– If encouraged to diversify perfectly at all costs, then banks can wind up hold the same

aggregate risk if diversify away all idiosyncratic risk– If the costs to bank failures are non-linearly increasing in number of failures, then this

form of diversification could be welfare-reducing• Even ignoring the possibility of individual institutions becoming more

correlated as they reduce their own risks, Basel ignores endogenous or dynamic evolution of risks of underlying assets – E.g., AAA-backed residential MBS: Basel providing a relative advantage to this asset

class explicitly encouraged greater lending in the aggregate– As banks lent down the quality curve->worse mortgages->although MBS historically

safe a static favorable risk-weight made it endogenously risky

.

Basel III Capital & Liquidity Standards: Critique (continued)

• Basel rules ignore that when risk of an asset class materializes, since the institutions are over-leveraged on this asset class & in a correlated manner, they face endogenous liquidity risk – E.g., all firms at once attempts to de-leverage by selling its AAA MBS implying that

there is not enough capital in the system to deal with this & systemic risk is created ex post as well as ex ante

– In this sense, Basel requirements induce pro-cyclicality over and above the fact that risks are inherently pro-cyclical

• In economic terms the Basel risk-weight approach attempts to target relative prices for activities vs. restrict quantities directly– Absent price-discovery of day-to-day markets regulators have little hope in

achieving price efficiency sufficiently dynamic & reflective of latent risk– But concentration limits on asset class exposure for the economy as a whole or

simple leverage restriction are more likely to be robust and counter-cyclical macro-prudential tools

– They do not directly address systemic risk but at least offer hope of limiting risks of individual financial firms and asset classes

Jacobs Dodd Frank&Basel3 July12 7 15 12 V16

Documents

Transcript of Jacobs Dodd Frank&Basel3 July12 7 15 12 V16