Dodd-Frank and Basel III: Post-Financial Crisis

Developments and New Expectations in Regulatory

CapitalMichael Jacobs, Ph.D., CFA

Senior Financial Economist

Credit Risk Analysis Division / Office of the Comptroller of the Currency

Pace University-GARP

October 2011

Important Disclaimer: The views expressed herein are those of the author and do not necessarily represent the views of the Office of the Comptroller of the Currency or the Department of the Treasury.

Outline

• Frank-Dodd and Implications for Financial Institutions– History– Summary– Critique

• Overview of Basel III New Capital & Liquidity Standards– Key Elements– Implementation Issues

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

.

Frank-Dodd & Implications for Financial Institutions: History

• 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

Frank-Dodd & Implications for Financial Institutions: History

• 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

Frank-Dodd & Implications for Financial Institutions: History

• Net result was that balance sheets at large complex financial institutions (LCFIs) grew 2-fold 2004 to 2007

• 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

Frank-Dodd & Implications for Financial Institutions: Summary

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

Frank-Dodd & Implications for Financial Institutions: Summary

• 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 and 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

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 & 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

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

What are the key elements of the new regulations?•Higher Minimum Tier 1 Common Equity Requirement

– Tier 1 Common Equity Requirement: increase from 2% to 4.5%– The ratio will be set at 3.5% from 1 January 2013, 4% from 1 January

2014 and 4.5% from 1 January 2015

•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

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

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 (e.g., Switzerland) or be subject to at least additional supervision– Rules for SIFIs will be defined by the Basel Committee by mid 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

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

• 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 US 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

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

• 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

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

• 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