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Jacobs Dodd Frank&Basel3 July12 7 15 12 V16

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1. Dodd-Frank and Basel III: Post-Financial Crisis Developments and New Expectations in Regulatory Capital Michael Jacobs, Ph.D., CFA Senior Manager Deloitte and Touche…
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  • 1. Dodd-Frank and Basel III: Post-Financial Crisis Developments and New Expectations in Regulatory Capital Michael Jacobs, Ph.D., CFA Senior Manager Deloitte and Touche LLP Governance, Regulatory and Risk Strategies / Enterprise Risk Service July 2012Important Disclaimer: The views expressed herein are those of the author and do not necessarilyrepresent the views of Deloitte & Touche LLP
  • 2. 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
  • 3. Motivation: The Financial Crisis and “Too Big to Fail” • Bank losses in Figure 3: Average Ratio of Total Charge-offs to Total Value of Loans for Top 50 Banks as of 4Q09 the recent 0.035 (Call Report Data 1984-2009) financial crisis exceed levels 0.03 observed in 0.025 recent history! 0.02 • This illustrates 0.015 the inherent limitations of 0.01 backward 0.005 looking models 0 – we must anticipate risk 84 1 85 1 86 0 87 0 87 1 88 1 89 0 90 0 90 1 91 1 92 0 93 0 93 1 94 1 95 0 96 0 96 1 97 1 98 0 99 0 99 1 00 1 01 0 02 0 02 1 03 1 04 0 05 0 05 1 06 1 07 0 08 0 08 1 09 1 30 19 033 19 123 19 093 19 063 19 033 19 123 19 093 19 063 19 033 19 123 19 093 19 063 19 033 19 123 19 093 19 063 19 033 19 123 19 093 19 063 19 033 20 123 20 093 20 063 20 033 20 123 20 093 20 063 20 033 20 123 20 093 20 063 20 033 20 123 09 84 19• 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
  • 4. Motivation: The Financial Crisis and “Too Big to Fail” (cont’d.) Averaged efficiencies from each estimator FIX 1 RND • Across several HT 0.95 PSS1 econometric 0.9 PSS2W PSS2G models, we find 0.85 PSS3 BC evidence that the 0.8 BIE average the efficiency of the Efficiency 0.75 largest banks has 0.7 decreased over 0.65 time, as the 0.6 financial sector in 0.55 the U.S. has 0.5 10 20 30 40 50 60 70 80 90 100 grown Time• 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
  • 5. 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.
  • 6. 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
  • 7. 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
  • 8. Frank-Dodd & Implications for Financial Institutions: History • Table 1: Distribution of the United States real- estate exposures, source – Lehman Brothers Fixed Income Report, June 2008• 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
  • 9. 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
  • 10. Frank-Dodd & Implications for Financial Institutions: SummaryHighlights 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
  • 11. 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 & 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
  • 12. 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
  • 13. 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
  • 14. 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
  • 15. 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
  • 16. Basel III Supervisory Expectations and Guidance (cont’d.)• 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
  • 17. Basel III Supervisory Expectations and Guidance (cont’d.)• 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
  • 18. Basel III Supervisory Expectations and Guidance (cont’d.)• 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
  • 19. Basel III Supervisory Expectations and Guidance (cont’d.)• 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
  • 20. Basel III Supervisory Expectations and Guidance (cont’d.)• 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
  • 21. Overview of Basel III New Capital & Liquidity Standards • Basel III proposes many new capital, leverage & liquidity standards to strengthen the regulation, supervision & risk management of the banking sector• 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
  • 22. 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)
  • 23. 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 requirementsWhat 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
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