Jacobs Dofdd Frank&Basel3 Risk Nov11 11 8 11 V1

odd-Frank and Basel III Post-Financial Crisis Developments and New Expectations in Regulatory Capital. Following the recent global financial crisis of 2009, financial regulators have responded with arrays of proposals to revise existing risk frameworks for financial institutions with the objective to further strengthen and improve upon bank models. In this meeting, Dr. Michael Jacobs will discuss new developments and expectations in regulatory capital with particular reference to the definition of the capital base, counterparty credit risk, procyclicality of capital, liquidity risk management, and sound compensation practices. He will also explain the implications of the Frank-Dodd rule for financial institutions and will conclude by presenting the implementation schedule for Basel III.
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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 Financial Economist Credit Risk Analysis Division / Office of the Comptroller of the Currency Pace University-GARP October 2011
  • 2. 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.
  • 3. Outline <ul><li>Frank-Dodd and Implications for Financial Institutions </li></ul><ul><ul><li>History </li></ul></ul><ul><ul><li>Summary </li></ul></ul><ul><ul><li>Critique </li></ul></ul><ul><li>Overview of Basel III New Capital & Liquidity Standards </li></ul><ul><ul><li>Key Elements </li></ul></ul><ul><ul><li>Implementation Issues </li></ul></ul>
  • 4. Frank-Dodd & Implications for Financial Institutions: History <ul><li>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 </li></ul><ul><li>The Banking Act of 1933 (“Glass-Steagall”), designed to prevent against financial panics that occurred since the mid-19 th century, had been largely undone by the dawn of the financial crisis circa 2004 </li></ul><ul><li>Intent of Glass-Steagall was to prevent bank runs & provide an orderly resolution of troubled banks before they failed </li></ul><ul><li>Established the Federal Deposit Insurance Corporation (FDIC) to protect retail depositors & ring-fenced banks’ permissible activities </li></ul><ul><ul><li>Commercial lending, government bonds & general-obligation municipals </li></ul></ul><ul><ul><li>Riskier capital markets activity to be spun off into investment banks </li></ul></ul><ul><li>. </li></ul>
  • 5. Frank-Dodd & Implications for Financial Institutions: History <ul><li>It has been argued that overall Glass-Steagall reflected a sound economic approach to regulation: </li></ul><ul><ul><li>Identify the market failure: collective outcome of individual economic agents does not lead to socially efficient outcomes (depositor runs) </li></ul></ul><ul><ul><li>Address market failure through a government intervention (insuring retail depositors against losses) </li></ul></ul><ul><ul><li>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) </li></ul></ul><ul><li>Easy regulatory era starting in the 1970s allowed a “shadow” banking system (money market funds, investment banks, derivatives & securitization markets) to evolve. </li></ul><ul><ul><li>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. </li></ul></ul><ul><li>This is considered the beginning of the end for of Glass-Seagall </li></ul>
  • 6. Frank-Dodd & Implications for Financial Institutions: History <ul><li>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 </li></ul><ul><li>They began to manufacture huge quantities of “tail risk”: i.e, small likelihood but catastrophic outcomes. </li></ul><ul><ul><li>Key example: senior, AAA rated tranches of subprime-backed mortgages that would fail only if there was a secular collapse in the housing </li></ul></ul><ul><li>A credit boom was fueled as LCFIs were willing buy loans from originating lenders, distribute or hold after repackaging them </li></ul><ul><ul><li>In 2008 over 20% of the US mortgage-backed exposure was guaranteed by “non-agencies” (the private sector ) </li></ul></ul><ul><li>Unlike traditional securitization in which the AAA-tranches get placed with institutional investors, in a significant measure these were originated and retained by banks </li></ul>
  • 7. Frank-Dodd & Implications for Financial Institutions: History <ul><li>Net result was that balance sheets at large complex financial institutions (LCFIs) grew 2-fold 2004 to 2007 </li></ul><ul><li>LCFIs (plus Fannie, Freddie-Mac & AIG) had taken a highly undercapitalized one-way bet on the housing market </li></ul><ul><li>While these institutions seemed individually safe, collectively they were vulnerable: as the housing market crashed in 2007, the tail risk materialized & LCFIs crashed too </li></ul><ul><li>Table 1: Distribution of the United States real-estate exposures, source – Lehman Brothers Fixed Income Report, June 2008 </li></ul>
  • 8. Frank-Dodd & Implications for Financial Institutions: Summary <ul><li>The first big banks to fail were in the shadow banking world were initially propped up by Fed assistance </li></ul><ul><li>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 </li></ul><ul><li>A panic ensued internationally making it clear that the entire global banking system was imperiled & needed taxpayer funds </li></ul><ul><li>In the aftermath of this governments and regulators looked for ways to prevent or render less likely its recurrence. </li></ul><ul><li>Led first to a bill from the House of Representatives & then from the Senate, combined into the Dodd-Frank Act </li></ul><ul><li>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 </li></ul>
  • 9. Frank-Dodd & Implications for Financial Institutions: Summary <ul><li>Highlights of the Dodd-Frank Act are : </li></ul><ul><li>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 </li></ul><ul><ul><li>Also establishes an Office under the Treasury to collect, analyze and disseminate relevant information for anticipating future crises. </li></ul></ul><ul><li>Proposing an end to “too-big-to-fail”: requires funeral plans & orderly liquidation procedures for unwinding of systemically important institutions </li></ul><ul><ul><li>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 </li></ul></ul><ul><li>Expands the responsibility & authority of the Fed: authority over all systemic institutions & responsibility for financial stability </li></ul><ul><li>Restricts discretionary regulatory interventions: prevent or limit emergency federal assistance to single non-bank institutions </li></ul>
  • 10. Frank-Dodd & Implications for Financial Institutions: Summary <ul><li>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 </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul><ul><li>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 </li></ul>
  • 11. Frank-Dodd & Implications for Financial Institutions: Critique <ul><li>It is highly encouraging that the purpose is explicitly aimed at developing tools to deal with systemically important institutions </li></ul><ul><li>Strives to give regulators authority & tools to deal with this risk </li></ul><ul><ul><li>Requirement of funeral plans to unwind LCFIs should help demystify their organizational structure & resolution challenges when they fail </li></ul></ul><ul><li>If enforced well, it could serve as a “tax” on complexity, another market failure in that private far exceed the social gains </li></ul><ul><li>But the final language is a highly diluted version of the original Volcker Rule proposal limiting LCFI’s proprietary trading </li></ul><ul><ul><li>Volcker Rule provides a more direct restriction on complexity & would help simplify their resolution </li></ul></ul><ul><ul><li>Also addresses moral hazard: direct guarantees to banks are meant to support payment / settlement systems & ensure robust lending </li></ul></ul><ul><ul><li>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 </li></ul></ul>
  • 12. Frank-Dodd & Implications for Financial Institutions: Critique <ul><li>Another positive feature is comprehensive overhaul of derivatives markets to promote transparency & avoid market failures when large derivatives dealer fails (e.g., Bear Stearns) </li></ul><ul><ul><li>Transparency of prices, volumes and exposures to regulators & public enables better pricing & assessing of counterparty in bilateral contracts </li></ul></ul><ul><li>The Act also pushes for greater transparency by making systemic non-bank firms subject to scrutiny by the Fed & SEC </li></ul><ul><li>But the Act requires over 225 new financial rules across 11 federal agencies with little attempt at regulatory consolidation </li></ul><ul><ul><li>The financial sector will have to live with great uncertainty left unresolved until various regulators (Fed, SEC, CFTC) details the implementation </li></ul></ul><ul><li>Economically sound & robust regulation: weaknesses remain </li></ul><ul><ul><li>Implicit government guarantees persist in some & escalate in other areas </li></ul></ul><ul><ul><li>Capital allocation may migrate to these pockets & newer ones may arise </li></ul></ul><ul><ul><li>Implementation of the Act and future regulation may guard against this danger, but that remains to be seen </li></ul></ul>
  • 13. Overview of Basel III New Capital & Liquidity Standards <ul><li>The capital standards & new capital buffers will require banks to hold more & higher quality of capital than under current Basel II </li></ul><ul><li>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 </li></ul><ul><li>Basel III proposes many new capital, leverage & liquidity standards to strengthen the regulation, supervision & risk management of the banking sector </li></ul>
  • 14. Overview of Basel III New Capital & Liquidity Standards (cont’d.) <ul><li>Alongside higher capital requirement & increased capital ratios, Basel III introduces new liquidity & leverage ratios </li></ul><ul><li>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) </li></ul>
  • 15. Basel III Capital & Liquidity Standards: Key Elements <ul><li>New regulations raise the quality, consistency & transparency of the capital base and strengthen the risk coverage of the capital framework </li></ul><ul><li>Basel III strengthens the three Basel II pillars, especially pillar 1 with enhanced minimum capital and liquidity requirements </li></ul><ul><li>What are the key elements of the new regulations? </li></ul><ul><li>Higher minimum Tier 1 capital requirement </li></ul><ul><ul><li>Tier 1 Capital Ratio: increases from 4% to 6% </li></ul></ul><ul><ul><li>The ratio will be set at 4.5% from 1 January 2013, 5.5% from 1 January 2014 and 6% from 1 January 2015 </li></ul></ul><ul><ul><li>Predominance of common equity will now reach 82.3% of Tier 1 capital, inclusive of capital conservation buffer </li></ul></ul><ul><li>New Capital Conservation Buffer </li></ul><ul><ul><li>Used to absorb losses during periods of financial and economic stress </li></ul></ul>
  • 16. Basel III Capital & Liquidity Standards: Key Elements (cont’d.) <ul><li>What are the key elements of the new regulations? </li></ul><ul><li>New Capital Conservation Buffer (continued) </li></ul><ul><ul><li>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% </li></ul></ul><ul><ul><ul><li>4.5% common equity requirement and the 2.5% capital conservation buffer </li></ul></ul></ul><ul><ul><li>The capital conservation buffer must be met exclusively with common equity </li></ul></ul><ul><ul><li>Banks that do not maintain the capital conservation buffer will face restrictions on payouts of dividends, share buybacks and bonuses </li></ul></ul><ul><li>New Countercyclical Capital Buffer </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>When in effect, this is an extension to the conservation buffer </li></ul></ul>
  • 17. Basel III Capital & Liquidity Standards: Key Elements (cont’d.) <ul><li>What are the key elements of the new regulations? </li></ul><ul><li>Higher Minimum Tier 1 Common Equity Requirement </li></ul><ul><ul><li>Tier 1 Common Equity Requirement: increase from 2% to 4.5% </li></ul></ul><ul><ul><li>The ratio will be set at 3.5% from 1 January 2013, 4% from 1 January 2014 and 4.5% from 1 January 2015 </li></ul></ul><ul><li>Liquidity Standards </li></ul><ul><ul><li>Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are available for one month survival in case of a stress scenario. </li></ul></ul><ul><ul><ul><li>Introduced 1 January 2015 </li></ul></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Additional liquidity monitoring metrics focused on maturity mismatch, concentration of funding and available unencumbered assets </li></ul></ul>
  • 18. Basel III Capital & Liquidity Standards: Key Elements (cont’d.) <ul><li>What are the key elements of the new regulations? </li></ul><ul><li>Leverage Ratio </li></ul><ul><ul><li>A supplemental 3% non-risk based leverage ratio which serves as a backstop to the measures outlined above </li></ul></ul><ul><ul><li>Parallel run between 2013-2017; migration to Pillar 1 from 2018 </li></ul></ul><ul><li>Minimum Total Capital Ratio </li></ul><ul><ul><li>Remains at 8% </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Tier 2 capital instruments will be harmonized; tier 3 capital will be phased out </li></ul></ul>
  • 19. Basel III Capital & Liquidity Standards: Implementation <ul><li>The Basel Committee has outlined phase-in arrangements </li></ul><ul><li>Specific implementation timelines for individual countries, both members and non-members of the Basel Committee on Banking Supervision, may vary </li></ul>
  • 20. Basel III Capital & Liquidity Standards: Implementation(cont’d.) <ul><li>The new Basel III regulations will affect all banks, however the severity of the impact may differ across types and size of banks </li></ul><ul><li>Most impacted by increases in quantity & quality of capital, liquidity & leverage ratios, new Pillar 2 & capital preservation </li></ul><ul><li>Most sophisticated banks affected by the amended treatment of counterparty credit risk, more robust market ri
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