Basel 2.5, Basel III. Their Tasks Are To Identify Risks To The Financial Stability of The

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DODDFRANK ACT

The DoddFrank Act in the United States was signed into law in July 2010. Its aim is
to prevent future bailouts of financial institutions and protect the consumer. A
summary of the main regulations is as follows:
1. Two new bodies, the Financial Stability Oversight Council (FSOC) and the
Office of Financial Research (OFR) were created to monitor systemic risk and
Basel 2.5, Basel III. Their tasks are to identify risks to the financial stability of the
United States, promote market discipline, and maintain investor confidence.
2. The orderly liquidation powers of the Federal Deposit Insurance Corporation
(FDIC) were expanded. The Office of Thrift Supervision was eliminated.
3. The amount of deposits insured by the FDIC was increased permanently to
$250,000.
4. Regulations were introduced requiring large hedge funds and similar financial
intermediaries to register with the SEC and report on their activities.
5. A Federal Insurance Office was created to monitor all aspects of the insurance
industry and work with state regulators.
6. Proprietary trading and other similar activities of deposit taking institutions
were curtailed. This is known as the Volcker rule because it was proposed by
former Federal Reserve chairman, Paul Volcker. (The main difficulty with this rule is
that of distinguishing between hedging and speculative trades.)
7. Some high-risk trading operations were required to be spun off into separately
capitalized affiliates.
8. Standardized over-the-counter derivatives were required to be cleared by central
clearing parties (CCPs) or by exchanges. Swap execution facilities (SEFs) were
mandated to facilitate OTC trading and provide more transparency on prices in the
OTC market. The Commodity Futures Trading Commission (CFTC) was given
responsibility for monitoring the activities of CCPs and SEFs.
9. The Federal Reserve was required to set risk management standards for
systemically important financial utilities engaged in activities such as payment,
settlement, and clearing.
10. Protection for investors was increased and improvements were made to the
regulation of securities.
11. Rating agencies were required to make the assumptions and methodologies
behind their ratings more transparent and the potential legal liabilities of rating
agencies were increased. An Office of Credit Ratings was created at the SEC to
provide oversight of rating agencies.

12. The use of external credit ratings in the regulation of financial institutions was
banned. (This provision of the Act brings DoddFrank into direct conflict with the
Basel Committee, which as we have seen in this chapter and the last one, does
make some use of external credit ratings.)
13. A Bureau of Financial Protection was created within the Federal Reserve to
ensure that consumers get clear and accurate information when they shop for
financial products such as mortgages and credit cards.
14. Issuers of securitized products were required (with some exceptions) to keep
5% of each product created.
15. Federal bank regulators were required to issue regulations that discourage the
use of compensation arrangements that might lead to excessive risk taking (e.g.,
compensation arrangements based on short run performance). Shareholders were
given a non-binding vote on executive compensation. A requirement that board
compensation committees be made up of independent directors was introduced.
16. Mortgage lenders were required to make a reasonable good faith
determination based on verified and documented information that the borrower
has the ability to repay a loan. Failure to do this might lead to a foreclosure being
disallowed.
298 RISK MANAGEMENT AND FINANCIAL INSTITUTIONS
17. Large financial firms were required to have board committees where at least
one expert has risk management experience at a large complex firm.
18. The FDIC is allowed to take over a large financial institution when it is failing
and sell its assets, imposing losses on shareholders and creditors with the costs of
failures being paid for by the financial industry.
19. FSOC and OFR, which as mentioned in 1 above have the responsibility of
monitoring systemic risk, are charged with identifying systemically important
financial institutions (SIFIs). As indicated in Section 13.2, any bank in the United
States with assets of more than $50 billion is a SIFI. The criteria for nonbank
SIFIs is less clear. FSOC has been given the authority to impose extra capital
requirements on SIFIs.
20. The Federal Reserve Board and the FDIC require all SIFIs to prepare what is
known as living wills mapping out how they can be safely wound up in the event of
failure. SIFIs tend to have developed complex organizational structures for tax and
regulatory purposes. The living will requirement may result in this being simplified
so that the different activities of a SIFI are in separately capitalized legal
entities. Regulators have the option of forcing SIFIs to divest certain operations,or
even break up entirely, if their living wills are deemed unsatisfactory.

The DoddFrank Act did not define a future role for Fannie Mae and Freddie Mac,
which were key players in the U.S. mortgage market. These agencies were taken
over by the U.S. government in September 2008 in what will undoubtedly prove
tobe the most expensive part of the credit crisis for U.S. taxpayers.
An important objective of legislators post-crisis is to increase transparency of
derivatives markets. One way they are doing this is by creating a trade repository of
all derivatives transactions. A key part of this will be the creation of a new Legal
Entity Identifier system. In the United States, this will be the responsibility of the
Office of Financial Research. AIGs positions in credit derivatives were apparently
unknown to financial regulators prior to the bailout in September 2008. A central
repository for all derivatives transactions should mean that regulators are never
taken by surprise in this way again.
13.5 LEGISLATION IN OTHER COUNTRIES
The large banks are truly global and when regulations vary throughout the world,
they are liable to move all or part of their operations from one jurisdiction to
another.
Although all countries are subject to the same Basel III rules, the extra discretionary
capital charged by regulators does vary from country to country. In 2011, the Swiss
bank UBS made headlines by suggesting that it might move its investment bank
headquarters from Zurich to London, Singapore, or New York to avoid the higher
capital requirements imposed by Swiss regulators.
The previous section outlined the rules introduced by legislators in the United
States. Legislation in other countries has addressed some of the same issues. Some
rules are similar to those in the United States. For example, the DoddFrank Act
requires originators of securitized products in the United States to keep 5% of all
assets created. A similar provision exists in the Capital Requirement Directive 2
Basel 2.5, Basel III, and DoddFrank 299
(CRD2) of the European Union. But there are some important differences. For
example, the Volcker provision of the DoddFrank Act restricts proprietary tradingby
U.S. banks, but most other governments have not introduced similar provisions.
Most national legislators have agreed that standardized over-the-counter derivatives
should be cleared through central clearing houses instead of being cleared
bilaterally.The rules in different countries are similar, but not exactly the same. A
bank may find that it can avoid central clearing rules on some transactions by
choosing the jurisdiction governing its transactions carefully.
The central concern of all national legislators is of course the implicit too big-tofail guarantee. This creates moral hazard, encouraging banks to take risks
because, if things work out badly, they will be bailed out. The increases in the Basel

capital charges should go some way toward reducing the moral hazard. For
systemically important banks, living wills are important. Regulators want banks to
be structured so that one part (e.g., one concerned with trading activities) can fail
without other parts (e.g., those concerned with deposit-taking) being affected. Most
countries with large banks are actively trying to introduce legislation on living wills.
Compensation is an important issue. Pre-crisis, the annual bonus was a large part of
the compensation for many traders and other employees and led them to have a
relatively short-term horizon in their decision making. If losses were incurred after
the payment of a bonus, they did not have to return the bonus. Many banks have
recognized the problem and voluntarily moved to bonuses that are deferred by
being spread out over three to five years, rather than all being paid in one year. If a
trader shows good results in one year and bad results in the next, some of the
bonus applicable to the good year will be deferred and then clawed back during
the bad year. The DoddFrank Act restrictions on pay in the financial sector are
relatively mild. When financial institutions received funds during the crisis under the
Troubled Asset Relief Program (TARP), compensation was restricted. But, as soon as
the funds were paid back, banks had much more freedom in their compensation
arrangements.
Some other countries have restricted compensation, but usually only temporarily.
For example, the UK introduced a one-time supertax on bonuses in excess of
25,000. Of course, there is a limit to what any one country can do. If it restricts
bonuses or taxes them too heavily, banks will simply move key personnel to another
jurisdiction.
SUMMARY
The financial crisis that started in 2007 was the worst that many parts of the world
had seen since the 1930s. Some financial institutions failed. Others had to be bailed
out with taxpayers money. Not surprisingly, both the Basel Committee and national
governments decided that a major overhaul of the regulations affecting financial
institutions was required.
The Basel 2.5 regulations increased how much capital banks were required to keep
for market risk. They recognized that capital should reflect the volatilities and
correlations experienced during stressed market conditions as well as during normal
conditions. However they eliminated some of the ways banks could reduce
regulatory capital by moving items from the banking book to the trading book; and
they created a special capital requirement for derivatives dependent on credit
correlation, which had been a particular problem during the crisis.
Basel III dramatically increased the amount of equity capital banks were required to
keep. It also recognized that many of the problems of banks during the crisis were

liquidity problems and imposed new liquidity requirements for financial institutions
National governments have also introduced new regulations for financial
institutions. In the United States, the DoddFrank Act has many provisions designed
to protect consumers and investors, avoid future bailouts, and monitor the
functioning of the financial system more carefully.
Exactly how Basel III and national legislation such as DoddFrank will be
implemented is still uncertainand this uncertainty is one of the major risks that
banks face. How successful will the measures be once they have been
implemented? We will not know this for some time. One problem facing regulators is
what are referred to as unintended consequences. Basel I had the unintended
consequence of discouraging loans to high quality corporations because of the
100% risk weight that would
be assigned. The 1996 Amendment and the development of the credit derivatives
market that came after it encouraged banks to find ways of moving credit risks from
the banking book to the trading book in order to reduce capital requirements. There
will no doubt be unintended consequences of Basel III and the legislation that is
being introduced throughout the world. (For example, the higher equity capital
requirements may lead banks to find ways of taking more risks in an effort to
maintain their return on equity.) Hopefully, the benefits of the new measures will
outweigh any harm to the financial system arising from them.

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