Basel 2.5, Basel 3, and DoddFrank
This time is the same:
Regulation follows crises
National Bank Act of
1864
Federal Reserve Act
of 1913
To Amend the
National Banking
Laws and the Federal
Reserve Act
Banking Act of 1933
• The Glass-Steagall
Act.
Banking Act of 1935
• FDIC
Depository
Institutions
Deregulation and
Monetary Control
Act of 1980
Depository
Institutions Act of
1982
• Garn-St Germain
Economic Growth
and Regulatory
Paperwork
Reduction Act of
1996
Gramm-LeachBliley Act of 1999
International Money
Laundering
Abatement and
Financial AntiTerrorism Act of
2001
Financial Institutions
Regulatory and
Interest Rate Control
Act of 1978
Competitive Equality
Banking Act of 1987
Riegle-Neal
Interstate Banking
and Branching
Efficiency Act of
1994
International
Banking Act of 1978
Financial Institutions
Reform, Recovery,
and Enforcement Act
of 1989 (FIRREA)
Riegle Community
Development and
Regulatory
Improvement Act of
1994
Sarbanes-Oxley Act
of 2002
Bank Holding
Company Act of
1956
Crime Control Act of
1990
RTC Completion
Act
Fair and Accurate
Credit Transactions
Act of 2003
Federal Deposit
Insurance Act of
1950
Federal Deposit
Insurance
Corporation
Improvement Act of
1991 (FDCIA)
Housing and
Community
Development Act of
1992
Dodd–Frank Wall
Street Reform and
Consumer Protection
Act of 2010
This time
• Basel 2.5: Redefinition of market risk
requirements
– Substantial increase in capital for banks with large
trading activities
• Basel 3: New capital standards, but fully
implemented in 2019
– Substantial increase in common equity requirement,
especially for SIFIs; liquidity requirements
• Dodd-Frank: Addresses all aspects of the financial
sector except for Fannie and Freddie.
Dodd-Frank
Oversight
and
Systemic
Risk
Financial Stability
Oversight Council
Financial
Institutions
Regulation of banking
organizations
Capital
Markets
Business
Conduct and
Practices
Derivatives and swaps
clearinghouses
Governance and
compensation
Volcker Rule
Securitization
Orderly Liquidation
Authority
Private fund
investment advisers
Credit Rating
Agencies
Insurance companies
Consumer protection
Federal Reserve
Emergency Credit
Supervision of
payment, clearing and
settlement
Investor protection
and securities
enforcement
But
• We have a long way to go with Dodd-Frank.
• Parts of it could get repealed.
• The most important rules may be the ones
that are discussed little: Bailouts have become
much harder to implement.
• Yet, there is no solution of resolution of
multinational banks.
Do the changes matter?
• Banks will have to more than double their
common equity capital compared to before
the crisis.
• Banks look at the world through ROE. Hence,
their ROE falls in half if they do nothing.
• Few banks have market-to-book greater than
1. So, they are more likely to work on their
balance sheet than to issue equity.
• Not all activities are affected equally.
WHAT BANKS NEED TO DO
3
X
Product-specific RoEs show highest impact on
structured products, especially credit and rates
Delta, percent
Most significant
impact
RoE (effect), Percent (Percentage points)
B II.5
Asset class
1
Mkt
risk
Pre
regulation
1 FX
2a Rates - Flow
2b Rates - Strctrd
30
19
15
Basel III/Other
2
CCR
8a
RWA
red.
8b
Rev.
impact
3
Cap. /
Lev
6/7
Lqd./
Fund.
-8
0
0
0
-4
-2
-6
-5
4
-1
-2
-1
-4
-6
1
-1
-1
-1
3a Credit - Flow
18
-8
0
0
-1
-1
-1
3b Credit - Strctrd
17
-9
-2
1
-1
-1
-1
-6
-3
1
-1
-2
-2
4 Commodities
20
Post
regulation
16
-46
-59
8
-77
4
-65
6
-83
3
-61
8
5 Cash Equities
25
-5
0
0
0
-3
-2
6a EQD - Flow
25
-8
-1
2
-5
-2
-2
9
-65
-10
-4
1
-1
-2
-2
9
-68
0
0
0
0
-6
-1
8
-46
-22
-1
0
-1
-2
-2
7
-80
-7
-3
2
-1
-2
-1
7
-64
6b EQD - Strctrd
7 Prime Svcs
27
15
8 Prop Trading
Total
35
20
Borrowed from McKinsey/Toni
Santomero
15
-39
9
Consequences
• Banks will shrink.
• Tailored products will become more
expensive.
• Non-bank financial activities will expand.
• Offshore financial activities will expand.
Do the changes address the causes of
bank poor performance during the
crisis?
• Did an international study of performance of
large banks during the crisis with Andrea
Beltratti.
• All public banks with more than $50 billion
assets.
• Stock performance from July 2007 to
December 2008.
Key differences
80.00%
70.00%
60.00%
50.00%
Bottom quartile
40.00%
Top quartile
30.00%
20.00%
10.00%
0.00%
Fagility
Deposits
Tangible equity
Ownership
Board index
Where the banks that did better
less risky in 2006?
•
•
•
•
•
No, except for leverage.
They had higher idiosyncratic volatility.
They had lower distance to default.
Same beta, same real estate beta.
However, much higher tangible equity:
– 6.35% versus 4.10%
Regression results: Key variables
Banks
Tier 1
Tangible equity
Funding fragility
Real estate beta
Board
Banks + Non-banks
45.026***
-0.636***
-65.649***
-3.421***
2.122
-0.250***
-61.371***
-3.013**
Is Volcker right?
• Regulation is not related to performance
except that banks from countries with more
restrictions on bank activities did better.
• But, banks from countries with more
restrictions were not less risky.
• Those banks could not invest in some
activities that performed poorly, but these
activities were not expected to perform
poorly.
Regulation, governance, macro
• Banks that did better come from tougher
regulation, weaker governance, current
account surplus countries.
• All banks in the bottom quartile of
performance come from countries with formal
deposit insurance.
Are we on the right track?
• Ever more complicated and intrusive
regulation can’t work.
• It would be much better to make the system
safer by making sure that the collapse of a
financial institution has no significant impact.
• We have gone the opposite way, though.