The Effects of the Dodd-Frank Act and Basel III on US
Financial Institutions
Gonzalo Alberto Mostaccero Fernandez Davila (2111726)
David Taz Graper (2111734)
The Economics of Banking and Finance
Final Course Paper
15/5/2023
Table of Contents
1. Introduction................................................................................................................................2
2. Capital Requirements................................................................................................................ 3
3. Basel III.......................................................................................................................................3
3.1. Risk Weighted Assets......................................................................................................... 4
4. The Dodd-Frank Act................................................................................................................. 5
4.1. The Collins Amendment..................................................................................................... 6
5. Impact on US financial institutions.......................................................................................... 7
5.1. The DFA impact on US financial institutions.....................................................................7
5.2. Basel III impact on US financial institutions....................................................................10
6. Conclusions...............................................................................................................................13
7. References................................................................................................................................. 16
1
1.
Introduction
Financial Institutions have been part of the United States almost since the country
declared independence from Great Britain in 1776. In 1780 the Bank of Philadelphia was
founded by merchants to help fund the revolutionary war. In 1791, just 11 years later and after
independence was won, George Washinton, the first president of the new United States, signed a
law that created the First Bank of the United States (Hill, The First Bank of the United States).
The banking industry today in the United States is much larger than it was then, and
extraordinarily more complex. The largest banks in the United States today also are some of the
largest in the world, and total bank assets make up over half of the United States economy. In
2021 there were close to 5,000 separate FDIC insured banks, all regulated by a combination of
national, state, and in some cases local supervisory bodies (Banking in the United States, 2023).
Since the beginning of banking there have always been bank failures due to a lack of
bank liquidity in times of stress. This was especially prevalent in the 19th century and early 20th
century. In 1913 the Federal Reserve was created to begin enacting monetary policy, and to try
and shore up America’s financial system. In 1929 the Great Depression led to the Glass-Steagall
Act which separated commercial banks from investment banks. Post World War II leading up to
the 21st century, government and financial supervisors eased their regulations on the economy
and banks, and ultimately repealed the Glass-Steagall Act in 1999, eight years before the
beginning of the 2008 Financial Crisis.
This Crisis brought attention more than ever to the need for stronger and more thoughtful
regulations of financial institutions in the United States. It was clear that previous regulations
were ineffective, and they needed to be revamped. Two new sets of regulations soon emerged;
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first was the Dodd-Frank Act, legislation that put into place a set of regulations that changed the
ways financial institutions could operate in the United States. Second was Basel III, an
international set of suggested regulations and requirements that are not laws in the United States
or anywhere in the world, but instead implemented by use of moral suasion, in an effort to bring
all countries with developed economies and financial systems together under the same or very
similar rules.
In this paper we will dive into and discuss the capital regulations and requirements set by
the Dodd-Frank Act and Basel III. We will also cover what effects they hold over US financial
and banking institutions.
2.
Capital Requirements
Capital requirements refer to the amount of liquid capital a bank is required to maintain.
It is a tool used by regulators to ensure that financial institutions have enough capital to stay
solvent in the event of financial stress and/or a crisis. As such, it provides an adequate basis of
analysis to discuss and compare how the two regulations mentioned, the Dodd-Frank Act and
Basel III, impacted US financial institutions in order to prevent, mitigate or control future crises.
3.
Basel III
Basel III is an augmentation of the requirements set forth by Basel I and Basel II. It was
the global financial crisis in 2008 that led to the changes and additions to Basel II that is Basel
III. We will now take a look at these changes.
3
Basel III places significant emphasis on the capital requirements for financial institutions
as a key tool to promote financial stability. The regulatory document introduces a higher
minimum level of capital that banks are required to maintain in relation to their risk-weighted
assets (RWAs). The minimum RBCR Tier 1 capital ratio, which includes common equity and
retained earnings, increases from 4% to 6%. Banks will also be required to maintain a new
"capital conservation buffer" of 2.5% in addition to the minimum capital ratios (Berger et al.,
2015). This buffer must be met with high-quality, easily sellable securities, and its aim is to
ensure that banks have an additional cushion of capital to absorb losses during periods of
financial stress. This specifically helped to combat the ‘pro-cyclical’ nature of the previous
accords, which contributed to over-lending in stable economic times and under-lending in
volatile economic times.
3.1.
Risk Weighted Assets
Risk-weighted assets (RWAs) is a concept within Basel III that is a way of ensuring that
banks maintain adequate levels of capital to cover the risks they face in their operations. The
Basel III accord recognizes that different types of assets carry different levels of risk, and
therefore require different levels of capital to be set aside as a buffer against potential losses.
Under Basel III, banks are required to assign a risk weight to each of their assets based on
the level of risk it poses. The risk weight is a percentage that reflects the probability of the
specific asset defaulting or suffering a loss. Naturally, riskier assets are assigned higher risk
weights. For example, loans to highly-rated corporate borrowers may be assigned a risk weight
of 50%, while loans to lower-rated corporate borrowers may be assigned a risk weight of 100%
or higher. The risk weights are then multiplied by the value of the asset to arrive at the
risk-weighted asset amount. The higher the risk-weighted asset amount, the more capital the
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bank is required to hold against potential losses tied to that asset. By using RWAs, Basel III seeks
to ensure that banks are appropriately capitalized to manage the risks they face in their lending
and investment activities.
Included in Basel III is a new category of capital, known as "Common Equity Tier 1"
(CET1), which is considered to be the highest-quality form of capital. CET1 capital includes
retained earnings, common shares, and other instruments that are considered to be always
available to absorb losses. Banks are required to maintain a minimum CET1 capital ratio of 4.5%
under Basel III.
The Basel III regulations also include measures to discourage the excessive use of debt by
banks, known as the "leverage ratio". The leverage ratio is a simple measure of a bank's total
exposure to risk relative to its total capital. Basel III requires banks to maintain a leverage ratio
of at least 3%, which means that their Tier 1 capital must be at least 3% of their total exposure
(Berger et al., 2015).
Overall, the capital requirements set out by Basel III are designed to ensure that banks are
better able to withstand financial shocks and maintain the confidence of their depositors and
investors. By increasing the quantity and quality of capital that banks hold, Basel III aims to
reduce the likelihood of bank failures and limit the impact of any failures that do occur. Basel III
takes the same big picture idea of the previous Basel accords, and makes them more specific, and
stronger.
4.
The Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act, from now on referred
to as the Dodd-Frank Act (DFA), is legislation imposed in July 2010 in the United States as a
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response to the 2008 financial crisis and collapse. It's a regulatory framework designed to
strengthen financial stability and prevent further shortcomings in the financial sector. The DFA
resulted in several successes including higher capital requirements, especially for systemically
important banks and nonbanks; new authority and mechanisms to wind down failed financial
institutions; the creation of the Consumer Financial Protection Bureau (CFPB); and greater
transparency for swaps and derivatives trades.
The capital requirements set out in the Dodd-Frank Act are designed to ensure that
financial institutions have enough capital to withstand financial shocks and maintain the
confidence of their depositors and investors. By increasing the quantity and quality of capital that
banks hold, the DFA aims to reduce the likelihood of bank failures and limit the impact of any
failures that do occur. The Act addresses and expands on all the capital scrutiny and new
requirements in the section called “The Collins Amendment”.
4.1.
The Collins Amendment
Under the Collins Amendment, regulators are required to set minimum risk-based capital
and leverage requirements for insured depository institutions, bank holding companies,
intermediate holding companies of foreign banking organizations, and systemically important
non-bank financial institutions (Baily et al., 2017). The minimum requirements applicable are
subject to two floors. They must be (i) not less than the generally applicable risk-based capital
requirements and the generally applicable leverage capital requirements, and (ii) not
quantitatively lower than the above requirements that were in effect for insured depository
institutions as of the date of enactment of the bill, which was July 21, 2010 (Tahyar, 2010). In
other words, the Amendment establishes a floor for both risk-based and leverage capital
requirements equal to the ratios in effect when the DFA was passed.
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The capitalization requirements provided by the Collins Amendment also include
categories for Tier 1 and Tier 2 requirements. Tier 1 capital applies to banks and thrift holding
companies with more than $15 billion in assets. This section will also eliminate hybrid securities,
such as trust preferred securities, as a component of Tier 1 capital and will only allow them to be
included in Tier 2 capital (Moody’s Analytics, 2011).
Regarding capital adequacy guidelines from Basel III, the Amendment establishes the
above mentioned minimum leverage and capital floors and allows US regulatory authorities to
implement Basel III capital requirements only if they do not violate what is implemented by the
Collins Amendment. This means that the Basel III capital requirements in the US can be more
stringent, but must be no less stringent than the capital requirements in effect during July 2010
(Paskelian & Bell, 2013).
Overall, the Dodd-Frank Act forced US regulators to impose higher capital requirements
for Systemically Important Financial Institutions as well as other firms with significant activity
in derivatives, securitization products, financial guarantees, securities borrowing and lending,
and repos (Herring & Carmassi, 2015). Furthermore, it provided the Federal Reserve with the
power to determine and decide if such requirements are not appropriate for the financial
institution. In that case, the Federal Reserve is allowed to impose custom capital control
mechanisms, which have to be similarly stringent (Davis et al., 2010).
5.
Impact on US financial institutions
5.1.
The DFA impact on US financial institutions
As mentioned in the previous section, the Dodd- Frank Act attempted to find long term
solutions to prevent further problems in the financial sector and future crises, especially by
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increasing banks' loss-absorbing cushions through higher capital requirements. An increase in
this can have several effects on bank lending and economic growth.
Higher capital requirements could potentially reduce bank lending, affecting small
businesses the most as they are the biggest bank dependent borrowers. This could negatively
impact economic growth. Also, more stringent regulation on capital will increase the cost of
equity as well as reduce the cost of debt. Higher equity costs might be passed on to borrowers in
the form of higher lending rates. In this case, credit demand decreases and economic growth
decelerates. Lastly, higher capital levels reduces incentives for banks to take risk and provides
them with a buffer against losses. This will stimulate economic growth through stronger financial
stability and lower credit volatility (Martynova, 2015). Despite all of these effects, Takáts and
Upper (2013) find that lower bank lending does not necessarily slow down economic growth.
They analyzed the correlation between economic growth and bank credit growth after a financial
crisis, and concluded that there is no statistically significant correlation between the two.
The Dodd-Frank Act did impact bank lending. Since the bill’s passage, more capitalized
banks have increased their overall lending. This includes credit card, auto and mortgage loans
(Gelzinis, Zonta & Valenti, 2017). However, this is mostly the case for larger banks. In terms of
community banks, the DFA has negatively affected mortgage lending. Community banks provide
lending to small, local businesses and play a key role in the overall health of the economy. They
were also greatly impacted by a significant increase in compliance costs, which rose by more
than $50 billion per year due to the number of regulations and requirements imposed by the
DFA. The effect was such that community banks could not make profits to cover the costs
because they rely on limited sources of funding and do not benefit from economies of scale, like
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the large banks do. As a result, roughly more than 1,700 community banks disappeared leaving
rural communities with even less access to basic banking services (Hogan, 2019; Schorgl, 2018).
It is worth mentioning that the DFA has also impacted US financial institutions through
other means. It created the Consumer Financial Protection Bureau (CFPB) to manage financial
products and services provided to consumers. The CFPB imposed several regulations to protect
consumers from abusive and unfair practices, such as requiring lenders to disclose the terms and
costs of loans more clearly and prohibiting banks from charging excessive fees on debit and
credit cards. These regulations have helped to ensure that consumers are better informed and
protected when using financial services. The DFA also established the Financial Stability
Oversight Council (FSOC) to keep control over the financial system and identify potential risks
(Baily, Klein & Schardin, 2017). These measures have improved the ability of regulators to
monitor and manage risks in the financial system, enhancing the overall safety and soundness of
the system.
Another way the DFA has impacted US financial institutions is through the Volcker Rule.
This rule subjects deposit-funded, licensed commercial banks in the United States, or bank
holding companies with US affiliates to heightened capital requirements and quantitative limits
with respect to their proprietary trading or investing in or sponsoring private equity funds and
hedge funds. The purpose for the Volcker Rule was to protect insured deposits from activities
that were thought to be especially risky (Tahyar, 2010).
The Dodd-Frank Act has had a significant impact on US financial institutions. It has
introduced a range of new regulations and requirements, including higher capital and liquidity
requirements, stress testing, and living wills. These measures are intended to promote financial
stability and reduce the likelihood of bank failures. However, they have also increased
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compliance costs for financial institutions, which has led to concerns about the impact on
profitability and competitiveness. Some critics argue that the Dodd-Frank Act has gone too far in
its efforts to regulate the financial sector, and that it has stifled innovation and growth. Others
argue that it has not gone far enough, and that more needs to be done to address the systemic
risks posed by large financial institutions. Overall, the impact of the Dodd-Frank Act on US
financial institutions is complex and multifaceted.
5.2.
Basel III impact on US financial institutions
Basel III has impacted US financial institutions in many ways, mostly through the
changes in capital requirements. These have significantly affected both institutions and the
financial system as a whole in the United States by increasing stability, reducing risk, increasing
the cost of capital, reducing lending, and increasing complexity.
Basel III has increased financial stability in the United States by improving capital ratios
at banks, thus improving their resilience. Since the crisis in 2008 and the release of Basel III in
2011, weighted average capital ratios in the US have more or less doubled and average liquidity
ratios have risen by about 25 percent. Additionally, banks with lower capital and liquidity ratios
during the enactment of legislation and release of Basel III generally experienced the greatest
relative increases (Evaluation of the impact and efficacy of the Basel III Reforms, 2022).
Additionally, risk has been reduced because of the implementation of the Basel III capital
requirements. Since banks have decreased their individual risk, it has helped contribute to a
lessening of system wide risk as well. An analysis by the Basel Committee on Banking
Supervision found that the financial system has become less susceptible to the risks of an
individual bank and the severity of the interconnectedness of banks has declined. Additionally, it
is found that during times of stress, systemic risk increased less than it had previously before the
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Basel III reforms (Evaluation of the impact and efficacy of the Basel III Reforms, 2022). Finally,
the effect of Global Systemically Important Banks on the financial system relating to their risk
has seen a higher decrease due to the specific and more thorough scrutiny of these banks.
A potential negative effect of Basel II has been the increased cost of capital and reduced
lending activities. A study by the IMF finds that post 2008, there was a sharp decline in lending
in the United States, across all areas. However, in 2011 lending started to recover, but not in the
same way has it had before. Commercial loan growth was higher than retail and other types of
lending (Naceur et al., 2017). Additionally, there were differences in the lending and financing
activities of large vs small banks in the United States. It was found that small U.S. banks
increased their capital soundness and loss absorption capabilities when increasing lending to
commercial and retail-and-other borrowers. However, large U.S. banks only increased their
financial strength when granting riskier commercial loans that were illiquid in nature. Bigger
banks benefit from having greater access to capital while smaller banks have to rely more heavily
on funding from traditional sources like bank deposits. In either scenario, the increase in capital
required to buffer against more lending leads to higher costs of borrowing from banks and less
loan availability.
A direct example of the enormous and expensive amounts of capital that banks must have
on their balance sheets to buffer against their lending activities and liabilities can be seen in JP
Morgan Chase & Co’s 2022 annual report.
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Source: (2022 complete annual report - JPMorgan Chase & Co.. 2023)
Source: (2022 complete annual report - JPMorgan Chase & Co.. 2023)
As can be seen in the bar chart, JPMC is required to have a minimum of 12.5% required
capital ratio based on their RWAs, under the standard calculations. However, it is mentioned that
at the end of 2022 their CET1 real ratio is actually 13.2%. To put these ratios into perspective,
see the table above where it is explained that JPMC’s CET1 capital ratio of 13.2% amounts to
nearly 219 billion dollars. JPMC’s total capital against RWAs is a massive 277 billion dollars.
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This is a large amount of money that JPMC needs to hold inorder to comply with Basel III
regulations.
Finally, Basel III and the capital requirements brought about by it have increased the
complexity of compliance enormously. Since its implementation, there are notably more complex
risk-weighting methodologies which lead to the necessity for banks to invest more in technology
and human capital in order to comply. For example, JPMC notes that in their workforce alone,
they have 3,700 compliance workers, 1,400 lawyers, and 7,100 workers in risk management. This
doesn't include their audit team (2022 complete annual report - JPMorgan Chase & Co.. 2023).
The cost of those 12,000+ workers alone is in the hundreds of millions or billions of dollars. This
is a cost that the bank gets very little return on, banks are not paid to be in compliance with these
regulations, they are simply not punished.
6.
Conclusions
In the lead-up to the financial crisis, the financial sector was highly leveraged and
undercapitalized. This meant that, when losses piled up in the sector, banks did not have
sufficient equity capital to bear those losses and either experienced devastating bankruptcies or
were bailed out by the government. As a result, the need for regulatory reforms to improve
stability of financial institutions around the world arose prominently. Two new sets of regulations
soon emerged: the Dodd-Frank Act and Basel III.
Throughout this paper, we have reviewed both regulatory frameworks, contrasted them
and analyzed their specific implications on US financial institutions especially in terms of capital
requirements. Regarding the Dodd-Frank Act, the effect is mostly positive as it sets minimum
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capital and leverage floors with the Collins Amendment further benefiting the cushion to stay
solvent during financial stress events and crises. It has also improved oversight of the financial
system to better identify potential risks with the FSOC; increased consumer protection and
overall protection from risky activities with the CFPB and Volker Rule respectively. However, the
Act has had a few shortcomings regarding community banks and compliance costs due to the
number of regulations and requirements implemented.
As for Basel III, this set of regulations lays the foundation for what capital requirements
banks in the United States must abide by. Basel III significantly increased all facets of the
previous capital requirements, forcing banks to hold an ever higher amount of high quality
capital against their risky assets. Additionally, Basel III further developed the definitions of risk
weighted assets (RWAs), and thus made them more effective, as well as more complex for banks
to determine. Basel III had generally positive impacts on U.S. banks, although its application is
less intense when it comes to smaller banks, and thus affects them differently. In the bigger
picture, Basel III has strengthened the financial system in the U.S. in our view, and notably,
seems to have reduced systemic risk, pro-cyclicality, and interconnectedness.
Where Basel III and the Dodd-Frank Act contrast is very simple. Both are regulatory
frameworks aimed to strengthen the regulation, supervision and risk management of the banking
sector in order to prevent further deficiencies exposed during the financial crisis. One of the ways
through which they managed to achieve that is through higher capital requirements. Basel III is
nothing more than a template, a suggested set of guidelines and rules that countries can follow,
and hopefully will if their financial system is developed enough, to help ensure stability within
their nation and the global economy. The Dodd-Frank Act is the specific legislation within the
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U.S. that began to put Basel III into effect, as well as some other adjustments and additions such
as more regulatory organizations. In other words, Basel III is the base and the DFA is the
authority that implements and adds to that base within the U.S.
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