A Flawed Approach to Marriage – Basel III & Dodd Frank

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Rejigging and increasing financial regulation is back in vogue. But, in the world of international finance, how well do different regulatory systems join up? There is increased evidence the US Dodd Frank Act and Basel III are, in part, incompatible and that harmonizing them may lead to unintended consequences. The US ought to tread carefully here but should also try hard to maintain the spirit of better financial regulation.

This is an issue that Takeo Hoshi discusses in a recent VOXEU communique (Dec. 23^rd) titled Implementation of Basel III in the US will bring back the regulatory arbitrage problems under Basel I.

In the aftermath of the global financial crisis, many countries are redesigning their financial regulatory frameworks. In the US, the Dodd Frank Act of 2010 specified the direction for new financial regulations. The US financial regulatory agencies (over 40), including those that were newly created by Dodd-Frank, have been busy writing and rewriting the rules.

At the international level, the Basel Committee on Banking Supervision has come up with the third implementation of the international standard for minimum capital regulation, ‘Basel III’ along with other nations writing their own regulations. However, in several areas, the requirements of Dodd-Frank and other regulations being written at the national level are apparently inconsistent with those of Basel III and thus US regulators face a difficult task of reconciling and implementing the two regulatory initiatives.

Recently, the US Office of the Comptroller of the Currency, the Federal Reserve System, and the Federal Deposit Insurance Corporation came up with three ‘Notices of Proposed Rulemaking’ on regulatory capital rules. These proposals entail new capital regulations for the US banks, reconciling apparent discrepancies between Dodd-Frank and Basel III, but could have serious unintended consequences, if implemented.

Dodd-Frank sets “the generally applicable risk-based capital requirements” as a floor that regulated financial institutions must satisfy in addition to any other minimum risk-based capital requirements that the regulators may impose.  Banks that calculate the risk-weighted assets using advanced approaches are required to hold enough capital required by the standardized approach. The problem is that the standardized approach is based on the old methodology of classifying assets into several risk buckets, which was originally used in Basel I regulation.

As a result, this led some banks to shift their portfolios to hold more risky (and hence higher return) assets within the same risk assets category, thereby increasing their risk without increasing regulatory capital. Because all the sovereign bonds of investment grade had the same risk weights (zero), banks were able to increase the return by increasing the holding of the most risky ones.

Because highly rated tranches of securitized loan products carried lower risk weights than individual loans, banks were able to economize on regulatory capital by selling the loans that they originated and by buying (highly rated) securitized loan products.

It is now well understood that the incentive for these regulatory arbitrages created by the Basel regulation increased risk in the banking system without a corresponding increase in risk-weighted assets – and hence regulatory capital.  The Basel III classification system is an improvement, but is still insufficient to make the risk-weighted assets sensitive enough to risks calculated by more advanced approaches.

Another problem is caused by the inevitably ad hoc nature of assignment of a risk weight to each category of assets. Because of this problem, creation of finer “buckets” can actually distort bank behaviors even more if the allocated risk weights differ from the risk differentials that banks perceive. For example, a 30-year amortizing mortgage with the loan-to-value ratio between 60% and 80% gets risk weight of 50%, while an interest-only loan with the same loan-to-value ratio receives increase the 100% risk weight.  This works if the bank sees the interest-only loan as twice as risky as the 30-year amortizing loan and requires twice as much capital. If that is not the case, the bank will have an incentive to reduce one type of loan and increase the other.

The international Basel III allows banks to use the advanced approach to calculate the regulatory capital, so the banks in Europe and Japan that are qualified to use the advanced approach do not have the problem faced by US banks. The problem is that Dodd-Frank requirements for US banks set a floor of the “generally applicable risk-based capital requirements”. To avoid reviving the problems we know from Basel I regulation, US regulators should find a way around imposing the standard approach to advanced approaches banks, while respecting the spirit of Dodd-Frank at the same time.  A patchwork regulatory system is not the answer.

www.voxeu.org/article/implementation-basel-iii-us-will