No doubt, Dodd-Frank Act brings
up recommendations with good intention to devise tools to address the concerns
raised during the financial crisis and also bestows government powers and other
tools to the regulatory system to deal with the risk. It also introduces the
funeral plans to dissolve the large financial companies/institutions which
would certainly help in demystifying their organisational structure.
Dodd-Frank Act, in reality, does
little for the government guarantee problem knowing that it has been the part
of the financial system for quite long time. It also does not attempt to reform
the government sponsored enterprises (GSEs) which were heavily exposed to the
guaranteed debt. There is no attempt in Dodd-Frank to address the key problem
of government subsidization of mortgage risk, and the exposures of Fannie Mae , Freddie Mac
and the Federal Housing Administration are still growing.
The Act recommends a plethora of
government powers and agencies/entities with authority in the financial system
and economy. The Act requires over 225 new financial rules across 11 federal
agencies (Source: The Economist). There
has been minimal attempt at regulatory consolidation. The roles of many of
these entities are overlapping and may lead to a lot of confusion and in
addition, making their funding (often requiring Congress approval) more exotic.
Consequently, the financial sector will have to live with the great deal of
uncertainty that is left unresolved until the various regulators (the Fed, the
SEC, and the Commodities and Futures Trading Commission (CFTC)(refer to figure
below). The problem also lies in the way they operate. With officials given power
to regulate more intrusively, it makes their functionary more whimsical and
thus may push the financial institutions into more red tape. The lack of
clarity which follows from the sheer complexity of the proposal will sometimes
will serve for the unreliability.
 |
| New Government powers/entities per Dodd-Frank Act (Source: JPMorgan Chase) |
The
Volcker Rule attempts to prohibit proprietary trading within banks. The
fundamental problem with that is that it would be hard to define proprietary
trading, because obviously, an essential role of banks
is to help make markets in various financial
instruments and to execute trades for their clients. The problem that persists
is to define the limits of proprietary trading. From the myriad complicated
responses that they have received, it has become clear that there is no hope of
being able to describe what it is the Act is trying to prohibit in a way that
can be predictably identified, so that banks can know whether or not are they
are in violation(Source:www.barrons.com). The Volcker Rule prohibits banks from
proprietary trading, even if against the value of securities they are
underwriting and peddling to the public, just as Goldman Sachs, for one,
notoriously did. This is certainly in desired direction, but it does very
little about high-frequency trading, the largest and perhaps most dangerous of such
practices.
The main
reasons for the crisis were housing bubble and imprudent lending to the
innumerable borrowers into it. To a certain extent, the responsibility also
goes to the US government for this mess. The government legislated a high
percentage of private-sector mortgages to be on a non-commercial basis, issued
exclusive orders to the large pseudo-private-sector Fannie Mae and Freddie Mac
to make the majority of their mortgage loans on that basis and kept interest
rates and mortgage equity requirements so low for so long, enlarging the
liquidity bubble to the extent of the burst. This was certain to lead to
mountains of excess residential housing and worthless mortgages (Source: www.nationalreview.com).
The BASEL
III framework proposes a paradigm shift in capital and liquidity standards.
Most of the proposals appear unfinished and has a very long time line to
implement. BASEL III has scientific approach and proposed measure tools to
control the problems. Though a sound prudential framework should focus on the
systematic risk but BASEL III mostly focuses on the individual risk of the
financial firms and reducing the individual risk may fundamentally aggravate
the systematic risk. For example, a bank fails to diversify properly even
though it is encouraged to do so. In such scenario, the bank will continue to
have the same aggregate risk despite diversifying its idiosyncratic risk. As
per BASEL III, the unsecured bonds of the banks are not eligible for LCR while
they qualify for NFSR while sovereign debts and cover bonds are eligible under
both. This indicates that the supply of covered bonds and sovereign debts will
increase generally while the supply for the unsecured bonds will increase only
for long term to meet the requirements of NFSR. Consequently, the
recommendations in BASEL III to address the liquidity will promote a partial
swap on banks’ balance sheets. This increase in sovereign debt will lead to
increase in sovereign risk in banking as well as insuring sector. The
countercyclical buffers introduced to be utilised during stressed period to
offset procyclicality. It is problematic to identify the stressed or bad times
and coming up with a figure for the capital buffer to counter losses is
extremely challenging. Moreover defining the capital ratios again will not
solve the problem related with the capital ratio on RWAs. The new proposal
boosts the procyclicality with not even addressing the regulatory arbitrage.
Another problem with BASEL III is that it is not a legally binding framework
which does not mandates any country to follow. Though intended to be
implemented across the globe, there is no way to ensure that it will be
implemented uniformly around the world. Besides, the implementation timings
will not be same. BASEL III recommends the individual countries to consider
increasing their national capital requirements in case of unsafe credit
creation. Now, many multinational banks have problems in adhering to the
countercyclical buffer of any one country but may need to maintain the weighted
average of the requirements in all the countries of operations. This adds to
the complexity of the rules.
Few
recommendations of BASEL III and Dodd Frank concerned with capital control are
not consistent. For instance, BASELIII still relies on the external
credit-ratings in determining the capital charges for few assets while
Dodd-Frank Act recommends the removal of any reference to credit ratings in
federal agency regulations. Besides, there are implementation date differences
for few provisions where there are consistencies between BASEL III and
Dodd-Frank Act. For example, Dodd-Frank mandates exclusion of preferred
securities (e.g trust preferred) from Tier 1 capital and gives a timeline of 3
years to implement exempting the smallest banks. On the contrary, BASEL III
sets a longer time line to implement this and does not talk about any
exemption.
CONCLUSION:
The crisis of this magnitude
having adverse impact across the global economy should be immediately be
addressed by the government. The investment banks, credit rating agencies,
lenders, mortgage brokers and the federal government were the main causes of
the financial crisis. Though many reforms were proposed with each one under the
global financial industry’s scrutiny, many of them still have some loopholes.
Many inconsistencies too exist among these reforms and need to be aligned soon.
Another area of concern which the government need to consider is the
implementation of different proposals. There is also a potential threat of
overregulation or misregulation and should be addressed properly. At the same
time, measuring the efficiency of the regulatory changes contributing to the
improvement of the financial sector performance will be a tough task to do. There
are still several area which have not been addressed. Few of them are the heavy
government debts which may be a big subject of concern. The Financial Reform
Act also does not adequately addresses the “too big to fail” problem.
Nonetheless, no reform can be perfect and these reforms are intended to be in
the correct direction.
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