Subprime Crisis - My Take - Reforms

REFORMS POST-CRISIS

The turmoil created by the sub-prime crisis had rippling effect across the global economy and necessitated urgent reforms in the financial reforms. The confidence of people reached abysmal after the failure of big financial institutions, defaulting of AAA products rated by known credit-rating agencies, inefficiency of the federal government as many claim. Confidence is an important driver of economic activity. As the following figure shows, falls in coincide with economic slowdown.

Crumbling confidence of the business and consumers (Source: OECD Factbook 2010)

Any problem during recession is heavy debt. The governments borrowed money to keep the financial institutions floating and stimulate the economy. In 2008, in OECD (Organisation for Economic Co-operation and Development) countries the government debt rose drastically and reached almost at par with their GDP. There was urgent action required but it had the risk of transferring the crisis from the private sector to the public sector.

Government debts as a percentage of GDP (Source: OECD Factbook 2010)

 While recognising regulatory failings, the governments and many international bodies such as G20 and IMF recommended immediate reforms. Many committees like Dodd Committee, Volcker Committee and BASEL committee (for banking), were given the responsibilities of coming up with corrections. In this report, we will discuss primarily the Volcker rule, few reforms suggested in BASEL III and Dodd Frank’s act.

Dodd-Frank’s Act:

In order to fix the broken US financial system, Dodd-Frank Act was passed in an attempt to create a sound economic foundation to grow jobs, protect consumers, to end bailouts and most importantly to prevent another financial crisis. For the same, among the various reforms were recommended in Dodd-Frank Act, only mortgage reforms, credit-rating agencies’ reforms and Volcker’s rule , the last being an amendment in the act, will be discussed in detail.

Mortgage reforms:

Myriad complications germinated from steering of the borrowers by the mortgage brokers into exotic loans. The Act addresses this problem by requiring the creditor to adhere to a fully amortizing repayment schedule while evaluating the borrower’s capability to repay. It also prohibits pre-payment penalties which trapped many borrowers into unaffordable loans. It also prohibits mortgage originator from receiving from any person, directly or indirectly, compensation that varies based on terms of loan. In this way, it attempts to prohibit the incentives of encouraging the borrower into a costly loan. It also tries to protect the borrowers against the foreclosure for these standards by establishing penalties for irresponsible lending. The Act further protects the borrowers for the high-cost mortgages by reducing the interest rate and fee requirements that define high-cost loans. It establishes Consumer Financial Protection Bureau (CFPB), as an independent body under Federal Reserve Bank (FRB), to prohibit creditors from making residential mortgage loans unless creditor makes good faith determination that at time loan was consummated, consumer had reasonable ability to repay loan according to its terms, and all applicable taxes, insurance and assessments (Source: Mortgage Bankers Association). The Act also addresses adjustable rate mortgages (ARMs) as per which the lender must furnish the borrower a notice that includes the valid reason of reset, estimate of new payment, a list of alternatives and contact information of the borrower counselling agencies. Besides, the Act also establishes an office of housing counselling under Housing and Urban Development (HUD) to boost counselling on house ownership and rental housing. Furthermore, the Act increases the upper-limit for civil liability.

Credit-rating agencies and Investment banks reforms:

During the analysis of the causes creating the financial turmoil, the committee unearthed that the credit-rating agencies played a significant role.  The credit-rating agencies had a high level of public oversight and thus accountability. The increased conflict of interest, which these agencies faced, had to be scrutinized. The Act created an office of Credit-ratings at the Security and Exchange Commission (SEC) with proficiency and its own resources. It also vests SEC to suspend the registration of or fine any credit-rating agency for any security in case it fails to produce credit-ratings with integrity. To address the conflict of interest, the Act mandates the credit-rating agencies to have at least half of members of the board of directors to be independent. To bring more accountability and transparency, the credit-rating agencies are now required to disclose their historic performance and methodology to measure the ratings and to perform various studies and generate multiple reports.

The investment banks were operating with “no skin in the game” since they were selling off the risk and were supposedly “too big to fall” as their failure would crumble the economy. This Act tries to address both these concerns. The Act enforces the investment banks to have minimum risk retention of 5% (except when the loans fulfill the criteria to establish low-credit risk). It means that these firms would face stricter regulation and possibly be required to set aside more capital as a buffer against losses. The immensely big banking industry in US contributed to the “too big to fail” risk to the economy. The Act restricted the merger, consolidation and acquisition of all or majority of assets of other company. As per the Act, big financial firms can be broken up in case their size posed a risk to the financial system, provided the Fed and two-thirds of the regulatory council agreed. In case the big firms failed, shareholders and secured creditors would be required to absorb losses first wherein additional losses would be taken by an emergency fund financed by assessments on big financial firms.

Volcker’s Rule:

This actually is subsection of Dodd-Frank Act but has significant ramifications and thus, has been discussed separately. This rule is premised on the finding that the speculative trading also contributed to the financial crisis. The reform originally did not contain the provisions recommended in by Volcker. This rule prohibits any banks including any affiliates of banking firms from investing in or sponsoring a hedge fund, private equity fund and any pooled investment vehicles like venture capital funds and real estate funds. It also prohibits them from engaging in “proprietary trading” majorly involving short-term trading. It also addresses the moral hazard that the guarantees to the commercial banks are mainly devised to safeguard the payment and settlement system and also ensures the robust lending to the households and corporations.

Flow diagram of the Volcker’s Rule (Source:www.volckersrule.com)

BASELIII:

The Dodd-Frank Act is not very scientific since it does not measure the risk which is taken care in BASEL III. BASEL III is a series of amendments to the precedent BASEL II framework. Even though the banks were adhering to BASEL II, the amount of capital held by them was not preventing insolvency. The financial crisis was a blend of liquidity and insolvency. This necessitated the amendments to be made in the BASEL II. The intention was to provide increased protection from such problems by bringing up the lower-limit of the capital and the liquidity levels. It further builds up on the three pillars of BASEL II framework – capital reforms, liquidity standards and systematic risk. It is planned to be implemented in phases with the final one being in 2019.

Breakdown of the BASEL III proposals (Source: KPMG)

BASEL III raises the resilience of the banking industry by further strengthening the capital framework. It retains the core solvency ratio at 8% of risk weighted assets (RWAs). The common equity component has been raised from the current minimum of 2% to 4.5% while the overall Tier 1 element (comprising of ordinary share capital and retained profits) of the capital (including common equity) will be raised from 4% minimum to 6%. It recommends a “capital conservation buffer” consisting of common equity which should be 2.5% of RWAs (when fully phased). Any firm will be exposed to restrictions on dividend payouts, share buybacks and bonuses if the capital falls within the buffer range. In addition, the BASEL III committee also recommends a “countercyclical capital buffer” which checks the excessive credit growth. It also changes the constituents of the capital – primarily abolishing the Tier 3 capital which was mostly unsecured subordinated debt.

Capital Ratio requirement per BASEL III

Despite having adequate capital levels, many banks and financial institutions did not manage their liquidity prudently and faced severe difficulties during the crisis. This reiterated the significance of the liquidity management. The committee further strengthens the liquidity framework by developing two complementary requirements. The first being – Liquidity Coverage ratio (LCR) introduced to avoid the disruptions over a 30 day stressed period. It will ensure that the financial institutions have enough liquid assets to offset the net cash outflow under sever short stressed period. To address the long term liquidity issues, Net Stable Funding Ratio (NSFR) has been proposed which recommends the banks to have stable funding in place to encounter funding needs over a stressed 1 year period.

The third aspect which also has been addressed in BASEL III is the systematic risk and interconnectedness. Existing approaches of evaluating the credit risk of the bank’s assets remain intact in BASEL III. It fortifies the risk coverage in various areas – adding Credit Valuation Adjustments (CVA) risk and encouraging banks to manage risk more efficiently. It also proposes calibration of counter-party credit risk modelling approaches such as Internal Model Methods (IMM). It also strengthens the standard for collateral management and margining for the OTC derivatives and incentivises to use more central counterparty (CCPs) and increases the capital level for systematic derivatives.