Brown-Vitter no Substitute for Basel III, Dodd-Frank

An article by New York Institute of Finance instructor Mayra Rodriguez Valladares.

Bank scandals surrounding the JP Morgan whale, Barclays central role in LIBOR, HSBC money laundering, Goldman’s and Morgan Stanley’s lack of disclosure on CDOs, and egregious behavior by numerous banks such as Bank of America with improper foreclosures, have frustrated Americans trying to live in the post crisis world of anemic US economic growth and a mostly recessionary Eurozone.

The fact that no high level executive from the banks has even been indicted, much less gone to jail for Wall Street’s role in worsening the standard of living of millions of Americans has also understandably angered many people and fueled the fire behind the Too big To Fail (TBTF) voices. 

With a great desire to reform the banking sector, it is easy how some may be very pleased with Democratic Ohio Senator Sherrod Brown and Republican Louisiana Senator David Vitter who on April 23rd unveiled a bill Terminating Bailouts for Taxpayer Fairness" Act which proposes increasing capital requirements for big banks.  If no other frameworks or laws existed that call for bank reform, the Brown and Vitter bill might look like an attempt to reform banks. Given that two-thirds of The Wall Street Reform and Consumer Protection Act (Dodd-Frank) rules such as the Volcker rule have yet to be finalized and that the Basel III minimum capital standards are far from even being fully proposed in the US, the Brown-Vitter bill adds more regulatory uncertainty and confusion to a financial sector and market which desperately need clarity and direction.

Dodd-Frank’s Title I, Financial Stability—Systemic Risk Regulation and Oversight, empowers bank regulators to require banks and non-banks over $50 billion in assets to have the necessary capital and liquidity, so that they do not collapse and cause systemic risk.   Specifically, Section 165 of the Dodd-Frank Act requires the Federal Reserve to issue enhanced prudential standards for:

  • US bank holding companies with $50 billion or more in total consolidated assets
  • Foreign banking organizations with $50 billion or more in global total consolidated assets
  • US & foreign nonbank financial components that have been designated as systemically important by the Financial Stability Oversight Council

The enhanced prudential standards include:

  • Heightened capital standards
  • Liquidity standards
  • Single counterparty credit limits
  • Risk management requirements
  • Stress testing requirements and
  • Early remediation framework

It is regulators who have chosen to take guidance from the Basel frameworks, which have their origins in the early 1970s as more countries realized how interconnected their banking systems were becoming.  Basel is international guidance; that is, member countries agreed to have national discretion. Plainly, this means our regulators can choose to impose whatever requirements are necessary given the nature of our banking system and what our economic conditions are.

Title I also requires big banks to write living wills so that banks are fully aware of how the bank is structured and where all the financial exposures lie.  According to FDIC and Federal Reserve banks must explain the identification process for its domestic and international funding, liquidity needs, interconnections and interdependencies, and management information systems.

The main reason that Brown-Vitter introduced their bill is that they feel that Dodd-Frank has enshrined the practice of bailing out banks. Both Title I and Title II are predicated by the belief that taxpayers should be protected and should not ever bail out banks again.  Dodd-Frank very specifically through Title II, the Orderly Liquidation Authority, prohibits bailing out of banks by taxpayers.  Some have opposed the OLA because they feel that our existing bankruptcy laws are sufficient. Yet, when a financial institution declares bankruptcy, as was with the case with Lehman, a panic often happens making an unsavory situation even worse.  The purpose of having a living will and having the FDIC use the OLA to establish a Single Point of Entry to prepare a bank to eventually go through the US bankruptcy system could help minimize the panic that can cripple a market.

Principally, the Brown-Vitter bill calls for large banks to use higher quality capital. This is an excellent idea, since unfortunately it took the financial crisis for many to finally see that tax deferred assets and hybrid capital have no loss absorbency value in a time of stress.  Yet, higher quality capital requirements are a key part of Basel III’s Pillar I and a great improvement in comparison to what was acceptable under Basel II.   US banks, fortunately, are in a much better position to raise equity or deleverage to be able to have loss absorbent capital.

Secondly, Brown-Vitter want large banks to hold 15% capital again non risk based assets.  Basel III already requires much higher capital than did Basel II, but also each local regulator can call for more capital if necessary.  Calling for higher capital for Significant Financial Institutions is already part of Basel III; it’s called the SIFI buffer.  Remember Basel is about minimum not maximum standards.

The major reasons that Brown-Vitter are against Basel III is because they say that it is complex and that allocating capital based on the system of risk weighted assets.  Like most of the media, they focus on risk weighted assets and the fact that banks can ‘manipulate’ them. Those banks that are approved by their bank regulator to use their own inputs for credit or market risk models must meet numerous requirements before they can use their inputs and then still have to calculate capital according to Basel guidelines for agreed upon formulae.  There is no doubt that great variance exists in RWAs. In my experience working on Basel projects for over a decade globally, I can say that indeed, some variance is because of bank manipulation. Yet, other variance is because banks get to pick their models and have legitimate assumptions for risk drivers.  Other variance because supervisors have subjectivity in opining what models are well designed or not; sometimes supervisors are not trained to understand models and are hesitant or not knowledgeable to ask the relevant questions.  If Basel III’s Pillar III, which provides guidelines for transparency were to be implemented and supervised uniformly, the market would have a much better understanding about how banks calculate their risk capital.  If market participants are that suspect of RWAs, why are we not seeing shareholders, equity or credit analysts asking questions about RWAs at shareholder meetings.

Brown and Vitter argue that Basel’s leverage requirement is too low which for US and UK banks is certainly true. It is only 3% of non-risk weighted assets. Every bank regulator has the power to propose and impose a higher leverage ratio.  There is no need to go through a prolonged bureaucratic process in legislative chambers.  Moreover, it is not the job of legislators to decide how much capital banks should have; that is the job of bank regulators.  Legislators should provide them with the resources to do their job rather than all too often siding with the lobbyists camping out at regulators’ doors.

Thirdly, Brown-Vitter ostensibly calls for the US to abandon its involvement in the Basel framework which began in the early 1970s.  Never mind that the US pulling away from Basel III would signal to the rest of the world that we are not interested in global uniform capital standards and which no doubt would only exacerbate bank regulatory arbitrage even more.  As I have been writing in other publications, Basel III is not just about capital allocation for credit, market, and operational risks and capital conservation, procyclicality, liquidity, and leverage buffers; its three pillars are designed to improve banks’ risk management and transparency.  Basel is not about managing by number and neither should any regulatory framework.  Neither the US nor most of Europe have finalized Basel III rules, and hence are far from implementing this international framework to which 27 countries are party.

Even the Dodd-Frank rules that are finalized are not necessarily all being implemented and some are being legally challenged in courts.  Brown-Vitter have argued that they are frustrated with the implementation pace of Dodd-Frank.  It is unclear how they can think that if their bill were to pass, regulators would be able to write and rules any faster given their continued resource constraints and continued pressure from numerous lobbies.  Laws mean nothing until the relevant authorities, in this case the bank regulators, CFTC, and SEC, write the rules which will insure that the spirit and intent of the law are followed.

According to Senators Brown and Vitter, the Wall Street Reform and Consumers Protection Act (Dodd-Frank) have enshrined that banks will be bailed out.  As they wrote in a New York Times editorial on April 24th  ‘the nation’s four largest banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — are nearly $2 trillion larger than they were before the crisis, with a greater market share than ever. And the federal help continues — not as direct bailouts, but in the form of an implicit government guarantee. The market knows that the government won’t allow these institutions to fail.’  Yes, these banks are huge; no one disputes this.   It was bipartisan efforts during the Clinton era that abolished Glass-Steagall and began a wave of traditional banks entering capital markets and financial derivatives transactions.  More recently, let’s not forget that a major reason that JP Morgan and Bank of America became this big is because of government pressured shot gun marriages JPMorgan to Bear and Bank of America to Merrill Lynch.

Also, it is important to understand that it is not the government saying that it will rescue banks.  Dodd-Frank states the opposite.  It is the rating agencies that give banks higher ratings when they feel that the government would rescue the big banks in case of failure. The market interprets these higher ratings favorably which in turn lowers the banks cost of borrowing, which many smaller banks understandably interpret as being unfairly advantageous to the big banks.  Big banks will always have lower borrowing costs often due to economies of scale.

A number of senators have already expressed opposition to Brown-Vitter.  Senate Banking Committee Chairman Tim Johnson, a South Dakota Democrat, stated that bank regulators should be allowed to finish writing Dodd-Frank rules and implementing them.  Also in the Senate Banking Committee, Senator Mike Crapo of Idaho did not feel that legislators could be setting banks’ capital standards, but rather that it is the responsibility of bank regulators.   Democratic Senator Carl Levin also opposed the new bank reform bill, because like Johnson, he felt that Dodd-Frank deserves a chance.

Brown-Vitter injects more financial regulatory uncertainty at a time that banks have been spending millions of dollar upgrading systems to comply with Dodd-Frank and Basel III.  Even if Brown-Vitter’s capital requirements were implemented, US banks would be at a competitive disadvantage vis-à-vis European banks and those of other countries where they have not implemented Basel III, which even when implemented will be done incrementally until 2019.

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