ADBI Working Paper Series The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, and Lessons for Emerging Markets Viral V. Acharya No. 392 October 2012 Asian Development Bank Institute Viral V. Acharya is C. V. Starr Professor of Economics, Department of Finance, New York University (NYU) Stern School of Business. This paper was prepared for the International Growth Commission. The author is grateful to Ashima Goyal, Y. V. Reddy, and Eswar Prasad for useful suggestions. The paper relies heavily on material the author coauthored and coedited in the two NYU–Stern volumes on the Dodd-Frank Act: Regulating Wall Street: The Dodd-Frank Act and the new Architecture of Global Finance (2010), and Dodd-Frank: One Year On (2011) (see References). For parsimony, the author has only cited his own (coauthored) work in References. All relevant links, of interest to the readers, are contained in that cited work. 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The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, and Lessons for Emerging Markets. ADBI Working Paper 392. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/working- paper/2012/10/29/5292.dodd.frank.act.basel.iii.emerging.markets/ Please contact the author for information about this paper. Email: [email protected] Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2012 Asian Development Bank Institute ADBI Working Paper 392 Acharya Abstract This paper is an attempt to explain the changes to finance sector reforms under the Dodd-Frank Act in the United States and Basel III requirements globally; their unintended consequences; and lessons for currently fast-growing emerging markets concerning finance sector reforms, government involvement in the finance sector, possible macroprudential safeguards against spillover risks from the global economy, and, finally, management of government debt and fiscal conditions. The paper starts with a summary of reforms under the Dodd-Frank Act and highlights four of its primary shortcomings. It then focuses on the new capital and liquidity requirements under Basel III reforms, arguing that, like its predecessors, Basel III is fundamentally flawed as a way of designing macroprudential regulation of the finance sector. In contrast, the Dodd-Frank Act has several redeeming features, including requirements of stress-test-based macroprudential regulation and explicit investigation of systemic risk in designating some financial firms as systemically important. It argues that India should resist the call for blind adherence to Basel III and persist with its (Reserve Bank of India) asset-level leverage restrictions and dynamic sector risk-weight adjustment approach. It concludes with some important lessons for regulation of the finance sector in emerging markets based on the global financial crisis and proposed reforms that have followed in the aftermath. JEL Classification: G2, G21, G28 ADBI Working Paper 392 Acharya Contents 1. Introduction: The Dodd-Frank Act ................................................................................... 3 1.1 The Dodd-Frank Act: An Overall Assessment ....................................................... 5 1.1.1 Government Guarantees Remain Mispriced, Leading to Moral Hazard ................. 6 1.1.2 Individual Firms are not Sufficiently Discouraged from Putting the System at Risk 7 1.1.3 The Dodd-Frank Act Falls into the Familiar Trap of Regulating by Form, not Function ................................................................................................................ 8 1.1.4 Large Parts of the Shadow Banking Sector Remain in Current Form .................... 8 2. Basel III Requirements ................................................................................................... 9 2.1 Capital Requirements ..........................................................................................10 2.2 Liquidity Requirements ........................................................................................12 2.3 Basel Capital Requirements: An Assessment ......................................................13 3. Contrast of Basel III with the Dodd-Frank Act ................................................................16 4. Current Implementation Status of Dodd-Frank Act and Basel III Reforms ......................21 5. Conclusion: Lessons for Emerging Markets from the Global Financial Crisis, the Dodd- Frank Act, and Basel III .................................................................................................22 5.1 Government Guarantees .....................................................................................22 5.2 Systemic Risk of Emerging Markets and Coordinated Regulation ........................24 5.3 Macroprudential Regulation: Leverage Restrictions versus Sector Risk-Weight Adjustments .........................................................................................................25 5.4 Government Fiscal Policy and Debt Management ...............................................27 References ...............................................................................................................................28 ADBI Working Paper 392 Acharya 1. INTRODUCTION: THE DODD-FRANK ACT The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enacted by the Obama administration in the United States (US), is perhaps the most ambitious and far-reaching overhaul of financial regulation since the 1930s.1 The backdrop for the act is now well understood but is worth repeating. When a large part of the finance sector is funded with fragile short-term debt and is hit by a common shock to its long- term assets, there can be mass failures of financial firms and disruption of intermediation to households and corporations. Having witnessed such financial panics from the 1850s until the Great Depression, Senator Carter Glass and Congressman Henry Steagall pushed through the so-called Glass–Steagall provisions of the Banking Act of 1933. They put in place the Federal Deposit Insurance Corporation (FDIC) to prevent retail bank runs and to provide an orderly resolution of troubled depository institutions—“banks”—before they failed. To guard against the risk that banks might speculate at the expense of the FDIC, their permissible activities were limited to commercial lending and trading in government bonds and general-obligation municipals, requiring the riskier capital markets activity to be spun off into investment banks. At the time it was legislated, and for several decades thereafter, the Banking Act of 1933 reflected in some measure a sound economic approach to regulation: • identify the market failure, or in other words, why the collective outcome of individual economic agents and institutions does not lead to socially efficient outcomes, which in this case reflected the financial fragility induced by depositor runs; • address the market failure through a government intervention, in this case by insuring retail depositors against losses; and • recognize and contain the direct costs of intervention, as well as the indirect costs due to moral hazard arising from the intervention, by charging banks up-front premiums for deposit insurance, restricting them from riskier and more cyclical investment banking activities, and through subsequent enhancements, requiring that troubled banks face “prompt corrective action” that would bring about their orderly resolution at an early stage of their distress. Over time, however, the banking industry nibbled at the perimeter of this regulatory design, the net effect of which was to keep the government guarantees in place but largely do away with any defenses the system had against banks exploiting the guarantees to undertake excessive risks. What was perhaps an even more ominous development was that the light-touch era of regulation of the finance sector starting in the 1970s allowed the evolution of a parallel (“shadow”) banking system, consisting of money market funds, investment banks, derivatives and securitization markets, etc. The parallel banking sector that was both opaque and highly leveraged and, in many ways, reflected regulatory arbitrage, provided the opportunity for the finance sector to adopt organizational forms and financial innovations that would circumvent the regulatory apparatus designed to contain bank risk taking. Over time, the Banking Act began to be highly compromised. Fast forward to 2004, which many argue was the year when a "perfect storm" began to develop that would eventually snare the global economy. Global banks were seeking out massive capital 1 Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. 111–203, 124 Stat. 1376 (2010). http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/content-detail.html 3 ADBI Working Paper 392 Acharya flows into the US and the United Kingdom (UK) by engaging in short-term borrowing, increasingly through uninsured deposits and interbank liabilities, financed at historically low interest rates. They began to manufacture huge quantities of “tail risk,” i.e., a low likelihood but with catastrophic outcomes. A leading example was the so-called “safe assets” (such as the relatively senior [AAA-rated] tranches of subprime-backed mortgages) that would fail only if there was a secular collapse in the housing markets. As the large and complex financial institutions (LCFIs) were willing to pick up loans from originating mortgage lenders and pass them around or hold them on their own books after repackaging them, a credit boom was fueled in these economies. As Table 1 shows, more than 20% of US mortgage-backed exposure was guaranteed by “nonagencies”, i.e., by the private sector (Table 1, columns 5–7), but unlike traditional securitization, in which the AAA-rated tranches would get placed with the pension fund of proverbial Norwegian village, these were to a significant extent (originated and) retained by banks and thrifts, and broker-dealers (column 5, Table 1). The net result of all this was that the global banking balance sheet doubled from 2004 to 2007, but its risk appeared small. The LCFIs had, in effect, taken a highly undercapitalized one-way bet on the housing market, joined in equal measure by the US government’s own shadow banks—Fannie-Mae and Freddie-Mac—and AIG, the world’s largest insurer. While these institutions seemed individually safe, collectively they were vulnerable. And as the housing market crashed in 2007, the tail risk materialized, and the LCFIs crashed like a house of cards. The first big banks to fail were in the shadow banking world. They were put on oxygen in the form of Federal Reserve (Fed) assistance, but the strains in the interbank markets and the inherently poor quality of the underlying housing bets, even in commercial bank portfolios, meant that when the oxygen ran out in the autumn of 2008 some banks had to fail. A panic ensued internationally, making it clear that the entire global banking system was imperiled and needed—and markets expected them to be given—a taxpayer-funded lifeline. Table 1: Distribution of United States Real-Estate Exposures Notes: GSEs = Government Sponsored Enterprises, FHLB = Federal Home Loan Banks, HELOC = Home Equity Lines of Credit, MBS = Mortgage-Backed Securities, CDO = Collateralized Debt Obligations, and AAA = highest rating class attributable to fixed income securities. Source: Lehman Brothers. 2008. Fixed Income Report. June. 4 ADBI Working Paper 392 Acharya In the aftermath of this disaster, governments and regulators began to cast about for ways to prevent—or render less likely—a recurrence. The crisis created focus and led first to a bill from the House of Representatives, then one from the Senate, that were combined and distilled into the Dodd-Frank Act. The critical task for the Dodd-Frank Act was to address the increasing propensity of the finance sector to put the entire system at risk and, eventually, to be bailed out at the taxpayer’s expense. The highlights of the Act are as follows: • Identifying and regulating systemic risk: sets up a council that can deem nonbank financial firms systemically important, regulate them, and, as a last resort, break them up; also establishes an office under the Treasury to collect, analyze, and disseminate relevant information for anticipating future crises. • Proposing an end to too-big-to-fail: requires "funeral plans" and orderly liquidation procedures for unwinding systemically important institutions, ruling out taxpayer funding of wind downs and instead requiring that management of failing institutions be dismissed, wind-down costs be borne by shareholders and creditors, and, if required, ex post levies be imposed on other (surviving) large financial firms. • Expanding the responsibility and authority of the Federal Reserve. Grants the Fed authority over all systemic institutions and responsibility for preserving financial stability. • Restricting discretionary regulatory interventions: Prevents or limits emergency federal assistance to individual nonbank institutions. • Reinstating a limited form of Glass–Steagall (the “Volcker rule”): Limits bank holding companies to de minimis investments in proprietary trading activities such as hedge funds and private equity, and prohibits them from bailing out these investments. • Regulation and transparency of derivatives: Provides for central clearing of standardized derivatives, regulation of complex derivatives that can remain over-the- counter (i.e., outside of central clearing platforms), transparency of all derivatives, and separation of "non-vanilla" positions into well-capitalized subsidiaries, all with exceptions for derivatives used for commercial hedging. In addition, the Act introduces a range of reforms for mortgage lending practices, hedge fund disclosure, conflict resolution at rating agencies, origination and securitization, risk-taking by money market funds, and shareholder say on pay and governance. And perhaps its most popular reform, albeit tangential to the financial crisis, the Act creates a bureau of consumer financial protection that will write rules governing consumer financial services and products offered by banks and nonbanks. 1.1 The Dodd-Frank Act: An Overall Assessment The first reaction to the Act is that it certainly has its heart in the right place. It is highly encouraging that the purpose of the new finance sector regulation is explicitly aimed at developing tools to deal with systemically important institutions. And it strives to give prudential regulators the authority and the tools to deal with this risk. The requirement of funeral plans to unwind LCFIs should help demystify their organizational structures, and the attendant resolution challenges when they experience distress or fail. If the requirement is enforced well, it could serve as a “tax” on complexity, which seems to be another market failure in that private gains from it far exceed the social ones. 5 ADBI Working Paper 392 Acharya In the same vein, even though the final language in the Act is a highly diluted version of the original proposal, the Volcker rule, limiting proprietary trading investments of LCFIs, provides a more direct restriction on complexity and should help simplify their resolution. The Volcker rule also addresses a moral hazard issue, which is that direct guarantees to commercial banks are largely designed to safeguard payment and settlement systems and to ensure robust lending to households and corporations. However, through the bank holding company structure, direct guarantees effectively lower the costs for more cyclical and riskier functions, such as making proprietary investments and running hedge funds or private equity funds, where there are thriving markets and a commercial banking presence is not critical. Equally welcome is the highly comprehensive overhaul of derivatives markets aimed at removing the veil of opacity that has led markets to seize up when a large derivatives dealer experiences problems (e.g., Bear Stearns). The push for greater transparency of prices, volumes, and exposures—to regulators and in aggregated form to the public—should enable markets to deal better with counterparty risk in terms of pricing it into bilateral contracts as well as understanding its likely impact. The act also pushes for greater transparency by making systemic nonbank firms subject to tighter scrutiny by the Fed and the Securities and Exchange Commission (SEC). However, the Act requires over 225 new financial rules across 11 federal agencies. The attempt at regulatory consolidation has been minimal. In the end, the finance 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) spell out the details of implementation. Perhaps more importantly, from the standpoint of providing an economically sound and robust regulatory structure, are the act’s weaknesses on at least four important counts, as we explain below. The net effect of these four basic faults is as follows: (i) implicit government guarantees to the finance sector will persist in some pockets and escalate in others; and (ii) capital allocation may migrate in time to these pockets and newer ones that will develop in the future shadow banking world and, potentially, sow seeds of the next significant crisis. Implementation of the act and future regulation may guard against this danger, but that remains to be seen. 1.1.1 Government Guarantees Remain Mispriced, Leading to Moral Hazard In 1999, economists John Walter and John Weinberg of the Federal Reserve Bank of Richmond performed a study of how large the financial safety net was for US financial institutions. Using fairly conservative criteria, they reported that 45% of all liabilities ($8.4 trillion) received some form of guarantee. A decade later, the study was updated by Nadezhda Malysheva and John Walter with staggering results—now 58% of all liabilities ($25 trillion) were under a safety net. Without appropriate pricing, government guarantees are highly distortionary: they lead to subsidized financing of financial firms, moral hazard, and the loss of market discipline, which, in turn, generate excessive risk taking. Examples include (i) FDIC insurance provided for depository institutions; (ii) implicit backing of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac (as described in detail in Acharya, Van Nieuwerburgh, Richardson, and White 2011); and (iii) the much-discussed too-big-to-fail mantra of LCFIs. The financial crisis of 2007–2009 exposed the depth of the problem with the failure of numerous banks and the need to replenish FDIC funds, the now-explicit guarantee of GSE debt, and the extensive bailouts of LCFIs. The Dodd-Frank Act makes little headway on the issue of government guarantees. While admittedly such guarantees have been a problem for many years, the Act nonetheless makes little attempt to re-address the pricing of deposit insurance. And while the GSEs are the most 6 ADBI Working Paper 392 Acharya glaring examples of systemically important financial firms whose risk choices went awry given their access to guaranteed debt, the Act makes no attempt to reform them.2 The distortion here is especially perverse, given the convenience of having them around to pursue political objectives of boosting subprime home ownership and using them as “bad” banks to avoid another titanic collapse of housing markets. Finally, there are several large insurance firms in the US that can—and did in the past—build leverage through minimum guarantees in standard insurance contracts. Were these to fail, there is little provision in the Act to deal adequately with their policyholders; there are currently only the tiny state guarantee funds, which would never suffice for resolving the large insurance firms. Under the Act, there would be no advance systemic risk charges on these firms, but it is highly unlikely that their policyholders will be wiped out or that the large banks will be made to pay for these policies (as the Act proposes)! Taxpayer bailout of these policies is the more likely outcome. These institutions remain too-big- to-fail and could be the centers of the next excess and crisis. Of course, proponents of the Act would argue that at least the issue of too-big-to-fail has been dealt with once and for all through the creation of the Orderly Liquidation Authority (OLA). But when one peels back the layers of the OLA, it is much less clear. Choosing an FDIC-based receivership model to unwind such large and complex firms creates much greater uncertainty than would a restructured bankruptcy code for LCFIs, or the forced debt-to-equity conversions inherent in “living wills.” Time will tell whether the OLA is considered credible enough to impose losses on creditors (FDIC-insured depositors aside), but market prices of LCFI debt will be able to provide an immediate answer through a comparison of yield spreads with firms that are not too-big-to-fail. 1.1.2 Individual Firms are not Sufficiently Discouraged from Putting the System at Risk Since the failure of systemically important firms imposes costs beyond their own losses—to other financial firms, households, the real sector, and, potentially, other countries—it is not sufficient to simply wipe out their stakeholders—management, shareholders, and creditors. These firms must pay in advance for contributing to the risk of the system. Not only does the Act rule this out but it also makes the problem worse by requiring that other large financial firms pay for the costs, precisely at a time when they are likely to face the risk of contagion from failing firms. This is simply poor economic design for addressing the problem of externalities. It is somewhat surprising that the Act has shied away from adopting an advance charge for systemic risk contributions of LCFIs. And, in fact, it has most likely compromised its ability to deal with their failures. It is highly incredible that, in the midst of a significant crisis, there will be the political will to levy a discretionary charge on the surviving financial firms to recoup losses inflicted by failed firms. It would, in fact, be better to reward the surviving firms from the standpoint of incentives in advance and relax their financing constraints later to boost the flagging economic output in that scenario. Under the proposed scheme, therefore, the likely outcomes are that the finance sector will most likely not pay for its systemic risk contributions— as happened in the aftermath of this crisis—and that to avoid any likelihood that they have to pay for others’ mistakes and excesses, financial firms will herd by correlating their lending and investment choices. Both of these would increase, not decrease, systemic risk and financial fragility. Equally problematic, the argument can be made that the Act has actually increased systemic risk in a financial crisis. While it is certainly true that the Financial Stability Oversight Council of regulators has more authority to address a systemic crisis as it emerges, there is the implicit 2 For a detailed treatment of the role played by the GSEs in the housing boom and bust in the US, see Acharya, Van Nieuwerburgh, Richardson, and White (2011). 7 ADBI Working Paper 392 Acharya assumption that the council will have the wherewithal to proceed. Given the historical experience of regulatory failures, this seems like a tall order. In contrast, the Act reduces the ability of the Federal Reserve to provide liquidity to non-depository institutions, and, as mentioned above, provides no advance funding for solvent financial institutions hit by a significant event. The council will be so restricted that its only choice in a liquidity crisis may be to put systemically important firms through the OLA process, which, given the uncertainty about this process, could initiate a full-blown systemic crisis. Much greater clarity on exact procedures underlying the OLA would be necessary to avoid such an outcome. 1.1.3 The Dodd-Frank Act Falls into the Familiar Trap of Regulating by Form, not Function The most salient example of this trap is the Act’s overall focus on bank holding companies, after clarifying that nonbanks may also be classified as systemically important institutions and be regulated accordingly. As we just explained, the Act allows for provision of federal assistance to bank holding companies under certain conditions, but restricts such assistance to other systemically important firms, large swap dealers in particular. This will create a push for the acquisition of small depositories just as nonbanks anticipate trouble, undermining the intent of restriction. There are also important concentrations of systemic risk that will develop, e.g., as centralized clearing of derivatives starts being implemented. And when their systemic risk materializes, employing the Fed’s lender-of-last-resort function may be necessary, even if temporarily so, to ensure orderly resolution. Consider a central clearinghouse of swaps (likely to be credit default swaps to start with, but eventually several other swaps, including interest rate swaps). As Mark Twain would put it, it makes sense to “put all your eggs in one basket” and then “watch that basket.” The Act allows for prudential standards to watch such a basket. But if the basket was on the verge of a precipitous fall, an emergency reaction would be needed to save the eggs—in this case, the counterparties of the clearinghouse. The restriction on emergency liquidity assistance from the Fed when a clearinghouse is in trouble will prove disastrous, as an orderly liquidation may take several weeks, if not months. The most natural response in such cases is to provide temporary federal assistance, eventual pass-through of the realized liquidation losses to participants in the clearinghouse, and its private recapitalization through capital contributions from participants. Why force intermediate liquidity assistance to go through a vote of the Financial Stability Oversight Council and have the markets deal with discretionary regulatory uncertainty? 1.1.4 Large Parts of the Shadow Banking Sector Remain in Current Form The story of the financial crisis of 2007–2009 was that financial institutions exploited loopholes in capital requirements and regulatory oversight to undertake risky activities that were otherwise meant to be well capitalized and closely monitored. Examples are numerous: (i) financial firms choosing unqualified regulatory agencies to oversee them (e.g., American International Group’s choice of the Office of Thrift Supervision for its financial products group); (ii) the loading up of so-called AAA-rated securities in a regulatory setting ripe for conflicts of interest between rating agencies, security issuers, and investors; and (iii) the development of a parallel banking sector that used wholesale funding and over-the-counter (OTC) derivatives to conduct identical banking activities, as commercial banks were not yet subject to the same rules and regulations. To be fair, the Dodd-Frank Act does not ignore all of this in its financial reform. For example, it takes major steps to deal with the regulatory reliance and conflict of interest problems with rating agencies, OTC derivatives are brought back into the fold, and leverage-enhancing tricks such as off-balance-sheet financing are recognized as a major issue. But the basic principle that 8