Basel 2.5, Basel 3, and Dodd-Frank

National Bank Act of 1864

Federal Reserve Act of 1913

To Amend the National Banking Laws and the Federal Reserve Act

Banking Act of 1933

•The Glass-Steagall Act.

Banking Act of 1935

•FDIC Federal Deposit Insurance Act of 1950

Bank Holding Company Act of 1956

International Banking Act of 1978

Financial Institutions Regulatory and Interest Rate Control Act of 1978

Depository Institutions Deregulation and Monetary Control Act of 1980

Depository Institutions Act of 1982

•Garn-St Germain

Competitive Equality Banking Act of 1987

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)

Crime Control Act of 1990

Federal Deposit Insurance Corporation Improvement Act of 1991 (FDCIA)

Housing and Community Development Act of 1992

RTC Completion Act

Riegle Community Development and Regulatory Improvement Act of 1994

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

Economic Growth and Regulatory Paperwork Reduction Act of 1996

Gramm-Leach-Bliley Act of 1999

International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001

Sarbanes-Oxley Act of 2002

Fair and Accurate Credit Transactions Act of 2003

Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010

This time is the same: Regulation follows crises

This time

• Basel 2.5: Redefinition of market risk requirements – Substantial increase in capital for banks with large

trading activities

• Basel 3: New capital standards, but fully implemented in 2019 – Substantial increase in common equity requirement,

especially for SIFIs; liquidity requirements

• Dodd-Frank: Addresses all aspects of the financial sector except for Fannie and Freddie.

Oversight and

Systemic Risk

Financial Stability Oversight Council

Orderly Liquidation Authority

Federal Reserve Emergency Credit

Financial Institutions

Regulation of banking organizations

Volcker Rule

Private fund investment advisers

Insurance companies

Supervision of payment, clearing and

settlement

Capital Markets

Derivatives and swaps clearinghouses

Securitization

Credit Rating Agencies

Investor protection and securities enforcement

Business Conduct and

Practices

Governance and compensation

Consumer protection

Dodd-Frank

But

• We have a long way to go with Dodd-Frank.

• Parts of it could get repealed.

• The most important rules may be the ones that are discussed little: Bailouts have become much harder to implement.

• Yet, there is no solution of resolution of multinational banks.

Do the changes matter?

• Banks will have to more than double their common equity capital compared to before the crisis.

• Banks look at the world through ROE. Hence, their ROE falls in half if they do nothing.

• Few banks have market-to-book greater than 1. So, they are more likely to work on their balance sheet than to issue equity.

• Not all activities are affected equally.

9

7

8

9

9

8

3

6

4

8

7

15

16

Product-specific RoEs show highest impact on

structured products, especially credit and rates

Total 20

Prop Trading 35

Prime Svcs 15

EQD - Strctrd 27

EQD - Flow 25

Cash Equities 25

Commodities 20

Credit - Strctrd 17

Credit - Flow 18

Rates - Strctrd 15

Rates - Flow 19

FX 30

Pre regulation

1

2a

2b

3a

3b

4

5

6a

6b

7

8

Post regulation Asset class

-59

-77

-65

-83

-61

-39

-65

-68

-46

-80

0

-8

-6

-4

-8

-9

-6

-5

-8

-10

-22

-7

1 3 2 6/7

X Delta, percent

Most significant impact

8a 8b

RoE (effect), Percent (Percentage points)

Mkt risk

RWA red.

Rev. impact

Cap. / Lev CCR

B II.5 Basel III/Other

Lqd./ Fund.

0

-5

-6

0

-2

-3

0

-1

-4

0

-1

-3

4

2

1

0

0

1

1

0

1

0

0

2

-5

-1

-1

0

-1

-1

-1

0

-1

0

-1

-1

-4

-2

-1

-1

-1

-2

-3

-2

-2

-6

-2

-2

-2

-2

-1

-1

-1

-1

-2

-2

-2

-1

-2

-1 -64

-46

3 WHAT BANKS NEED TO DO

Borrowed from McKinsey/Toni Santomero

Consequences

• Banks will shrink.

• Tailored products will become more expensive.

• Non-bank financial activities will expand.

• Offshore financial activities will expand.

Do the changes address the causes of bank poor performance during the

crisis?

• Did an international study of performance of large banks during the crisis with Andrea Beltratti.

• All public banks with more than $50 billion assets.

• Stock performance from July 2007 to December 2008.

Key differences

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

Fagility Deposits Tangible equity Ownership Board index

Bottom quartile

Top quartile

Where the banks that did better less risky in 2006?

• No, except for leverage.

• They had higher idiosyncratic volatility.

• They had lower distance to default.

• Same beta, same real estate beta.

• However, much higher tangible equity:

– 6.35% versus 4.10%

Banks Banks + Non-banks

Tier 1 45.026***

Tangible equity 2.122

Funding fragility -0.636*** -0.250***

Real estate beta -65.649*** -61.371***

Board -3.421*** -3.013**

Regression results: Key variables

Is Volcker right?

• Regulation is not related to performance except that banks from countries with more restrictions on bank activities did better.

• But, banks from countries with more restrictions were not less risky.

• Those banks could not invest in some activities that performed poorly, but these activities were not expected to perform poorly.

Regulation, governance, macro

• Banks that did better come from tougher regulation, weaker governance, current account surplus countries.

• All banks in the bottom quartile of performance come from countries with formal deposit insurance.

Are we on the right track?

• Ever more complicated and intrusive regulation can’t work.

• It would be much better to make the system safer by making sure that the collapse of a financial institution has no significant impact.

• We have gone the opposite way, though.