obele, ogo - basel ii

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THESIS:

The current financial crisis both caught the global economy unawares and demonstrated how complex

the financial industrys services and products have become. Additionally, the continuing fallout of the

crisis shows how the financial industry and its capital flows have created a truly interconnected global

economy. Prior to the financial crisis, the Basel II regulatory framework was intended to strengthen the

international financial markets by establishing a global financial standard for measuring and addressing

risk. The framework sought to accomplish this goal by establishing a more modern approach to

identifying and addressing risk in order to keep pace with financial innovation and instruments. In

addition to providing more modern qualitative and quantitative metrics for measuring risk, the framework

increased capital requirements for banking institutions to ensure the global financial industrys ability to

withstand shocks and to promote the safety of the institutions.

Despite the high-minded aspirations of the regulators that created the framework, Basel II failed to

reach its goal. Moreover, Basel II arguably played a key role in influencing bank behavior that directly

led to the financial crisis. Basel II failed to address certain flaws in the transparency and incentive

alignment inherent in the financial industry. Basel II also allowed banking institutions to game the

system and pursue increasingly risky behavior in order to generate record profits.

As the global economy seeks to recover from the current financial crisis, regulators are attempting to

develop and implement new regulatory frameworks that will hopefully prevent another such crisis from

occurring again. In developing new regulatory frameworks and laws, regulators seek to address the

structural flaws in the banking industry that the failure of Basel II and the financial crisis exposed. Two

examples of this effort to develop modern financial regulations are the Basel III framework and the Dodd-

Frank Act. Even though neither Basel III nor Dodd-Frank have been fully implemented, the tone of and

response to these new regulations, as well as other new regulations, evidence that the future of financial

regulation is still in a state of flux as it struggles with balancing economic growth and financial risk.


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BASEL II: BACKGROUND

Basel II was created by the Basel Committee, formally known as the Committee on Banking

Regulations and Supervisory Practices.1The primary objective of the committee is to improve the

supervisory understanding and the quality of banking supervision internationally. The Basel Committee

possesses no international regulatory authority in that its recommendations possess not legal authority.2

Rather, the committee provides a broad regulatory framework the fosters international convergence

towards common approaches and standards, such as those in Basel II, which States modify to best suit the

individual state.3In 1988, the Basel Committee established the Basel Capital Accord (Basel I) in

recognition of the need for an international accord to strengthen the stability of international banking

system by stressing the importance of capital ratios.4However, as the banking system became

increasingly international and financial instruments became increasingly complex, the Basel Committee

introduced Basel II accommodate the banking systems evolution.

The primary goal of Basel II is to provide a framework that, when implemented, strengthens the

stability of the international banking system by promoting the adoption of stronger risk management

practices.

5

In order to accomplish this goal, the Basel II framework employs a three-pillar framework that

provides more a detailed approach to measuring credit risk, establishing explicit capital requirements for

operational risk, and addresses market risk.6

BASEL II: PILLAR 1 Minimum Capital Requirements

1The Banking Association of South Africa, The Bankers Guide to the Basel II Framework (December 2005)

*hereinafter Bankers Guide+, p. 1, available at

http://www.banking.org.za/documents/2005/DECEMBER/InfoDoc_29781.pdf2Basel II The Securitisation Framework, Deloitte (2006) *hereinafter Deloitte-Basel II], p. 3, available at

http://www.deloitte.com/assets/Dcom-

SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-

TheSecuritisationFramework_090107.pdf3Bankers Guide, p. 1

4Bankers Guide, p. 2


http://www.banking.org.za/documents/2005/DECEMBER/InfoDoc_29781.pdfhttp://www.banking.org.za/documents/2005/DECEMBER/InfoDoc_29781.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20II-TheSecuritisationFramework_090107.pdfhttp://www.banking.org.za/documents/2005/DECEMBER/InfoDoc_29781.pdf


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The Basel II framework seeks to ensure that applicable entities maintain adequate capital in relation

to the risk profile of an entitys activities and assets.7As under Basel I, Basel II requires banks to

maintain a minimum total capital ratio of 8%.8The numerator in this ratio represents the regulatory

capital available to the bank and the denominator represents the combined credit risk, operational risk and

market risk of an entitys risk assets.9

Figure 1: Components of Risk Weighted Capital Requirement under Basel II.10

CREDIT RISK

The Basel II framework improves upon Basel I by providing entities with two methods for calculating

credit risk.11The intent for providing entities with the alternative methods is to allow banks that engage in

more sophisticated risk-taking and have developed more sophisticated risk measurement systems greater

latitude to select the most appropriate method for measuring.12The two methods are the Standardized

7Deloitte-Basel II, p. 3

8Federal Reserve, Capital Standards for Banks: The Evolving Basel Accord, Federal Reserve Bulletin (September

2003), p. 396-405[hereafter FED Bulletin 2003], p. 398, available at

http://www.federalreserve.gov/pubs/bulletin/2003/0903lead.pdf9FED Bulletin 2003, p. 398

10FED Bulletin 2003, p. 398

11Bank for International Settlements, International Convergence of Capital Measurement and Capital Standards,

Basel Committee on Banking Supervision (June 2006) [hereinafter BIS-Basel II], para. 50, available at

http://www.bis.org/publ/bcbs128.pdf12

Feb Bulletin 2003, p. 399
http://www.federalreserve.gov/pubs/bulletin/2003/0903lead.pdfhttp://www.federalreserve.gov/pubs/bulletin/2003/0903lead.pdfhttp://www.bis.org/publ/bcbs128.pdfhttp://www.bis.org/publ/bcbs128.pdfhttp://www.bis.org/publ/bcbs128.pdfhttp://www.federalreserve.gov/pubs/bulletin/2003/0903lead.pdf


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Approach (SA) and the Internal Ratings Based Approach (IRB).13Within the IRB, banking entities are

permitted to use either the Foundation Approach (FIRB) or the Advanced Approach (AIRB).14

Figure 2: Comparison between Basel I and Basel II Risk-weighting for different assets. 15

The main distinction of the Standardized Approach (SA) is that the risk weighting for a credit

exposure is determined by external credit assessments.16Under the SA, credit exposures are assigned to

categories based on the characteristics of the credit exposure: some of the main categories are sovereign

debt, multilateral development banks, banks, corporate debt, and retail debt.17Each categorys risk

weighting is then determined by a credit rating established by an external credit rating agency. In order to

use the external agencys rating, the rating must be provided by an agency that meets with the Basel II

criteria of objectivity, independency, transparency, and credibility.18In the event there is no external

rating for the loan, the loan is generally assigned a risk weighting of 100%.19Although the SA uses the

same risk-weighting scheme as Basel I, it establishes risk weightings for certain assets that are higher

13BIS-Basel II, para. 50-52


15Deloitte Basel II, p. 9

16BIS-Basel II, para. 52

17Bankers Guide, p10




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(150%) than under Basel I (100%). Some of the assets that are subject to here weightings are sovereigns

and banks rated below B-, and corporates rated below BB-.20(See Figure 2)

In contrast to the SA approach and its use of externally assigned risk weights, the IRB approach

permits banking entities to use internally developed information about the banks own credit exposures,

risk measurement and risk management to determine the appropriate risk weights for its exposures.21

However, an entity must satisfy certain minimum conditions and disclosure requirements as well as

receive supervisory approval in order to employ the IRB approach.22The banks credit exposures are

categorizes into broad classes of assets (corporate, sovereign, bank, retail, and equity) based on the

underlying risk characteristics of the asset.23If there is no specific IRB treatment for an asset then the

assigned risk-weighting is 100%.24The IRB approach is based on measures of Unexpected Loss and

Expected Loss, but the risk weighting functions of the IRB approach only focus on determining the

requisite capital buffer needed to cover the Unexpected Loss portion.25

Under the IRB approach, banking entities internally determine the appropriate risk-weight for a

particular credit asset class using following four parameters: Probability of Default (PD); Loss Given

Default (LGD); Exposure at Default (EAD); Maturity (M).

26


21Bankers, p12-14


23Bankers Guide, p. 14. See also BIS-Basel II, para. 215.

24BIS-Basel II, para 213

25Bankers Guide, p. 14. See also BIS-Basel II, para. 212.



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Table 1: Four Parameters for determining credit exposure risk under the IRB approach. 27

Within the IRB approach, banking entities can employ two different methods with which to

calculate the risk weight for each asset class. Under the Foundation IRB approach, banking entities

internally establish estimates for the PD parameter and use external supervisory estimates for the other

parameters. Under the Advanced IRB approach, banking entities used internally developed estimates for

all four parameters.28

Table 2: Risk Component estimation under FIRB and AIRB.29

Given the reliance on internal data to determine estimates for risk-weights under the IRB approach,

different banking entities could, in theory, establish different capital requirement estimates for the same

asset.30In order to ensure comparability amongst banks risk weightings, banks must meet the minimum

qualifying criteria for using the IRB approach that covers the banks internal credit risk assessment

27Deloitte-Basel II, p. 9

28Bankers Guide, p. 17-18. See also BIS-Basel II, para 245.


30Basel II and Banks: Key Aspect and Likely Market Impacts, Nomura Securities International, Inc., Nomura Fixed

Income Research (September 20, 2005), p. 1 [hereinafter Nomura-Basel II], available at

http://people.stern.nyu.edu/igiddy/ABS/BaselII_Nomura.pdf
http://people.stern.nyu.edu/igiddy/ABS/BaselII_Nomura.pdfhttp://people.stern.nyu.edu/igiddy/ABS/BaselII_Nomura.pdfhttp://people.stern.nyu.edu/igiddy/ABS/BaselII_Nomura.pdf


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procedures. Within the IRB framework, the qualification criteria are more stringent for the Advanced

Approach than the Foundation Approach.31

OPERATIONAL RISK

Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events.32This definition includes legal risk such as

exposure to fines and penalties but excludes strategic and reputational risk.33The four categories of risk

within the operational risk assessment framework can be explained as follows.34

a) Inadequate of failed internal processes: operational risk that may result from the myriad ofprocesses banking institutions use to deliver their products/services to end users, e.g. transactions

processes incorrectly

b) People: operational risk that can occur due to worker compensation claims, violations ofemployee health and safety rules, inadequate training and management, lack of integrity or

honesty

c) Systems: operational risk that can arise due to institutions dependence on certain systems thatfacilitate daily operations and the potential for these systems to fail, e.g. dependence on IT

systems exposes the institution to the operational risk of its IT system failing or data becoming

corrupted

d) External events: operational risk that can arise from both the idiosyncratic risk of firm and thebusiness strategy it pursues and the market risk resulting from participating in the general

business environment

The operational risk framework provides three methods for calculating operational risk capital

charges based on the institutions level of sophistication: the Basic Indicator Approach; the Standardised



33BIS-Basel II, para. 644. See also Bankers Guide, p. 23

34Bankers, p24


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Approach; and the Advanced Measurement Approach.35The three methods represent a continuum of

increasing sophistication sensitivity to risk and, much like with the credit risk measurement methods,

more sophisticated banks are encouraged to employ the more sophisticated operational risk measurement

methods.36In fact, once a banking entity selects a measurement method, it is not permitted to revert to a

less sophisticated method.37Additionally, once a method is selected, supervisors are permitted to review

the capital requirement produced by the method for general credibility in relation to the firms peers and

in the event credibility is lacking, the supervisor can exercise appropriate remedial action under Pillar 2 of

Basel II.38

Under the Basic Indicator Approach (BIA), a banking entity uses its gross income as a proxy for

operational risk and must maintain a capital charge equal 15% of the average gross income for the last

three years.39This method defines gross incomeas net interest income plus net non-interest income

subject to additional stipulations such as the exclusion of realized profits and losses from the sale of

securities in the banks banking book.40In the event a bank generates no or negative gross income in a

given year within the three year timeframe, the figures for that year should be excluded from the

calculation.41

Banks that meet specific minimum requirements may employ the Standardised Approach (SA) to

determine their operational risk capital charge.42SA uses gross income as a proxy for operational risk as

well. However, unlike the BIA, the SA divides the banking entitys activities into eight business lines and

uses the gross income generated from each business lines as a proxy for the relative scale of operational

35BIS-Basel II, para 645-644

36BIS-Basel II, para 645-644

37Bankers Guide, p. 25. See also BIS Basel II, para 648


39BIS Basel II, para 649


41BIS-Basel II, para. 649. See alsoBankers, p. 25



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risk exposure within each business line.43The eight business lines are: corporate finance; trading & sales;

retail banking; commercial banking; payment & settlement; agency services; asset management; and retail

brokerage.44The gross income generated from each business line is multiplied by the appropriate beta

factor risk-weight to determine the appropriate capital charge for the individual business line and then

each individual business lines capital charge is aggregated to determine the total operational risk capital

charge for the banking entity.45

Table 3: Beta Factors for Specific Business Lines under the SA.46

The SA approach also offers an alternate method (the Alternate Standardised Approach or ASA)

for retail and commercial banking at the discretion of the banks national supervisors discretion.47Under

this approach, a banks volume of outstanding loans is multiplied by the appropriate beta factor and the

result is multiplied by 3.5% in order to determine the appropriate capital charge.48

As with the SA, banks that meet specific minimum requirements may elect to use the more

sophisticated Advanced Measurement Approach (AMA).49Under the AMA, the regulatory capital

requirement is equal to the risk measure generated by the banks internal operational risk measurement









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system.50The system should be based on internal loss data, external loss data, scenario analysis and

business environment and internal control factors.51Moreover, the system must be deemed adequate by

the banking entities supervisors.52

MARKET RISK

The Basel II framework defines market risk as the risk of losses in on and off-balance-sheet

positions arising from movements in market prices.53In essence, market risk is the risk of financial loss

associated with a banks trading book, in which the bank may trade for its own account or on behalf of its

clients.54The framework explicitly states that the risks encapsulated in the definition of market risk are

risks associated with interest rate related instruments and equities in a banking entitys trading book and

foreign exchange risk and commodities risk throughout the bank.55

Basel II offers banking entities two methods with which to measure their market risk: the

Standardised Measurement Method and the Internal Methods Approach. Under the Standardised

Measurement Method, the capital charge for market risk is the sum of five categories of risk: interest rate

risk; equity position risk; foreign exchange risk; commodities risk; and treatment of options.56In order to

use the Internal Methods Approach, the banking entity must satisfy specific minimum requirements and

receive supervisory authority approval.57

BASEL II: PILLAR 2 The Supervisory Review Process


Bankers, p2752

Fed Bulletin 2003, p. 399. See also BIS-Basel II, para 666-675 for in-depth explanation of criteria used to

determine adequacy of an entitys system and system inputs.53

BIS-Basel II, para 638(i)54

Bankers, p2855

BIS-Basel II, para 638(i)56

Deloitte Basel II, p. 757

BIS-Basel II, para 718(LXX-LXXiii)


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The aim of Pillar 2 is to describe the key principles for supervisory review, risk management

guidance and supervisory transparency and accountability. Pillar 2 focuses on the following. 58

a) The responsibility of bank management in developing internal assessment processes and settingappropriate capital targets for abanks risk profile.

b) The responsibility of the supervisors role in evaluating how well a bank is assessing its capitalneeds relative to its risks and to intervene where appropriate

c) Addressing the treatment of risks not fully captured under Pillar I, such as credit concentrationrisk, and factors external to the bank, such as the business cycle.

d) The assessment of a banks compliance with the minimum standards and disclosure requirementsof the more advanced methods in Pillar I

In outlining the requirements for supervisory review, the Basel Committee established four key

principles.

a) Principle 1: Banks should have a process for assessing their overall capital adequacy in relation totheir risk profile and a strategy for maintaining their capital levels.59

b) Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessmentsand strategies, as well as their ability to monitor and ensure compliance with regulatory capital

ratios. Supervisors should take appropriate supervisory action of they are not satisfied with the

result of this process.60

c) Principle 3: Supervisors should expect banks to operate above the minimum regulatory capitalratios and should have the ability to require banks to hold capital in excess of the minimum.61

58Bankers, p37

59BIS-Basel II, p. 205




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d) Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from fallingbelow the minimum levels required to support the risk characteristics of a particular bank and

should require rapid remedial action if capital is not maintained or restored.62

BASEL II: PILLAR 3 Market Discipline

Market discipline complements the capital requirements and the supervisory review process

established in the first two pillars. Basel II encourages market discipline by means of a set of disclosure

requirements that enable market participants to assess the capital, risk exposures, risk assessment

processes and capital adequacy of an institution.63However, the disclosures required under Pillar 3 do not

conflict with the requirements under the prevailing accounting standards and do not need to be audited by

an external auditor.64

BASEL II CRITICISM

Despite the improvements over Basel I, Basel II drew a lot of criticism for the financial and

market risks that it failed to address. One major criticism of the Basel II framework is that is doesnt

penalize banks for asset concentration and the associated diversification risk inherent in asset

concentration. The risk weighting models under Basel II relied on the assumption that loan portfolios are

portfolio invariant. This critical assumption states that the capital required to back a loan should

depend only on the risk of that [individual] loans, not on the portfolio to which it is added.65A major

shortcoming of this assumption is that it does not reflect the importance of asset concentration within a



64Deloitte Basel II, p. 15

65Adrian Blundell-Wignall & Paul Atkinson, Thinking Beyond Basel III: Necessary Solutions for Capital and

Liquidity, Volume 2010-Issue 1 Organisation for Economic Co-operation and Development (OECD) Journal:

Financial Market Trends (2010) [hereinafter Wingnall & Atkinson], p. 4, available at

http://www.oecd.org/dataoecd/42/58/45314422.pdf
http://www.oecd.org/dataoecd/42/58/45314422.pdfhttp://www.oecd.org/dataoecd/42/58/45314422.pdfhttp://www.oecd.org/dataoecd/42/58/45314422.pdf


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portfolio. Rather, Pillar 1 ignores concentration risk and leaves it to supervisors to address under Pillar

2.66

The Basel II framework is also criticized for its use on subjective inputs for determining risk factors

and capital charges. For example, under the IRB approach for determining credit risk capital

requirements, sophisticated banks can use internally developed estimates for the inputs used to determine

its capital requirement. The FIRB approach permits a bank to estimate its own PD risk parameter and the

AIRB permits a bank to use internally developed estimates for all four of the parameters used to

determine its credit risk capital requirement.67However, banks cannot predict the future changes in or

volatility of the asset prices.68Even for the smaller banks that used external rating to determine their

required capital benefited from this institutionalized subjectivity as the external rating agencies published

rating were vulnerable to the same subjectivity within the rating firm.69

Another risk that Basel II fails to address is pro-cyclicality. Generally speaking, banking is pro-

cyclical in that when the economy is good risks are underestimated and when the economy is bad risks are

overestimated. The Basel II framework did nothing to counter the effects of pro-cyclical practices within

the banking industry.

70

This failure is compounded by the assertion that the Basel II framework in effect

reduces capital requirements for banks. Impact studies of the effect Basel II on required capital levels

forecasted large capital reductions amongst institutions relative to Basel I. An FDIC report in 2003

(revised in 2004) forecasted that bank capital level would drop considerably under Basel II.71The FDIC

report showed that banks using the most sophisticated method, the AIRB Approach, would be able to

66Wingnall & Atkinson, p. 4




70Wingnall & Atkinson, p. 5-6

71Estimating the Capital Impact of Basel II in the United States, Federal Deposit Insurance Corporation (Revised

August 5, 2004; Original December 8, 2003), available at

http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.html
http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.htmlhttp://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.htmlhttp://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.html


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lower their capital levels by as much as 14%.72Quantitative Impact Studies performed jointly with the

Basel Committee itself showed that Basel II would allow banks to dramatically reduce their capital

levels.73

Pillar 2 is often criticized because the framework reliance on supervisors to predict the future

outcome of banking entities activities in order to assess the real-time adequacy of a banks required

capital buffer and risk management systems is implausible.74Given the pro-cyclical nature of the banking

industry and the misalignment of incentives prevalent prior to the current financial crisis, the Basel II

framework provides little incentive for bank supervisors to sacrifice short-term profitability for future

potential risk mitigation.75Pillar 3 is criticized because it assumes that markets are efficient, in that

markets process all available information rapidly and adjust prices accordingly. However, the history of

the financial markets demonstrates that markets do not possess informational efficiency and therefore the

additional disclosures were ineffective in imposing market discipline on banks.76Even more interesting is

how the Basel II frameworks failure to address these risks contributed to the activities that led to the

current financial recession.

BASEL II & THE GREAT RECESSION

MORTGAGE ASSETS & RISK WEIGHTS

The Basel II risk-weighting scheme arguably made mortgage assets more attractive to banks by

reducing the credit risk weight associated with the assets.77Under the Basel II framework, the capital

72American Banker press release; available at

http://63.240.127.120/article.html?id=2003120878YJ6YND&from=WashRegu73Basel II and the Potential Effect on Insured Institutions in the United States: Results of the Fourth Quantitative

Impact Study 9QIS-4), Federal Deposit Insurance Corporation (Last revised December 6, 2005), available at

http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin05/accounting_news.html74

Wingnall & Atkinson, p. 775



Adrian Blundell-Wignall, Paul Atkinson & Se Hoon Lee, The Current Financial Crisis: Causes and Policy Issues,

Organisation for Economic Co-operation and Development (OECD) Journal: Financial Market Trends (2008)

[hereinafter Wingnall, Atkinson & Lee], p. 5, available athttp://www.oecd.org/dataoecd/47/26/41942872.pdf
http://63.240.127.120/article.html?id=2003120878YJ6YND&from=WashReguhttp://63.240.127.120/article.html?id=2003120878YJ6YND&from=WashReguhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin05/accounting_news.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin05/accounting_news.htmlhttp://www.oecd.org/dataoecd/47/26/41942872.pdfhttp://www.oecd.org/dataoecd/47/26/41942872.pdfhttp://www.oecd.org/dataoecd/47/26/41942872.pdfhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin05/accounting_news.htmlhttp://63.240.127.120/article.html?id=2003120878YJ6YND&from=WashRegu


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charge risk weighting for mortgage assets fell from 50% under Basel I to 35% under the SA and to as

little as 15-20% under the IRB. The lower risk weighting both loweredbanks capital cost for holding

mortgage assets and increasedbanksrate of return on these assets. In order to juice returns and

increase profitability, banks became increasing concentrated in mortgage assets.78Banks were able to

accelerate the return on these low-risk-weighted mortgage assets by securitizing and distributing them,

therefore incentivizing the originate and distribute banking model versus the originate and hold

model.79The securitization of these assets fed this virtuous circle of credit risk allocation by freeing up

capital on banksbalance sheets and allowing them to purchase even more mortgage assets that could be

securitized and distributed.

The bank run on and nationalization of Northern Rock, a bank in the UK, demonstrate the impact and

risk-exploitation incentives of the Basel II risk-weighting framework. During the ten year period from

1997 to 2006, Northern Rock dramatically increased the assets on its balance sheet more than six-fold

from 15.8 billion to 101 billion.80The rapid increase in the institutions asset base was comprised

largely of residential mortgage loans: by the end of 2006, 89.2% of Northern Rocks assets were

residential mortgages.81Comparatively, during this time the retail deposit base for Northern Rock grew

from 9.9 billion in 1997 to 22.6 billion by the end of 2006.82In order to fund this growth, Northern

Rock adopted an originate to distribute business model, originating residential mortgages for the sole

purpose of securitizing the mortgage assets and distributing them to the market place. The funds

generated by the securitization process accounted for roughly 50% of the firms overall funding.83

78Wingnall, Atkinson & Lee, p. 5-679

Michael Pomerleano, The Basel II Concept Leads to a False Sense of Security, commentary; VoxEU Debate on

the Global Crisis (February 5, 2010), available athttp://www.voxeu.org/index.php?q=node/456180

The Run on the Rock, House of Commons Treasury Committee, Fifth Report of Session 2007-2008, Volume I

(January 2008) [hereinafter House of Commons Treasury Committee], para. 12, available at

http://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdf81

House of Commons Treasury Committee, para 1382

House of Commons Treasury Committee, para 1783

House of Commons Treasury Committee, para. 15
http://www.voxeu.org/index.php?q=node/4561http://www.voxeu.org/index.php?q=node/4561http://www.voxeu.org/index.php?q=node/4561http://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdfhttp://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdfhttp://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdfhttp://www.voxeu.org/index.php?q=node/4561


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During this period of growth, the Basel II framework served to give Northern Rocks management a

false sense of security. As a result of transitioning to Basel II, Northern Rock was permitted to use the

AIRB approach to calculate its credit risk capital requirement.84Northern Rocks decision to use the

AIRB approach impacted the firm in two profound ways.

First, the lower risk-weighting scheme under Basel II helped to free-up capital on the Northern

Rocks balance sheet. While testifying before the UK Treasury in the aftermath of the firm being

nationalized, the Northern Rock CEO said that when you get your Basel II approval, the relative risk

weighting of certain assets in your balance sheet changes. So what we had ... was you saw our risk

weighting for residential mortgages come down from 50% t0 15%. That clearly required less capital

behind it.85The lower risk-weighting for residential mortgages allowed Northern Rock to dramatically

increase it residential loan portfolio with an alarming small amount of capital underpinning it.

Second, the Basel II framework hid the weakening quality of Northern Rocks loan assets. During the

expansion of Northern Rocks assets, the quality of loans in Northern Rocks portfolio was called into

question.86The CEO of Northern Rock defended the firm from these accusations and was cited as saying

that analysis undertaken as part of the Basel II process had shown that Northern Rocks last 18 months

lending is actually better quality than the previous two to three years.87Soon after the CEO made this

statement, there was a run on Northern Rock and the bank was nationalized. As in the case of Northern

Rock, the risk-weighting scheme of the Basel II framework distorted banks perception of risk and

enabled them to take on increasing amounts of risk without maintaining the appropriate amount of capital

to serve as buffer for the risk.

REGULATORY ARBITRAGE

84House of Commons Treasury Committee, para. 43





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Basel II created an incentive for banks to pursue regulatory arbitrage in order to increase profitability.

Basel II incentivized regulatory arbitrage through the use of securitizations designed to produce lower

regulatory capital charges.88Banks accomplished this by pooling assets with higher risk-weightings and

structuring the pools into collateralized debt obligations (CDOs) through the use of special-purpose

vehicles. All but the most junior tranches of these CDOs would receive investment grade rating from

external rating agencies and the more senior tranches would be sold to investors or to other banks. The net

effect of the securitization process was that banks had effectively reduced the amount of higher risk-

weighted assets on their balance sheets, and in some instances replaced these assets with investment grade

securitized assets that had lower risk-weightings, and lowered their required capital.89In this respect, the

Basel regulatory framework created an incentive for increased securitization activity, even if it was not

the primary motivation for the securitizations.

Banks also used credit default swaps (CDS) to execute regulatory arbitrage.90The Basel I framework

accepted only cash and government securities as collateral that could be used for risk mitigation purposes

in order to reduce a banks required capital charge. Under Basel II, the acceptable forms of collateral

expanded to include credit derivatives like credit default swaps.91Basel IIs expanded risk mitigation

measures permitted banks to lower the risk-weighting for their riskier assets by hedging them with credit

derivatives such as credit default swaps. Perhaps the most infamous perpetrator of this practice was AIG.

In its 2007 10-K, AIG stated that it held $527 billion in notional exposure in a super senior credit default

swap portfolio and that of the stated exposure, $379 represents derivatives written for financial

institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather

88Kevin Dowd, Martin Hutchinson, Simon Ashby & Jimi M. Hinchliffe, Capital Inadequacies: The Dismal Failure of

the Basel Regime of Bank Capital Regulation, Policy Analysis No. 681, Cato Institute (July 29, 2011) *hereinafter

Dowd, Hutchinson, Ashby & Hinchliffe] , p3, available athttp://www.cato.org/pubs/pas/pa681.pdf89

Dowd, Hutchinson, Ashby & Hinchliffe, p. 2390

Sam Jones, AIG and an overlevered Europe?, Financial Times, Alphaville blog site, Oct. 01, 2008, available at

http://ftalphaville.ft.com/blog/2008/10/01/16559/aig-and-an-overlevered-europe/?source=rss91

Bankers Guide, p. 10
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than risk mitigation.92Because AIG was highly rated during the heyday of the derivatives market

activity, AIG did not have to post collateral on its credit default exposure and simply pocketed the stream

of insurance premiums paid to it be these institutions.

FUTURE OF CAPITAL MARKET REGULATION

The prominent role the banking industry played in the cause and aftermath of the financial crisis

drew the ire of the public and of government officials. In the immediate aftermath of the financial crisis,

new laws and regulations were passed with the expressed intent of curbing the dangerous risk-taking

activities of financial institutions. Of the new laws and regulations passed, two of the most prominent are

Basel III and the Dodd-Frank Act. The application of Basel III is global in scope and seeks to build upon

the Basel II framework while addressing many of the problems inherent in Basel II. In contrast, the Dodd-

Frank Act is US legislation that is global in its impact, if not in scope, and unprecedented in the amount

or power it grants the government over financial institutions.

BASEL III

In the aftermath of the financial crisis, the Basel Committee submitted and passed numerous

proposals, collectively called Basel 2.5.93The committee made additional changes to the Basel framework

that, in conjunction with the Basel 2.5 proposals, compromise Basel III. Basel III incorporates numerous

changes born from the lessons learned during the financial crisis. The Basel III framework attempts to

further promote the stability of the banking industry by requiring banks to hold more capital to serve as

buffer to shocks, imposed liquidity standards intended to help banks survive runs on the banking system,

and established leverage ratios intended to ensure banks do not become overly leveraged.94However, the

92AIG Form 10-K 2007 Annual Report, p. 122, available at

http://www.ezodproxy.com/AIG/2008/AR2007/images/AIG_10K2007.pdf.93

Proposed Enhancement to Basel II Framework, Bank for International Settlements (BIS), January 2009, available

athttp://www.bis.org/publ/bcbs150.htm94

Basel Committee Releases Final Text of Basel III Framework, Mayer Brown Legal Update (January 7, 2011)

[hereinafter Mayer Brown Legal Update], p. 1-2, available at

http://www.mayerbrown.com/publications/article.asp?id=10235
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requirements of Basel III may be overly onerous or beyond the capacity of banks in the current

recessionary environment. As recently as April of 2012, the Bank of International Settlements (BIS)

stated that banks are still falling far short of the capital and liquidity targets established by the new

regulation.95

Capital Requirements

One important aspect of Basel III is that is requires banks to hold more capital to serve as a buffer in

the event of shocks to the banking sector. Basel III increases the minimum level of core Tier 1 capital,

composed of common equity that banks must hold, from 2% to 4.5%. The framework also requires that

banks maintain a minimum total Tier 1 capital level of 6%.

96

These increases will be phased in 2013. The

new framework also requires larger banks to hold an additional Tier 1 conservation buffer of 2.5%. The

requirement for increase will be phased in beginning in 2016. In sum, Basel III increases the minimum

total capital, comprised of Tier 1 and Tier 2 capital, to 10.5%, including 2.5% buffer, from 8% under

Basel II.97Moreover, if a bank does not maintain the capital conservation buffer, the bank may continue

its normal banking operations but may not use a specified percentage of its earnings for dividends, share

buy-backs, other payments and distributions on Tier 1 capital instruments, or discretionary bonuses.

98

Certain countries which headquarter banks that have asset balances larger than the countries respective

GDP, and therefore the country cannot afford to bail out the bank in the event of another financial crisis,

95Geoffrey T. Smith, BIS Says Banks Still Fail to Hit Basel III Targets, The Wall Street Journal(pay wall), April 12,

2012, available at

http://online.wsj.com/article/SB10001424052702304444604577339831399445486.html?mod=googlenews_wsj 96Basel III: Issues and Implications, KPMG LLP (2011) [hereinafter KPMG-Basel III Framework], p. 9, available at

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/basell-III-issues-

implications.pdf97

Bank of International Settlements, Basel III: A Global Regulatory Framework for More Resilient Banks and

Banking System, Basel Committee on Banking Supervision (December 2010; revised June 2011) [hereinafter BIS-

Basel III], para. 129, available athttp://www.bis.org/publ/bcbs189.pdf.See also KPMG-Basel III Framework, p. 9.98

Basel III: A New Environment for International Banks, Latham & Watkins Client Alert Memorandum No. 1138

(February 3, 2011) [hereinafter Latham & Watkins Client Alert No. 1138], p. 5, available at

http://www.lw.com/search?searchText=basel+III
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have imposed total capital requirements much higher than the minimum requirement outlined in Basel

III.99

Basel III imposes another capital requirement intended to directly counter one flaw of the Basel II

framework: pro-cyclicality. The Basel III framework includes a counter-cyclical capital buffer that is

intended to further strengthen a banks capital position when accelerating credit growth is deemed to pose

a system-wide risk in the macro-financial environment.100Depending on the level of systemic risk

present, the counter-cyclical buffer can range from 0-2.5% of risk-weighted assets.101This requirement

will be phased in commencing 2016. Additionally, the countercyclical buffer must be met entirely by Tier

1 common equity, although the Committee is considering whether other fully loss-absorbing capital may

qualify. As with the capital conservation buffer, if and as long as the countercyclical capital buffer is not

met, a bank may continue its normal banking operations but may not use a specified percentage of its

earnings for dividends, share buy-backs, other payments and distributions on Tier 1 capital instruments,

and discretionary bonuses.102

Liquidity Requirements

The Basel III framework includes two minimum liquidity standards designed to counter the liquidity

risk that was realized during and greatly contributed to the financial crisis. The Liquidity Coverage Ratio

(LCR) is a metric that promotes short-term resilience of a banks liquidity risk profile by requiring banks

to maintain unencumbered high-quality assets sufficient to meet at least 100% of net cash requirements

over a 30-day stress test period.103The scenarios for the 30-day stress testing period includes run-off of a

proportion of retail deposits, a stipulated partial or loss of unsecured wholesale funding capacity, a

stipulated partial loss of secured short-term funding with certain collateral and counterparties, additional

99Rachel Wolcott, Feds Capital Proposal Not as Tough as Feared, May Give US Banks Advantage, Reuters,

Financial Regulatory Forum blog site, December 22, 2011, available athttp://blogs.reuters.com/financial-

regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/100

BIS-Basel III, para 137101


Latham & Watkins Client Alert No. 1138, p. 9103

http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/http://blogs.reuters.com/financial-regulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/


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contractual outflows arising from a presumed downgrade in the banks public credit rating of up to and

including three notches, additional collateral posting requirements under derivatives, unscheduled draws

on committed but unused credit and liquidity facilities, and a stipulated buy back of debt or honoring of

non-contractual obligations to mitigate reputational risk.104As can be seem, the intent of the ratio is to

force banks to prepare for scenarios that were unimaginable prior to the financial crisis.

Similar to the LCR, the Net Stable Funding Raito (NSFR) promotes liquidity over the one-year time

horizon by creating additional incentives for a bank to fund its operations with more stable sources of

funding.105To that end, a banks Available Stable Funding (ASF) must equal or exceed its Required

Stable Funding (RSF).106The ASF equals a banks stock of regulatory capital, composed of both Tier 1

and Tier 2 after deductions, together with certain additional assets subject to haircuts and limited

applicability.107The RSF equals the sum of the assets held by a bank and the off-balance sheet

commitments of the bank, multiplied by the relevant RSF factor. For example, unencumbered cash and

money market instruments, unencumbered securities with effective remaining maturities of less than one

year, and unencumbered loans to financial institutions that are not renewable or for which lender has an

irrevocable call right, all will have a 0% RSF factor, meaning that they do not form part of abanks

Required Stable Funding. In contrast, unencumbered loans to retail and small business customers with

residual maturity of less than one year will have an 85 percent RSF and all balance sheet items not

otherwise assigned an RSF factor will have a 100% RSF factor.108

Leverage Ratio

Basel III also establishes a minimum leverage ratio intended to prevent financial institutions from

building-up excessive on- and off-balance-sheet leverage similar to the amount of leverage that

104Latham & Watkins Client Alert No. 1138, p. 11-12

105BIS-Basel III, para 38

106Latham & Watkins Client Alert No. 1138, p. 12




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exacerbated the financial crisis. The leverage ratio is not risk-based because it is intended to reinforce and

serve as a backstop to the frameworks general risk-weighting scheme.109During the initial phasing in

of Basel III, the framework requires that banks maintain a Tier 1 leverage ratio of 3%.110In effect, this

means that a banks total assets, both on- and off-balance-sheet, should never by more than 33x the

banks capital. However, the combination of a lack of risk weighting for these assets and a limitation on

the leverage the bank can employ may incentivize banks to pursue high-risk/high-return strategies in

order to generate requisite levels of returns in the absence of leveraged returns.111

Impact on Securitizations

The Basel III framework impacts the securitization market in numerous ways. For example, the Basel

III framework significantly increases the risk weights applied to re-securitization exposures under both

the Standardised Approach and Internal Ratings Based approaches to better reflect the inherent risks in

these positions.112As a result of the higher risk-weighting, the capital requirements for these positions

have risen dramatically.113Additionally, the liquidity requirements imposed under the new framework

will limit future demand for securitized products by the banking sector. Under Basel III, securitizations

are considered 100% illiquid assets and therefore are not included amongst the high-quality liquid assets

used to calculate the Basel III liquidity ratios.114Because Basel III regulations exclude asset-backed

securities (ABS) from the list of securities eligible for meeting the proposed LCR and NSFR, banks will

be forced to shift their demand for securitized assets from ABS to assets with lower risk weightings that

109BIS-Basel III site, para 151

110BIS-Basel III, para 154

111KPMG-Basel III Framework, p. 10

112Bank for International Settlements, Report on Asset Securitisation Incentives, Basel Committee on Banking

Supervision (July 2011) [hereinafter Basel Securitization Incentives], p. 24, available at

http://www.bis.org/publ/joint26.pdf113

Basel Securitization Incentives, p. 24114

Basel Securitization Incentives, p. 24
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can be used to satisfy these liquidity requirements.115This shift in asset allocation by large banking

institutions may adversely impact the securitization market because banks will not be able to pursue

securitization to the same extent they did prior to the new Basel III framework.116

Criticisms

Despite these improvements, the Basel III framework still elicits criticism for neither addressing some

of flaws in the Basel II framework nor remedying the structural issues that are sowing the seeds of the

next financial crisis.

One major criticism of the Basel III framework is that is maintains the same risk-weights as Basel II

for most bank assets. This decision has drawn significant criticism because the low risk weights in Basel

II contributed to banksdecision to engage in and securitize assets, such as mortgage loans, that

represented greater risk than the Basel II framework assigned to the asset by means its assigned risk-

weighting.117The failure to match an assets risk-weight to the assetstrue inherent risk will continue to

incentivize a bank to increase its concentration in that asset because the potential reward still outweighs

the risk.118As was seen with the Basel II and the practices that contributed to the current financial crisis,

the unjustifiably low risk weighting allows that bank to gain funding at a cost that is lower than its true

cost of capital.119Basel III will likely continue to incentive such herd behavior amongst banks. One

often cited example is the LCR and how it incentivizes concentration in government bonds of highly rated

115Hans J. Blommestein, Ahmet Keskinler & Carrick Lucas, Outlook for the Securitisation Market, Volume 2011 -

Issue 1 Organisation for Economic Co-operation and Development (OECD) Journal: Financial Market Trends (2011),

[hereinafter Blommestein et al.], p. 9, available athttp://www.oecd.org/dataoecd/36/44/48620405.pdf116

Barua et al., p. 12117

N.M., Third Times the Charm?, The Economist, Free Exchange blog site, September 13, 2010, available at

http://www.economist.com/blogs/freeexchange/2010/09/basel_iii118

Wingnall, Atkinson & Lee, p. 16119

Robert C. Pozen, Risk-Weighting of MBS and Soveriegn Debt Under Financial Regulations, The Brookings

Institution (December 5, 2011), available at

http://www.brookings.edu/opinions/2011/1206_sovereign_debt_pozen.aspx
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governments.120In truth, banks are already demonstrating this behavior as they begin to comply with the

Basel III requirements.121

Another criticism of Basel III, and financial regulation at large, is the degree of influence banking

institutions have on the regulatory formation process and the decision markers within the regulatory

agencies. Financial institutions have arguably accomplished this regulatory capture in several ways.

During the previous couple of decades, senior personnel from the financial services industry increasingly

filled powerful positions within the US government, leading to increasing deregulation of the financial

industry that coincided with increased profitability and wages amongst financial services personnel.122

This allowed financial institutions to hire the best and the brightest as well as consistently deploy more

resources in outmaneuvering regulators.

Additionally, the wealth generated within the private sector increasing appealed to and drew talent

from the public sector, further blurring the lines between the financial institutions and the persons that

were tasked with regulating them.123Financial institutions promulgated the ethics of and captured the

middle class imagination with capitalism and free markets. The virtues of capitalism and the perception

that hard work and elbow grease are the key ingredients to success fostered the acceptance of

capitalism.124This mantra convinced the public that it was okay to systematically deregulate the financial

services industry and, in some instances, to not regulate financial innovation at all.125This unquestioning

belief in the ideals of capitalism and free markets empowered financial institutions and their advocates to

120Rustom Barua et al., Basel III: Whats New? Business and Technological Challenges, Algorithmics, an IBM

Company (September 17, 2010) [hereafter Barua et al.], p. 14, available at

http://www.algorithmics.com/en/media/pdfs/algo-wp0910-lr-basel3-exd.pdf121John Carney, Jamie Dimon Confirms Worst Fears About Basel III, CNBC, January 13, 2012, available at

http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_III122

Simon Johnson, The Quiet Coup, The Atlantic, May 2009, available at

http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/2/123

Simon Johnson, The Atlantic, May 2009124

Luigi Zingales, Capitalism After the Crisis, National AffairsIssue No. 1, Fall 2009, available at

http://www.nationalaffairs.com/publications/detail/capitalism-after-the-crisis125

Peter S. Goodman, Taking a Hard Look at a Greenspan Legacy, TheNew York Times, October 8, 2008, available

athttp://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=all
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counter attempts to regulate their activity by claiming that increased regulation would restrict the free

market.126

DODD-FRANK WALL STREET REFORM ACT

President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection

Act (Dodd-Frank) into lawon July 21, 2010.127Dodd-Frank contains numerous new financial

regulations and even created several new federal regulatory agencies. Two of the more pertinent new

regulations outlined in Dodd-Frank are the new rules pertaining to credit rating agencies and the risk

retention rules for securitizations.

Credit Rating Agencies

Credit rating agencies endured a lot of public outrage for their alleged role in the cause and

aftermath of the financial crisis. In accordance with the Basel II regulations, the three biggest agencies

that compromise the Nationally Recognized Statistical Rating OrganizationsS&P, Moodys and Fitch

were blamed for providing inflated ratings to the securitized assets issued by banks in order to generate

business from these banks.128Little attention was paid to the inherent conflict of interest inherent in the

rating agencies relationship with these banking institutions.129Rightly or wrongly, many investors based

their investment decisions on the rating issued by these agencies due to the government sanctioned role

they played in the financial system. When the housing bubble burst, these same agencies were force to

126Alan Fram, Financial Reform: Republicans Fight To Dilute Wall Street Regulations, The Huffington Post, July 5,

2011, available athttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-

warren_n_890090.html127The Dodd-Frank Reform Act: Implications for Energy Companies, Utilities and Other Over-the-Counter Market

Participants, Accenture (2011) *hereinafter Accenture-Dodd Frank], p. 3, available at

http://www.accenture.com/us-en/landing-pages/management-consulting/risk-

management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdf128

James Surowiecki, Ratings Downgrade, The New Yorker September 28, 2009, available at

http://www.newyorker.com/talk/financial/2009/09/28/090928ta_talk_surowiecki129

Rupert Neate, Ratings Agencies Suffer Conflict of Interest, says Former Moodys Boss, The Guardian[UK],

August 22, 2011, available athttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-

interest
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downgrade the inflated rating they provided to many of these MBS and ABS they rated prior to the

financial crisis.130

In response to the public outcry about the rating agencies role in the financial crisis, Dodd-Frank

includes reforms that address the objectivity of both rating agencies and their ratings. Dodd-Frank takes

steps to improve the corporate governance of the conflicts of interest inherent to the rating agencies. For

example, the act requires rating agencies to submit annual compliance reports to the SEC, maintain an

independent board of directors, empowers the SEC to adopt rules to reduce conflicts of interest by placing

restrictions on the ability of rating agencies to provide services other than credit ratings, and permits the

SEC to suspend or revoke a rating agencys registration for rating particular classes of securities for

failing to satisfy certain requirements.131In addition to corporate governance issues, the act attempts to

increase the transparency of these agencies rating methodology as well.

The act requires rating agencies to use a standardized form to publicly disclose their rating

methodology. Moreover, to facilitate comparison among rating agencies, each agency will be required to

periodically disclose information about the historical accuracy of its prior credit ratings.132The act also

authorizes the SEC to establish mechanisms to change how rating agencies are selected by banks, in order

to prevent rating-shopping by issuing banks.133Perhaps the biggest reform emplaced by Dodd-Frank is

that it rescinds the liability exemptionpreviously afforded to these rating agencies for the accuracy and

objectivity their ratings.134Prior to Dodd-Frank, rating agencies effectively defended their ratings on

constitutional grounds, arguing that the rating they issue are purely the rating agencys opinion and are

130Rachelle Younglai & Sarah N. Lynch, Credit Rating Agencies TriggeredFinancial Crisis, US Congressional Report

Finds, The Huffington Post, June 13, 2011, available athttp://www.huffingtonpost.com/2011/04/13/credit-rating-

agencies-triggered-crisis-report_n_848944.html131

Gregory A. Fernicola and Joshua B. Goldstein, Credit Rating Agencies , Skadden, Arps, Slate, Meagher& Flom

LLP & Affiliates, Commentary on the Dodd-Frank Act(July 9, 2010) [hereinafter Skadden Credit Rating Agencies

Commentary], available athttp://www.skadden.com/Index.cfm?contentID=51&itemID=2135132

Skadden Credit Rating Agencies Commentary133


Skadden Credit Rating Agencies Commentary
http://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.htmlhttp://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.htmlhttp://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.htmlhttp://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.htmlhttp://www.skadden.com/Index.cfm?contentID=51&itemID=2135http://www.skadden.com/Index.cfm?contentID=51&itemID=2135http://www.skadden.com/Index.cfm?contentID=51&itemID=2135http://www.skadden.com/Index.cfm?contentID=51&itemID=2135http://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.htmlhttp://www.huffingtonpost.com/2011/04/13/credit-rating-agencies-triggered-crisis-report_n_848944.html


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protected by the First Amendment.135However, Dodd-Frank removes this exemption, exposes rating

agencies to liability of the rating agency consent to the inclusion of their credit rating in an issuance

registration statement and permits civil remedies for plaintiffs against rating agencies.136

Securitization Risk Retention and Disclosure

Dodd-Frank also addresses another major aspect of the Basel II and the financial crisis: risk

retention by banks for securitized assets. Under Basel II, banking institutions could purchase assets, such

as loans, securitize these assets for sale and remove the riskiness of the loans from their balance sheets

through the securitization process.137Under Dodd-Frank, the entity that securitizes such assets must retain

no less than 5% of the credit risk in the assets is sells into securitization, unless the assets meet certain

specific exempting requirements.138The entity can accomplish the risk retention using the following five

options: 1) a vertical slice option; 2) a horizontal slice option; 3) a horizontal cash reserve fund; 4) an L

shaped option combining aspects of both the vertical and horizontal option; and 5) a representative

sample.139Each option requires specific disclosures associated.

Additionally, the Act prohibits the hedging or transferring of the retained credit risk, though

certain exemptions are provided for adjusting the amount of risk retained or the hedging of the retained

risk.140The Act also increases the level of disclosure required of institutions that issue securitized assets.

At a minimum, the issuers of asset backed securities are required to disclose asset-level or loan-level data,

135Jonathan Stempel, Five Ohio Pension Funds Say Lost $457 mln On Bad Ratings, Reuters, September 27, 2011,

available athttp://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927136


Yener Altunbas, Leonardo Gambacorta & David Marques, Securitisation and the Bank Lending Channel,

European Central Bank Working Paper Series No. 838 (December 2007), p. 13, available at

http://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdf138

Andrew M. Faulkner, Richard F. Kadlick & David H. Midvidy, Securitization , Skadden, Arps, Slate, Meagher&

Flom LLP & Affiliates, Commentary on the Dodd-Frank Act(July 9, 2010) [hereinafter Skadden Securitization

Commentary], available athttp://www.skadden.com/Index.cfm?contentID=51&itemID=2131139

Overview of the Proposed Credit Risk Retention Rules for Securitizations, Mayer Brown (April 8, 2011)

[hereinafter Mayer Brown Risk Retention Overview], p. 5, available at

http://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-

0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDF 140

Skadden Securitization Commentary
http://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927http://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927http://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927http://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdfhttp://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdfhttp://www.skadden.com/Index.cfm?contentID=51&itemID=2131http://www.skadden.com/Index.cfm?contentID=51&itemID=2131http://www.skadden.com/Index.cfm?contentID=51&itemID=2131http://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDFhttp://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDFhttp://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDFhttp://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDFhttp://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d-0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDFhttp://www.skadden.com/Index.cfm?contentID=51&itemID=2131http://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdfhttp://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927


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to include the identity of brokers or originators of the assets, compensation for the brokers and originators

and the amount of risk retained by the originator or securitizing entity.141

The impact of this requirement on the securitization market is two-sided. One the one hand, this

requirement will adversely impact the securitization market by increasing both the administrative and the

capital cost for originators and the due diligence burden for both investors and issuers.142These increased

costs, which are generally seen as unnecessary costs imposed by government intervention in the

securitization market, will also affect the average consumer by driving up the cost of consumer credit.143

On the other hand, this requirement may impact the securitization market in positive way by reducing

the risk of financial instability arising from incentive misalignment and informational

asymmetries between the investor and the earlier securitization supply chain participants.144The

combination of risk retention and increased disclosure requirements may improve the quality of

loans used to fuel the securitization market because participants will be forced to internalize the

costs of poor underwriting.145

CONCLUSION:

The global economy is still reeling from the effects of the financial crisis. Regulatory authorities,

motivated by public outrage and their failure to foresee or prevent the crisis, have learned from their past

mistakes and are enacting laws intended to prevent another such crisis. Basel III attempts to better capture

the risks associated with certain asset classes and to curtail risk-taking behavior of banking institutions.

141Skadden Securitization Commentary

142Blommestein et al., p. 9

143Mayer Brown Risk Retention Overview, p. 32

144Timothy F. Geithner, Microeconomics Effects of Risk Retention Requirements, Financial Stability Oversight

Council (January 2011) [hereinafter Geithner-Risk Retention Requirement], p. 16, available at

http://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FIN

AL).pdf145

Geithner-Risk Retention Requirements, p. 16
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Similarly Dodd-Frank seeks to address the misalignment of incentives of influential credit rating agencies

and of the participants in the securitization market.

However, banking institutions are pushing back against these proposed laws and regulations.

Specifically, these institutions are pushing back against increased capital requirements and constraints on

leverage.146These constitutions also claim that Basel III static risk-weighting scale does not solve the

problem.147Additionally, influential international banking entities are seeking to mitigate the impact of

laws such as Dodd-Frank by divesting themselves of operations such as proprietary trading.148Despite the

on-going struggle between banking institutions and the entities that seek to regulate them, the only thing

that is clear is that the public perception of and trust in banks and these entities have suffered irreparable

harm as a result of the financial crisis.149As of yet, it is still unclear how this lack of trust and

dissatisfaction will impact the future of the banking industry and banking regulation.

146Matt Egan, Looming Rules Pressure Big Banks, Fox Business News, January 3, 2012, available at

http://www.foxbusiness.com/industries/2011/12/29/looming-rules-pressure-big-bank-business-model/147

John Carney, Jamie Dimon Confirms Worst Fears About Basel III, CNBC, January 13, 2012, available at

http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_III148

Suzy Khimm, Banks Preemptive Strike Against Dodd -Frank, The Washington Post, March 23, 2012 (revised

March 24, 2012), available athttp://www.washingtonpost.com/business/economy/banks-preemptive-strike-

against-dodd-frank/2012/03/23/gIQATnUmWS_story.html149

Claes Bell, Bank CEO Blasts Banking Industry, Bankrate.com blog site, April 10, 2012, available at

http://www.bankrate.com/financing/banking/bank-ceo-blasts-banking-industry/
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