LO 59.8: Explain the major changes to the US financial market regulations as a result of Dodd-Frank.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was signed into law in July 2010. The act is intended to protect consumers from abuses and prevent future bailouts and/or collapses of banks and other financial firms. Dodd-Frank has several provisions aimed at regulating banks. Some of the major changes include: The establishment of the Financial Stability Oversight Council (FSOC). The job of the FSOC is to look out for risks that affect the entire financial system. The body monitors systemic risks.
The establishment of the Office of Financial Research (OFR). The OFR conducts
research on the state of the economy and it, along with the FSOC, identifies risks to the financial stability of the United States. The bodies seek to maintain investor confidence and promote market discipline.
The FSOC and the OFR are charged with identifying systemically important financial institutions (SIFIs). SIFIs must establish living wills that map out how the firm can be safely wound down in the event of failure. Banks that are considered too-big-to-fail must be identified and could be broken up under Dodd-Frank if their living wills are judged unacceptable. The FSOC can impose extra capital requirements on SIFIs. In the United States, a bank with more than $50 billion in assets qualifies as a SIFI. The definition is less clear for non-banks.
The elimination of the Office of Thrift Supervision, a former supervisory body that
regulated savings and loan institutions.
The expansion of the Federal Deposit Insurance Corporations (FDICs) powers to
liquidate banks. For example, the FDIC is allowed to take over large firms that are failing and sell their assets, even at a loss to shareholders and creditors. The financial industry, not taxpayers, should bear the costs of failures.
Permanently increasing the FDIC deposit insurance limit from $100,000 to $250,000. Greater reporting requirements for large hedge funds and similar firms. These firms must
now register with the SEC.
The establishment of Federal Insurance Office that will work with state insurance
regulators and monitor the insurance industry.
The establishment of the Volcker Rule, intended to curtail proprietary trading by
institutions (like banks) that accept insured deposits as a source of funding. One of the problems with this rule is that it can be difficult to distinguish between a banks speculative trading and hedging activities.
The requirement that some financial firms spin off high-risk trading operations into
separately capitalized subsidiaries.
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Increased regulation and improved transparency of over-the-counter (OTC) derivatives including requiring standardized OTC derivatives be cleared by exchanges or by central clearing parties (CCPs). To facilitate OTC trading, swap execution facilities (SEFs) were mandated. The Commodity Futures Trading Commission (CFTC) was given responsibility to monitor CCPs and SEFs. A trade repository of all derivatives transactions will be established, improving transparency. A new Legal Entity Identifier (LEI) system will be created to assist with this goal. An LEI is a reference code that identifies a legally distinct entity engaging in a financial transaction. The Federal Reserve must set risk management standards for systemically important financial institutions engaged in clearing, settlement, and payment functions. The requirement that rating agencies be more transparent in their assumptions and methods used to rate firms. An Office of Credit Ratings was created to monitor rating agencies. The potential legal liabilities of rating agencies were also increased under Dodd- Frank. The use of external credit ratings in the regulation of banks and other financial institutions was banned. This is in direct conflict with the Basel Committee, which uses external credit ratings to set some capital requirements. Individual protections were increased, both for investors and consumers. The Bureau of Financial Protection was created within the Federal Reserve to ensure that consumers understand loan applications and terms for things like mortgages and credit cards. The goal is that consumers receive clear and accurate information when they shop for financial products and services. Firms are required, with some exceptions, to keep a minimum of 5% of the assets they securitize. Changes in compensation. Compensation packages that encourage short-term performance goals that may lead to increased risk taking are discouraged. Shareholders were given a non-binding vote on executive compensation packages. Board compensation committees must be made up of independent directors. Banks are required to assess a mortgage borrowers ability to repay. Foreclosures may be disallowed if a bank does not make a good faith effort to determine that the borrower can repay the loan. At least one board member should have risk management experience at large, complex organizations.
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K e y C o n c e p t s
LO 59.1 Basel II. 5 requires banks to calculate two market risk VaRs. The first is the usual VaR required in Basel II, using the historical simulation method. The second is a stressed VaR, using a 250-day period of stressed market conditions. To calculate the stressed VaR, banks must identify a one-year period when their portfolios performed poorly. The total market risk capital charge is the sum of the usual bank VaR and the stressed VaR.
LO 59.2 The Basel Committee proposed an incremental default risk charge (IDRC) in 2005 to correct for the fact that the banking book was attracting more capital than the trading book in most banks. For instruments in the trading book that are sensitive to default risk, the IDRC requires the bank to calculate a 99.9% confidence level, one-year time horizon VaR. This was altered to account for ratings change sensitivities in addition to default sensitivities following the 20072009 financial crisis and became known as the incremental risk charge (IRC). Banks must estimate a liquidity horizon for each instrument and rebalance the portfolio if credit quality declines.
LO 59.3 The comprehensive risk measure (CRM) accounts for risks in the correlation book. Asset-backed securities (ABS) and collateralized debt obligations (CDOs) are sensitive to the default risk of other assets. For example, they are sensitive to the default risk of the securitized assets that collateralize the instruments. The committee has specified a standardized approach to assign capital charges for rated instruments. Resecuritizations, such as CD Os of ABSs, have higher risk weights than normal securitizations, such as mortgage-backed securities. For unrated instruments or instruments rated below BB, the bank must deduct the principal amount of the exposure from capital which is equivalent to a 100% capital charge.
LO 59.4 Basel III increased capital requirements for credit risk and tightened the definition of what qualifies as Tier 1 and Tier 2 capital. Basel III eliminated Tier 3 capital. Under Basel III, a banks total capital consists of Tier 1 equity capital (primarily common stock plus retained earnings), additional Tier 1 capital (primarily non-cumulative perpetual preferred), and Tier 2 capital (primarily debt subordinated to depositors with an original maturity of at least five years). By January 1, 2015, Tier 1 equity capital must be at least 4.5% of risk-weighted assets, total Tier 1 capital must be 6% of risk-weighted assets, and total capital (Tier 1 plus Tier 2) must be at least 8% of risk-weighted assets.
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LO 59.5 The capital conservation buffer protects banks in times of financial distress. Banks are required to build up a buffer of Tier 1 equity capital equal to 2.5% of risk-weighted assets in normal times, which will then be used to cover losses in stress periods. This means that in normal times a bank should have a minimum 7% Tier 1 equity capital ratio. Total Tier 1 capital must be 8.5% of risk-weighted assets and Tier 1 plus Tier 2 capital must be 10.5% of risk-weighted assets in normal periods. Dividend restrictions apply when capital ratios fall below required levels.
Basel III also recommends that banks have a capital buffer to protect against the cyclicality of bank earnings, called the countercyclical buffer. This requirement is left to the discretion of individual country supervisors and can range from 0% to 2.5% of risk-weighted assets.
LO 59.6 One of the primary goals of Basel III is to improve liquidity risk management in financial institutions. Basel III requires banks to meet the following three liquidity ratios: 1. A minimum leverage ratio (capital / total exposure) of 3%. Total exposure includes all items on the balance sheet in their entirety (i.e., not risk-weighted) and some off- balance sheet items, such as loan commitments.
2. A minimum liquidity coverage ratio (high quality liquid assets / net cash outflows in a 30-day period) of 100%. The LCR focuses on the banks ability to weather a 30-day period of reduced/disrupted liquidity.
3. A minimum net stable funding ratio (amount of stable funding / required amount of stable funding) of 100%. The NSFR focuses on the banks ability to manage liquidity over a period of one year.
LO 59.7 Contingent convertible bonds (CoCos) convert to equity automatically when certain conditions are met, usually when the company or bank is experiencing financial stresses. The motivation for banks to issue CoCos is that during normal financial periods, the bonds are debt and thus do not weigh down return on equity (ROE). However, in periods of financial stress, the bonds convert to equity, providing a cushion against loss and preventing insolvency and potentially allowing the bank to avoid a bailout.
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LO 59.8 Dodd-Frank was signed into law in July 2010. The act is intended to protect consumers from abuses and prevent future bailouts and/or collapses of banks and other financial firms. Dodd-Frank has many provisions aimed at regulating banks. Some of the more important provisions are as follows: The establishment of the Financial Stability Oversight Council (FSOC). The job of the
FSOC is to look out for risks that affect the entire financial system.
The establishment of the Office of Financial Research (OFR). The OFR conducts
research on the state of the economy and it, along with the FSOC, identifies risks to the financial stability of the United States.
The FSOC and the OFR are charged with identifying systemically important financial institutions (SIFIs). SIFIs must establish living wills that map out how the firm can be safely wound down in the event of failure. Banks that are considered too-big-to-fail must be identified and could be broken up under Dodd-Frank if their living wills are judged unacceptable. SIFIs may also be required to hold additional capital.
Permanently increasing the FDIC deposit insurance limit from $100,000 to $250,000. The establishment of the Volcker Rule, intended to curtail proprietary trading by banks. The Bureau of Financial Protection was created within the Federal Reserve to ensure that
consumers understand loan applications and terms for things like mortgages and credit cards. The goal is that consumers receive clear and accurate information when they shop for financial products and services. Increased regulation and improved transparency for over-the-counter (OTC) derivatives including requiring standardized OTC derivatives be cleared by exchanges or by central clearing parties (CCPs).
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
C o n c e pt C h e c k e r s
1.
2.
3.
4.
5.
Which of the following statements about a stressed VaR, required under Basel II.5, is correct? A. Basel II.5 has established the year 2008 as the stress period. All banks use data
from 2008 to calculate the stressed VaR.
B. The stressed VaR replaces the normal VaR for the purpose of calculating
capital for credit risks.
C. Market risk capital under Basel II.5 should be at least double that of market risk
capital under Basel II due to the addition of the stressed VaR.
D. The stressed VaR must be calculated using a 99.9% confidence interval.
Banks are required to rebalance their portfolios as the creditworthiness of bonds decline, leading to losses over time but generally not to outright default. This requirement to specify a liquidity horizon for each instrument in the portfolio and rebalance at the end of the liquidity horizon is part of the: A. incremental risk charge calculation. B. net stable funding charge formula. C. countercyclical buffer estimation. D. comprehensive risk measure calculation.
Which form of capital must be adjusted downward to reflect deficits in defined benefit pension plans under Basel III? A. Tier 1 capital. B. Tier 2 capital. C. Tier 3 capital. D. There is no requirement under Basel III to adjust capital downward to reflect
deficits in defined benefit pension plans.
The capital conservation buffer: A. B. can be set between 0.0% and 2.5% of risk-weighted assets, and is at the
is intended to protect banks from the countercyclical nature of bank earnings.
discretion of the regulators in individual countries.
C. causes the Tier 1 equity capital ratio requirement to increase to 7% of risk-
weighted assets in normal economic periods.
D. requires that total capital to risk-weighted assets must be 10.5% at all times.
Highlands Bank has estimated stable funding in the bank to be $100 million. The bank estimates that net cash outflows over the coming 30 days will be $137 million. The bank has capital of $5 million and a total exposure of $140 million. The bank estimates that it has high-quality liquid assets of $125 million. What is the banks liquidity coverage ratio (LCR) ? A. 89.3%. B. 91.2%. C. 73.0%. D. 3.6%.
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Co n c e pt Ch e c k e r A n sw e r s
1. C Basel II.5 required banks to calculate two VaRs, the usual VaR, using the historical
simulation method, and a stressed VaR, using a 99% confidence level, 250-day period of stressed market conditions. The total market risk capital charge is the sum of the usual bank VaR and the stressed VaR. Initially, regulators thought the year 2008 would be ideal for stressed market conditions. However, banks are now required to identify a one-year period when their portfolios performed poorly. This means the stressed period may be different across banks.
2. A As part of the incremental risk charge (IRC) calculation, banks are required to estimate a liquidity horizon for each instrument in the portfolio. For example, assume an AA+-rated bond in the portfolio has a liquidity horizon of three months. If, at the end of three months, the bond has defaulted or has been downgraded, it is assumed that the bank will replace the bond with an AA+-rated bond comparable to the one held at the start of the period. This rebalancing is assumed at the end of each three-month period (or six months, nine months, etc., depending on the estimated liquidity horizon). Rebalancing allows banks to take losses as instruments are downgraded but generally allows the bank to avoid defaults.
3. A Tier 1 includes common equity including retained earnings (called Tier 1 equity capital or Tier 1 common capital) and non-cumulative perpetual preferred stock (additional Tier 1 capital, part of total Tier 1 capital). Tier 1 capital does not include goodwill, deferred tax assets, changes in retained earnings arising from securitized transactions, or changes in retained earnings arising from the banks credit risk. Tier 1 capital is adjusted downward to reflect defined benefit pension plan deficits (but is not adjusted upward for surpluses). Tier 2 or supplementary capital includes debt subordinated to depositors with an original maturity of five years or more. Tier 3 capital was eliminated under Basel III.
4. C The capital conservation buffer is meant to protect banks in times of financial distress. Banks are required to build up a buffer of Tier 1 equity capital equal to 2.5% of risk-weighted assets in normal times, which will then be used to cover losses in stress periods. This means that in normal times, a bank should have a minimum 7% Tier 1 equity capital to risk-weighted assets ratio, an 8.5% total Tier 1 capital to risk-weighted assets ratio, and a 10.5% Tier 1 plus Tier 2 capital to risk-weighted assets ratio. The capital conservation buffer is a requirement and is not left to the discretion of individual country regulators. It is not a requirement at all times but is built up to that level in normal economic periods and declines in stress periods.
5. B Basel III requires a minimum liquidity coverage ratio of 100%. The LCR focuses on the banks ability to weather a 30-day period of reduced/disrupted liquidity. The formula is computed as follows:
high-quality liquid assets / net cash outflows in a 30-day period
LCR= $125 million / $137 million = 0.912 or 91.2%.
In this case, Highlands Bank does not meet the minimum 100% requirement and is in violation of the rule.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Fu n d a me n t a l Re v i e w o f t h e Tr a d i n g Bo o k
Topic 60
E x a m F o c u s
The new banking capital requirements, as specified in this topic, will profoundly change the way that capital for market risk is calculated. There are several key innovations that will cause this change. First, banks will be required to forgo using the 99% confidence interval VaR measure in favor of the 97.5% confidence interval expected shortfall measure. This change will better capture the potential dollar loss (i.e., tail risk) that a bank could sustain in a given window of time. Many risk managers have already begun using expected shortfall in practice for internal audits. Second, risk assets will be divided into liquidity horizons that better reflect the volatility in specific asset categories. The third innovation is a rules-based criteria for an asset being categorized as either a trading book asset or a banking book asset. This step will help mitigate the potential for regulatory arbitrage.
M a r k e t R i s k C a p i t a l C a l c u l a t i o n