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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
5Bankers Guide, p. 2
6Bankers Guide, p. 3
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.pdf8/12/2019 Obele, Ogo - Basel II
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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.pdf8/12/2019 Obele, Ogo - Basel II
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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
14Bankers Guide, p. 10
15Deloitte Basel II, p. 9
16BIS-Basel II, para. 52
17Bankers Guide, p10
18Bankers Guide, p12
19Bankers 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
20Bankers Guide, p11
21Bankers, p12-14
22BIS-Basel II, para. 211
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.
26Bankers Guide, p. 17
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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.
29Bankers Guide, p. 17
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.pdf8/12/2019 Obele, Ogo - Basel II
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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
31Bankers Guide, p19
32BIS-Basel II, para. 644
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
38Bankers Guide, p25
39BIS Basel II, para 649
40BIS-Basel II, para 650
41BIS-Basel II, para. 649. See alsoBankers, p. 25
42BIS-Basel II, para 660
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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
43BIS Basel II, para 653
44BIS Basel II, para 652
45BIS Basel II, para 653
46BIS-Basel II, para 654
47BIS-Basel II, para 652
48Bankers Guide, p. 26
49BIS-Basel II, para 664
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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
50BIS Basel II, para 65551
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
60BIS-Basel II, p. 209
61BIS-Basel II, p. 211
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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
62BIS-Basel II, p. 212
63Bankers Guide, p. 49
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.pdf8/12/2019 Obele, Ogo - Basel II
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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
67Bankers Guide, p. 17
68Wingnall & Atkinson, p. 6
69Wingnall & Atkinson, p. 6
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.html8/12/2019 Obele, Ogo - Basel II
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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
Wingnall & Atkinson, p. 776
Wingnall & Atkinson, p. 777
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=WashRegu8/12/2019 Obele, Ogo - Basel II
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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
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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
85House of Commons Treasury Committee, para. 44
86House of Commons Treasury Committee, para. 18
87House of Commons Treasury Committee, para. 13
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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
BIS-Basel III, para 139102
Latham & Watkins Client Alert No. 1138, p. 9103
BIS-Basel III, para 38
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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
107Latham & Watkins Client Alert No. 1138, p. 12
108Latham & 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
http://www.algorithmics.com/en/media/pdfs/algo-wp0910-lr-basel3-exd.pdfhttp://www.algorithmics.com/en/media/pdfs/algo-wp0910-lr-basel3-exd.pdfhttp://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_IIIhttp://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_IIIhttp://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/2/http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/2/http://www.nationalaffairs.com/publications/detail/capitalism-after-the-crisishttp://www.nationalaffairs.com/publications/detail/capitalism-after-the-crisishttp://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=allhttp://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=allhttp://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=allhttp://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=allhttp://www.nationalaffairs.com/publications/detail/capitalism-after-the-crisishttp://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/2/http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_IIIhttp://www.algorithmics.com/en/media/pdfs/algo-wp0910-lr-basel3-exd.pdf8/12/2019 Obele, Ogo - Basel II
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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
http://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.htmlhttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.htmlhttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.htmlhttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.htmlhttp://www.accenture.com/us-en/landing-pages/management-consulting/risk-management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdfhttp://www.accenture.com/us-en/landing-pages/management-consulting/risk-management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdfhttp://www.accenture.com/us-en/landing-pages/management-consulting/risk-management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdfhttp://www.newyorker.com/talk/financial/2009/09/28/090928ta_talk_surowieckihttp://www.newyorker.com/talk/financial/2009/09/28/090928ta_talk_surowieckihttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-of-interesthttp://www.newyorker.com/talk/financial/2009/09/28/090928ta_talk_surowieckihttp://www.accenture.com/us-en/landing-pages/management-consulting/risk-management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdfhttp://www.accenture.com/us-en/landing-pages/management-consulting/risk-management/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdfhttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.htmlhttp://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gop-warren_n_890090.html8/12/2019 Obele, Ogo - Basel II
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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 Commentary134
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.html8/12/2019 Obele, Ogo - Basel II
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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
Skadden Credit Rating Agencies Commentary137
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-idUSS1E78Q0XY201109278/12/2019 Obele, Ogo - Basel II
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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
http://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FINAL).pdfhttp://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FINAL).pdfhttp://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FINAL).pdfhttp://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FINAL).pdfhttp://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FINAL).pdf8/12/2019 Obele, Ogo - Basel II
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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
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