Dodd-Frank vs Basel III

By Felix Salmon
January 20, 2011

When the big financial-overhaul bill was working its way through Congress, Treasury persuaded legislators to avoid passing rules on bank capital or liquidity. Leave all that to Basel, they said, so that there could be a global, unified system. And that’s what happened. But if two huge new systems are passed by two highly complex bureaucracies, there are bound to be conflicts. And Melvyn Westlake has a great story in Global Risk Regulator on one of those conflicts: the role of the ratings agencies.

Under Dodd-Frank, the official role of ratings agencies was severely curtailed: regulators are not allowed to use credit ratings when promulgating rules. Under Basel III, however, regulators have to measure the riskiness of bond portfolios somehow, in order to work out how much capital banks should be required to hold against them. Credit ratings are particularly central, under the Basel regime, when it comes to securitizations and measuring both liquidity and counterparty risk.

Squaring this circle, it turns out, is very hard indeed:

“Nobody has put forward any really satisfactory ideas,” admits a Federal Reserve regulator. Already, the absence of a practical alternative to credit ratings has begun to impair new rulemaking in Washington…

The inability to find a solution and the looming deadline is “a source of a great deal of concern,” says Karen Petrou, executive director of Federal Financial Analytics, a Washington consultancy on regulation. “The agencies are informally admitting that they are stumped. But the deadline is only six months away, so something has got to happen. The law is very clear. It says there may be no reference to ratings,” she adds. “We are going to have a hell of a time with the Basel III rules because of the way ratings are still embedded in them,” Petrou reckons…

Finding an alternative to ratings “is not proving an easy task,” confirms Nancy Hunt, associate director for capital markets in the FDIC’s supervision and consumer protection division. “We are looking at several approaches, some more mathematical than others, and trying to backtest them to see if they perform better than rating agencies,” she says. “It’s a very complex and involved process. But we have a law, and we have to figure out how to do this.”

Backtesting is important, of course, but it’s also dangerous: it assumes that the future will be like the past, when the whole point of crises is that they happen when something unprecedented happens. Given the wobbliness of a lot of OECD sovereign debt, for instance, it would surely not be a good idea to put in place a rule which assumes that no OECD debt will ever default or be restructured.

And this, too, is worrisome:

One approach that has been considered by the agencies is using probability of default (PD) and loss given default (LGD) calculations.

I’ve seen that approach before. In fact, I wrote about it at length, in a cover story for Wired entitled “The formula that killed Wall Street.” One would hope that at this point it was discredited.

The alternative, I think, is dumb regulation: just slap conservative risk ratios on pretty much everything, like we did in Basel I, and don’t try to be clever when it comes to measuring risk. That’s just a recipe for regulatory arbitrage. It’s not perfect — dumb regulation never is. But in this case, the perfect is very much the enemy of the good.

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