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.

Comments
6 comments so far

Thanks for having me reread the well written Wired article. It’s one of the reasons I came to your blog.

End of article quote…As Li himself said of his own model: “The most dangerous part is when people believe everything coming out of it.”

Posted by hsvkitty | Report as abusive

Conservative risk ratios is not dumb regulation, it is the only reliable tool for preventing instability. Risk can not be accurately predicted, so depending on those predictions is asking for problems that are guaranteed to happen when the forecasts are wrong.

Ratios should be used to control growth, instead of interest rates. When growth is higher than the economy can sustain (i.e., demand exceeds supply, causing inflation), then capital ratios can be increased. This should be done anyway, as risk of big failures is amplified during high growth periods, when over-leverage combined with arrogance yields disaster.

Posted by KenG_CA | Report as abusive

The PD/LGD approach isn’t discredited at all (and I’m not sure why you “hope” it would be): in fact, it is at the heart of the IRB approach under Basel II, and Basel III doesn’t change that. See in particular section II (Risk Coverage) of http://www.bis.org/publ/bcbs189.pdf.

Posted by Kamekon | Report as abusive

What the article does not make fully clear though is the role of the regulators.

It is perfectly normal that bankers believe they can master risks of default. Who would want to deal with a banker who does not believe so? … And it is the role of the regulators to tell the bankers “No you can’t… and besides there are so many other risks to be considered than just avoiding the defaults of your clients and the defaults of yourselves”.

What really created the crisis was that the regulators themselves had a go at it like risk-managers when imposing their own very arbitrary risk-weights.

A credit rating sends out on its own a very positive or negative signal to the market. When regulators based the capital requirements of banks on those same credit ratings, they dramatically augmented the strength of those signals… to such an extent that banks went and drowned themselves in triple-A rated waters wearing no capital at all… to such an extent that lending to the “risky” small businesses and entrepreneurs has come to a halt because that requires too much capital, especially when bank capital is very scarce as a result of having invested or lent too much to the ex-ante “not risky”.

What the regulators have not understood is that the risk that they are in charge of is not the risk covered by the credit ratings but the risk of how the banks might act upon those credit ratings… which includes of course the banks going excessively into areas where suddenly the credit ratings could turn out to be wrong.

Currently the regulators, who totally failed as risk-managers in handling some simple risks of defaults, by foolishly playing around with capital requirements based on perceived risks that ignoring that systemic crisis never ever results from timely perceived risks… are now arrogantly tackling even much more God-like events like pro-cyclicality. God help us!

Please see the video and help me to voice the message
http://subprimeregulations.blogspot.com/ 2010/09/financial-crisis-simple-why-and- what-to.html

Posted by PerKurowski | Report as abusive

Thank you for the post! Great article!

For a concise summary of Basel II vs. Basel III see the following link:

http://tinesworld.com/?p=130

Posted by Strachnyi | Report as abusive

Thanks for your post, Thomson Reuters Risk Management has also written an interesting article on Basel III on its blog, Risk in the Market http://riskinthemarket.thomsonreuters.co m/2011/basel-iii/

Posted by HCLR | Report as abusive
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