Dodd-Frank, Basel III and the Age of Uncertainty

SC-dodd-frank-wp.pngThe two-year anniversary of the passage of the Dodd-Frank Act is a good occasion to consider where we stand with respect to the proposals adopted in response to the financial crisis. Moreover, we do so in an environment of continued turmoil in the financial markets and banking industry. 

It is a restatement of the obvious to observe that the 2007 to 2009 financial crisis has led to a fundamental re-ordering of the regulatory landscape for large banking institutions. Just like the Great Depression was the impetus behind the passage of landmark legislation, including the Glass-Steagall Act and the Securities Act of 1933, the perceived lessons of the recent financial crisis have provided the inexorable impetus behind the passage of the Dodd-Frank Act.

While sweeping, however, the Dodd-Frank Act is but one component of this re-ordering of the U.S. and international bank regulatory environment. Aspects of these fundamental reforms include: the international adoption of significantly enhanced capital requirements and the implementation of mandated liquidity ratios; the introduction of effective floating, minimum capital requirements under stressed scenarios in the U.S.; increased efforts towards “ring-fencing” the local operations of internationally active banks; and the imposition of new analytical frameworks that seek to discourage the buildup of systemic risks through additional capital surcharges and limits on growth through acquisitions.

The emerging regulatory landscape is certainly more stringent and less forgiving. In many ways, this is rightly so—the crisis revealed deficiencies that needed to be fixed (although in the case of the Volcker Rule, one cannot readily identify a need for it in the 2007 to 2009 experience). One may debate the relative merits of some of the specific changes being made, at least in the case of measures that are in final enough form to permit evaluation. More crucially, however, it is proving very difficult to analyze how this new regulatory landscape will operate in practice to shape the very nature of the U.S. and international banking industry as a whole. Thus, in the short term at least, a dominant characteristic of the regulatory landscape emerging in the wake of the financial crisis is:

  • uncertainty arising out of specific rules that require important clarifications, or actually remain to be written; and
  • uncertainty as to how exactly all the rules will work (or not) together.

How Will Basel III Impact Banks?

With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.

How will the new Basel III capital requirements impact the banking industry in the U.S.?

Luigi-DeGhenghi.jpgBasel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.

—Luigi L. De Ghenghi, Partner, Davis Polk

Gregory-Lyons.jpgIf adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes.  Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry.  For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010.  Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.  

—Greg Lyons, Debevoise & Plimpton

Mark-Nuccio.jpgThe impact will be positive in the long term.  Basel III’s higher capital requirements will be phased in over a number of years.  While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources.  The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 

—Mark Nuccio, Ropes & Gray

Jonathan-Hightower.jpgThe real impact will be the change on Main Street.  The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.

This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.

—Jonathan Hightower, Bryan Cave

rob_fleetwood.jpgThe implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.

We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.

—Rob Fleetwood, Barack Ferrazzano

Peter-Weinstock.jpgBasel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking.  Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting.  Yet, the Basel accord now mandates it for the securities portfolio.  The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans.  Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions.  Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.

—Peter Weinstock, Hunton & Williams

What audit committees need to know


Robert Fleetwood, a partner in Chicago-based law firm Barack Ferrazzano who specializes in financial institutions, will be speaking at Bank Director’s Bank Audit Committee conference June 14-15 in Chicago.  Here, he discusses the increasing importance of audit committees understanding capital issues, the advent of risk committees, and the one thing all audit committee members should do.

What is the most important thing that audit committees should be focusing on in today’s environment?

I am always hesitant to say that there is one “most important” issue or factor on which audit committees should be focused. Proper governance and adhering to practical, sound procedures are always critical, and should never be dismissed or overlooked.

audit-mtg.jpgFrom an issue standpoint, it is critical that audit committees, as well as the entire board, understand the ever-increasing importance of capital in the industry’s current environment. The audit committee must understand the organization’s capital structure, the risks inherent within that structure, and the possible effects of Dodd-Frank, Basel III and the overall regulatory environment. As the past few years have illustrated, capital is key. An organization must have a clear plan regarding how to maximize its capital resources now, and how to keep its options open for the future. The audit committee can play a key and important role in that overall process.

How have the responsibilities for audit committees changed during the last few years?

One change that I have witnessed over the past few years is the audit committee’s evolving role in overall risk management. A few years ago, it was common to have the audit committee oversee the organization’s board-level risk management. As audit committees became more and more overwhelmed, enterprise risk management systems have developed and risk committees have become more common.

Recently, it has become more common that overall risk management is not centered with the audit committee, particularly at larger organizations, but instead with a risk committee or the board generally. This is filtering down to smaller organizations, but in my experience smaller companies still are more likely to have the audit committee involved in overall risk management practices. I expect that this trend will continue to evolve over the next few years.

Name a best practice that you would like to see more audit committees adopt.

There are actually a number of best practices that many audit committees do not adopt or implement, often for very good reasons. We stress that there is not a “one size fits all” when it comes to governance. Just because one of your peers implements something, does not mean that you have to adopt it, particularly if it doesn’t make sense within your organization.

One practice that is applicable to all companies, all boards and all committees, however, is the importance of having directors actively participate, ask questions and engage in meaningful dialogue with management, the company’s advisors and other directors. We often hear of situations in which directors have not asked any questions, or did not engage in any meaningful discussions, regarding important decisions affecting the company. Not only does this potentially hinder the decision-making process, but it may not allow the directors to adequately establish that they satisfied their fiduciary duties in the decision-making process. The lack of participation, or the lack of proper documentation of participation through meeting notes and other mechanisms, opens the organization, as well as the directors, to potential liability if the action ultimately has a negative impact on stakeholders.