The 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.
Basel 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.
If 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. 
The 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. 
The 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.
The 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.
Basel 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.
From 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.