Dodd-Frank and Basel III's knowledge problem.

• Author: Pappenfus, James M.

1. INTRODUCTION II. BACKGROUND A. Landscape B. The Dodd-Frank Act C. The Basel Committee on Banking Supervision D. Current State of Implementation and Possible Conflicts III. UNCERTAINTY AND THE KNOWLEDGE PROBLEM A. Defining the Problem B. Economic Policy Uncertainty C. Dodd-Frank Derivatives D. Liquidation and Acquiescence IV. CONCLUSION I. INTRODUCTION

   In 2010, a pair of responses to the 2008 financial crisis were released the Dodd-Frank Wall Street Reform and Consumer Protection Act (1) and the Third Basel Accord. (2) Much scholarly attention has been paid to the Dodd-Frank Act, (3) but little has addressed its subtle--but consequential--nuances where interplay with Basel III implicates considerable knowledge problems. (4) That Dodd-Frank's implementation, particularly in the area of bank capital requirements, is coincidental with that of Basel III, raises concerns in the areas of both domestic and international business transactions. (5) Because it is only a recommended framework, countries are free to implement or not implement Basel III, in whole or in part. (6) Given the myriad policy choices and incentives among its potential adopters, the potential for market and competitive advantages between countries is enormous. (7) Thus, U.S. regulators must create rules that ensure domestic firms engaged in international commerce are not disadvantaged or hamstrung by the U.S. version of Basel III, and the Basel Committee has a strong interest in ensuring a level playing field. (8) In similar fashion, market uncertainty follows the implementation of Dodd-Frank. The regulatory scheme seeks to segregate systemically important financial institutions for enhanced treatment, (9) opening the door and creating incentives for policy makers and regulators to push policy initiatives through those regulated institutions. (10)

   The purpose of this Comment is to analyze the potential unintended consequences of Dodd-Frank and Basel III's implementation. Particular attention will be paid to the uncertainty they create and the potential effects of the knowledge problem. Part I contains a historical overview and brief explanation of the relevant legislative path. In it, emphasis is given to U.S. regulators' response to the crisis, as the historical market conditions and consequent incentives play a significant role in later analysis. This background information concludes with a summary of the current state of the relevant agencies' Dodd-Frank and Basel III rulemaking efforts. Part II focuses on the knowledge problem and the uncertainty created by these reforms. It will look to the purportedly simplified regulatory structure of the U.S. capital markets brought on by Dodd-Frank, and the problems that a hodgepodge implementation of international reforms, through Basel III, could exacerbate among U.S. financial firms.

1. BACKGROUND

   1. Landscape

      American financial regulation traces its contemporary roots to President Roosevelt and the New Deal Congress. (11) The purpose of this Comment renders unnecessary a full recitation of the interim regulatory climate, but the tendency to flip-flop through periods of enhanced regulation and deregulation is relevant to its premise. (12) The housing market's collapse triggered the 2008 financial crisis. (13) Improper lending practices, government policy, and the distribution of risk through the use of financial engineering all led to the expansion of the housing boom. (14) In general, mortgage loans provide a relatively stable cash flow for lenders, an attribute that makes them particularly suitable for securitization. (15) Banks seeking to mitigate their exposure to mortgage default risk frequently sell their loans to investment banks, who in turn package the loans into complex mortgage-backed securities. (16) After securitization, these mortgage-backed securities can be further securitized into collateralized debt obligations (CDOs). (17) Broadly speaking, a CDO is a pooling of asset-backed debt obligations, further securitized into tranches to be sold to investors with various risk preferences. (18) To complicate matters further, investment banks frequently engage a counterparty in credit-default swaps (CDS) to further diversify their risk. (19) Mortgage originators are not the only parties seeking mitigation of risk; oil companies, energy providers, airlines, buyers and sellers in international markets, and agricultural operators frequently use derivatives to engage in risk management. (20) It is perhaps most important to note these engineered products are encapsulated--they are derivatives of derivatives--and this Author's Futures and Options professor described the harm from their misuse quite aptly: "The cover graphic of your textbook--a tumbling line of dominoes--is a rather appropriate analogy."

      From these market conditions, two principal mechanisms by which derivatives accelerated (21) the housing crisis are apparent: (1) their ability to systematically infect the market with risk through almost infinite derivation; and (2) by their opaque nature, financial institutions were capable of taking enormous positions on that widespread risk, resulting in an inability to determine the true nature of any one firm's exposure. (22) In the four years leading to the crisis, the notional principal value (23) in the CDS market was estimated by the Bank for International Settlements to increase tenfold, from $5 trillion to a peak of $57 trillion. (24)

      A party to a derivatives contract faces not only the relative riskiness of the underlying reference entity, (25) but also the risk of his counterparty's default. (26) This potential for nonperformance under the contract is referred to as "counterparty credit risk" and has serious implications in the event of a crisis. (27) When the reference entity is in default at the same time as the CDS protection seller, the buyer of that protection faces a double default and loses his protection at precisely the time he needs it most. (28)

      To understand the systemic (29) harm such a scenario may pose to the financial system, consider the implications of the failure of a large counterparty. Consider a bank's agreement to loan a certain sum to an electricity provider for use as working capital. The bank may rationally determine its inability to fully build a default premium into the interest it charges the borrower, and decide to "buy protection" through the use of a CDS. Later, when the electricity provider defaults on its loan, the bank faces exposure to a loss. However, the bank properly evaluated its risk and engaged a counterparty for the purpose of mitigating its exposure to such a credit event. In this scenario, however, instead of settling the contract upon the credit event whereupon the buyer has purchased protection, the counterparty (protection seller) defaults on the CDS. This causes the protection-buying bank to fully realize the loss created by the initial credit event, plus the payments it has remitted to the protection seller in the interim. When the defaulting counterparty is large and interconnected, such a failure spreads enormous losses throughout the system because other institutions become exposed to unhedged positions at the same time the protection is needed. (30) It is precisely this sort of scenario that cascaded through the financial markets beginning in early 2008, precipitating the Federal Reserve's provision of an emergency loan to Bear Stearns whereupon it assumed a portion of Bear Stearns' credit risk. (31)

      JP Morgan Chase was incentivized to purchase Bear Stearns based on the Fed's intervention, (32) which signaled to the market the administration's willingness to prop up systemically important firms. (33) Despite being several times larger than Bear Stearns, federal regulators provided no assistance to Lehman Brothers and instead, in September of 2008, directed it into bankruptcy. (34) In the days and weeks that followed, the Fed bailed out American International Group (AIG), (35) and together with the Treasury, announced its request for the $700 billion Troubled Asset Relief Program (WARP). (36) The administration furthered its bailout policy in 2009, by partly financing the sale of Chrysler in Chapter 11 bankruptcy, (37) and by providing funding for General Motors to buy itself out of Chapter 11. (38)

      The financial crisis developed through the systemic breakdown of the financial system that precipitated damage to the real economy. (39) The failure of large and interconnected financial institutions, as a direct result of the housing bubble, triggered that systemic breakdown. (40) The financial system is largely composed of intermediaries, markets, and the infrastructure necessary to support payment, settlement, and trading mechanisms. (41) Systemic risk spread through this system as a contagion, whereby the failure of one financial intermediary led to the failure of others. (42)

   2. The Dodd-Frank Act

      In response to the need for a new financial regulatory framework, the Dodd-Frank Act was signed by President Obama in July 2010. (43) The President touted the sweeping Dodd-Frank reforms as creating a framework where markets "can function freely and fairly, without ... suddenly bring[ing] the risk of financial collapse." (44) While recognizing the constructive nature of financial derivatives, he declared their destructive tendencies would be mitigated by Dodd-Frank's "common-sense rules." (45) The Act bills itself as a promoter of U.S. financial stability and a protector of the American taxpayer by ending bailouts. (46) Indeed, President Obama's remarks at the signing make the intent explicit: "[t]here will be no more tax-funded bailouts--period." (47) More generally, it possesses two clear objectives. (48) The first is to mitigate the systemic risk imposed by complex contemporary finance; the second is to mitigate the harm caused by the collapse of a large financial entity. (49)

      The Act purports to accomplish these goals by...