Beyond Basel and the Dodd-Frank Bill

Recently, the U.S. government passed a major financial regulatory overhaul known as the Dodd-Frank bill. Soon thereafter, the Basel Committee revised its capital standards to boost minimum tier one equity requirements for banks over time.

The stated purpose of the US's Dodd-Frank financial regulatory reform bill, and the Basel reforms, was to fix the problems that came to light during the recent financial crisis. Do these reforms address those problems?

Three factors were particularly important in contributing to the subprime financial crisis:

• Loose monetary policy and global imbalances kept US interest rates extremely low from 2002 to 2005, producing abundant credit and the under-pricing of risk.
• A long list of government-supported housing finance policies by Fannie Mae, Freddie Mac, the Federal Housing Administration and other government instrumentalities subsidized mortgage credit risk by relaxing mortgage leverage and underwriting standards to encourage highly levered purchases of homes by borrowers with poor credit records and little wealth (the governmentencouraged standard became an undocumented mortgage with a 3% down payment).
• The combination of predictable government protection of banks (via deposit insurance and toobig-to-fail bailouts) led financial institutions to be too complacent about risk management. Meanwhile, the failures of prudential standards to measure and constrain risk-taking permitted complacent banks to expose themselves to underpriced mortgage risks without maintaining equity capital buffers commensurate with the high risk they were bearing.

The first factor was a necessary but not sufficient condition for the financial crisis; both government sins of commission in the mortgage market (the second factor) and sins of omission in prudential regulation (the third factor) played crucial roles in producing a deep and lasting crisis. Logic and historical experience suggest that even in the presence of loose monetary policy and global imbalances, if the US government had not been playing the role of risky-mortgage pusher in the years leading up to the crisis, mortgage-related losses would have been cut by more than half.

Similarly, if prudential regulation had measured the outsized mortgage risks accurately on a forwardlooking basis, sufficient equity capital would have been required to prevent the mortgage meltdown from creating financial meltdown.

Looking over the more than 2300 pages of text in the new financial reform legislation, what is notable is the lack of connections between these causes of the crisis and most of the legislation. The Pew Trusts Task Force on Financial Reform, of which I was a member, brought together a bipartisan group of prominent financial experts to suggest financial reforms and, in December 2009, the group issued a statement with detailed proposals for restructuring regulation and other government policies in light of the crisis. It is striking how little the recommendations of that group, or those of any other group of experts commenting on the crisis, influenced the Dodd-Frank bill.

The Pew Task Force recommendations do intersect with the new financial reform bill in some areas, notably the encouragement of derivatives clearing on exchanges, improvements in derivatives disclosure, the creation of a macro-prudential regulatory mandate to vary prudential requirements over the business cycle, the setting up of a consumer protection agency to prioritize the enforcement of financial standards to prevent abuse, and the creation of a resolution authority for non-bank financial institutions. But even in these areas of intersection, the legislation often misses the mark.

Read the full report here.