THESIS: The current financial crisis both caught the global economy unawares and demonstrated how complex

the financial industrys services and products have become. Additionally, the continuing fallout of the crisis shows how the financial industry and its capital flows have created a truly interconnected global economy. Prior to the financial crisis, the Basel II regulatory framework was intended to strengthen the international financial markets by establishing a global financial standard for measuring and addressing risk. The framework sought to accomplish this goal by establishing a more modern approach to identifying and addressing risk in order to keep pace with financial innovation and instruments. In addition to providing more modern qualitative and quantitative metrics for measuring risk, the framework increased capital requirements for banking institutions to ensure the global financial industrys ability to withstand shocks and to promote the safety of the institutions. Despite the high-minded aspirations of the regulators that created the framework, Basel II failed to reach its goal. Moreover, Basel II arguably played a key role in influencing bank behavior that directly led to the financial crisis. Basel II failed to address certain flaws in the transparency and incentive alignment inherent in the financial industry. Basel II also allowed banking institutions to game the system and pursue increasingly risky behavior in order to generate record profits. As the global economy seeks to recover from the current financial crisis, regulators are attempting to develop and implement new regulatory frameworks that will hopefully prevent another such crisis from occurring again. In developing new regulatory frameworks and laws, regulators seek to address the structural flaws in the banking industry that the failure of Basel II and the financial crisis exposed. Two examples of this effort to develop modern financial regulations are the Basel III framework and the DoddFrank Act. Even though neither Basel III nor Dodd-Frank have been fully implemented, the tone of and response to these new regulations, as well as other new regulations, evidence that the future of financial regulation is still in a state of flux as it struggles with balancing economic growth and financial risk.

BASEL II: BACKGROUND Basel II was created by the Basel Committee, formally known as the Committee on Banking Regulations and Supervisory Practices.1 The primary objective of the committee is to improve the supervisory understanding and the quality of banking supervision internationally. The Basel Committee possesses no international regulatory authority in that its recommendations possess not legal authority.2 Rather, the committee provides a broad regulatory framework the fosters international convergence towards common approaches and standards, such as those in Basel II, which States modify to best suit the individual state.3 In 1988, the Basel Committee established the Basel Capital Accord (Basel I) in recognition of the need for an international accord to strengthen the stability of international banking system by stressing the importance of capital ratios.4 However, as the banking system became increasingly international and financial instruments became increasingly complex, the Basel Committee introduced Basel II accommodate the banking systems evolution. The primary goal of Basel II is to provide a framework that, when implemented, strengthens the stability of the international banking system by promoting the adoption of stronger risk management practices. 5 In order to accomplish this goal, the Basel II framework employs a three-pillar framework that provides more a detailed approach to measuring credit risk, establishing explicit capital requirements for operational risk, and addresses market risk.6 BASEL II: PILLAR 1 Minimum Capital Requirements

The Banking Association of South Africa, The Bankers Guide to the Basel II Framework (December 2005) *hereinafter Bankers Guide+, p. 1, available at http://www.banking.org.za/documents/2005/DECEMBER/InfoDoc_29781.pdf 2 Basel II The Securitisation Framework, Deloitte (2006) *hereinafter Deloitte-Basel II], p. 3, available at http://www.deloitte.com/assets/DcomSouthAfrica/Local%20Assets/Documents/ZA_FinancialInstitutionServices_Basel%20IITheSecuritisationFramework_090107.pdf 3 Bankers Guide, p. 1 4 Bankers Guide, p. 2 5 Bankers Guide, p. 2 6 Bankers Guide, p. 3

The Basel II framework seeks to ensure that applicable entities maintain adequate capital in relation to the risk profile of an entitys activities and assets.7 As under Basel I, Basel II requires banks to maintain a minimum total capital ratio of 8%.8 The numerator in this ratio represents the regulatory capital available to the bank and the denominator represents the combined credit risk, operational risk and market risk of an entitys risk assets.9

Figure 1: Components of Risk Weighted Capital Requirement under Basel II.10

CREDIT RISK The Basel II framework improves upon Basel I by providing entities with two methods for calculating credit risk.11 The intent for providing entities with the alternative methods is to allow banks that engage in more sophisticated risk-taking and have developed more sophisticated risk measurement systems greater latitude to select the most appropriate method for measuring.12 The two methods are the Standardized

7 8

Deloitte-Basel II, p. 3 Federal Reserve, Capital Standards for Banks: The Evolving Basel Accord, Federal Reserve Bulletin (September 2003), p. 396-405[hereafter FED Bulletin 2003], p. 398, available at http://www.federalreserve.gov/pubs/bulletin/2003/0903lead.pdf 9 FED Bulletin 2003, p. 398 10 FED Bulletin 2003, p. 398 11 Bank for International Settlements, International Convergence of Capital Measurement and Capital Standards, Basel Committee on Banking Supervision (June 2006) [hereinafter BIS-Basel II], para. 50, available at http://www.bis.org/publ/bcbs128.pdf 12 Feb Bulletin 2003, p. 399

Approach (SA) and the Internal Ratings Based Approach (IRB). 13 Within the IRB, banking entities are permitted to use either the Foundation Approach (FIRB) or the Advanced Approach (AIRB).14

Figure 2: Comparison between Basel I and Basel II Risk-weighting for different assets. 15

The main distinction of the Standardized Approach (SA) is that the risk weighting for a credit exposure is determined by external credit assessments.16 Under the SA, credit exposures are assigned to categories based on the characteristics of the credit exposure: some of the main categories are sovereign debt, multilateral development banks, banks, corporate debt, and retail debt.17 Each categorys risk weighting is then determined by a credit rating established by an external credit rating agency. In order to use the external agencys rating, the rating must be provided by an agency that meets with the Basel II criteria of objectivity, independency, transparency, and credibility.18 In the event there is no external rating for the loan, the loan is generally assigned a risk weighting of 100%.19 Although the SA uses the same risk-weighting scheme as Basel I, it establishes risk weightings for certain assets that are higher
13 14

BIS-Basel II, para. 50-52 Bankers Guide, p. 10 15 Deloitte Basel II, p. 9 16 BIS-Basel II, para. 52 17 Bankers Guide, p10 18 Bankers Guide, p12 19 Bankers Guide, p10

(150%) than under Basel I (100%). Some of the assets that are subject to here weightings are sovereigns and banks rated below B-, and corporates rated below BB-.20 (See Figure 2) In contrast to the SA approach and its use of externally assigned risk weights, the IRB approach permits banking entities to use internally developed information about the banks own credit exposures, risk measurement and risk management to determine the appropriate risk weights for its exposures.21 However, an entity must satisfy certain minimum conditions and disclosure requirements as well as receive supervisory approval in order to employ the IRB approach. 22 The banks credit exposures are categorizes into broad classes of assets (corporate, sovereign, bank, retail, and equity) based on the underlying risk characteristics of the asset.23 If there is no specific IRB treatment for an asset then the assigned risk-weighting is 100%.24 The IRB approach is based on measures of Unexpected Loss and Expected Loss, but the risk weighting functions of the IRB approach only focus on determining the requisite capital buffer needed to cover the Unexpected Loss portion.25 Under the IRB approach, banking entities internally determine the appropriate risk-weight for a particular credit asset class using following four parameters: Probability of Default (PD); Loss Given Default (LGD); Exposure at Default (EAD); Maturity (M).26

20 21

Bankers Guide, p11 Bankers, p12-14 22 BIS-Basel II, para. 211 23 Bankers Guide, p. 14. See also BIS-Basel II, para. 215. 24 BIS-Basel II, para 213 25 Bankers Guide, p. 14. See also BIS-Basel II, para. 212. 26 Bankers Guide, p. 17

Table 1: Four Parameters for determining credit exposure risk under the IRB approach.27

Within the IRB approach, banking entities can employ two different methods with which to calculate the risk weight for each asset class. Under the Foundation IRB approach, banking entities internally establish estimates for the PD parameter and use external supervisory estimates for the other parameters. Under the Advanced IRB approach, banking entities used internally developed estimates for all four parameters.28

Table 2: Risk Component estimation under FIRB and AIRB.29

Given the reliance on internal data to determine estimates for risk-weights under the IRB approach, different banking entities could, in theory, establish different capital requirement estimates for the same asset.30 In order to ensure comparability amongst banks risk weightings, banks must meet the minimum qualifying criteria for using the IRB approach that covers the banks internal credit risk assessment
27 28

Deloitte-Basel II, p. 9 Bankers Guide, p. 17-18. See also BIS-Basel II, para 245. 29 Bankers Guide, p. 17 30 Basel II and Banks: Key Aspect and Likely Market Impacts, Nomura Securities International, Inc., Nomura Fixed Income Research (September 20, 2005), p. 1 [hereinafter Nomura-Basel II], available at http://people.stern.nyu.edu/igiddy/ABS/BaselII_Nomura.pdf

procedures. Within the IRB framework, the qualification criteria are more stringent for the Advanced Approach than the Foundation Approach. 31 OPERATIONAL RISK Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.32 This definition includes legal risk such as exposure to fines and penalties but excludes strategic and reputational risk.33 The four categories of risk within the operational risk assessment framework can be explained as follows.34 a) Inadequate of failed internal processes: operational risk that may result from the myriad of processes banking institutions use to deliver their products/services to end users, e.g. transactions processes incorrectly b) People: operational risk that can occur due to worker compensation claims, violations of employee health and safety rules, inadequate training and management, lack of integrity or honesty c) Systems: operational risk that can arise due to institutions dependence on certain systems that facilitate daily operations and the potential for these systems to fail, e.g. dependence on IT systems exposes the institution to the operational risk of its IT system failing or data becoming corrupted d) External events: operational risk that can arise from both the idiosyncratic risk of firm and the business strategy it pursues and the market risk resulting from participating in the general business environment The operational risk framework provides three methods for calculating operational risk capital charges based on the institutions level of sophistication: the Basic Indicator Approach; the Standardised
31 32

Bankers Guide, p19 BIS-Basel II, para. 644 33 BIS-Basel II, para. 644. See also Bankers Guide, p. 23 34 Bankers, p24

Approach; and the Advanced Measurement Approach.35 The three methods represent a continuum of increasing sophistication sensitivity to risk and, much like with the credit risk measurement methods, more sophisticated banks are encouraged to employ the more sophisticated operational risk measurement methods.36 In fact, once a banking entity selects a measurement method, it is not permitted to revert to a less sophisticated method.37 Additionally, once a method is selected, supervisors are permitted to review the capital requirement produced by the method for general credibility in relation to the firms peers and in the event credibility is lacking, the supervisor can exercise appropriate remedial action under Pillar 2 of Basel II.38 Under the Basic Indicator Approach (BIA), a banking entity uses its gross income as a proxy for operational risk and must maintain a capital charge equal 15% of the average gross income for the last three years. 39 This method defines gross income as net interest income plus net non-interest income subject to additional stipulations such as the exclusion of realized profits and losses from the sale of securities in the banks banking book.40 In the event a bank generates no or negative gross income in a given year within the three year timeframe, the figures for that year should be excluded from the calculation.41 Banks that meet specific minimum requirements may employ the Standardised Approach (SA) to determine their operational risk capital charge.42 SA uses gross income as a proxy for operational risk as well. However, unlike the BIA, the SA divides the banking entitys activities into eight business lines and uses the gross income generated from each business lines as a proxy for the relative scale of operational

35 36

BIS-Basel II, para 645-644 BIS-Basel II, para 645-644 37 Bankers Guide, p. 25. See also BIS Basel II, para 648 38 Bankers Guide, p25 39 BIS Basel II, para 649 40 BIS-Basel II, para 650 41 BIS-Basel II, para. 649. See alsoBankers, p. 25 42 BIS-Basel II, para 660

risk exposure within each business line. 43 The eight business lines are: corporate finance; trading & sales; retail banking; commercial banking; payment & settlement; agency services; asset management; and retail brokerage. 44 The gross income generated from each business line is multiplied by the appropriate beta factor risk-weight to determine the appropriate capital charge for the individual business line and then each individual business lines capital charge is aggregated to determine the total operational risk capital charge for the banking entity.45

Table 3: Beta Factors for Specific Business Lines under the SA.46

The SA approach also offers an alternate method (the Alternate Standardised Approach or ASA) for retail and commercial banking at the discretion of the banks national supervisors discretion.47 Under this approach, a banks volume of outstanding loans is multiplied by the appropriate beta factor and the result is multiplied by 3.5% in order to determine the appropriate capital charge.48 As with the SA, banks that meet specific minimum requirements may elect to use the more sophisticated Advanced Measurement Approach (AMA).49 Under the AMA, the regulatory capital requirement is equal to the risk measure generated by the banks internal operational risk measurement

43 44

BIS Basel II, para 653 BIS Basel II, para 652 45 BIS Basel II, para 653 46 BIS-Basel II, para 654 47 BIS-Basel II, para 652 48 Bankers Guide, p. 26 49 BIS-Basel II, para 664

system. 50 The system should be based on internal loss data, external loss data, scenario analysis and business environment and internal control factors.51 Moreover, the system must be deemed adequate by the banking entities supervisors.52 MARKET RISK The Basel II framework defines market risk as the risk of losses in on and off-balance-sheet positions arising from movements in market prices.53 In essence, market risk is the risk of financial loss associated with a banks trading book, in which the bank may trade for its own account or on behalf of its clients. 54 The framework explicitly states that the risks encapsulated in the definition of market risk are risks associated with interest rate related instruments and equities in a banking entitys trading book and foreign exchange risk and commodities risk throughout the bank.55 Basel II offers banking entities two methods with which to measure their market risk: the Standardised Measurement Method and the Internal Methods Approach. Under the Standardised Measurement Method, the capital charge for market risk is the sum of five categories of risk: interest rate risk; equity position risk; foreign exchange risk; commodities risk; and treatment of options.56 In order to use the Internal Methods Approach, the banking entity must satisfy specific minimum requirements and receive supervisory authority approval.57 BASEL II: PILLAR 2 The Supervisory Review Process

50 51

BIS Basel II, para 655 Bankers, p27 52 Fed Bulletin 2003, p. 399. See also BIS-Basel II, para 666-675 for in-depth explanation of criteria used to determine adequacy of an entitys system and system inputs. 53 BIS-Basel II, para 638(i) 54 Bankers, p28 55 BIS-Basel II, para 638(i) 56 Deloitte Basel II, p. 7 57 BIS-Basel II, para 718(LXX-LXXiii)

The aim of Pillar 2 is to describe the key principles for supervisory review, risk management guidance and supervisory transparency and accountability. Pillar 2 focuses on the following. 58 a) The responsibility of bank management in developing internal assessment processes and setting appropriate capital targets for a banks risk profile. b) The responsibility of the supervisors role in evaluating how well a bank is assessing it s capital needs relative to its risks and to intervene where appropriate c) Addressing the treatment of risks not fully captured under Pillar I, such as credit concentration risk, and factors external to the bank, such as the business cycle. d) The assessment of a banks compliance with the minimum standards and disclosure requirements of the more advanced methods in Pillar I In outlining the requirements for supervisory review, the Basel Committee established four key principles. a) Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.59 b) Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action of they are not satisfied with the result of this process.60 c) Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. 61

58 59

Bankers, p37 BIS-Basel II, p. 205 60 BIS-Basel II, p. 209 61 BIS-Basel II, p. 211

d) Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.62 BASEL II: PILLAR 3 Market Discipline Market discipline complements the capital requirements and the supervisory review process established in the first two pillars. Basel II encourages market discipline by means of a set of disclosure requirements that enable market participants to assess the capital, risk exposures, risk assessment processes and capital adequacy of an institution.63 However, the disclosures required under Pillar 3 do not conflict with the requirements under the prevailing accounting standards and do not need to be audited by an external auditor.64 BASEL II CRITICISM Despite the improvements over Basel I, Basel II drew a lot of criticism for the financial and market risks that it failed to address. One major criticism of the Basel II framework is that is doesnt penalize banks for asset concentration and the associated diversification risk inherent in asset concentration. The risk weighting models under Basel II relied on the assumption that loan portfolios are portfolio invariant. This critical assumption states that the capital required to back a loan should depend only on the risk of that [individual] loans, not on the portfolio to which it is added.65 A major shortcoming of this assumption is that it does not reflect the importance of asset concentration within a

62 63

BIS-Basel II, p. 212 Bankers Guide, p. 49 64 Deloitte Basel II, p. 15 65 Adrian Blundell-Wignall & Paul Atkinson, Thinking Beyond Basel III: Necessary Solutions for Capital and Liquidity, Volume 2010-Issue 1 Organisation for Economic Co-operation and Development (OECD) Journal: Financial Market Trends (2010) [hereinafter Wingnall & Atkinson], p. 4, available at http://www.oecd.org/dataoecd/42/58/45314422.pdf

portfolio. Rather, Pillar 1 ignores concentration risk and leaves it to supervisors to address under Pillar 2.66 The Basel II framework is also criticized for its use on subjective inputs for determining risk factors and capital charges. For example, under the IRB approach for determining credit risk capital requirements, sophisticated banks can use internally developed estimates for the inputs used to determine its capital requirement. The FIRB approach permits a bank to estimate its own PD risk parameter and the AIRB permits a bank to use internally developed estimates for all four of the parameters used to determine its credit risk capital requirement. 67 However, banks cannot predict the future changes in or volatility of the asset prices.68 Even for the smaller banks that used external rating to determine their required capital benefited from this institutionalized subjectivity as the external rating agencies published rating were vulnerable to the same subjectivity within the rating firm.69 Another risk that Basel II fails to address is pro-cyclicality. Generally speaking, banking is procyclical in that when the economy is good risks are underestimated and when the economy is bad risks are overestimated. The Basel II framework did nothing to counter the effects of pro-cyclical practices within the banking industry.70 This failure is compounded by the assertion that the Basel II framework in effect reduces capital requirements for banks. Impact studies of the effect Basel II on required capital levels forecasted large capital reductions amongst institutions relative to Basel I. An FDIC report in 2003 (revised in 2004) forecasted that bank capital level would drop considerably under Basel II. 71 The FDIC report showed that banks using the most sophisticated method, the AIRB Approach, would be able to

66 67

Wingnall & Atkinson, p. 4 Bankers Guide, p. 17 68 Wingnall & Atkinson, p. 6 69 Wingnall & Atkinson, p. 6 70 Wingnall & Atkinson, p. 5-6 71 Estimating the Capital Impact of Basel II in the United States, Federal Deposit Insurance Corporation (Revised August 5, 2004; Original December 8, 2003), available at http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.html

lower their capital levels by as much as 14%.72 Quantitative Impact Studies performed jointly with the Basel Committee itself showed that Basel II would allow banks to dramatically reduce their capital levels.73 Pillar 2 is often criticized because the framework reliance on supervisors to predict the future outcome of banking entities activities in order to assess the real-time adequacy of a banks required capital buffer and risk management systems is implausible.74 Given the pro-cyclical nature of the banking industry and the misalignment of incentives prevalent prior to the current financial crisis, the Basel II framework provides little incentive for bank supervisors to sacrifice short-term profitability for future potential risk mitigation.75 Pillar 3 is criticized because it assumes that markets are efficient, in that markets process all available information rapidly and adjust prices accordingly. However, the history of the financial markets demonstrates that markets do not possess informational efficiency and therefore the additional disclosures were ineffective in imposing market discipline on banks.76 Even more interesting is how the Basel II frameworks failure to address these risks contributed to the activities that led to the current financial recession. BASEL II & THE GREAT RECESSION MORTGAGE ASSETS & RISK WEIGHTS The Basel II risk-weighting scheme arguably made mortgage assets more attractive to banks by reducing the credit risk weight associated with the assets.77 Under the Basel II framework, the capital

72

American Banker press release; available at http://63.240.127.120/article.html?id=2003120878YJ6YND&from=WashRegu 73 Basel II and the Potential Effect on Insured Institutions in the United States: Results of the Fourth Quantitative Impact Study 9QIS-4), Federal Deposit Insurance Corporation (Last revised December 6, 2005), available at http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin05/accounting_news.html 74 Wingnall & Atkinson, p. 7 75 Wingnall & Atkinson, p. 7 76 Wingnall & Atkinson, p. 7 77 Adrian Blundell-Wignall, Paul Atkinson & Se Hoon Lee, The Current Financial Crisis: Causes and Policy Issues, Organisation for Economic Co-operation and Development (OECD) Journal: Financial Market Trends (2008) [hereinafter Wingnall, Atkinson & Lee], p. 5, available at http://www.oecd.org/dataoecd/47/26/41942872.pdf

charge risk weighting for mortgage assets fell from 50% under Basel I to 35% under the SA and to as little as 15-20% under the IRB. The lower risk weighting both lowered banks capital cost for holding mortgage assets and increased banks rate of return on these assets. In order to juice returns and increase profitability, banks became increasing concentrated in mortgage assets. 78 Banks were able to accelerate the return on these low-risk-weighted mortgage assets by securitizing and distributing them, therefore incentivizing the originate and distribute banking model versus the originate and hold model.79 The securitization of these assets fed this virtuous circle of credit risk allocation by freeing up capital on banks balance sheets and allowing them to purchase even more mortgage assets that could be securitized and distributed. The bank run on and nationalization of Northern Rock, a bank in the UK, demonstrate the impact and risk-exploitation incentives of the Basel II risk-weighting framework. During the ten year period from 1997 to 2006, Northern Rock dramatically increased the assets on its balance sheet more than six-fold from 15.8 billion to 101 billion.80 The rapid increase in the institutions asset base was comprised largely of residential mortgage loans: by the end of 2006, 89.2% of Northern Rocks assets were residential mortgages.81 Comparatively, during this time the retail deposit base for Northern Rock grew from 9.9 billion in 1997 to 22.6 billion by the end of 2006.82 In order to fund this growth, Northern Rock adopted an originate to distribute business model, originating residential mortgages for the sole purpose of securitizing the mortgage assets and distributing them to the market place. The funds generated by the securitization process accounted for roughly 50% of the firms overall funding.83

78 79

Wingnall, Atkinson & Lee, p. 5-6 Michael Pomerleano, The Basel II Concept Leads to a False Sense of Security, commentary ; VoxEU Debate on the Global Crisis (February 5, 2010), available at http://www.voxeu.org/index.php?q=node/4561 80 The Run on the Rock, House of Commons Treasury Committee, Fifth Report of Sessio n 2007-2008, Volume I (January 2008) [hereinafter House of Commons Treasury Committee], para. 12, available at http://www.publications.parliament.uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdf 81 House of Commons Treasury Committee, para 13 82 House of Commons Treasury Committee, para 17 83 House of Commons Treasury Committee, para. 15

During this period of growth, the Basel II framework served to give Northern Rocks management a false sense of security. As a result of transitioning to Basel II, Northern Rock was permitted to use the AIRB approach to calculate its credit risk capital requirement.84 Northern Rocks decision to use the AIRB approach impacted the firm in two profound ways. First, the lower risk-weighting scheme under Basel II helped to free-up capital on the Northern Rocks balance sheet. While testifying before the UK Treasury in the aftermath of the firm being nationalized, the Northern Rock CEO said that when you get your Basel II approval, the relative risk weighting of certain assets in your balance sheet changes. So what we had ... was you saw our risk weighting for residential mortgages come down from 50% t0 15%. That clearly required less capital behind it.85 The lower risk-weighting for residential mortgages allowed Northern Rock to dramatically increase it residential loan portfolio with an alarming small amount of capital underpinning it. Second, the Basel II framework hid the weakening quality of Northern Rocks loan assets. During the expansion of Northern Rocks assets, the quality of loans in Northern Rocks portfolio was called into question.86 The CEO of Northern Rock defended the firm from these accusations and was cited as saying that analysis undertaken as part of the Basel II process had shown that Northern Rocks last 18 months lending is actually better quality than the previous two to three years.87 Soon after the CEO made this statement, there was a run on Northern Rock and the bank was nationalized. As in the case of Northern Rock, the risk-weighting scheme of the Basel II framework distorted banks perception of risk and enabled them to take on increasing amounts of risk without maintaining the appropriate amount of capital to serve as buffer for the risk. REGULATORY ARBITRAGE

84 85

House of Commons Treasury Committee, para. 43 House of Commons Treasury Committee, para. 44 86 House of Commons Treasury Committee, para. 18 87 House of Commons Treasury Committee, para. 13

Basel II created an incentive for banks to pursue regulatory arbitrage in order to increase profitability. Basel II incentivized regulatory arbitrage through the use of securitizations designed to produce lower regulatory capital charges.88 Banks accomplished this by pooling assets with higher risk-weightings and structuring the pools into collateralized debt obligations (CDOs) through the use of special-purpose vehicles. All but the most junior tranches of these CDOs would receive investment grade rating from external rating agencies and the more senior tranches would be sold to investors or to other banks. The net effect of the securitization process was that banks had effectively reduced the amount of higher riskweighted assets on their balance sheets, and in some instances replaced these assets with investment grade securitized assets that had lower risk-weightings, and lowered their required capital.89 In this respect, the Basel regulatory framework created an incentive for increased securitization activity, even if it was not the primary motivation for the securitizations. Banks also used credit default swaps (CDS) to execute regulatory arbitrage.90 The Basel I framework accepted only cash and government securities as collateral that could be used for risk mitigation purposes in order to reduce a banks required capital charge. Under Basel II, the acceptable forms of collateral expanded to include credit derivatives like credit default swaps.91 Basel IIs expanded risk mitigation measures permitted banks to lower the risk-weighting for their riskier assets by hedging them with credit derivatives such as credit default swaps. Perhaps the most infamous perpetrator of this practice was AIG. In its 2007 10-K, AIG stated that it held $527 billion in notional exposure in a super senior credit default swap portfolio and that of the stated exposure, $379 represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather

88

Kevin Dowd, Martin Hutchinson, Simon Ashby & Jimi M. Hinchliffe, Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation, Policy Analysis No. 681, Cato Institute (July 29, 2011) *hereinafter Dowd, Hutchinson, Ashby & Hinchliffe] , p3, available at http://www.cato.org/pubs/pas/pa681.pdf 89 Dowd, Hutchinson, Ashby & Hinchliffe, p. 23 90 Sam Jones, AIG and an overlevered Europe?, Financial Times, Alphaville blog site, Oct. 01, 2008, available at http://ftalphaville.ft.com/blog/2008/10/01/16559/aig-and-an-overlevered-europe/?source=rss 91 Bankers Guide, p. 10

than risk mitigation.92 Because AIG was highly rated during the heyday of the derivatives market activity, AIG did not have to post collateral on its credit default exposure and simply pocketed the stream of insurance premiums paid to it be these institutions. FUTURE OF CAPITAL MARKET REGULATION The prominent role the banking industry played in the cause and aftermath of the financial crisis drew the ire of the public and of government officials. In the immediate aftermath of the financial crisis, new laws and regulations were passed with the expressed intent of curbing the dangerous risk-taking activities of financial institutions. Of the new laws and regulations passed, two of the most prominent are Basel III and the Dodd-Frank Act. The application of Basel III is global in scope and seeks to build upon the Basel II framework while addressing many of the problems inherent in Basel II. In contrast, the DoddFrank Act is US legislation that is global in its impact, if not in scope, and unprecedented in the amount or power it grants the government over financial institutions. BASEL III In the aftermath of the financial crisis, the Basel Committee submitted and passed numerous proposals, collectively called Basel 2.5.93 The committee made additional changes to the Basel framework that, in conjunction with the Basel 2.5 proposals, compromise Basel III. Basel III incorporates numerous changes born from the lessons learned during the financial crisis. The Basel III framework attempts to further promote the stability of the banking industry by requiring banks to hold more capital to serve as buffer to shocks, imposed liquidity standards intended to help banks survive runs on the banking system, and established leverage ratios intended to ensure banks do not become overly leveraged.94 However, the

92

AIG Form 10-K 2007 Annual Report, p. 122, available at http://www.ezodproxy.com/AIG/2008/AR2007/images/AIG_10K2007.pdf. 93 Proposed Enhancement to Basel II Framework, Bank for International Settlements (BIS), January 2009, available at http://www.bis.org/publ/bcbs150.htm 94 Basel Committee Releases Final Text of Basel III Framework, Mayer Brown Legal Update (January 7, 2011) [hereinafter Mayer Brown Legal Update], p. 1-2, available at http://www.mayerbrown.com/publications/article.asp?id=10235

requirements of Basel III may be overly onerous or beyond the capacity of banks in the current recessionary environment. As recently as April of 2012, the Bank of International Settlements (BIS) stated that banks are still falling far short of the capital and liquidity targets established by the new regulation.95 Capital Requirements One important aspect of Basel III is that is requires banks to hold more capital to serve as a buffer in the event of shocks to the banking sector. Basel III increases the minimum level of core Tier 1 capital, composed of common equity that banks must hold, from 2% to 4.5%. The framework also requires that banks maintain a minimum total Tier 1 capital level of 6%.96 These increases will be phased in 2013. The new framework also requires larger banks to hold an additional Tier 1 conservation buffer of 2.5%. The requirement for increase will be phased in beginning in 2016. In sum, Basel III increases the minimum total capital, comprised of Tier 1 and Tier 2 capital, to 10.5%, including 2.5% buffer, from 8% under Basel II.97 Moreover, if a bank does not maintain the capital conservation buffer, the bank may continue its normal banking operations but may not use a specified percentage of its earnings for dividends, share buy-backs, other payments and distributions on Tier 1 capital instruments, or discretionary bonuses.98 Certain countries which headquarter banks that have asset balances larger than the countries respective GDP, and therefore the country cannot afford to bail out the bank in the event of another financial crisis,

95

Geoffrey T. Smith, BIS Says Banks Still Fail to Hit Basel III Targets, The Wall Street Journal (pay wall), April 12, 2012, available at http://online.wsj.com/article/SB10001424052702304444604577339831399445486.html?mod=googlenews_wsj 96 Basel III: Issues and Implications, KPMG LLP (2011) [hereinafter KPMG-Basel III Framework], p. 9, available at http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/basell-III-issuesimplications.pdf 97 Bank of International Settlements, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking System, Basel Committee on Banking Supervision (December 2010; revised June 2011) [hereinafter BISBasel III], para. 129, available at http://www.bis.org/publ/bcbs189.pdf. See also KPMG-Basel III Framework, p. 9. 98 Basel III: A New Environment for International Banks, Latham & Watkin s Client Alert Memorandum No. 1138 (February 3, 2011) [hereinafter Latham & Watkins Client Alert No. 1138], p. 5, available at http://www.lw.com/search?searchText=basel+III

have imposed total capital requirements much higher than the minimum requirement outlined in Basel III.99 Basel III imposes another capital requirement intended to directly counter one flaw of the Basel II framework: pro-cyclicality. The Basel III framework includes a counter-cyclical capital buffer that is intended to further strengthen a banks capital position when accelerating credit growth is deemed to pose a system-wide risk in the macro-financial environment.100 Depending on the level of systemic risk present, the counter-cyclical buffer can range from 0-2.5% of risk-weighted assets.101 This requirement will be phased in commencing 2016. Additionally, the countercyclical buffer must be met entirely by Tier 1 common equity, although the Committee is considering whether other fully loss-absorbing capital may qualify. As with the capital conservation buffer, if and as long as the countercyclical capital buffer is not met, a bank may continue its normal banking operations but may not use a specified percentage of its earnings for dividends, share buy-backs, other payments and distributions on Tier 1 capital instruments, and discretionary bonuses.102 Liquidity Requirements The Basel III framework includes two minimum liquidity standards designed to counter the liquidity risk that was realized during and greatly contributed to the financial crisis. The Liquidity Coverage Ratio (LCR) is a metric that promotes short-term resilience of a banks liquidity risk profile by requiring banks to maintain unencumbered high-quality assets sufficient to meet at least 100% of net cash requirements over a 30-day stress test period.103 The scenarios for the 30-day stress testing period includes run-off of a proportion of retail deposits, a stipulated partial or loss of unsecured wholesale funding capacity, a stipulated partial loss of secured short-term funding with certain collateral and counterparties, additional
99

Rachel Wolcott, Feds Capital Proposal Not as Tough as Feared, May Give US Banks Advantage, Reuters, Financial Regulatory Forum blog site, December 22, 2011, available at http://blogs.reuters.com/financialregulatory-forum/2011/12/22/feds-capital-proposal-not-as-tough-as-feared-may-give-u-s-banks-advantage/ 100 BIS-Basel III, para 137 101 BIS-Basel III, para 139 102 Latham & Watkins Client Alert No. 1138, p. 9 103 BIS-Basel III, para 38

contractual outflows arising from a presumed downgrade in the banks public credit rating of up to and including three notches, additional collateral posting requirements under derivatives, unscheduled draws on committed but unused credit and liquidity facilities, and a stipulated buy back of debt or honoring of non-contractual obligations to mitigate reputational risk.104 As can be seem, the intent of the ratio is to force banks to prepare for scenarios that were unimaginable prior to the financial crisis. Similar to the LCR, the Net Stable Funding Raito (NSFR) promotes liquidity over the one-year time horizon by creating additional incentives for a bank to fund its operations with more stable sources of funding.105 To that end, a banks Available Stable Funding (ASF) must equal or exceed its Required Stable Funding (RSF).106 The ASF equals a banks stock of regulatory capital, composed of both Tier 1 and Tier 2 after deductions, together with certain additional assets subject to haircuts and limited applicability.107 The RSF equals the sum of the assets held by a bank and the off-balance sheet commitments of the bank, multiplied by the relevant RSF factor. For example, unencumbered cash and money market instruments, unencumbered securities with effective remaining maturities of less than one year, and unencumbered loans to financial institutions that are not renewable or for which lender has an irrevocable call right, all will have a 0% RSF factor, meaning that they do not form part of a banks Required Stable Funding. In contrast, unencumbered loans to retail and small business customers with residual maturity of less than one year will have an 85 percent RSF and all balance sheet items not otherwise assigned an RSF factor will have a 100% RSF factor.108 Leverage Ratio Basel III also establishes a minimum leverage ratio intended to prevent financial institutions from building-up excessive on- and off-balance-sheet leverage similar to the amount of leverage that

104 105

Latham & Watkins Client Alert No. 1138, p. 11-12 BIS-Basel III, para 38 106 Latham & Watkins Client Alert No. 1138, p. 12 107 Latham & Watkins Client Alert No. 1138, p. 12 108 Latham & Watkins Client Alert No. 1138, p. 12

exacerbated the financial crisis. The leverage ratio is not risk-based because it is intended to reinforce and serve as a backstop to the frameworks general risk-weighting scheme.109 During the initial phasing in of Basel III, the framework requires that banks maintain a Tier 1 leverage ratio of 3%.110 In effect, this means that a banks total assets, both on- and off-balance-sheet, should never by more than 33x the banks capital. However, the combination of a lack of risk weighting for these assets and a limitation on the leverage the bank can employ may incentivize banks to pursue high-risk/high-return strategies in order to generate requisite levels of returns in the absence of leveraged returns.111 Impact on Securitizations The Basel III framework impacts the securitization market in numerous ways. For example, the Basel III framework significantly increases the risk weights applied to re-securitization exposures under both the Standardised Approach and Internal Ratings Based approaches to better reflect the inherent risks in these positions. 112 As a result of the higher risk-weighting, the capital requirements for these positions have risen dramatically.113 Additionally, the liquidity requirements imposed under the new framework will limit future demand for securitized products by the banking sector. Under Basel III, securitizations are considered 100% illiquid assets and therefore are not included amongst the high-quality liquid assets used to calculate the Basel III liquidity ratios.114 Because Basel III regulations exclude asset-backed securities (ABS) from the list of securities eligible for meeting the proposed LCR and NSFR, banks will be forced to shift their demand for securitized assets from ABS to assets with lower risk weightings that

109 110

BIS-Basel III site, para 151 BIS-Basel III, para 154 111 KPMG-Basel III Framework, p. 10 112 Bank for International Settlements, Report on Asset Securitisation Incentives, Basel Committee on Banking Supervision (July 2011) [hereinafter Basel Securitization Incentives], p. 24, available at http://www.bis.org/publ/joint26.pdf 113 Basel Securitization Incentives, p. 24 114 Basel Securitization Incentives, p. 24

can be used to satisfy these liquidity requirements.115 This shift in asset allocation by large banking institutions may adversely impact the securitization market because banks will not be able to pursue securitization to the same extent they did prior to the new Basel III framework.116 Criticisms Despite these improvements, the Basel III framework still elicits criticism for neither addressing some of flaws in the Basel II framework nor remedying the structural issues that are sowing the seeds of the next financial crisis. One major criticism of the Basel III framework is that is maintains the same risk-weights as Basel II for most bank assets. This decision has drawn significant criticism because the low risk weights in Basel II contributed to banks decision to engage in and securitize assets, such as mortgage loans, that represented greater risk than the Basel II framework assigned to the asset by means its assigned riskweighting.117 The failure to match an assets risk-weight to the assets true inherent risk will continue to incentivize a bank to increase its concentration in that asset because the potential reward still outweighs the risk.118 As was seen with the Basel II and the practices that contributed to the current financial crisis, the unjustifiably low risk weighting allows that bank to gain funding at a cost that is lower than its true cost of capital.119 Basel III will likely continue to incentive such herd behavior amongst banks. One often cited example is the LCR and how it incentivizes concentration in government bonds of highly rated

115

Hans J. Blommestein, Ahmet Keskinler & Carrick Lucas, Outlook for the Securitisation Market, Volume 2011 Issue 1 Organisation for Economic Co-operation and Development (OECD) Journal: Financial Market Trends (2011), [hereinafter Blommestein et al.], p. 9, available at http://www.oecd.org/dataoecd/36/44/48620405.pdf 116 Barua et al., p. 12 117 N.M., Third Times the Charm?, The Economist, Free Exchange blog site, September 13, 2010, available at http://www.economist.com/blogs/freeexchange/2010/09/basel_iii 118 Wingnall, Atkinson & Lee, p. 16 119 Robert C. Pozen, Risk-Weighting of MBS and Soveriegn Debt Under Financial Regulat ions, The Brookings Institution (December 5, 2011), available at http://www.brookings.edu/opinions/2011/1206_sovereign_debt_pozen.aspx

governments. 120 In truth, banks are already demonstrating this behavior as they begin to comply with the Basel III requirements.121 Another criticism of Basel III, and financial regulation at large, is the degree of influence banking institutions have on the regulatory formation process and the decision markers within the regulatory agencies. Financial institutions have arguably accomplished this regulatory capture in several ways. During the previous couple of decades, senior personnel from the financial services industry increasingly filled powerful positions within the US government, leading to increasing deregulation of the financial industry that coincided with increased profitability and wages amongst financial services personnel. 122 This allowed financial institutions to hire the best and the brightest as well as consistently deploy more resources in outmaneuvering regulators. Additionally, the wealth generated within the private sector increasing appealed to and drew talent from the public sector, further blurring the lines between the financial institutions and the persons that were tasked with regulating them.123 Financial institutions promulgated the ethics of and captured the middle class imagination with capitalism and free markets. The virtues of capitalism and the perception that hard work and elbow grease are the key ingredients to success fostered the acceptance of capitalism.124 This mantra convinced the public that it was okay to systematically deregulate the financial services industry and, in some instances, to not regulate financial innovation at all.125 This unquestioning belief in the ideals of capitalism and free markets empowered financial institutions and their advocates to

120

Rustom Barua et al., Basel III: Whats New? Business and Technological Challenges, Algorithmics, an IBM Company (September 17, 2010) [hereafter Barua et al.], p. 14, available at http://www.algorithmics.com/en/media/pdfs/algo-wp0910-lr-basel3-exd.pdf 121 John Carney, Jamie Dimon Confirms Worst Fears About Basel III, CNBC, January 13, 2012, available at http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_III 122 Simon Johnson, The Quiet Coup, The Atlantic, May 2009, available at http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/7364/2/ 123 Simon Johnson, The Atlantic, May 2009 124 Luigi Zingales, Capitalism After the Crisis, National Affairs Issue No. 1, Fall 2009, available at http://www.nationalaffairs.com/publications/detail/capitalism-after-the-crisis 125 Peter S. Goodman, Taking a Hard Look at a Greenspan Legacy, The New York Times, October 8, 2008, available at http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?pagewanted=all

counter attempts to regulate their activity by claiming that increased regulation would restrict the free market.126 DODD-FRANK WALL STREET REFORM ACT President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law on July 21, 2010.127 Dodd-Frank contains numerous new financial regulations and even created several new federal regulatory agencies. Two of the more pertinent new regulations outlined in Dodd-Frank are the new rules pertaining to credit rating agencies and the risk retention rules for securitizations. Credit Rating Agencies Credit rating agencies endured a lot of public outrage for their alleged role in the cause and aftermath of the financial crisis. In accordance with the Basel II regulations, the three biggest agencies that compromise the Nationally Recognized Statistical Rating Organizations S&P, Moodys and Fitch were blamed for providing inflated ratings to the securitized assets issued by banks in order to generate business from these banks.128 Little attention was paid to the inherent conflict of interest inherent in the rating agencies relationship with these banking institutions.129 Rightly or wrongly, many investors based their investment decisions on the rating issued by these agencies due to the government sanctioned role they played in the financial system. When the housing bubble burst, these same agencies were force to

126

Alan Fram, Financial Reform: Republicans Fight To Dilute Wall Street Regulations, The Huffington Post, July 5, 2011, available at http://www.huffingtonpost.com/2011/07/05/financial-reform-wall-street-gopwarren_n_890090.html 127 The Dodd-Frank Reform Act: Implications for Energy Companies, Utilities and Other Over-the-Counter Market Participants, Accenture (2011) *hereinafter Accenture-Dodd Frank], p. 3, available at http://www.accenture.com/us-en/landing-pages/management-consulting/riskmanagement/Documents/Accenture_The_Dodd_Frank_Wall_Street_Reform_Act.pdf 128 James Surowiecki, Ratings Downgrade, The New Yorker September 28, 2009, available at http://www.newyorker.com/talk/financial/2009/09/28/090928ta_talk_surowiecki 129 Rupert Neate, Ratings Agencies Suffer Conflict of Interest, says Former Moodys Boss, The Guardian [UK], August 22, 2011, available at http://www.guardian.co.uk/business/2011/aug/22/ratings-agencies-conflict-ofinterest

downgrade the inflated rating they provided to many of these MBS and ABS they rated prior to the financial crisis.130 In response to the public outcry about the rating agencies role in the financial crisis, Dodd-Frank includes reforms that address the objectivity of both rating agencies and their ratings. Dodd-Frank takes steps to improve the corporate governance of the conflicts of interest inherent to the rating agencies. For example, the act requires rating agencies to submit annual compliance reports to the SEC, maintain an independent board of directors, empowers the SEC to adopt rules to reduce conflicts of interest by placing restrictions on the ability of rating agencies to provide services other than credit ratings, and permits the SEC to suspend or revoke a rating agencys registration for rating particular classes of securities for failing to satisfy certain requirements. 131 In addition to corporate governance issues, the act attempts to increase the transparency of these agencies rating methodology as well. The act requires rating agencies to use a standardized form to publicly disclose their rating methodology. Moreover, to facilitate comparison among rating agencies, each agency will be required to periodically disclose information about the historical accuracy of its prior credit ratings. 132 The act also authorizes the SEC to establish mechanisms to change how rating agencies are selected by banks, in order to prevent rating-shopping by issuing banks.133 Perhaps the biggest reform emplaced by Dodd-Frank is that it rescinds the liability exemption previously afforded to these rating agencies for the accuracy and objectivity their ratings.134 Prior to Dodd-Frank, rating agencies effectively defended their ratings on constitutional grounds, arguing that the rating they issue are purely the rating agencys opinion and are

130

Rachelle Younglai & Sarah N. Lynch, Credit Rating Agencies Triggered Financial Crisis, US Congressional Report Finds, The Huffington Post, June 13, 2011, available at http://www.huffingtonpost.com/2011/04/13/credit-ratingagencies-triggered-crisis-report_n_848944.html 131 Gregory A. Fernicola and Joshua B. Goldstein, Credit Rating Agencies , Skadden, Arps, Slate, Meagher& Flom LLP & Affiliates, Commentary on the Dodd-Frank Act (July 9, 2010) [hereinafter Skadden Credit Rating Agencies Commentary], available at http://www.skadden.com/Index.cfm?contentID=51&itemID=2135 132 Skadden Credit Rating Agencies Commentary 133 Skadden Credit Rating Agencies Commentary 134 Skadden Credit Rating Agencies Commentary

protected by the First Amendment.135 However, Dodd-Frank removes this exemption, exposes rating agencies to liability of the rating agency consent to the inclusion of their credit rating in an issuance registration statement and permits civil remedies for plaintiffs against rating agencies.136 Securitization Risk Retention and Disclosure Dodd-Frank also addresses another major aspect of the Basel II and the financial crisis: risk retention by banks for securitized assets. Under Basel II, banking institutions could purchase assets, such as loans, securitize these assets for sale and remove the riskiness of the loans from their balance sheets through the securitization process.137 Under Dodd-Frank, the entity that securitizes such assets must retain no less than 5% of the credit risk in the assets is sells into securitization, unless the assets meet certain specific exempting requirements. 138 The entity can accomplish the risk retention using the following five options: 1) a vertical slice option; 2) a horizontal slice option; 3) a horizontal cash reserve fund; 4) an L shaped option combining aspects of both the vertical and horizontal option; and 5) a representative sample.139 Each option requires specific disclosures associated. Additionally, the Act prohibits the hedging or transferring of the retained credit risk, though certain exemptions are provided for adjusting the amount of risk retained or the hedging of the retained risk.140 The Act also increases the level of disclosure required of institutions that issue securitized assets. At a minimum, the issuers of asset backed securities are required to disclose asset-level or loan-level data,

135

Jonathan Stempel, Five Ohio Pension Funds Say Lost $457 mln On Bad Ratings, Reuters, September 27, 2011, available at http://www.reuters.com/article/2011/09/27/ohio-ratings-lawsuit-idUSS1E78Q0XY20110927 136 Skadden Credit Rating Agencies Commentary 137 Yener Altunbas, Leonardo Gambacorta & David Marques, Securitisation and the Bank Lending Channel, European Central Bank Working Paper Series No. 838 (December 2007), p. 13, available at http://www.ecb.int/pub/pdf/scpwps/ecbwp838.pdf 138 Andrew M. Faulkner, Richard F. Kadlick & David H. Midvidy, Securitization , Skadden, Arps, Slate, Meagher& Flom LLP & Affiliates, Commentary on the Dodd-Frank Act (July 9, 2010) [hereinafter Skadden Securitization Commentary], available at http://www.skadden.com/Index.cfm?contentID=51&itemID=2131 139 Overview of the Proposed Credit Risk Retention Rules for Securitizations, Mayer Brown (April 8, 2011) [hereinafter Mayer Brown Risk Retention Overview], p. 5, available at http://www.mayerbrown.com/files/Publication/d8c8d62e-3b3e-48f5-9d2d0d9cb9aa2eaf/Presentation/PublicationAttachment/49575b0b-0f37-4ac9-83b4-d6a3bf593610/10782.PDF 140 Skadden Securitization Commentary

to include the identity of brokers or originators of the assets, compensation for the brokers and originators and the amount of risk retained by the originator or securitizing entity.141 The impact of this requirement on the securitization market is two-sided. One the one hand, this requirement will adversely impact the securitization market by increasing both the administrative and the capital cost for originators and the due diligence burden for both investors and issuers.142 These increased costs, which are generally seen as unnecessary costs imposed by government intervention in the securitization market, will also affect the average consumer by driving up the cost of consumer credit.143 On the other hand, this requirement may impact the securitization market in positive way by reducing

the risk of financial instability arising from incentive misalignment and informational asymmetries between the investor and the earlier securitization supply chain participants.144 The combination of risk retention and increased disclosure requirements may improve the quality of loans used to fuel the securitization market because participants will be forced to internalize the costs of poor underwriting. 145
CONCLUSION: The global economy is still reeling from the effects of the financial crisis. Regulatory authorities, motivated by public outrage and their failure to foresee or prevent the crisis, have learned from their past mistakes and are enacting laws intended to prevent another such crisis. Basel III attempts to better capture the risks associated with certain asset classes and to curtail risk-taking behavior of banking institutions.

141 142

Skadden Securitization Commentary Blommestein et al., p. 9 143 Mayer Brown Risk Retention Overview, p. 32 144 Timothy F. Geithner, Microeconomics Effects of Risk Retention Requirements, Financial Stability Oversight Council (January 2011) [hereinafter Geithner-Risk Retention Requirement], p. 16, available at http://www.treasury.gov/initiatives/wsr/Documents/Section%20946%20Risk%20Retention%20Study%20%20(FIN AL).pdf 145 Geithner-Risk Retention Requirements, p. 16

Similarly Dodd-Frank seeks to address the misalignment of incentives of influential credit rating agencies and of the participants in the securitization market. However, banking institutions are pushing back against these proposed laws and regulations. Specifically, these institutions are pushing back against increased capital requirements and constraints on leverage.146 These constitutions also claim that Basel III static risk-weighting scale does not solve the problem.147 Additionally, influential international banking entities are seeking to mitigate the impact of laws such as Dodd-Frank by divesting themselves of operations such as proprietary trading.148 Despite the on-going struggle between banking institutions and the entities that seek to regulate them, the only thing that is clear is that the public perception of and trust in banks and these entities have suffered irreparable harm as a result of the financial crisis.149 As of yet, it is still unclear how this lack of trust and dissatisfaction will impact the future of the banking industry and banking regulation.

146

Matt Egan, Looming Rules Pressure Big Banks, Fox Business News, January 3, 2012, available at http://www.foxbusiness.com/industries/2011/12/29/looming-rules-pressure-big-bank-business-model/ 147 John Carney, Jamie Dimon Confirms Worst Fears About Basel III, CNBC, January 13, 2012, available at http://www.cnbc.com/id/45988683/Jamie_Dimon_Confirms_Worst_Fears_About_Basel_III 148 Suzy Khimm, Banks Preemptive Strike Against Dodd -Frank, The Washington Post, March 23, 2012 (revised March 24, 2012), available at http://www.washingtonpost.com/business/economy/banks-preemptive-strikeagainst-dodd-frank/2012/03/23/gIQATnUmWS_story.html 149 Claes Bell, Bank CEO Blasts Banking Industry, Bankrate.com blog site, April 10, 2012, available at http://www.bankrate.com/financing/banking/bank-ceo-blasts-banking-industry/