SIFI Contemporary Banking Jurisprudence:
Basel III-Dodd-Frank-Volcker Big Bang
Author
Jamila Awad
Rights Reserved
JAW Group
Date
January 2013
Executive Summary
The financial crisisof 2008 instigated a global financial meltdown and fomenteda hazardous liquidity crisis. The essence of the paperis to cement a contemporary banking jurisprudence framework intended for banking systematically important financial institutions (SIFI). The dissertation conjugates Basel III surveillance banking prescript with the Dodd-Frank Act that governs the Volcker regulation to quest a safe and robust banking SIFI financial risk management protocol. The international financial community and its participants aspire torespire a new era in sage prudential banking practices.
Introduction
The global recessionand the liquidity crisis induced from the international financial meltdown of 2008 triggered the reconstitution of the banking system fuselage. A widespread sequence of economic authority guidance and parliamentarians mobilized to backfire the international financial crisis and to mastermind a contemporary era of financial risk management.
The premise of the paper is to engineer a contemporary banking jurisprudence framework that projects a grandiose picture destined for banking systematically important financial institutions (SIFI). The discourse merges Basel III superintendant banking guidelines with the Dodd-Frank Act that bolsters the Volcker regulation to route a safe and robust banking SIFI financial risk management framework.
The Basel III model targets banking institutions to cement global capital consolidation with harmonized financial liquidity standards and espouse superintendant financial instruments. The recent Basel protocol delivers monitoring tools released from stress-test scenarios to shield short-term and future liquidity clashes. Moreover, the code empowers financial risk management methodologies and buttresses banking disclosures. The prescript addresses sophisticated financial instruments and routes transparency in derivative trading to insure bearable risk-mitigation hedging techniques. Finally, Basel III foundation strengthens a microprudential regard on banking financial activities consistent with the Basel II scope of application.
The Dodd-Frank Act in conjunction with the Volcker regulation pioneers a groundbreaking era to introduce an innocuous trustworthy sage financial system presenting rigorous bank trading frontiers. Thus, a new epoch presaging robust financial risk management in money game institutions is destined to armor public safety and international economic immunity.
The Volcker rule essence to safeguard common man depositors from financial institutions distorted incentives in proprietary trading and hazardous dimensional outwardness in global economy.The Volcker frame of reference dictates permissible financial risk market-wide activity layers and adjudicates intolerable conflicts of interest between financial entities and their customers. Furthermore, the code mandates a continuous reporting and collaboration between financial entities and superintendant organizations during the transitional financial system reformation.
The paper is segmented infive sections. The Basel III frame is examined inthree sequenced distinctive composites. The initiating module elaborates the global capital consolidation and liquidity risk standards. The second section summarizes the banking SIFI prescribed harmonious invigilate monitoring tools. The terminating constituent resumes the transitional coordination and theBasel III scope implementation. The outstanding discourse elements assemble the Dodd-Frank Act governing the Volcker regulation. The fourth section introduces the Dodd-Frank foundation and pledge. The concluding section establishes the Volcker frame of conduct: proprietary trading prescripts, hedge fund and private equity fund confinement, repercussion on securitizations, and finally, the impact on insurance company investment activities.
1. Global Capital Consolidation and Liquidity Risk Standards Surveillance
The inaugural Basel III framework componentaccentuatesstandards to promote liquidity risk superintendence. The Liquidity Coverage Ratio (LCR) as well as the Net Stable Funding Ratio (NSFR) revive retained ratios targeted to cement sage global capital consolidation. The liquidity funding harmonization pioneers a new era in prudential financial risk management and entangles an international impartial competitive playground in contemporary banking system.
1.1 Liquidity Coverage Ratio
The Liquidity Coverage Ratio (LCR) aspires to guarantee primordial caliber liquidity to battle rigorousthirty calendar days into the future timeframestress scenarios. In precise terms, LCR addresses short-term banking liquidity risk backlashes. The mathematical solution equates dividing stock of high-liquid assets by the total net cash outflows over the next 30 calendar days. Basel III dictates SIFI entities to preserve an uninterrupted LCR ratio equal or above 100% and chamber prime liquid assets to manu militari liquidity stress contends. Furthermore, a rigid guideline induces the parameters to mimic stress-test scenarios resulting from idiosyncratic and market-wide shocks while encouraging financial institutions to perform internal stress tests in parallel. Descriptive instructions are channeled in Basel III curriculum to characterize unburdened assets that fast pace immediate conversion into cash with minimal value erosion under severe stress financial market conditions.Hence, austere financial liquidity risk management enhances confidence in the banking system without obstructing the capacious financial system.
A tenacious inquiry in Basel III framework introduces the calculation behind total net cash outflows in stress environment sphere calculated in prospectus for the thirty upcoming days. Total anticipated cash outflows are schematized through a multiplication of outstanding balances illustrating liability classes and off-balance sheet pledges by adjunct draining rates. A user-friendly protocol announces run-off factor percentiles to map various asset categories funding transactions and converts potential risk elements into compelled inventory of high-quality liquid assets. Finally, the LCR consolidates a complementary parameter to merge with the Net Stable Funding Ratio. The paired standardsadvert to persist transparent within the jurisdiction and internationally.
1.2 Net Stable Funding Ratio
TheNet Stable Funding Ratio (NSFR)goals to praise medium as well as long-term financial backing from retained assets and institutional activities over one-year timeframe firm-specific stress scenario. The metric depicts a standard that safeguards long-term asset funding through minima financial sound liabilities sums in cohesion with peculiar liquidity risk categories. The NSFR ratio portraits the available amount of stable funding divided by the required amount of stable funding. The Basel III prescript requiresfinancial entities to preserve the specified metric greater than 100%. Furthermore, stable funding is injected through equity and liability financing blocks conjectured as staunch sources of funds in severe stressful conditions to encompass a one-year time horizon. Available stable funding types are then paired to adjunct factors to schematize sound figures. In addition, distinctive off-balance sheet exposures are sorted with specific required stable funding factors. Notwithstanding, the NSFR unification with LCR embodies an optimal funding methodology to assess liquidity risk during thriving financial market conditions.
2.InvigilateMonitoring Instruments
Basel III second composite establishes invigilate monitoring instruments concomitant to liquidity risk measures grail at ceasing relevant information from a financial institution’s balance sheet and cash flow statement. The common metrics enables international consistency in alternate supervision tools. The frame of reference encourages firms to design tools to reinforce liquidity risk specific modules to their jurisdictions. The invigilate monitoring instruments are segmented intofive summarizedcategories.
2.1 Contractual Maturity Discrepancy
The contractual maturity discrepancy seeks to label disparity between contractual liquidity inflows and outflows from on and off-balance sheet items for sequenced time periods. Therefore, the maturity disparity discloses the potential liquidity required to fund sequenced time periods if all outflows abound at precursor dates. This tool exposes banking reliance on current contracts maturity alteration. Supervisors in financial institutions are appointed to construct market-wide views to determine a jurisdiction feasible template suitable to monitor the contractual maturity discrepancy instrument.
2.2 Financial Backing Concentration
The financial backing concentration aims at looping highly significant sources of wholesale funding that could motion liquidity problems if withdrawn. This metric anticipates superintendants to assess funding liquidity risk by grouping financial liabilities from the bank’s balance sheet into categories relying on their density ponderations: counterparty, instruments and currencies. Hence, surveillance administrators will excel in diversifying funding sources while continuously monitoring the instruments under market-wide stress scenarios to capture hazardous risks.
2.3 Accessible Unburdened Assets
The accessible unburdened assets represent marketable resources that can be merchantable as pledge in secondary financial markets or can be qualified for central banks’ running facilities. This proctor tool gathers relevant information on unburdened assets accounting for currency denomination and location while placing emphasis on potential ability to cumulate additional secured funds during stressful scenario screens. However, the accessible unburdened assets measurement scale provides an accurate estimation of liquidity risk when complemented with the contractual maturity discrepancy metric.
2.4 Liquidity Coverage Ratio by Significant Currency
The liquidity coverage ratio by significant currency symbolizes an invigilator tool to apprehend potential currency discrepancies denominated in LCR. This instrument equates the ratio of high-quality liquid assets in significant currency inventory divided by the total net cash outflows over a 30-day time period in the retained significant currency. Nonetheless, banking proctors in various jurisdictions are held responsible to determine minimum foreign exchange ratios relying on stress assumptions and evaluate their banks competence to transfer liquidity surpluses from currency markets.
2.5 Market-related Surveillance Devices
Market-related surveillance devices characterize monitoring tools targeted at providing continuous high frequency financial market data to presage banking liquidity hardships. Superintendants are encouraged to monitor market-wide information and study the data to anticipate funding projections and liquidity turbulences. In addition, they stand in charge of tracking the financial discipline as a whole to foreshadow liquidity agitation. Finally, supervisors are requested to track bank-specific information such as market confidence towards their financial institution. This metric considers reactions of other market participants to financial data changes.
Brief, the invigilate monitoring instruments enhances a macroprudential regard to banking supervision and supplements global capital consolidation standards to face liquidity risk challenges.
3. Transitional Coordination and Scope Implementation
The global consolidation instruments and the invigilate monitoring tools should be conjectured continuously to sustain concordance with Basel III concluding component. Financial liquidity instruments such as LCR and NSFR are performed as well as reported with minimal time lag during stressed situations. The Basel frame of reference postulates LCR widespread on January 1, 2015 and NSFR shift to a minimum standard by January 1, 2018. The recent Basel scope implementation pursues indications derived from Basel II framework while emphasizing on guarantying consistency and impartiality between domestic and cross-border banks. The liquidity standards are projected to consolidate home and host jurisdictions while considering market-wide stress-test scenarios. The Basel Committee envisages examiningbanks transitional coordination with financial markets and economic growth.
4. The Dodd-Frank Act
The Dodd-Frank Act aims at securing financial participant depositors from perilous banking practices and pledges a rigid banking code of conduct. Thus, the Dodd-Frank Act rules SIFIs to intermittently communiqué plan of actions for fast pace and adequate resolution in the occurrence of material financial distress or failure. Hence, SIFI are required to solution a contingency proposal and its affairs under the U.S. Bankruptcy Code in drowning material financial torment times. Article II presaging the Dodd-Frank Act appoints the Federal Deposit Insurance Corporation (FDIC) as receiver pursuant to the Orderly Liquidation Authority to settle potential insolvent SIFIs. Finally, The Dodd-Frank Act administers the Volcker regulation.
5. Volcker Regulation
The Volcker governance incites banking entities to comply with the regulation by July 21, 2014 with maximum three one-year extensions. Theguiding principles direction the following financial sectors: proprietary trading, private funds, securitizations and insurances companies.
5.1 Proprietary Trading Prescripts
The rationale of proprietary trading prescripts is to dictate financial institutions managerial activities destined to ameliorate the safety of their operations while preserving traditional client-oriented financial services. The rigorous guideline imposes significant recordkeeping and reporting requirements to police frontiers between banned proprietary trading and acceptable activities. Hence, covered banking institutions are prohibited from proprietary trading in covered financial positions. In precise terms, SIFI are bound to engineer fundamental changes in their trading accounting practices given the complexity of contemporary modern settlement practices and the panoply accounting involved. Banking establishments are requested to articulate activities undertaken for bona fide liquidity management and in harmony with an articulated liquidity conduct ordinance to circumvent accounts to be considered trading accounts. SIFIneed tocomply with Basel III bylaws by ensuring available liquid assets to meet short-term needs even during periods of market disclocation. The Volcker frame of conduct red carpets regulatory agencies to embrace prescripts that would promote precautious and sage financially stable activities.
The compensation packages designated to market making underwriters is subject to the Volcker governance by forbidding reward proprietary risk-taking. In addition, a tailored internal compliance procedure is commanded to reflect the magnitude, specter and complexity of activities and business structures of covered banking organizations. SIFI revenues are expected to route from activities not attributable to appreciation in the value of the financial positions it holds or from the hedging of covered financial positions. The Volcker code authorizes banking entities to engage in underwriting activities when designed to warrant near-term demand of clients, customers and counterparties. A multifaceted approach dictates commissioned market-related activities from the purchase and sale of covered financial positions by ordering banking firms to render a reporting regime that discloses quantitative market making measurements. The proposed Basel III invigilate monitoring instruments facilitatebona fide market making banking requirements and foresee liquidity near-term demand from large block trades and risk-mitigating hedging techniques exempt from prohibited proprietary trading. Banking entities are required to conduct evaluations following the protocol measurements to reasonably expected liquidity near-term demands of clientsand document reports to relevant agencies. None withstanding, market making-related functions must be coherent with surveillance agency instructions to distinguish proprietary trading from market making activities.
Finally, the Volcker manual embodies a focus on conflicts of interest disclosures and its supervision to face transactions that involve banking firms interest being materially adverse to the interest of contributive parties.
5.2 Hedge Fund and Private Equity Fund Confinement
The Volcker rule frame proscribes banking institutions to sponsor or invest in hedge funds or private equities however guidelines certain exceptions. A sponsor is defined as an entity that contributes as a covered fund managing partner or commodity pool operator. Concise definitions of covered funds are cited in the Act to filter SIFI forbidden activities such as owning or retaining interest in certain types of covered funds. A strict prescript retains ownership of covered fund interests to purpose risk-mitigation hedging techniques. Banking organizations are granted authority to acquire bank owned life insurances and transact with corporate organization vehicles to safeguard financial activities. Furthermore, a frame of reference is dictated to settle treatment of commodity pools. The Volcker protocol permits exceptions in covered funds such as legitimate services in compliance with statutory and regulatory requirements. Banking firms must document credible plan to outline bona fide services. A rigid single fund investment limitation is set up to a three percent maximum of the total amount or value of covered fund and three percent of its Tier 1 capitalto structure banking firms’ investment boundaries.
The Dodd-Frank Act presents a segment to propose SIFI to integrate a statutory language preventing insurance covered fund obligations and performances.The authorized covered funds are prohibited to incorporate the word bank or share the name of the banking entity. Administrators and employees directly engaged in activities with covered funds are forbidden to retain ownership interest in the funds they manage. SIFI are subject to prominently document to actual and prospective investors in covered funds disclosures to comply with the Volcker regulation. The Dodd-Frank Act examines U.S. and non U.S. jurisdictions to rule sponsoring covered fund activities in the pertained funds. Finally, the closing element of the hedge fund and private equity fund confinement divulgates conflict of interest material and managerial ordinance.
5.3 Repercussion on Securitizations
The Volcker frame of reference restricts banking entities from contributing in common securitization practices in asset-backed markets such as commercial papers and collateralized debt obligations. Furthermore, SIFIare prohibited from engaging ownership interest in covered funds aside from narrow exceptions. The alternative investment company act exempts certaingroupof traditional securitizations such as mortgages, real-estate trusts, automobile and credit card loans. Banking institutions are allowed to hold interest in asset-backed securities (ABS) when it does not qualify with the ownership definition similar to the rationale with covered funds. ABS transactions remain subject to recent alterations dictated by the Securities and Exchange Commission (SEC). The three percent exception ordinance is applicable in securitizations pertaining similar guidance with the hedge fund and private equity fund prescript code. SIFI are entitled to retain amounts attributed under risk retention procedures in securitized asset markets such as ABS transactions following a rigorous set of regulations in concordance with the Dodd-Frank Act. The Volcker rule mitigates the effect of securitization on proprietary trading prohibition by addressing ABS issuers not bound to covered funds. The concluding segment on securitization repercussion exposes conflict-of-interest relationships between ABS participants and distributors while embracing bona fide risk-mitigation methodologies.