US Banks Between a Rock and Hard Place: Dodd-Frank and Basel III Compliance

The environment in which financial institutions operate, both globally and domestically, is poised to undergo immense change in the coming years as Basel III and Dodd-Frank are implemented. While both are considered game-changers for the market, some inconsistencies in the respective approaches are starting to emerge. These tensions could place financial institutions in an awkward position with important implications for both the US and global economies.

Some of the conflicts are rather basic and conspicuous as shown on page 11 of this piece from the Congressional Research Service. For instance, Basel III relies on the use of credit ratings from the like of Moody’s, Standard & Poors, and Fitch when assessing risk. However, Dodd-Frank steers clear of rating agencies given the recent misrepresentations of mortgage backed securities credit risk.

Another blatant inconsistency regards hybrid securities, such as trust-preferred securities, being bumped from the list of Tier 1 capital under both regulations. The pre-implementation prominence of trust-prefered securities can be seen in this Philly Fed research which highlights U.S. banks ability to have as much as 25% of Tier 1 capital in the form of hybrid securities. For U.S. banks with assets of $15 billion, the timeline for winding-down hybrid securities as Tier 1 varies between the two regulations. Basel III allows for a decade long wind-down where as Dodd-Frank looks for a three year phase-out.

There are other conflicts between the two regulations that are less apparent and revolve around subjectivity and interpretation. As pointed out on page 5 of this letter from prominent international banks to U.S. financial regulators, Basel III's liquidity coverage ratio and the "bona fide liquidity management" exception in the Volcker Rule are poised to conflict. The liquidity coverage ratio, set to take effect in 2015, requires banks to hold 30 days worth of high-quality liquid assets available for sale and conversion to cash in order to maintain solvency for 30 days in the event of a crisis. Currently, these assets, which would be mostly sovereign debt and cash, will have to meet four criteria:

• Low correlation with risky assets
• Low credit and market risk
• Ease and certainty of valuation
• Listed on a developed and recognized exchange market

Taking the proposed Volcker Rule at face value, U.S. banks would have to comply with the liquidity coverage ratio by holding only US debt and cash in their liquidity trading account. But, U.S. regulators could allow banks to use the "bona fide liquidity management" exception to the Volcker Rule. Under this exception, banks would be allowed to trade "an amount that is consistent with the banking entity's near-term needs". This could permit banks to comply with Basel III and diversify holdings for the liquidity coverage ratio beyond U.S. debt and cash, assuming it still met the four criteria. However, the key to the "bona fide liquidity management" component is how the regulators' will define "near-term". If their definition does not meet the 30 day threshold of Basel III, then banks will be limited in what assets they can hold to meet the liquidity coverage ratio.

In short, how U.S. regulators choose to define parts of the Volcker Rule will impact how U.S. banks comply with Basel III. Using interpretations which allow U.S. banks to trade non-U.S. sovereign debt under “bona fide liquidity management” and the liquidity coverage ratio would likely be favored by many foreign economic and finance leaders. There has been growing international sentiments from leaders abroad against the Volcker Rule’s bias towards U.S. government debt. The likes of Canada, Japan, the United Kingdom, and France have all expressed worries about global liquidity and stability if U.S. banks are not allowed to trade their sovereign debt (but are allowed to hold portfolios of U.S. debt).

At this point, it’s very difficult to game out exactly how regulators intend to implement upcoming financial regulations and potentially reconcile differences between Dodd-Frank and Basel III. There is also the chance for even greater conflict between the two in the near term. The recent events around Greece have brought to light the reality that there is no risk-free asset class, a title many once held out only for sovereign debt. As such, it’s at least possible that Basel III could look to require banks to hold a more diverse set of assets, including perhaps corporate debt. This would clearly put US regulators and banks in a tough spot as they look to advance domestic reforms.