Basel II, Basel III & the Financial Crisis – Bull by the Horns – a review.
Bull by the Horns: Fighting to save Main Street from Wall Street and Wall Street from itself by Sheila Bair, chronicles her tenure as FDIC Chairman from 2006 to 2011 during the Great Recession. It is a gripping read as one is taken through a regulator’s roller coaster ride of the financial crisis.
Sheila is very vocal about the need for stronger lending standards and feels that the crisis could have been averted had banks been held to tougher standards by their regulators rather than relying solely on self regulation and the free market. The absence of oversight, led to questionable and often predatory lending practices. The banks motive were skewed away from really helping low income segments of society to benefiting from fees received from refinancing to more and more complex loan structures- adjustable rate mortgages, negative amortization ARMS, etc -without adequate underwriting and documentation.
After the housing market down turn and when mortgage defaults began to rise, every effort should have been made to increase the servicing of loans and move to a systematic process of loan modifications. But banks’ and their servicer’s incentives for such modifications had been misaligned with the securitization of mortgages. Investors in these mortgages, in particular those in senior tranches benefited more from foreclosure as even though losses were higher overall in a foreclosure as compared to loan modifications, senior tranche investors had first claim to recoveries when homes were ceased and sold off. They did not care for the losses suffered by the subordinated tranches, nor the fact that millions lost their homes. Loan modifications on the other hand would have forced all the holders of the securitized investments to take a write down, however on an overall basis, all investors would have benefited and home owners would have continued to retain their homes.
Through her efforts in the Dodd Frank act, mortgage servicers are now required to retain 5% of the risk of loss from a mortgage going bad from the pool that is securitizes. This would mean that in the event of a loss servicers would claim the same from mortgage brokers who sold them the loans. This in turn would mean that brokers would be more careful to ensure that they obtain quality mortgages otherwise servicers would think twice before doing business with them.
A strong proponent to more stringent capital requirements, Sheila was opposed to the Basel II alternative approaches method for determining risk based capital requirements. She saw it as playing into the hands of the financial industry who sought opportunities for increasing return through increased leverage. Adopting Basel II alternative approaches would allow banks to reduce their capital in a self assessment process and increase their investment in risky high paying assets. Sheila strongly felt that leading into the crisis banks should have been made to strengthen their capital positions, but here she met resistance from other industry regulators. Due to her efforts the FDIC insured banks were not allowed to assess capital based on Basel II despite intense lobbying from the industry. However non-bank financial institutions, not under FDIC jurisdiction, were allowed to do so by their respective regulators. The consequence of this was that investments banks, thrifts and other non-bank FIs suffered tremendously due to their excessive leveraged positions and investments in high risk toxic securities with many failing and the Office of Thrift Supervisor (OTC), their regulator, itself being subsequently abolished.
In the years following the crisis she has been instrumental in the Basel III process, which has toughened capital requirements, increasing the minimum from Basel II levels and improving the quality. A separate additional surcharge was also imposed on significantly important financial institutions. She also has played a major role in the introduction of a global leverage ratio. The leverage ratio would be more effective than risk based ratios in making banks think twice before investing in high risk investments.
Her involvement in the enactment of Dodd-Frank act, has imposed stricter and higher quality capital requirements on larger banks (their capital requirements should be at least as strict as that of smaller institutions) and bank holding companies (their capital requirements should be at least as strict and the banks they own) with hybrid investments not to be counted towards capital.
It is amazing how much resistance she received when dealing with other regulators. Regulators like the OCC who she believed were held captive by the financial industry. These regulators were more interested in resisting stronger regulation for banks rather than in protecting the public who they were supposed to serve. Her disdain is very evident when she recalls the Citigroup bailout. In many instances she felt that measures were taken by the regulators, measures she is not entirely convinced were necessary such as the TARP program, just for the sake of saving this poorly managed behemoth institution and its creditors and shareholders without holding them accountable for them poor management.
She also championed the cause of obtaining resolution authority of banking and non-banking financial institutions for the FDIC and a ban on future bailouts by the government. The FDIC proved their experience in conducting orderly resolutions of failing insured bank institutions, through open and closed bid transactions so that insured depositors would have continued access to their funds after a break of only one business day. The efficient manner in which these resolutions were conducted by FDIC staff avoided possible run on banks. With resolution authority, shareholders and creditors of these failing financial institutions would be first in line to absorb the losses caused by their decisions, without passing this loss on to innocent tax payers. Senior management and board members would be held accountable and lose their jobs with significant compensation claw-backs in the event of failure. Under the Dodd-Frank act, large financial institutions, considered too big to fail and systemic in nature, were required to submit living wills on how their organizations could be resolved in the event of their failure without causing significant disruptions to the financial system. If they could not prove that this could be done, then the regulators would require significant restructuring of the institutions.
Her suggestions regarding credit default swaps, a form of insurance protection on the default of losses of debt securities seems like very sound advice to one who has worked in the insurance industry. Ensure that investors in such CDS have an insurable interest, i.e. would stand to lose financially if the event occurs. Speculative purchasers of CDS do not have exposure to the underlying debt instrument yet stand to gain if the entity issuing the debt instrument fails. Such investors have an incentive to game the system for failure which was very evident during the financial crisis.
I was inspired reading this book by the practical manner in which she worked for solutions to these tough problems given the limitations, restrictions and the continuing obstacles that the financial conditions, her fellow regulators and the financial industry imposed or placed in her path. Her efforts in dealing with the media and the open manner in which she educated the public of the risks and educated them of the efforts and actions being undertaken by her organization to address the issues are laudable. Her courageous stance and public objections and concerns on actions by other regulators, in particular the Treasury Secretary Tim Geithner, and financial industry lobbying often at significant personal risk are commendable.