This paper by Viral Acharya (NYU Stern), attempts to explain the changes to financial sector reforms under the Dodd-Frank Act in the United States and Basel III requirements globally; their unintended consequences; and, the risks to currently fast-growing nations such as India from transition of the global financial sector to these changes. The note also provides some broader lessons for India concerning financial sector reforms, government involvement in the financial sector, possible macro-prudential safeguards against spillover risks from the global economy, and finally, management of government debt and fiscal condition.
Acharya highlights four of its primary shortcomings:
1. Lack of any attention to distortive role played by government guarantees to the financial sector;
2. A somewhat ill-conceived resolution authority which will likely contribute to substantial uncertainty at the time of next crisis;
3. Regulating by form rather than function in several restrictions being imposed on the Federal Reserve‟s lender-of-last-resort role; and
4. Not adequately dealing with shadow banking, especially with collections of individually small contracts and markets such as repo financing and money market funds which are collectively systemically important.
The paper also looks at the new capital and liquidity requirements under Basel III reforms and arguea that Basel III, like its predecessors, is fundamentally flawed as a way of designing macro-prudential regulation of the financial sector:
1. Basel requirements employ static risk-weights on asset classes and fail to capture any time-variation in relative risks of assets;
2. They fail to recognize that risk weights alter incentives of the financial sector be exposed to different asset classes;
3. They ignore as a result any correlated or concentrated exposure of the financial sector to an asset class that has looked historically stable; and,
4. It does not employ more direct firm-level or asset-level leverage restrictions. In contrast, Dodd-Frank has several redeeming features including requirements of stress-test based macro-prudential regulation and explicit investigation of systemic risk in designating some financial firms as systemically important. These overall limitations and some benefits of Dodd-Frank and Basel III are also brought out in a “back to the future” exercise that asks what difference, if any, these reforms would have made had they been in place during 2003-2008.
India should resist the call for a blind adherence to Basel III and persist with its (Reserve Bank of India‟s) asset-level leverage restrictions and dynamic sector risk-weight adjustment approach. Indeed, these asset-level and dynamic approaches which are popular in India and some other Asian countries are useful for Basel committee and other Western regulators to consider in future financial reforms.
The then analyze transition risks to India from implementation of Dodd-Frank and Basel III reforms:
1. Banks, especially in the Eurozone, undergoing a slow “credit crunch” as they build capital through retained earnings rather than immediate recapitalization;
2. Flow of leverage and risk-taking to shadow banking world of hedge funds and asset managers, who are likely to chase fast-growing emerging markets but also withdraw flows rapidly when faced with home-country shocks;
3. Basel III‟s liquidity requirements inducing a “bubble” in Eurozone sovereign bond holdings relative to worthiness of their credit, strangling – or making more expensive – government borrowing for other economies; and,
4. The rising cost of financial sector bailouts in the Eurozone, its spillover to sovereign balance-sheets, and its interaction with inadequately capitalized financial sector that is significantly exposed to sovereign bond holdings.
Ideas for Growth
Some important lessons for regulation of financial section in India based on the crisis and proposed reforms in the aftermath are drawn out of this research, particularly:
1. Charge for government guarantees to the banking sector (especially the explicitly guaranteed, state-owned sector) and plan for a graceful exit to obtain a level-playing field in financial risk-taking;
2. Undertake a fully macro-prudential view of its financial sector regulation (covering not just banks but also “shadow banks”) so that the perimeter of leverage restrictions retains its sanctity;
3. Strive for a consensus amongst fast-growing emerging markets as well as in G20 for principles guiding systemic risk containment in the financial sector, which in turn can limit global spillover risks (such as Eurozone debt crisis);
4. Manage the government debt capacity and fiscal deficit in a counter-cyclical manner (relative to risks to rest of the economy), while also creating depth of institutions in credit and fixed-income markets to withstand economy-wide shocks and dampen the blow of equity-market‟s volatility induced by portfolio flows exposed to global risks.