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This summer, a significant number of Basel III rules were

finalized in the U.S. Numerous banks will be required to not

only have more capital, but also hold a higher-quality, more

loss-absorbing capital. Also in July, the Federal Deposit

Insurance Corp. proposed a leverage rule that has a larger

denominator because it covers off-balance-sheet items. This is

a much stricter leverage rule than what the Basel Committee

recommended this summer.

The market should expect the slew of Basel III guidelines

released this summer to be proposed and implemented by

member countries once they are finalized, probably by the end

of this year and next quarter.

Key developments in Dodd-Frank this year also have significant

potential to make large banks safer. The Commodity Futures

Trading Commission has worked at record speed to finalize

derivatives rules, which are impacting banks’ risk management.

All major U.S. systemically important banks have been

designated as swap dealers. They now have to transition their

trillion-dollar portfolios of uncleared, opaque over-the-counter

derivatives to cleared derivatives, which are more transparent

and have less credit and operational risk.

Additionally, the FDIC took an important step this April by

improving requirements for the largest firms’ living wills. The

new requirements force bank management to understand

more about their firm’s risk management policies, what their

subsidiaries do, and how the bank would be resolved if it failed.

The Fed’s Bank Regulation ChallengesMayra Rodriguez Valladares

November 15, 2013

This article was originally published for American Banker

Importantly, the Federal Reserve and FDIC have been having

numerous discussions with their foreign counterparts to find

ways to cooperate if a globally systemically important bank fails.

Given the global interconnectedness of our top banks and the

fact that U.S. regulators do not have power over bankruptcies in

foreign countries, this international cooperation is key.

Despite these marked improvements, Yellen, should she be

confirmed, inherits GSIBs that are larger, more internationally

interconnected and more concentrated by counterparties in

their derivatives transactions than before the global financial

crisis.

Even with its imperfections, the implementation of U.S. Basel

III rules only begins in January 2014 with capital improvements

implemented incrementally through the end of 2018.

Unfortunately, there is much from Basel III that the Basel

Committee has not proposed or finalized.

Firstly, rules to require solid capital requirements to sustain

unexpected losses due to failing derivatives counterparties have

not been finalized. Certainly, the crisis taught everyone that

sometimes your counterparty can be downgraded or even fail

before your derivatives contract matures.

Secondly, banks are still relying heavily on value-at-risk market

risk measurement frameworks. The inputs to these models are

highly subjective and not transparent to outsiders. Moreover,

In her prepared confirmation hearing remarks, Federal Reserve chairman nominee Janet Yellen mentioned that U.S. banks are

in much better shape than they were during the crisis. Indeed, this has been a banner year for new regulations that are already

changing U.S. banks forever.

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even when good, they cannot tell risk managers what the worst

possible outcome that could wipe out their banks’ capital is.

The Basel Committee is in discussions about other frameworks,

such as expected shortfall. Yet for the foreseeable future, GSIBs

will utilize the less than perfect VaR disproportionately to

measure their market risk.

Thirdly, many risk management practitioners continue to

ignore operational risk, and the Basel Committee has yet to

make any recommendations to its measurement component in

Basel III. Much of what led to the global financial crisis – lack of

due diligence, personnel errors, internal processes violations,

conflicts of interest, weak governance and fraud – are all

examples of breaches in operational risk.

Lastly, Basel II and Basel III’s Pillar III, which features

requirements for transparency, remains neglected. It has not

even been implemented in the U.S. In continental Europe, there

is little uniformity in banks’ disclosures rendering them of little

use to market participants who want to know more about how

banks identify, measure, control and monitor risks.

Additionally, it remains to be seen whether U.S. regulators will

make good use of Dodd-Frank’s Title I, which empowers them

to curb bonuses and dividend payments if banks cannot comply

with new Basel III capital conservation buffers.

Based off the conversations I’ve had with regulators, I am

convinced the living wills still have to be strengthened to be

credible. Unfortunately, only the executive summaries of living

wills are available to the public. As such, they are of little value

to anyone trying to glean anything meaningful about banks’

risks. For example, banks need to give more details about the

purpose of their subsidiaries. Also, it is imperative that banks

explain more about the inputs that go into their risk models

and whether those models are really used to minimize risks.

Bank management needs to come clean to regulators about

where they house both derivatives and the collateral for those

transactions. These details are imperative if regulators have

any hope of successfully resolving a large, global bank should

it fail. As I have argued in these columns, we should focus on

improving Title I, so that Title II, an FDIC-led resolution of a GSIB

never has to be invoked.

Yellen’s confirmation as Fed chair is widely accepted. Assuming

she can encourage the Fed to keep up the pace, she can

continue to push for a safer, banking system. Under her

leadership, it is critical that the Fed work more closely with

prudential and relevant global regulators. It is far better for the

Fed to lead in preventing a bank resolution rather than to lament

what undoubtedly would have dire consequences to the global

financial sector and the economy.

This information was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.

Mayra Rodríguez Valladares is Managing Principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm.