Dodd-Frank and Basel III's Knowledge Problem

Article excerpt

  I. INTRODUCTION   II. BACKGROUND      A. Landscape      B. The Dodd-Frank Act      C. The Basel Committee on Banking Supervision      D. Current State of Implementation and Possible         Conflicts  III. UNCERTAINTY AND THE KNOWLEDGE PROBLEM      A. Defining the Problem      B. Economic Policy Uncertainty      C. Dodd-Frank Derivatives      D. Liquidation and Acquiescence   IV. CONCLUSION 

I. INTRODUCTION

In 2010, a pair of responses to the 2008 financial crisis were released the Dodd-Frank Wall Street Reform and Consumer Protection Act (1) and the Third Basel Accord. (2) Much scholarly attention has been paid to the Dodd-Frank Act, (3) but little has addressed its subtle--but consequential--nuances where interplay with Basel III implicates considerable knowledge problems. (4) That Dodd-Frank's implementation, particularly in the area of bank capital requirements, is coincidental with that of Basel III, raises concerns in the areas of both domestic and international business transactions. (5) Because it is only a recommended framework, countries are free to implement or not implement Basel III, in whole or in part. (6) Given the myriad policy choices and incentives among its potential adopters, the potential for market and competitive advantages between countries is enormous. (7) Thus, U.S. regulators must create rules that ensure domestic firms engaged in international commerce are not disadvantaged or hamstrung by the U.S. version of Basel III, and the Basel Committee has a strong interest in ensuring a level playing field. (8) In similar fashion, market uncertainty follows the implementation of Dodd-Frank. The regulatory scheme seeks to segregate systemically important financial institutions for enhanced treatment, (9) opening the door and creating incentives for policy makers and regulators to push policy initiatives through those regulated institutions. (10)

The purpose of this Comment is to analyze the potential unintended consequences of Dodd-Frank and Basel III's implementation. Particular attention will be paid to the uncertainty they create and the potential effects of the knowledge problem. Part I contains a historical overview and brief explanation of the relevant legislative path. In it, emphasis is given to U.S. regulators' response to the crisis, as the historical market conditions and consequent incentives play a significant role in later analysis. This background information concludes with a summary of the current state of the relevant agencies' Dodd-Frank and Basel III rulemaking efforts. Part II focuses on the knowledge problem and the uncertainty created by these reforms. It will look to the purportedly simplified regulatory structure of the U.S. capital markets brought on by Dodd-Frank, and the problems that a hodgepodge implementation of international reforms, through Basel III, could exacerbate among U.S. financial firms.

I. BACKGROUND

A. Landscape

American financial regulation traces its contemporary roots to President Roosevelt and the New Deal Congress. (11) The purpose of this Comment renders unnecessary a full recitation of the interim regulatory climate, but the tendency to flip-flop through periods of enhanced regulation and deregulation is relevant to its premise. (12) The housing market's collapse triggered the 2008 financial crisis. (13) Improper lending practices, government policy, and the distribution of risk through the use of financial engineering all led to the expansion of the housing boom. (14) In general, mortgage loans provide a relatively stable cash flow for lenders, an attribute that makes them particularly suitable for securitization. (15) Banks seeking to mitigate their exposure to mortgage default risk frequently sell their loans to investment banks, who in turn package the loans into complex mortgage-backed securities. (16) After securitization, these mortgage-backed securities can be further securitized into collateralized debt obligations (CDOs). …