Dodd-Frank Review charts progress on 'too big to fail'

A review of the 2010 Dodd-Frank Act, which got underway in the United States last week, will provide useful insight into progress US policymakers have made in the development of "too big to fail" policies.

The principal aim of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was to ensure that no financial institution in the US should be so big or complex that its failure would put the US financial system at risk. This was the opening thrust of a review of the Dodd-Frank Act given by US Federal Reserve governor, Lael Brainard, last week.



The focus of the review is on assessing progress on too big to fail five years on. The review is both timely and topical given the tax changes on banks in the UK announced last week and on-going debate on a deposits tax in Australia, which is not motivated by concerns for ensuring systemic stability and distracts from such.



Perhaps something can be learnt from the tough regulatory approach of the Dodd-Frank Act and an apparent desire to break-up the largest and most complex US banks. The banks are not forcibly being broken-up but there seems to be a hope that the banks concerned may come to see such a move as an economic necessity.



Governor Brainard said: "As standards for systemically important firms tighten, some institutions may determine that it is in the best interest of their stakeholders to reduce their systemic footprint. Indeed, there already have been some notable structural changes at a few of the largest institutions over the past few years."



What are the incentives or "standards" that may encourage a reduction in a bank's systemic footprint? Capital, of course, is where it all starts and is the key but others cover liquidity, executive remuneration, living wills, and particular requirements for bank holding companies.

Eight US G-SIBs must maintain a minimum common equity tier one ratio of seven per cent of risk weighted assets. Our banks are only required to maintain a minimum CET1 ratio of 4.5 per cent.



On top of the minimum CET1 ratio the US G-SIBs must add a capital conservation buffer and any countercyclical capital buffer that may be required from time to time.

For our D-SIBs (the four major banks) a capital conservation buffer of 2.5 per cent will come into effect from 1 January 2016, as will a countercyclical buffer, which could add anywhere from zero to a further 2.5 per cent to the minimum CET1 ratio imposed on the banks.



In addition, a D-SIB capital impost on the major banks will come into effect at the same time. This impost is expected to be one per cent and should see a minimum CET1 ratio of at least eight per cent of risk-weighted asset applied to the major banks.



From the start of next year, the US G-SIBs will face capital surcharges ranging from one per cent to 4.5 per cent of risk weighted assets based on 2013 data. The size of the surcharge for individual G-SIBs will be determined by the estimated system-wide cost of their failure.



At its maximum, the capital surcharge could see a US G-SIB required to hold common equity amounting to at least 14 per cent of its risk weighted assets: nearly twice the requirement that will be imposed on our D-SIBs.



However, the capital imposts on the US G-SIBs do not end there. They will also be required to meet a leverage ratio of five per cent.

This is an absolute measure of gearing - no risk weighting of assets, and both on and off balance sheet assets will be measured. The assets of the G-SIBs cannot exceed 20 times common equity.



APRA has yet to decide on the implementation of a leverage ratio but APRA data to the end of March shows that the assets of our D-SIBs, excluding off-balance sheet assets, amounted to nearly 27 times their combined common equity. This is a leverage ratio of less than 3.75 per cent.



Should we be more concerned about the systemic implications of the failure of one of our D-SIBs?



Governor Brainard observes that the eight US G-SIBs account for 57 per cent of total assets in the US banking system. Our D-SIBs account for almost 80 per cent of all authorised deposit-taking institution assets.



A final consideration is that Governor Brainard celebrates the diversity of business activity among the US G-SIBs.

Our D-SIBs on the other hand, present a monoculture. If one does get into difficulty, it is very likely the other three will have similar problems.