FIN FPX 5710 Assessment 3 Organizational Review of Regulatory Policies

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Capella University

FIN-FPX 5710 Economic Foundations for Financial Decision Making

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Date

Introduction

This report aims to analyze and address the regulatory challenges faced by banks, both current and future, with a particular focus on the Dodd-Frank Act, Sarbanes-Oxley Act, and the Basel I, II, and III Accords. Midwest Global Investment Bank, as it contemplates transitioning from a private to a publicly traded bank in the investment banking sector, must navigate and understand these regulatory frameworks. The report will delve into the intricacies of each regulation and provide insights into how the bank can effectively manage these challenges.

Impact of Regulations: Dodd-Frank Act, Sarbanes-Oxley Act, and Basel Accords

Banking regulation in the United States has evolved into a complex system involving multiple regulatory agencies with overlapping jurisdictions (Mishkin, 2019). Regulations typically emerge as responses to industry growth, crises, and changes in technology and society, all of which affect the political climate. Key regulatory measures include the Dodd-Frank Act, Sarbanes-Oxley Act, and the Basel Accords.

The Dodd-Frank Act was enacted in response to the 2007-2009 financial crisis and introduced comprehensive reforms in seven categories, including consumer protection and annual stress tests for banks with assets exceeding $10 billion. It also addresses the “too-big-to-fail” issue through the Volcker Rule, which limits banks’ ability to trade with their own money and engage in high-risk activities (Mishkin, 2019). However, critics argue that the Act’s regulations have restricted lending and that certain aspects, like the Orderly Liquidation Authority, have not adequately mitigated risky behavior (Mishkin, 2019).

The Sarbanes-Oxley Act (SOX) of 2002 aims to improve governance, transparency, and accountability in corporate America. It was introduced in response to scandals involving companies like Enron and WorldCom. SOX applies to U.S. publicly traded companies, foreign companies registered with the U.S. Securities and Exchange Commission (SEC), and accounting firms that audit such companies (soxlaw.com). The Act’s 11 sections address various governance issues, including the personal accountability of CEOs and CFOs, enhanced financial disclosure, and increased penalties for white-collar crimes (soxlaw.com).

The Basel Accords—Basel I, II, and III—focus on mitigating risks related to off-balance sheet activities and risky assets. Basel I established risk-capital requirements, while Basel II introduced a three-pillar approach to link capital requirements more closely to actual risks. Basel III further strengthened the framework by addressing issues such as leverage and liquidity requirements (Mishkin, 2019).

Regulatory Framework Comparison

As Midwest Global Investment Bank considers transitioning to a publicly traded entity, it must carefully navigate the complex regulatory landscape shaped by the Dodd-Frank Act, Sarbanes-Oxley Act, and Basel Accords. Each of these regulatory frameworks brings unique challenges but also provides mechanisms for ensuring stability, transparency, and accountability in the banking sector.

Basel II and Basel III: A Comparative Analysis

Basel II, while successful in curbing excessive risk-taking, increased the complexity of banking regulations. However, the global financial crisis of 2007-2009 exposed several limitations of Basel II. For instance, it did not mandate banks to hold enough capital to withstand significant financial disruptions during the crisis. Furthermore, the standardized risk-weighting approach was overly dependent on credit ratings, which proved unreliable as the crisis unfolded (Mishkin, 2019). Additionally, Basel II was procyclical, meaning that during times of economic stress, when capital was most scarce, it required banks to hold more capital. As a result, banks’ capital balances deteriorated, leading to reduced lending and a subsequent slowdown in economic activity. Basel II also failed to address the critical issue of liquidity shortages, which led to the collapse of many financial institutions during the 2007-2009 financial crisis (Mishkin, 2019).

In response to these shortcomings, Basel III was introduced to enhance the resilience of banks and mitigate the risk of systemic financial shocks. Basel III aimed to strengthen capital requirements by not only raising them but also improving the quality of capital, reducing the procyclicality of capital requirements. It also introduced new regulations concerning credit ratings and liquidity management, ensuring that banks could withstand periods of financial stress (Bloomenthal, 2020). Furthermore, Basel III eliminated the riskiest tier 3 capital and raised tier 1 asset requirements from 4% to 6%, prioritizing less risky assets. Additionally, Basel III introduced leverage and liquidity requirements, including a 3% leverage ratio, to ensure banks maintain adequate liquidity during crises (Bloomenthal, 2020).

Economic Implications of Investment Banking Operations

Investment banking differs from commercial banking in that it does not generate profits from consumer deposits. Instead, investment banks earn commissions by acting as intermediaries between buyers and sellers across various markets and providing advisory services for mergers, acquisitions, and initial public offerings (IPOs). However, the introduction of the Volcker Rule under the Dodd-Frank Act placed restrictions on the level of risk investment banks could take on with their own capital, limiting their potential returns (Ross, 2020).

Investment banks play a vital role in the economy by facilitating large-scale projects, such as infrastructure development, that require substantial financial support. Although investment banks are critical to these projects, their substantial control over capital poses a risk to the broader economy should they face financial difficulties. Regulatory compliance is essential for minimizing these risks, but any failures in compliance can lead to penalties, fines, or even the closure of investment institutions.

Regulatory Considerations for Investment Banking Stakeholders

The regulatory environment for investment banking has become more stringent, with the primary goal of protecting stakeholders. These stakeholders include entities seeking investment funds, clients paying for advisory services, employees, investors, and others affected by the bank’s activities. The Dodd-Frank Act offers several key protections for these stakeholders, such as annual “stress tests” to assess a bank’s ability to handle economic downturns, the Orderly Liquidation Authority, and the Financial Stability Council, which identifies systemically important firms and imposes liquidity requirements (Bloomenthal, 2020). These regulations aim to safeguard stakeholders from risks such as employment loss, investment loss, and financial instability within investment firms.

However, some critics argue that these regulations, particularly the Volcker Rule and the Sarbanes-Oxley Act (SOX), impose undue burdens on firms, reducing profitability and making it harder to meet fiduciary responsibilities to stakeholders. Proponents of SOX, on the other hand, emphasize the importance of transparency and accountability, as the act holds the firm’s CEO and CFO legally accountable for misconduct (Sarbanes-Oxley Act, n.d.).

Conclusion

The regulatory landscape for both commercial and investment banking continues to evolve, driven by the need to protect the economy and stakeholders from financial crises. Basel III’s introduction represents a significant improvement over Basel II, with stricter capital, liquidity, and leverage requirements. Similarly, investment banking regulations such as the Dodd-Frank Act and the Sarbanes-Oxley Act aim to safeguard the financial system while balancing profitability with fiduciary responsibilities.

References

Bloomenthal, A. (2020). Basel III. Investopedia. https://www.investopedia.com/terms/b/basell-iii.asp

Mishkin, F. S. (2019). Economics of money, banking, and financial markets (12th ed.). Pearson.

FIN FPX 5710 Assessment 3 Organizational Review of Regulatory Policies

Ross, S. (2020). How investment banks make money. Investopedia. https://www.investopedia.com/articles/company-insights/092016/how-investment-banksmake-money-jpm-gs.asp
Sarbanes-Oxley Act of 2002. (n.d.). http://www.soxlaw.com