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Give examples of reforms in law and regulation that followed the 2007-2009 financial crisis.

FRM® Part II · Operational Risk and Resilience · Solvency, Liquidity, and Other Regulation After the Global Financial Crisis · FRM2.ORR.22.h

The idea

After the 2007 to 2009 crisis reform moved on several fronts. In the United States the Dodd-Frank Act of 2010 created the Financial Stability Oversight Council, an orderly liquidation authority for failing large firms, a consumer protection bureau and stress testing requirements. Its Volcker Rule bars deposit-taking banks from proprietary trading. It also limits their investments in hedge and private equity funds, while still allowing market making and hedging. Following G20 commitments, standardized OTC derivatives must be cleared through central counterparties and reported to trade repositories. Uncleared trades face margin requirements. The United Kingdom adopted ring-fencing of retail banking from investment banking within a banking group. Basel III added higher capital, buffers, and leverage and liquidity ratios. For the exam, match each reform to the failure it was aimed at.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does the Volcker Rule, part of the Dodd-Frank Act, do?

  1. It requires banks to hold a minimum 3% leverage ratio on all of their exposures to clientsWhy not: This is a Basel III measure, not the Volcker Rule.
  2. It separates commercial banking from investment banking by ownership across the whole industryWhy not: Describes the Glass-Steagall approach, which the Volcker Rule is not; it limits specific activities.
  3. It requires all standardized OTC derivatives to be cleared through central counterparties, nothing moreWhy not: This is the derivatives clearing mandate in a different Dodd-Frank title, not the Volcker Rule.
  4. It bars proprietary trading by deposit-taking banks and limits their hedge fund and private equity stakes - correct

The Volcker Rule bars proprietary trading by banks with deposit insurance access and limits their ownership of covered funds, while permitting market making and hedging.

A harder one

Which describes a post-crisis reform of over-the-counter derivatives markets that followed the G20 commitments?

  1. All OTC derivatives are banned for banks and replaced by exchange-listed futures contractsWhy not: The reforms target standardized products and do not ban OTC derivatives.
  2. Standardized OTC trades must be centrally cleared and reported to repositories, with margin on uncleared trades - correct
  3. Dealers must settle all trades bilaterally and apply a higher risk weight to every positionWhy not: The thrust was to move standardized trades to central clearing, not to rely on bilateral settlement.
  4. Only derivatives held by hedge funds must be cleared, while dealers stay exempt from clearingWhy not: Dealers are the main participants subject to clearing and margin; the rules are not hedge-fund only.

The G20 reforms moved standardized OTC derivatives to central clearing, required reporting to trade repositories and introduced margin for uncleared contracts, reducing counterparty contagion.

The hardest tier

Which pairing of a pre-crisis weakness with the post-crisis reform aimed at it is correct?

  1. Thin capital after payouts in good times: the Volcker Rule on proprietary tradingWhy not: The Volcker Rule restricts activities; the capital conservation buffer addresses distributions.
  2. Reliance on short-term wholesale funding: the countercyclical capital bufferWhy not: The LCR and NSFR address funding; the countercyclical buffer addresses credit cycles.
  3. Taxpayer bailouts of failing large firms: the Basel III leverage ratioWhy not: Resolution authority and loss-absorbing capital address bailouts; the leverage ratio limits leverage.
  4. Opaque bilateral OTC exposure to a failing dealer: central clearing and reporting - correct

Match reform to failure: clearing and reporting for derivatives opacity, buffers for procyclical capital, LCR and NSFR for funding fragility, resolution regimes for too-big-to-fail.

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