The Dodd-Frank Act and Basel III: Intentions, unintended consequences, and lessons for emerging markets

This paper is an attempt to explain the changes to finance sector reforms under the Dodd-Frank Act in the United States and Basel III requirements globally; their unintended consequences; and lessons for currently fast-growing emerging markets concerning finance sector reforms, government involvement in the finance sector, possible macroprudential safeguards against spillover risks from the global economy, and, finally, management of government debt and fiscal conditions. The paper starts with a summary of reforms under the Dodd-Frank Act and highlights four of its primary shortcomings. It then focuses on the new capital and liquidity requirements under Basel III reforms, arguing that, like its predecessors, Basel III is fundamentally flawed as a way of designing macroprudential regulation of the finance sector. In contrast, the Dodd-Frank Act has several redeeming features, including requirements of stress-test-based macroprudential regulation and explicit investigation of systemic risk in designating some financial firms as systemically important. It argues that India should resist the call for blind adherence to Basel III and persist with its (Reserve Bank of India) asset-level leverage restrictions and dynamic sector risk-weight adjustment approach. It concludes with some important lessons for regulation of the finance sector in emerging markets based on the global financial crisis and proposed reforms that have followed in the aftermath.