As European countries prepare to introduce Basel III, concerns are mounting that its implementation will highlight a chasm between different countries in terms of bank capital levels. Is the banking sector about to see a new era of regulatory arbitrage? “Anytime four New Yorkers get in a cab together without arguing, a bank robbery has just taken place.” American comedian Johnny Carson’s classic joke about New Yorkers might mischievously be adapted to parody the apparent unity among European regulators following the financial crisis: even as they call for harmony, there are signs their spirit of togetherness may be short-lived. When the Basel Committee on Banking Supervision set out its proposals for bank regulatory capital in September 2010, committee members lauded the insistence among national authorities that the rules should be applied equally across jurisdictions. Deviant financial practices must be eliminated, the battle cry sounded: all for one and one for all. The consensus lasted one day. On the Monday following the Basel announcement, Swiss regulators indicated they would go beyond new global banking rules and instead impose stricter requirements on the country’s banks, including UBS and Credit Suisse. The so-called ‘Swiss finish’ would make local banks more competitive, said officials at Swiss financial regulator Finma and the Swiss National Bank, because the higher standard would foster a greater level of trust among investors. In any event, the regulators said, the Basel package did not go far enough to prevent a big bank’s failure dragging down the whole economy. Switzerland was not alone in forging its own path. As the UK economy struggled to emerge from the effects of the financial crisis, with the bailouts of Lloyds Banking Group and Royal Bank of Scotland attracting negative press coverage, senior officials at the Bank of England launched increasingly acerbic attacks on the banking sector. Leading the charge was the central bank’s governor, Mervyn King, who said he was astonished at how muted public resentment was towards banks. Meanwhile, Adair Turner, chairman of the Financial Services Authority, described some trading room activities as “socially useless”. David Miles, an external member of the Bank of England’s monetary policy committee, published a detailed paper calling for much higher capital requirements than have been prescribed by the Basel Committee, in which he argued a doubling of capital would have a negligible impact on the cost of funding. Where Swiss and UK regulators led the way in breaking the mould, others were quick to follow, with some northern European countries bemoaning the lack of recognition in the Basel rules for covered bonds, issued in huge volumes by their local banks. German policymakers, meanwhile, voiced concerns over the treatment of ‘silent participations’, a form of non-voting capital excluded under Basel rules. Putting it into practice As European vested interests pick nits in the Basel proposals, the true test of the framework has yet to come, analysts say. But the day of reckoning is not far off as national regulators begin to implement the legislation, following its incorporation into Capital Requirements Directive IV this summer. “The implementation of Basel III into law and the new powers it gives regulators will introduce a whole new type of politics, with all the lobbying that goes along with it,” says Paul Atkinson, senior research fellow at independent economic think-tank GEM in Paris. “The Basel rules are laid down by unelected technocrats who do not operate in markets, and in Europe you have different languages and perspectives that will almost inevitably translate into a range of practices.” If the past is any guide, it seems likely there will be plenty of room for manoeuvre for national regulators. The 2006 Capital Requirements Directive, the common framework for the implementation of Basel II, specified some 140 options and national discretions for implementation. CRD IV, which will legislate for implementation of Basel III, is likely to offer an equal amount of discretion, and perhaps more given the added level of complication compared with the previous framework. This fact has not been lost on the US Congress, where the congressional research unit last October published a report on how Basel III will work. “The complexity of Basel III increases the probability that it would be unenforceable,” the research unit wrote. “As the Basel III framework was presented, it appeared to be as complex as Basel II that took six years to negotiate and was never fully implemented before the greatest financial crisis in 70 years began. “The Basel Committee in Basel III tries to simplify the definition of capital to improve transparency and enforceability. The industry through its regulators, however, forced the committee to include other types of assets. By including these assets with common tangible equity, the committee adds complexity to the process of enforcement…This complexity could undermine the ability to keep the international banking playing field level.” National implementation for Basel III is required by January 1, 2013. The body tasked with refereeing the process in Europe is the newly minted European Banking Authority, created last year to replace the relatively ineffectual Committee of European Banking Supervisors. The EBA has been assigned a broad set of competences, including preventing regulatory arbitrage, strengthening international supervisory co-ordination and promoting supervisory convergence. In a first test of its mettle, the EBA was criticised in recent weeks by regional German banks for its proposed stress tests, which Norddeutsche Landesbank and Landesbank Hessen-Thüringen claimed were unfair. Switzerland, meanwhile, has no time at all for the convergence principle. Using its discretionary powers under Pillar II of the Basel proposals, Finma in April set out five levels of capital buffer based on banks’ size and complexity, ranging from 10.5% to 14.4% of risk-weighted assets. That compares with 8% recommended under the Basel framework. Switzerland’s two biggest banks, UBS and Credit Suisse, have been required since 2008 to bolster their capital to levels of 50%–100% above the current Basel II standard. The Swiss parliament is currently debating whether to cement the standard for systemically important financial institutions at 19%; well above the most ambitious standards envisaged by Basel III. Officials at Finma claim to be unperturbed by concerns over the impact of tough rules on Swiss competitiveness, but at least one opposition party in the Swiss parliament has come out against the proposals. A spokesperson for the State Secretariat for International Financial Matters, a Swiss government financial body, says: “There is a debate first over whether Switzerland should go so quickly, rather than wait and see what is happening internationally, and also whether it should go beyond the Basel requirements. However, while there is opposition on one side there are also those that say we should go even further, and that the proposals are not tough enough.” Swiss politicians are likely to be less than impressed with the reaction of UBS chief executive Oswald Grübel, who was quoted as saying the new standards could force UBS to move units abroad. He added that investment banking activity across Europe could shift to the US and Asia if stricter capital requirements are enforced in the UK and Switzerland. Even within the Basel Committee, there was recognition in April that any move by national regulators to “punish” banks perceived to have exacerbated the financial crisis could encourage jurisdiction shopping among the most powerful firms. “If we have higher capital requirements, we are going to have higher incentives for regulatory arbitrage,” said José María Roldán, chairman of the standards implementation group of the Basel Committee. “Within banks, across banks, across countries, if you have an uneven application of Basel III you will see banking activity going to the country that has a softer approach.” The risk of regulatory arbitrage was an “unavoidable consequence” of the new framework, Roldan said. Under the Basel III proposals, the minimum total capital plus conservation buffer should reach 10.5% of risk-weighted assets by 2019, some 2.5% higher than the current minimum requirement. If another element, the countercyclical capital buffer, is fully added, the minimum total capital requirement will be 13% of risk-weighted assets. Amid sabre rattling from the likes of HSBC and Barclays, the UK has become a test case for the regulatory arbitrage debate, after the Independent Commission on Banking published its interim recommendations for the UK banking sector in April. One area in which the ICB stepped beyond the recommendations of the Basel Committee, or any European country, was on retail depositors, who it suggested should have legal preference over other creditors, in line with the US and Australia. The most controversial ICB proposal, however, focused on the breaking up of the universal banking model, and the ring-fencing of the domestic retail banking operations of the major UK banks, suggesting that the business be conducted in a separate legal entity, with its own capital requirements. No other country in Europe has considered changing its banking model in such a fundamental way, and with the ICB’s final recommendations due in the autumn, the idea has prompted a heated debate. “This is not an issue anywhere else in the world; other countries have moved on,” says Simon Hills, executive director at the British Bankers’ Association. “Universal full service banks provide small and medium-sized entities and other exporters with the full range of financial services to meet their needs. As a trading nation, seeking to re-emphasise the value of manufacturing exports, they are crucial to the success of the British economy.” While the banking industry is resolutely against any plan to split retail operations from the businesses famously described by UK business secretary Vince Cable as “casino banking”, others see the move as a more subtle play on the trade-off between capital requirements and financial stability. “What the ICB seems to be trying to do is to strike a balance between ring-fencing and capital requirements,” says Alistair Milne, reader in banking and finance at the Cass Business School. “Either you have ring-fenced banks that are quite restricted in what they do, or you give them more freedom and you put in a lot more capital. This is exactly the type of balance that could be struck variably in different European countries.” Branching out A related area of concern to UK regulators surrounds so-called branching powers. Under European bank “passports”, firms such as Deutsche Bank can set up “branches” in the UK rather than legal subsidiaries. Whereas branches are regulated by home authorities, subsidiaries come under UK authority, and would be subject, for example, to local deposit insurance schemes and bankruptcy law. The regulator’s stance on branching came after the UK Treasury was forced to pay out £7.5 billion in loans and compensation for savers after the Icelandic banking crisis. Linked to the worry over branching and the ICB’s proposals for ring-fencing is the wider debate in Europe over resolution plans. From the ICB’s perspective, ring-fencing would be a big step in the direction of making resolution simpler, with the separation of retail banking likely to ease the management of any of the riskier banking activities in any crisis. However, resolution is one area in which the international community is unlikely to push for the same uniformity of rules under Basel III that was required under Basel II, believes Milne. “An example may be France, where there is strong support for the universal banking model. In that scenario the European Banking Authority might then say, ‘Well, that is fine – keep universal banking but in exchange we need to see much stronger resolution plans or higher levels of capital.’ It’s all to play for but there will be a fair amount of politics in this.” Switzerland is already playing off capital against resolution, with the country’s largest banks expected to be given a discount on capital if they put an efficient resolution plan in place. The Basel-based Financial Stability Board has ordained that all member countries must run a pilot on living wills. This must comprise a rescue plan, designed to improve a bank’s capital and liquidity by raising capital or selling assets, and a resolution plan, defined as managing the demise of a firm in a way that minimises systemic disruption and costs to creditors and taxpayers. Part of the living will exercise involves an examination of the loss-absorbing capital held by any bank. Clearly equity is loss-absorbing, but also to be considered are contingent convertible securities and the distribution of losses against a wider range of creditors, including subordinated and possibly senior unsecured bondholders. The IMF, in its regional economic outlook published in May, urged European countries to push ahead with unified action on a common resolution regime. “Moving toward a robust and flexible framework for crisis management and resolution…is equally urgent,” the IMF said. “The EU proposal to harmonize these tools across countries is the right step toward ensuring more orderly ex-ante solutions. But more needs to be done to progress from a setting structured along national lines to an integrated EU framework…” Europe’s next top model Another illustration of the potential for nationally based solutions in Europe is the lack of a standardised approach to measuring risk-weighted assets. “As banks calculate their capital requirements they can use either point-in-time models or through-the-cycle models,” says Patricia Jackson, a partner in the risk management group at Ernst & Young. “The Basel Committee has not standardised the measure, meaning that a bank using a point-in-time model for its mortgage book could pick a moment with a low default rate, while a through-the-cycle model would produce a much higher number.” Under Basel III, it is estimated that banks will need to raise up to €1 trillion of additional common equity, not including the additional capital required for systemically important financial institutions, recommended by the Basel Committee to be set at 3%. “It will be the responsibility of national regulators to decide which firms in their jurisdictions are systemically important,” says Jackson. “While the big international firms are obviously going to be included, there may be differences over some of the local ones. It is extremely important that there is a level playing field, because otherwise the distortions are going to be huge.” While Pillar II of the Basel rules expressly allows for national regulators to impose local rules, there is also a surprising level of flexibility in the requirements laid out in Pillar I, particularly on the various buffers designed to embellish the basic requirements for common equity and tier 1 capital. The countercyclical buffer, set between 0% and 2.5% of total risk-weighted assets, is one area in which national authorities have the power to dictate the regulatory landscape; determining when excess credit growth poses a risk to the stability of the financial system. The Basel governors set no deadline for meeting the requirement. Local interests may also find some wiggle room on the proposed leverage ratio, the level of which is left up to each member country to determine, although a tentative minimum has been set at 3%. The ratio will be tested in a parallel run, from 2013 to 2015, with a view to it being incorporated into Pillar I requirements by 2018. “The unspoken message in the wording of the leverage ratio is that there is enormous scope for negotiation,” says Adrian Blundell-Wignall, special advisor to the secretary-general on financial markets at the Organisation for Economic Co-operation and Development. “All we know at the moment is that there is a fair amount of prevarication and the banks don’t like it.” As regulators ponder their options, what is certain over the coming years is that behind the scenes the bank lobbyists will be working hard to press the case for a lighter touch, with the threat of a move abroad their most powerful weapon. As was shown in 2010, when several Irish banks passed stress tests but required bailouts just two months later, the ability to clear hurdles can very much depend on the power of interpretation. “It may be the position of the Basel Committee that a safe banking system should be more attractive for stakeholders,” says Richard Barfield, a director at PricewaterhouseCoopers. “But many national regulators will be tempted to think the jury is still out on that. We may well see a greater emphasis on Pillar II emerging, where, currently, without common global standards, national regulators decide for themselves what they mean by strong risk management and supervision.”...
Start a FREE trial or subscribe to continue reading:
Start a 4 week free trial
Try Risk.net's premium content for a limited period. Register now for your FREE trial to one of our leading brands.
*not available to previous trialists or subscribers.
Log In or Subscribe Now
Subscribe to Risk.net Business now to access all our premium news & features content for 1 year.
Pay by Credit Card for immediate access.