27 Apr 2012, Michael Watt, Risk magazine
The publication of Basel III in December 2010 may have marked the end of an intense one-year period of consultations and rule-writing by the Basel Committee on Banking Supervision, but it was just the start of a much longer process of implementation. For individual regulators, it meant working to transpose the regulation into national law – a process that is under way in Europe, for instance, through the drafting of the fourth Capital Requirements Directive.
The problem – at least as far as global banks are concerned – is that a number of differences are emerging across individual jurisdictions. In certain cases, national regulators are erring on the side of caution and adding to the minimum requirements; in others, they are playing around with the timings. A few countries, meanwhile, have made little progress at all in terms of implementation.
This is bad news for internationally active banks that may need to meet multiple local requirements – something the Basel Committee has recognised. In October, it published its first-ever progress report on Basel III implementation, the start of an ongoing programme of monitoring to ensure member countries are meeting the agreed timelines and complying with the letter of the rules. This was followed up by a second report in April. The question is whether this strategy of peer pressure will make any differences. The Basel Committee thinks it will.
“We want to ensure there is consistent application of the standards and a level playing field,” says Mitsutoshi Adachi, a director in the examination planning division at the Bank of Japan in Tokyo and a member of the Basel Committee’s standards implementation group (SIG), which is responsible for overseeing the global implementation process. “It is true we are not policemen – we do not have the power to enforce it. But the level of Basel III monitoring is unprecedented. The committee hasn’t done such rigorous peer reviews in the past. By doing serious peer reviews, any jurisdiction or region that is not compliant will come under peer pressure, and there will be regular publication of a progress report on Basel III. Any jurisdiction that is non-compliant will be publicly exposed.”
Other market participants are not so sure this will work. They claim the sluggish global economy is dampening the enthusiasm of some politicians to force their own banks to implement the framework. Any further evidence of a slowdown could blow the project off course in some jurisdictions, they argue.
“There are already concerns at a very high political level that the reforms are placing too great a strain on the banking system. A fresh recession or an escalation of the eurozone crisis could throw the project off completely, and there is little the peer pressure approach could do to prevent this. Even a modest downturn could be the straw that breaks the camel’s back,” says one Scandinavian regulator.
Others make a similar point. “The economic recovery isn’t assured. You can make a strong case for saying that current and prospective regulatory reforms are playing a role in delaying the recovery. Requiring banks to raise more capital and more long-term funding in the current difficult circumstances is probably contributing to the de-leveraging, and that is hurting several of the mature economies. There is a recognition of the need to grasp the nettle when momentum for reform is high. But regulators need to recognise that elements of the reform programme may be placing such a strain on the banking system that it is actually contributing to economic weakness. It’s hard for banks to provide the credit needed to sustain a recovery under these circumstances,” says Paul Wright, a senior director at the Institute of International Finance (IIF) and a former regulator at the UK Financial Services Authority.
Even without the economy weighing on the process, a number of regulators have decided to go their own way. In some cases, authorities are keen to apply the minimum capital requirements set out in Basel III earlier than the officially mandated deadline. The Australian Prudential Regulation Authority, for instance, proposed in September 2011 that banks should meet the revised minimum capital ratios in full from January 1, 2013, and be fully compliant with the capital conservation buffer from January 1, 2016 – a timeline it reaffirmed in draft prudential standards released on March 30. In contrast, Basel III requires banks to meet a higher minimum common equity Tier I to risk-weighted asset (RWA) ratio of 4.5% by January 2015, and meet the 2.5% capital conservation buffer in full from January 2019.
In other cases, regulators are pushing much further than the Basel minimums. Along with the 4.5% common equity Tier I requirement and 2.5% capital conservation buffer, Basel III requires banks to hold 1.5% in additional Tier I and 2% in Tier II capital. Assuming the full 2.5% counter-cyclical buffer is switched on, a further surcharge of between 1% and 2.5% for global systemically important banks (G-Sibs) would bring total loss-absorbing capital to between 14% and 15.5%.
In contrast, Swiss regulators want the country’s two largest banks – Credit Suisse and UBS – to hold a minimum common equity Tier I to RWA ratio of 10%, plus a further 9% in contingent convertible instruments. The UK could go even further. In September 2011, the Independent Commission on Banking (ICB) – a group set up by UK chancellor of the exchequer George Osborne to improve the stability of the UK banking system – recommended certain crucial banking functions, such as payments services, retail deposits and lending to small and medium-sized enterprises, be carved out from the rest of the group and placed in separate legal entities with their own capital.
Under the ICB plans, large retail ring-fenced banks would have a minimum loss-absorbing capacity of 17% of RWAs. This translates into a common equity Tier I minimum of 4.5% plus the 2.5% capital conservation buffer, along with the 3.5% of additional Tier I and Tier II. A new common equity ring-fence buffer of 3% will be added for the largest retail banks, along with a minimum 3.5% of so-called bail-in bonds – debt that would be written down during a resolution process. The size of the ring-fence buffer is determined by the bank’s RWAs-to-GDP ratio – if less than 1%, the bank would not have to hold the additional equity cushion.
The ICB notes that UK investment banks should follow international rules to ensure they are not put at a competitive disadvantage – meaning these firms would be subject to Basel III. Nonetheless, the committee stresses the 17% minimum loss-absorbing capacity requirement would still apply to UK-headquartered G-Sibs. That means the largest UK G-Sibs would need to issue a minimum of 4% of loss-absorbing debt to ensure they get to the 17% figure proposed by the ICB, assuming they are subject to the maximum 2.5% G-Sib surcharge under Basel III (see figure 1).
Throw in the 2.5% counter-cyclical buffer, and a new 3% resolution buffer – which can be applied to ring-fenced banks and UK-headquartered G-Sibs if supervisors are worried about the complexity of a bank, its contribution to systemic risk, and the availability of available resolution tools – and it takes total loss-absorbing capital in the worst case to 22.5% of RWAs. As much as 15.5% of this could be common equity, as regulators can choose between equity and loss-absorbing debt for the resolution buffer.
These divergences are causing some unease within the banking industry. “We are very concerned at the amount of gold-plating and acceleration of implementation going on,” says the IIF’s Wright. “When a lot of countries go above and beyond the agreed standards and produce quite significant variations, it creates an unlevel playing field where firms face multiple versions of the same reforms on multiple different timescales. If regulators insist on treating the standards purely as minima, you run into all the problems of very different regulatory regimes that Basel III was meant to help solve.”
The Basel Committee, however, is relaxed about individual countries going further than the Basel III minimums. “Basel III is a set of minimum standards. If some countries are willing and able to implement the standards quickly or go above and beyond the standards, then that’s not a problem for the committee in any way. Countries will inevitably, over time, implement different measures over and above the original requirements to deal with particular issues,” says Wayne Byres, secretary-general of the Basel Committee.
Byres is more concerned about nations lagging behind than blazing ahead, hence the introduction of the monitoring and peer review process. But market participants fear the Basel Committee will be powerless if a large country takes its time over implementation or decides to abandon the rules entirely. The US, for instance, failed to implement Basel II on time – and some fear the same will happen with Basel III.
“US implementation is still a huge concern. The Americans won’t implement Basel III until they absolutely have to, probably much later than their European counterparts. In the meantime, there is a tonne of business going on that US banks will be able to snap up at the expense of firms in other jurisdictions,” says one senior banker.
US regulators deny they are lagging, and say a consultation document will be released this year. “We hope to have our proposed version of Basel III out in the public domain before the middle of the year. We want to get it out, get the consultation period completed and meet the timelines set down by Basel,” says Charles Taylor, deputy comptroller for regulatory policy at the Office of the Comptroller of the Currency in Washington, DC.
The process has been complicated by a Dodd-Frank Act ban on the use of credit ratings within US regulations – essentially forcing a delay to the Basel 2.5 trading book reforms, which officially came into force elsewhere on December 31, 2011. US regulators concocted a work-around at the end of last year, but this has run into criticism from domestic banks, which claim the proposal would put them at a competitive disadvantage (Risk February 2012, pages 19–21).
The Basel Committee isn’t just looking to monitor timelines and compliance with globally agreed minimums, however – it also wants to review consistency in the measurement of RWAs between banks. The SIG has begun an investigation into the issue, a move that has been met with hearty approval from some quarters.
“It’s about time that RWA calculations were looked at by regulators. If left untouched, the problem has the potential to undermine the whole process of capital regulation,” says David Benson, vice-chairman, risk and regulatory affairs, at Nomura in London.
Under Basel II, the most sophisticated banks are allowed to model their own RWA numbers based on an assessment of operational, credit and market risks. This latitude is seen by some market participants as the driving force behind a wide disparity in RWA numbers between banks (Risk July 2011, pages 36–39). For example, according to the Barclays 2011 annual report, its RWA-to-total-assets ratio stood at 25% on December 31, compared to 68% for JP Morgan Chase.
This kind of disparity has led to much huffing and puffing from market participants on both sides of the Atlantic, and has spurred regulators into action. The Basel Committee’s Byres says the current review could end up restricting the flexibility in RWA modelling that banks currently enjoy.
However, doing this will involve a delicate balancing act for the committee. While some market participants agree that changes are needed, there is still a lot of support for banks conducting the calculations in-house. In fact, some argue that variations in RWAs are a natural consequence of different views on risk – and, if everyone had the same opinion on default probabilities, it would lead to herd behaviour among banks.
“It is absolutely vital for RWA calculations to be as transparent as possible, and for there to be proper oversight of the process so investors can make informed decisions,” says Peter Sime, head of risk and research at the International Swaps and Derivatives Association in London. “But it is important for banks to be able to make their own risk judgements. I think everyone is agreed that the more sophisticated a firm is, the more latitude it should be given to calculate its own risk. They’ve got the sophistication and the computing power, so they are the best people to determine what the risk of their portfolios is. If you apply a simple set of rules to a complex portfolio, you get an over-conservative capital calculation. You also increase the likelihood of herd behaviour by banks, where everybody views every asset in exactly the same way, which is detrimental to the market.”
This point has been recognised by the Basel Committee, which is in for the long haul on the RWA review. “We hope to have the initial review completed by the end of the year, but it is likely to be an ongoing process. If we identify areas of material inconsistency, we have to think whether changes to policies or supervisory processes are necessary to narrow that inconsistency. And, over time, we’ll have to re-review to see whether the changes have been implemented and are effective, and whether any new areas of material inconsistency have emerged,” says Byres.
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