Basel changes stun bankers

Despite a year or so of conjecture and debate, the Basel Committee on Banking Supervision still managed to spring a few surprises when it published proposals for a major overhaul of bank regulation on December 17. For one thing, the proposals landed earlier than had been anticipated – eight days after the conclusion of a crunch meeting at the committee’s headquarters in Basel. For another, there’s still no agreement on the much-discussed counter-cyclical capital buffer and its future is unclear.

Other surprises were more upsetting for the banking industry. Regulators had not been expected to take aim at counterparty risk, but the proposals include three measures that bankers say would result in a doubling of the capital needed to support their exposures. In addition, rules on liquidity and capital quality are more restrictive than expected, a new de facto minimum capital level could be created, and regulators also signalled they would look at the issue of ‘unrealised gains’ in 2010 – a vague gesture that nonetheless has massive implications for the derivatives industry. Bankers are still digesting the proposals, but the initial reaction has been one of dismay.

“If you add up all these things and look at the totality of the package and the direction we are going, regulation is becoming so conservative and so risk-averse that if you impose all this, it will drive risk outside the financial sector because it is no longer profitable to take these risks within banks,” says the head of capital management at one European bank.

Regulators are attempting to soothe the industry by promising the cumulative impact of the various measures will be assessed. Over the first quarter of 2010, banks will fill out Excel spreadsheets detailing how the proposals would affect them, and the results will be used to adjust the final rules. Regulators say they will listen to the industry’s concerns. “The comment period is going to be very important and we’ll be taking it extremely seriously,” says one senior US regulator.

But the capital management head worries the two sides aretoo far apart to achieve a compromise: “Having come out with rules that are as specific and granular and as detailed as this, regulators can’t be seen pulling back too much at the request of the banks. I think they’ll be sensitive to accusations they’re being too soft.”

The proposals cover five areas: increased quality of capital, increased capital for counterparty credit risk, a leverage ratio, counter-cyclical capital and standards to establish minimum levels of liquidity. None are uncontroversial. On capital quality, for example, regulators are seeking to tighten the criteria on what can be counted towards Tier I – the basis for assessments of financial strength. In doing so, the proposals would disqualify billions of dollars of capital that had previously counted towards Tier I totals, such as minority investments and deferred tax assets.

Minority investments are residual stakes held in companies a bank already owns. “Let’s say we own 90% of a Polish bank and there remains 10% we couldn’t buy out at the time we purchased it, but we consolidate 100% of the company because we effectively own it. We’ve got to acknowledge the fact that 10% of that asset is owned by external parties, and my view is that 10% is there to absorb the losses you have within the entity. But these proposals wouldn’t allow us to include that any more,” explains the capital management head. At a single stroke, that measure would remove $1.5 billion from his employer’s Tier I total, he says.

Deferred tax assets are rebates owed to a bank because it overpaid in previous years – but it’s not always clear when the rebate will be paid and how big it will be. The capital management head says his bank has more than $40 billion in deferred tax assets on its balance sheet and currently counts only $15 billion towards Tier I, considering the rest too unreliable or distant. Under the proposals, that figure would shrink further, he says: “It’s unclear how much of that we’d be allowed to retain. We’ll be allowed to keep some because it is tax we’re getting back soon – but it’s not going to be very much.”

Other flashpoints are easy to find in the document. In principle, regulators see the counter-cyclical buffer working as a kind of capital conservation tripwire, a threshold below which banks would be prevented from buying back their own shares or paying dividends. But the Basel Committee has been unable to agree on a calculation method for the amount of capital to be held in the buffer, with central bankers favouring tying the buffer to some measure of macro-economic health, while supervisors are sceptical an appropriate measure can be found. After a failure to cement agreement, one attendee says some committee members now favour just slapping a fixed amount on top of the existing regulatory minimum. “It’s been a very hard road and there is always the option of just putting a fixed buffer on, which a lot of people like: let’s not be scientific, let’s just put one on,” she says.

The sections of the proposals dealing with the leverage ratio and liquidity buffers were less surprising, but with no less potential for friction. Finalising the rules will not be easy.