From micro to macro: Basel III tools eyed as systemic risk controls

Systemic regulators want to use Basel III’s micro-prudential tools to steer the wider economy, but no-one knows how these controls work – and bank supervisors may not be happy to take a back seat. By Michael Watt

A list is circulating among Europe’s financial policy-makers that would chill most bankers to the bone. Said to have been drawn up by the European Systemic Risk Board, it is a menu of 42 tools that could be used by national authorities to control economic growth and manage asset bubbles, according to two senior regulators who have seen it – from the liquidity ratios and risk-weighting regime laid out in Basel III, to margins on cleared and uncleared derivatives trades, and more traditional levers such as loan-to-value limits.

These micro-prudential tools – many of which were designed to manage the risks associated with individual transactions or portfolios – are now being co-opted to create a macro-prudential control panel, with central banks and systemic regulators pressing the buttons and twisting the dials. Instead of having to comply with static capital, liquidity and leverage ratios, banks may find those levels being tweaked up or down to stimulate credit supply or prevent certain businesses from overheating.

Can these untried, untested tools be used to pilot the financial system? Systemic regulators admit there will be some trial and error at first. They also accept there will be occasions when the aims of macro- and micro-prudential regulators collide. But they’re in no mood to listen to complaints from banks about the scheme as a whole.

“I don’t care about the banks’ point of view any more. They’ve caused enough problems recently. They’ll just have to live with it,” says one European regulator.

So far, the Bank of England’s interim Financial Policy Committee (FPC) has been most explicit about its plans. At its second meeting, on September 20, the new systemic risk body said it would need power over three broad categories of policy tool – affecting bank balance sheets, financial transactions and market structures – which it would use when there was an urgent need or when systemic concerns take precedence over the rules applicable at individual firms.

One of the difficulties is that there isn't a distinct set of instruments that are relevant to macro-prudential policy but aren't used for anything else

A record of the FPC’s meeting, published on October 3, alludes to tools that affect leverage and risk-taking, liquidity and funding, lending risks and collateral terms. None of the tools is identified by name, although the document concludes by calling for the UK Treasury to ensure European plans to implement Basel III as binding regulation do not hamper the FPC’s ability to use the new regime to effect macro-prudential policy (see box). But bank regulators may not be willing to share these tools. “One of the difficulties is that there isn’t a distinct set of instruments that is relevant to macro-prudential policy but isn’t used for anything else. Both macro- and micro-prudential regulators will sit on the FPC, so any problems that arise when the two overlap will hopefully be easily resolved. It’s quite hard to think of a better approach,” says Alastair Clark, a senior adviser on financial stability at the UK Treasury and a member of the 11-member FPC, along with Mervyn King, the Bank of England governor, and Adair Turner, chairman of the Financial Services Authority.

In the Netherlands, there has already been some friction about Basel III’s counter-cyclical capital buffer, an explicitly macroeconomic element of the new regime that allows a national regulator to raise capital requirements for its banks by up to 2.5% if it believes access to credit is too easy and the economy is overheating. Banks can then run down this extra 2.5% of capital in a downturn while continuing to lend – in theory preventing a credit crunch.

“Our examiners have told us that they will be happy to see capital levels go up if a credit bubble starts to emerge, but they are hesitant to permit banks to run down this capital if the bubble bursts. They think that doing so in the middle of a downturn would be too risky for the individual institutions that they supervise,” says Maarten Gelderman, head of macro-prudential analysis at De Nederlandsche Bank in Amsterdam.

Financial stability experts admit the potentially conflicting missions of micro- and macro-prudential supervisors will be a challenge. “There might be circumstances where the macro-supervisors want to use certain tools to reduce imbalances in the financial system, but the use of such tools may be seen by the micro-prudential supervisors as too costly for  the individual institutions,” says Mauro Grande, director-general for financial stability at the European Central Bank in Frankfurt. “The big question is how we manage this kind of conflict. One way is to clearly define the micro and macro mandates in national jurisdictions. After a couple of years’ experience, we should end up with a clear allocation of responsibility.”

Even if the micro and macro camps agree on when each of them has the lead, it is unclear whether the tools will work as intended. Regulators accept more work needs to be done in this area. “Using capital ratios or liquidity instruments to influence systemic risk across the banking sector, or credit growth in the wider economy, hasn’t been done before. Before the FPC can make proper recommendations to the Treasury over what powers it wants, a lot of effort needs to be put into finding empirical evidence of how these various tools will affect macroeconomic conditions,” says Clark.

That is going to be easier for tools such as capital ratios, where the historic relationship between higher or lower capital stocks and bank lending can be studied. But even here, there are new elements to consider, and emerging differences in how countries plan to implement them.

Again, the counter-cyclical buffer is a good example. The Basel Committee suggests the ratio of credit to GDP should be used when regulators are assessing whether to switch the buffer on – but this is only a guide, and national authorities are also told to use their judgement. Critics worry that macro-prudential supervisors will back away from the decision in the face of pressure from banks or politicians – particularly if, as is likely at a time of easy credit access, the economy appears to be performing well (Risk February 2011, pages 42–44).

Although all the Basel member countries will be implementing the counter-cyclical buffer, they won’t be using it the same way – or introducing it at the same time. “We want the buffer to be operational well before the Basel III target date of 2016, because we have signs of overheating in certain regions of the Swiss real estate market right now,” says Daniel Zuberbühler, vice-chair of the board of directors of the Swiss regulator, Eidgenössische Finanzmarktaufsicht – or Finma – in Berne. “We’ll also be using it in a more targeted way than is currently planned by the Basel Committee. Rather than applying a general 2.5% increase in required capital, we’ll be increasing capital requirements for specific lending activities to make the banking sector more resilient against a bubble in a particular economic sector, like real estate lending. This extra capital would then be removed to get banks lending again if a downturn occurred.”

Some market participants aren’t convinced this would work. “Central banks can ask firms to raise capital or generally de-risk, but it is very difficult to use these kinds of tools to pop certain economic bubbles, or influence a specific sector of the economy in a precise and targeted way. I don’t think it can be done,” says one regulatory expert at a large US bank.

Regulators looking to cool off an overheated mortgage lending market may be tempted to rely on more traditional instruments, such as loan-to-value (LTV) limits. Sweden’s mortgage lenders have been subject to a maximum LTV ratio of 85% – applied by the country’s central bank – since October 2010, and although regulators there have yet to run the official numbers, they say they are happy with its overall effect on what was thought to be an emerging housing market bubble.

If there’s little track record for the counter-cyclical buffer as a macro-prudential tool, there’s zero for Basel III’s two new liquidity standards – the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). Unlike the counter-cyclical buffer, both were designed as specifically micro-prudential tools. The LCR aims to ensure banks have enough liquid assets – primarily government bonds – to cover 100% of expected net outflows during a 30-day period of stress, and is due for implementation in 2015. The NSFR aims to eliminate funding mismatches by establishing a minimum required amount of stable funding based on the liquidity characteristics of a firm’s assets and activities over a one-year horizon. It is due for implementation in 2018.

The implementation date for each ratio reflects uncertainty in terms of final design. The LCR is the more concrete of the two, and is not expected to change dramatically before 2015, but the NSFR is more problematic – market participants have highlighted many flaws in its design, and a significant overhaul of the measure before 2018 is on the cards (Risk May 2011, pages 57–59).

That hasn’t stopped systemic regulators cooking up ways to use the two ratios. Some say compliance with the LCR could be raised from 100% to 105% of expected net outflows when regulators think the economy is overheating – forcing banks to allocate more of their asset base to safe, stable instruments – and then reduced again once it had cooled down, or once a downturn had set in. Others suggest the NSFR could be used in a more surgical way – regulators could target a specific sector of the economy by increasing the amount of required stable funding for certain types of lending and other activities.

But, like the tools on which they are based, these plans are still in their infancy, and some regulators aren’t convinced. “It does seem premature to start thinking about using the LCR or the NSFR in this way. We simply do not have sufficient experience with liquidity supervision. A liquidity equivalent to the counter-cyclical capital buffer probably won’t be formulated for at least another 10 years,” says Gelderman at De Nederlandsche Bank.

Seeking control over margin requirements for cleared and uncleared derivatives would also be a step into the unknown – but it’s under consideration at the FPC, for one, and in Sweden.

“The decision to change margin requirements would be based on measurements of volatility, rather than the course of the economic cycle. If markets were becoming particularly febrile, the regulator might decide to instruct market participants to increase initial or variation margin requirements. The key thing would be to do this before volatility hit its peak and then steadily decrease them when things calmed down. If you make the change at the peak of market ferment, you risk exacerbating the problem because firms already struggling for liquidity would be forced to post more of it as collateral,” says one European regulator.

Some market participants aren’t convinced. “The FPC, for example, would use margin requirements as part of monetary policy to influence interest rates and liquidity. However, enforcing this would be a challenge as sterling trades are also executed and cleared outside of the UK by non-UK institutions. It would quickly lead to regulatory arbitrage, so the efficacy of such a move is questionable. Moreover, regulators can only add to CCP margin requirements, not reduce them, which would otherwise undermine CCP stability,” says John Wilson, former global head of over-the-counter clearing at Royal Bank of Scotland.

Regulators admit that, once all their desired tools come online, a period of trial and error will ensue, as macro-prudential supervisors begin pressing buttons and adjusting dials in response to various economic events.

“Initially, we’ll have to go out on a limb and make the best judgements on how to use these instruments with the data we have available to us. Any decision we make will be subjective. We will never know for certain, after we’ve implemented the counter-cyclical buffer, for instance, whether a dangerous bubble was going to develop or not, but I think regulators would rather make the mistake of using something when it wasn’t needed, rather than ignoring the warning signs and letting the economy fall to pieces again,” says Lars Frisell, chief economist at Finansinspektionen, Sweden’s financial regulator.

 

BOX: Not so harmonious

Regulators’ freedom to play with the shiny new tools contained in Basel III depends in part on whether the European Union (EU) decides to implement the package of rules as a directive or a regulation. At this point, the implementation vehicle is still referred to as the fourth capital requirements directive (CRD IV), which would give national regulators the freedom to go above and beyond the minimum levels set in Basel III – essential if the different elements of the regime are to be used in a dynamic way to influence systemic risks.

Regulation, by contrast, is binding – and it received the backing of the European Commission (EC) in its CRD IV draft text in July. Without the ‘maximum harmonisation’ that regulation delivers, EC policymakers worry that EU jurisdictions will make their local capital regimes incrementally more punitive in order to avoid attracting riskier banking activities or shore up confidence.

If national regulators are looking for macro-prudential tools, the EC said, they would still be able to use the counter-cyclical buffer, and already have the freedom to increase capital requirements for individual institutions or groups of institutions under Pillar II of the existing Basel rules.

The Bank of England has been at the forefront of the campaign against maximum harmonisation – its governor, Mervyn King, voiced his opposition to the idea at a hearing held by the European Parliament’s Committee on Economic and Monetary Affairs in May this year, saying it would leave national authorities unable to combat excessive risk or leverage in their banking systems.

Alastair Clark, a member of the central bank’s interim Financial Policy Committee, concurs. “Maximum harmonisation would be a serious inhibitor on macro-prudential policy. It is a big concern for the UK,” he says.