Basel rules risk fragmentation after key compromise

Basel Committee ready to release new accord but patchy adoption of internal model floor and FRTB expected

  • The Basel Committee is set to announce the long-awaited package of Basel III reforms on December 7.
  • The likely EU-US compromise is an internal model output floor at 72.5% of the standard formula in return for a US commitment to FRTB.
  • Bankers and former regulators say EU implementation of the rules could differ from the Basel agreement, however, if standard formula risk weights are not updated to assuage domestic concerns.
  • One former US regulator says it would be illegal for US negotiators to promise FRTB implementation at this time because rules are under review by the Treasury and Fed.
  • Although the Basel Committee is under pressure to conclude negotiations, one banker says “a bad deal would be worse than no deal”.

Fans of track cycling will be familiar with the individual sprint event, where the two participants often spend the early part of the race competing to cycle as slowly as possible. The riders inch their way around the outside of the track, desperate not to lead the race and end up at a tactical disadvantage to their rival who can attack from behind.

A similar first-mover disadvantage has emerged in negotiations between the US and Europe over the Basel III banking accords. In an effort to reach a compromise, both sides have made concessions that they fear will lead to a loss of competitiveness for their respective banking industries and, potentially, wider economies. As a result, neither side is likely to be willing to be the first to introduce the new rules in full, and a protracted implementation process is inevitable, observers believe.

Like cycling, there could be a sprint finish as jurisdictions race to meet the eventual implementation date set by Basel. But the growing list of countries that seem relaxed about postponing the adoption of existing Basel rules suggests deadlines for the new package might also be missed, even if it includes long transition periods as market participants expect.

The widely signalled announcement of a deal on Basel III on December 7, therefore, may usher in a period of further uncertainty and disagreement over the new rules, rather than a harmonious accord between the two principal parties in the talks.

The main area of contention revolves around the output floor for internal risk models. In Europe, banks are heavily reliant on these models to calculate risk-weighted assets, and hence capital requirements. European policymakers, concerned about a hike in capital for the region’s banks from Basel III and the impact that would have on the real economy, have consistently pushed for a floor no greater than 70% of the standardised approach.

The US, however, is keen to see a higher figure because, under the so-called Collins Amendment, its banks are limited to a floor of 100% of the standardised approach, and it is unwilling for Europe’s banks to enjoy such a wide competitive advantage in risk-based capital ratios.

The Basel Committee’s compromise would set the output floor at 72.5% and, in return, the Europeans expect the US to agree to fully adopt the market risk element of Basel III, known as the Fundamental Review of the Trading Book (FRTB). But voices on both sides of the Atlantic have questioned whether a deal thrashed out at the Basel level will find sufficient support among lawmakers in the US and EU, risking fragmentation of the carefully constructed compromise once legislators begin the task of turning global standards into national laws.

We get the sense that it’s becoming more difficult to reach international agreements that can be consistently implemented

Hedwige Nuyens, International Banking Federation

In November, the vice-chair of the European Parliament’s economic and monetary affairs committee, MEP Markus Ferber, told “The compromise that is emerging in the Basel Committee is a rotten one.” And in a November 14 speech, German Bundesbank board member Andreas Dombret described the 72.5% floor as “anything but the result Germany had been hoping for”.

For its part, the US Treasury has questioned whether the FRTB constitutes an “unnecessary” burden on capital and liquidity, and has stressed it is in no rush to determine its calibration of the rules.

Banks have previously voiced their fears that a piecemeal and inconsistent roll-out of Basel rules across jurisdictions would lead to increased cost and complexity for large global players. Their argument is that if the US does not implement FRTB and the EU reduces the impact of an output floor in some form, although this might offer local capital relief, it would also reduce the ease of cross-border compliance and trading.

One London-based banker likens the Basel talks to the Brexit negotiations ongoing between UK and EU leaders, saying a bad deal would be worse than no deal. “If we have a hasty compromise, [the Basel Committee] might agree to everything – but the actual implementation in each jurisdiction would be watered down. That would be a bad deal.” 

Hedwige Nuyens, managing director at the International Banking Federation, says: “We get the sense that it’s becoming more difficult to reach international agreements that can be consistently implemented. With the increasing fear, especially from the European side, that an output floor of around 72.5% is going to become a hard limit, there might be a last minute twist to get a workable agreement.”

“If there is no change at the last minute, then the discussion will shift to the European Parliament who want to avoid any negative impact on the European economy,” she adds.

In the detail

As previously emphasised by regulatory experts speaking to, the internal model floor is only as important as the standard formula calibrations on which it is based. Although any announcement of a deal is likely put a spotlight on the output floor, the experts said the devil will be in the detail of standard formula calibrations.

Banks are hoping to see significant changes in what will be the third iteration of the Basel III standardised formula for calculating risk-weighted assets. Adrian Docherty, head of bank advisory at BNP Paribas, says that reading between the lines of recent speeches by regulators, he is confident some meaningful changes to the standardised approach have been agreed.

“By ‘better’ the regulators likely mean either more intellectually risk sensitive or less damaging to banks’ capital position. There was not much change between the first and second iteration of the standard formula, but I’m expecting more meaningful changes this time round,” he says.

Photo of Adrian Docherty
Adrian Docherty, BNP Paribas

“I hope that we do have a harmonious implementation; having said that, we are used to certain local tweaks. If the world’s largest economy doesn’t implement FRTB while others do, the competitive and risk dynamics could be distorted in a bad way,” he adds.

Although updating the standard formula risk weights offers Basel the opportunity to agree to capital charges that are more palatable to European lawmakers, those scrutinising Basel talks say those changes are difficult to agree.

Monsur Hussain, a senior director at Fitch Ratings, says setting the internal model output floor at 72.5% may present difficulties for certain European jurisdictions, which would require further adjustments to the already revised standardised risk weights.

A key asset class is low-risk mortgages, which make up a significant proportion of European banks’ balance sheet. Unlike most US banks which offload their higher quality mortgages to agencies Fannie Mae and Freddie Mac, European banks retain these mortgages, meaning their average internal risk-based (IRB) weightings for credit risk tend to be significantly lower. European legislators would be hostile to any standardised approach which penalised lower-risk mortgages.

“If you look at the December 2015 [revised standardised approach] proposals, the risk weighting granularity improved, but remains much higher than average IRB risk weightings of less than 10% for Nordic mortgages. For large French, German, UK, Italian, you’re talking about 11% to 16%, and over 16% for Spanish and Irish banks. If you compare that to the current 35% in the standard formula, translating to a floored risk weight of about 25%, then you can see that there’s quite a way to go to reach a satisfactory solution,” says Hussain.

“If the Basel Committee were to revise the BCBS standard risk weights, moving to a 20% risk weight floor, we believe this would go some way towards satisfying European regulators but it is hard to see them going this far,” he adds.

European lobbyists are pushing for greater recognition of the way European banks manage their credit risk in the standard formula, deeming this of more significance than the final output floor number.

“If it’s 70% or 72.25%, you could toss a coin and it doesn’t make much difference to any bank in Europe because it will be perhaps 25 basis points’ capital difference,” says José María Roldán, chair of the Spanish Banking Association and vice-chair of the European Banking Federation. “It’s a done deal in terms of substance. What needs to be recognised is that European banks retain high-quality, low-risk mortgages on their balance sheet, unlike US banks. It’s also a fact that the US economy is financed 75% by investment markets and 25% by banks, and vice versa for Europe, so it makes sense to be especially cautious when imposing rules on the banks in Europe.”

“At the same time, however, we see the value in an international agreement and shouldn’t do too much in Europe to deviate from the rules,” he adds.

One former regulator on the Basel Committee, who did not want to be named, says there are various ways the committee could apply the model output floor rules in order to soften their impact. He also foresees, however, European policymakers stepping in to doctor the rules after they are agreed at the Basel level.

Photo of Jose Maria Roldan
José María Roldán, European Banking Federation

One option already discussed is to have a lengthy transition period to implement the floor as long as six years from 2021 to 2027, but the usefulness of this has been criticised because investors are likely to consider banks’ capital ratios on a fully loaded basis. Offering a carve-out from the floor for low-risk mortgages might be a workable alternative, says the former regulator.

“Basel might offer floor exemptions to some portfolio categories like low-risk mortgages so you have something analogous to US qualified mortgages. There are a number of ways in which a Basel decision on the floor could be adjusted that give lip service to Basel but remove much of the pain,” he says.

If such a compromise is not decided at the Basel level, the debate would then be pushed to European policymakers keen to avoid any negative impact, he says. “Given the reluctance of the Parliament and Commission to accept the floor, this could carry through into the final implementation of the rules because I don’t see a sufficient groundswell of support for the floor.”

Go-slow in the US

Part of the European frustration with Basel talks centres on the US attitude towards FRTB under the current administration. A US Treasury report published in June following an executive order on regulation by president Donald Trump recommended “delaying the domestic implementation of the NSFR [net stable funding ratio] and FRTB rules until they can be appropriately calibrated and assessed”.

The Treasury report further stated: “Both of these standards represent additional regulatory burden, and would introduce potentially unnecessary capital and liquidity requirements on top of existing capital and liquidity requirements.”

Speeches by French and German central bankers in November suggested that European representatives at Basel would be willing to accept a higher internal model output floor only if the US promised to implement FRTB rules in full. Experts say this would likely come in the form of signing a commitment to all Basel III standards, including the market risk element, as part of any December deal.

An October speech by Jerome Powell, chairman-elect of the Federal Reserve, said the Fed was “a long way away from proposing something” on FRTB but also that “there isn’t any evidence that we’re not moving forward with those, again, subject to appropriate calibration”.

Given the state of US politics I don’t see how US representatives at Basel can give a commitment on FRTB

London-based consultant

However, those close to the procedure of US rule-making say it is impossible for US negotiators at Basel to offer assurances on FRTB implementation at this time given the Treasury and Federal Reserve are both reviewing the rules and will need to subject proposals to stakeholder consultation. They say they are left wondering how FRTB can form part of the EU-US Basel compromise, as well as how consistent US implementation of FRTB can be when domestic lawmakers are mulling significant reforms of the US market.

“Given the state of US politics I don’t see how US representatives at Basel can give a commitment on FRTB,” says one London-based consultant. “I see this as grandstanding by the Europeans, a way of putting the problem in the hands of the US. The Europeans have seemed the transigent ones so far, but knowing full well the Americas can’t give the assurances they’ve been asked for.”

A former US regulator, who did not want to be named, goes as far as to say it would be illegal for US regulators to offer a firm commitment on FRTB because of the statutory review that must be completed before regulation comes into force.

“If European regulators are looking for an assurance on FRTB from the US, they won’t get it,” he says. “At a minimum a rule of this type has to go through notice of proposed rule-making, with a reasonable comment period, then regulators need a reasonable period of time to go through a review with a public statement of how they’ve considered comments.”

The EU has already moved to delay FRTB implementation, originally scheduled for 2019. At the end of November, the Council of the EU recommended a four-year delay to the FRTB rules, followed by a two-year phase-in period.

Others are more optimistic since the US has shown itself willing to stay engaged with Basel talks, despite fierce opposition from some elements within the Republican party at the start of the year. The timeline for FRTB rules, however, remains unclear.

“What was indicated in the Treasury report on core principles of financial regulation was that the US is committed to the international process, but for FRTB and NSFR they are advocating a pause to make sure there are no unintended consequences,” says Andres Portilla, head of regulatory affairs at the Institute of International Finance in Washington, DC. “We see that chairman-elect Powell remains committed to the Basel process, with no indication that Basel rules won’t be implemented in full.”

Despite clear obstacles to an agreement at Basel, most believe the committee simply wanted to bring negotiations to a close since agreement has already been delayed for a year. The committee’s chairman, Stefan Ingves, is due to retire this year.

The former Basel Committee regulator says they want “some kind of face-saving formula” to produce at least the appearance of a result, having concluded that another year of discussions would not produce a different outcome. “I think Basel will find a way to draw a line under their effort,” he says. “But whether [there] is going to be an outright implementation of the floor is still open to doubt.”

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