Fears over consistency of Basel III implementation

With the final version of Basel III published in December, the focus is now on ensuring consistent implementation across the globe. But with divergences between jurisdictions already emerging, what can the Basel Committee do to make sure everyone ends up playing by the same rules? By Michael Watt

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When a close friend asked US President Theodore Roosevelt how best to negotiate the complex world of international diplomacy, he is said to have responded: “Speak softly and carry a big stick.”

Following the publication of the final version of Basel III on December 16, the Basel Committee on Banking Supervision might well wish it could follow this advice as it hands over the framework to national regulators, which will now transpose the rules into binding laws in their respective jurisdictions. Everyone seems to agree – publicly, at least – that consistent implementation of Basel III across the globe is vital. When push comes to shove, though, there are worries individual regulators may tweak certain parts of the rules to suit their own banking sectors. And, as it stands, there is very little the Basel Committee can do about it.

“The Basel Committee sets global standards but those are implemented only as each country sees fit. It’s not tower control – it can’t tell countries what to do or punish them if they don’t do it,” says Andrés Portilla, deputy director of regulatory affairs at the Institute of International Finance in Washington, DC.

The omens are not particularly good. In September, an own-initiative report was published by an Austrian member of the European Parliament, Othmar Karas, which called for action on 65 points of concern around the Basel rules – including the definition of core Tier I capital. Several countries have expressed worry about the liquidity coverage ratio (LCR), claiming there simply aren’t enough high-quality liquid assets to comply with the rules. There’s also concern about the timing of implementation, particularly in the US.

Some argue the Basel Committee does not have the teeth to force member countries to comply on time, and instead relies heavily on peer pressure – making consistent and timely implementation unlikely. “There are fundamental international differences in economic structure and corporate culture that will hinder consistent implementation. I find it difficult to accept regulatory peer pressure will be enough to overcome these,” says Andrew Jennings, chief regulatory liaison officer at Citigroup in London.

Not everyone agrees with that. The power of peer pressure is often underestimated, believes Charles Goodhart, emeritus professor at the London School of Economics. “If, as a regulator, you are found not to be implementing the agreed standards properly, your reputation for maintaining decent regulation would decline pretty rapidly among your international colleagues. One would definitely want to avoid that outcome,” he says.

Nonetheless, peer pressure can’t be relied on for every aspect of the framework. For instance, Basel III gives individual regulators the power to impose a counter-cyclical capital buffer on banks operating in their jurisdiction if they believe a credit bubble is emerging in the country. But the methodology used to determine whether credit growth is excessive might be inconsistent from one country to the next. Furthermore, there is no guarantee regulators will enforce it, particularly if other countries aren’t experiencing similar credit growth. “The Basel Committee can do little to ensure central banks or other regulatory bodies actually use this discretionary measure,” says Goodhart.

Individual regulators may also be deterred from implementing the rule in times of economic growth and easy access to credit, fearing a backlash from the public. Ultimately, it may be difficult to determine whether greater access to credit is the result of stable economic growth or an unsustainable bubble – and some regulators may be reluctant to make that call. “If the regulators were to try to slow down lending by imposing the buffer in these conditions, it would run into a storm of criticism from all sides. It remains very dubious as to whether a regulatory body would have the strength of character to do this,” Goodhart adds.

The Basel Committee has so far been helped by a strong political push to draw up new regulatory capital rules in the wake of the financial crisis. The Group of 20 (G-20) nations has been instrumental in setting a timeline for completion of Basel III, and insisted on an end-2010 target at its September 2009 Pittsburgh meeting. Apart from a few outstanding issues left to be thrashed out, this target was achieved – a G-20 communiqué issued at the Seoul summit in November 2010 endorsed the Basel III framework, and committed the member nations to fully adopt the standards by the official January 1, 2019 deadline.

However, this political momentum may start to wane as economies recover – and with it, the commitment of individual countries to implement the rules in full. “After the crisis, we had a window of opportunity to propose durable reforms, but implementation largely depends on maintaining the political momentum for reform generated by the financial crisis. People have a habit of forgetting things too quickly, and there is a real danger that momentum will slacken off. If that happens, the peer pressure the Basel Committee is able to exert will be reduced and Basel III may be damaged or delayed,” says Lars Frisell, chief economist at Finansinspektionen, Sweden’s financial regulator.

But given the scale of the crisis, and the extent of government support in many countries, it is unlikely political momentum will fade that quickly, some argue. Investor pressure and rating agencies will also play a part in making sure individual banks comply with the most visible parts of the new rules, such as the leverage ratio and minimum capital requirements.

“Memories are short, but I don’t think they’re that short. The crisis was a seminal event for both regulators and industry participants, and there is a strong desire to make sure it doesn’t happen again,” says Kevin Bailey, deputy comptroller for capital and regulatory policy in the Office of the Comptroller of the Currency in Washington, DC.

Despite this, the Basel Committee is looking to take a firmer approach than it perhaps has in the past. “I think everyone understands that if we don’t implement Basel III consistently, the health of the global banking system will suffer. We’ve put in place stronger mechanisms that give us a better chance of achieving a good implementation,” says Stefan Walter, secretary-general of the Basel Committee.

These mechanisms will consist of peer reviews conducted by various institutions, including the Basel Committee’s own standards implementation group (SIG), which meets four times a year and is headed by José María Roldán, director-general for banking regulation at the Banco de España.

According to members of the committee, the SIG will conduct a series of thematic peer reviews throughout the implementation period that will seek to identify problems with specific aspects of the package. However, the SIG is limited in what it can do. “It will have a role to play in ensuring a level playing field is created, but it won’t be singling out or criticising individual jurisdictions. The best it can do is gather information and ask how people have implemented the reforms,” says a senior European regulator.

Alongside the SIG, the Basel Committee can also turn to the International Monetary Fund’s (IMF) financial sector assessment programme. These assessments are conducted in conjunction with the World Bank and are designed to provide a detailed analysis of a nation’s financial health and its conformity with international financial regulations. Some regulators hope these assessments could provide a way to publicly highlight any jurisdiction that is taking a lax approach to Basel III standards.

“Undergoing a financial assessment is very burdensome and is taken seriously by regulators. You don’t want to be marked down as being non-compliant, and I think it will be a very effective tool to put pressure on regulatory bodies,” says Maarten Gelderman, head of macro-prudential analysis at De Nederlandsche Bank.

Other regulators have less faith in the concept, however. “A negative IMF verdict would certainly be a strong statement, but it would probably only have an effect on the emerging or medium-sized economies,” says Finansinspektionen’s Frisell.

It is the big players that many see as posing the biggest threat to Basel III implementation. “The success or failure of Basel III will depend on the willingness of major jurisdictions to implement. If regulators or legislators in these big-player jurisdictions decide to make substantial alterations to the package, that would be a worry for us. The Basel Committee will not be able to overrule them,” says Gelderman.

In this context, the European Parliament’s own-initiative report last September does not bode well. The document highlights a number of potential problems with Basel III – most notably, the fact that shares and retained earnings are the primary acceptable forms of core Tier I capital, a rule that could put Europe’s co-operatives, savings banks and mutuals at a disadvantage.

The European Commission (EC) is charged with drawing up the latest amendments to the European capital requirements directive, known as CRD IV. However, this legislation needs to be approved by the European Parliament and European Council. If parliament digs its heels in on certain points, the EC might be forced to revise sections of CRD IV, putting it at odds with Basel III. In an interview with Risk last year, author of the own-initiative report Karas said the Basel Committee has the first, not the last, word on the make-up of capital rules (Risk December 2010, pages 19–22).

It is not just the politicians at the European Parliament – individual European regulators are pushing for changes in certain areas. The LCR, which requires banks to hold enough high-quality, liquid assets to survive a 30-day period of acute stress, has been a major bone of contention.

The Basel Committee insists that at least 60% of this liquidity holding must comprise cash, central bank reserves or government debt issued in domestic currency – and some national supervisors have complained the stock of domestic high-quality assets is not big enough for their banks to meet the requirement. In December, the Basel Committee agreed to develop alternative rules for those countries with insufficient liquid assets, suggesting three possible approaches, including contractual committed liquidity facilities from the relevant central bank in return for a fee. The alternatives, along with the criteria to determine which countries will be eligible to apply them, will be drawn up during the observation period, ahead of the implementation date of January 2015.

Some regulators aren’t waiting that long. Denmark’s regulator, Finanstilsynet, submitted its own proposal to a CRD IV working group that would move the LCR away from a strict definition of eligible assets, towards a system where an asset could be reviewed on an ongoing basis by supervisory bodies and included in the buffer if it meets a series of liquidity criteria. It is understood the suggestion has won support from other European Union nations.

If this proposal is written into CRD IV independently of the Basel review, it could create a fissure between Europe and the rest of the world. The leverage ratio is another area highlighted by some as needing change. The European Parliament’s Karas, for instance, suggested in the December interview with Risk that the measure may not automatically migrate from Pillar II to Pillar I at the end of the transition period in 2018, as envisaged by the Basel Committee. US regulators, however, are determined the leverage ratio should be part of Pillar I.

“We feel very strongly it needs to be in Pillar I, where it will remain publicly measurable. Pillar II offers too much flexibility and regulator discretion,” says Sheila Bair, chairman of the Federal Deposit Insurance Corporation in Washington, DC.

Despite these differences in opinion, some believe the real danger is not that some countries will apply key parts of the rules differently, but that they may implement the rules according to different timelines. “I can’t see countries signing up to Basel III, as all the committee members have done, and then blatantly not implementing it, but countries could stall for time and extend their implementation period beyond the agreed timetable. The Basel Committee would find it very difficult to get them to move faster,” says Patricia Jackson, head of the prudential advisory practice at Ernst & Young (E&Y) in London.

On this point, the US has been guilty of slow implementation in the past, with its Basel II plans well behind those of Europe. Nonetheless, Bair stresses the US is committed to Basel III. “The committee has put together a strong regulatory package to improve both the quality and quantity of capital, and we are very committed to it. The FDIC is eager to begin the implementation,” she says.

But doubts remain. US regulators are neck-deep in drawing up detailed rules required under the Dodd-Frank Wall Street Reform and Consumer Protection Act – something that is likely to take priority over Basel III in the short term, some observers say.

“If the pace of implementation in the US is slow, regulators across the world may take this as an opportunity to ask for more time or for more relaxed standards, and the whole framework will start to fragment,” says Jackson at E&Y.

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