Q&A: Stefan Ingves, Basel Committee, on Europe, the NSFR and capital floors

Consistent implementation and outcomes are pillars of any successful regulation. At the moment, internationally agreed capital standards fall down on both counts. Stefan Ingves, chairman of the Basel Committee on Banking Supervision, talks to Cécile Sourbes about attempts to even up the new regime

Stefan Ingves, Basel Committee: regulatory consistency in Europe is essential

Last month, a crack squad of seven regulatory experts published a review of Europe's new bank capital rules, identifying more than 80 points on which they diverge from the internationally agreed standards in Basel III. At the end of the document is a section described, a bit misleadingly, as a "list of issues that the EU intends to address". It consists of a single item.

Put politely, it looks like a stand-off. Explaining themselves earlier in the document, European authorities argue the assessors "have arrived, in full good faith, at interpretations of the Basel framework that one may not necessarily share".

So, what happens next? Two things, says Stefan Ingves, chairman of the Basel Committee on Banking Supervision – the committee will review its own standards to see if they need clarifying, and members of the committee will apply "peer pressure" to Europe to bring it in line.

"Considering that Basel III is a global agreement, one would expect some adjustment on the EU side over time to ensure compliance," says Ingves.

It is too early to say whether this will work, but this is a watershed moment for the committee, which has been at the forefront of the post-crisis regulatory push, revamping capital requirements – the subject of the review – as well as agreeing two new liquidity ratios, a leverage ratio definition and a host of other items to be reviewed at a later date. Throughout, banks and others have worried about consistency of implementation, and regulators have responded by pointing to the review process – the first time the committee has tried to hold members' feet to the fire in this way. But it has now done all it can, Ingves says – it's up to the EU and other jurisdictions to determine what happens next.

Considering that Basel III is a global agreement, one would expect some adjustment on the EU side over time to ensure compliance

Ingves is also governor of Sweden's central bank, where Basel standards have been enforced rigorously – and exceeded in some instances. In a speech at the Federal Reserve Bank of Chicago on November 6, he noted that over the past 20 years or so, the risk weights for retail mortgages in the major Swedish banks have decreased from 50% to 35% with the adoption of Basel II to about 6% when banks themselves were allowed to model risk weights.

As a result, Finansinspektionen – the country's prudential regulator – has introduced a risk-weight floor on retail mortgages, which originally started at 15% and has since been increased to 25%. According to the Riksbank, this figure may need to go even higher. So it's no surprise that the Basel Committee, under Ingves, has begun clamping down aggressively on the comparability of risk-weights – one of its major work strands this year is to develop a framework of capital floors for banks that model their own requirements.

Ingves spoke to Risk one morning in early January. From his office at the Riksbank, for which he has been governor since 2006, he discussed the Basel Committee's attempts to strengthen the banking industry, and revealed he has no second thoughts about the rules introduced so far, despite growing concerns that they are making markets more fragile.

Risk: What have been your priorities since taking over the chairmanship of the Basel Committee in 2011?

Stefan Ingves: The work of the committee has been very much driven by what happened during the financial crisis, all the difficulties a number of banks ran into and what needed to be corrected to avoid a similar scenario in the future. In that sense, a particular milestone has been Basel III.

We still need to work on a number of issues though. That includes revising the standardised approach for credit risk, the review of the trading book and developing capital floors based on the standardised approaches.

The committee has also embarked on a regulatory consistency assessment programme (RCAP) to monitor what countries actually do when it comes to implementing the Basel III rules at the national level. This is a remarkable achievement in the sense that the Basel committee has been around for almost 40 years, and it's the first time such assessments have been conducted. A number of jurisdictions have already made quite a lot of changes to their domestic regulatory frameworks to ensure they are more in line with Basel III.

Risk: As part of the RCAP work, the committee determined in December that the EU's rules are "materially non-compliant" with Basel III. What happens next?

SI: This assessment has been conducted over an extended period of time. All these issues have been carefully considered by a group of very knowledgeable international experts and this is the conclusion that came out of this process. And considering that Basel III is a global agreement, one would expect some adjustment on the EU side over time to ensure compliance.

Risk: Over what kind of timeframe?

SI: It's hard for me to tell. This is determined by what is decided within Europe itself, and in some respects it also depends on the legislative process. The only thing the committee and the experts have said is ‘This is what was agreed and this is what you have done'. The rest of it is up to Europe to deal with.

I would like to stress that the Basel Committee is not backed by a legal framework and does not have formal enforcement authority. It's a group of countries that meet and reach a common agreement on what to do. If a jurisdiction joins, it is expected to comply with what has been agreed within the group. So, of course, now that the committee's view is public, there will be some elements of peer pressure coming from other jurisdictions.

We have looked at 17 out of 27 jurisdictions so far and a very large number of adjustments have been made in various parts of the world.

Risk: The EU authorities accept legislative change is needed on two points raised by the RCAP team – one being risk-weights for sovereign exposures. Here, in short, they say ‘Don't worry, because the EBA will produce guidelines in 2018'. Is that quick enough, and are guidelines sufficient?

SI: Sovereign risk is a difficult topic and issue. The committee has actually started doing work on that, reviewing the regulatory treatment of sovereign risk across the framework because sovereign risk, of course, shows up in many places in this framework.

As the committee embarks on a holistic review – and given that we will cover many aspects of this – it will also include the whole issue of risk-weights, especially for low-default portfolios. The issue is high on our agenda.

Risk: Do you have a timeline in mind?

SI: No. It would be premature to set any deadline, because we are talking about global standards that aim to tackle a very difficult issue. There are many different views on this topic, and it would be good to come up with something truly global. But it will take a little bit of time before we can develop a final framework.

Risk: On the second point – the exemptions provided to the CVA charge – the EBA itself has called for their removal, with Pillar II assessments filling in until the trading book review is complete. Is that reasonable?

SI: Again, Europe is not in compliance and peer pressure will assume that it needs to change its way.

Risk: In response to the RCAP work, EU authorities suggested it might be easier to win support for an end to the exemptions if it was easier to hedge CVA. Do you have any sympathy for that view?

SI: It's hard for me to comment on views from different countries, because part of this process is to get approval at the global level, but there are always many different views and countries have to adjust to reach a global agreement.

Risk: There were also four points on which the EU disagreed with the RCAP assessors – in essence, insisting Europe was not in breach of Basel III. One of these was the differential risk-weighting of mortgage loans, with the secured portion of a loan being subject to a lower weight. Is more clarity needed here?

SI: An important element of our implementation work is the information that feeds back into the policy process. Based on this feedback, we are looking at a number of issues to determine whether we need to provide more clarity.

Risk: Europe also gave member states the option to continue filtering out of equity unrealised gains and losses on available-for-sale (AFS) bonds. The US, for example, did not. What are the risks of this kind of unlevel playing field?

SI: To be honest, the committee always produces a level playing field – given that each jurisdiction is responsible for the implementation of the rules – provided countries in the end do what has been agreed. In the real world, countries sometimes do other things but over time, given the way work is organised, peer pressure should take care of that.

Risk: Europe argues the AFS opt-out is only temporary – ending with the endorsement of new financial instruments accounting standards, which they claim will happen later this year – and is therefore not likely to have an impact. Do you agree?

SI: On this subject, the Basel Committee experts in charge of conducting the EU assessment considered it not to be material. We will see whether that changes over time or not.

Risk: Some countries are also going above and beyond internationally agreed policies. US regulators recently proposed a capital surcharge based on a bank's consumption of wholesale funding – a risk Basel III tackles via the net stable funding ratio (NSFR). Does this mean the NSFR has failed?

SI: The Basel Committee's review of different countries' implementation of the framework for global systemically important banks (G-Sibs) has not started yet. We will have to see what assessment that delivers.

On a more general level, the NSFR has not failed because we have never had it in the past. So it's an achievement in itself. But, as always when you put in place new types of rules and introduce a regulatory framework that has not existed in the past, lessons will have to be learned from that. It will take a number of years before the NSFR comes into effect. We will then see what works and whether there are some adjustments that need to be made.

Risk: You understand the argument for a capital surcharge then?

SI: I cannot comment on what countries should or should not do. Within the committee, we designed the NSFR, but we are going to have to go through a learning process since the NSFR has never existed before.

Risk: In December, the Basel Committee issued a consultation on the design of a framework of capital floors. Why are capital floors needed in conjunction with the leverage ratio?

SI: Let me first say that we are currently working with three different ways of measuring capital. One is based on internal models and the use of risk weights, the second is a standardised approach to calculating risk weights and the third is the leverage ratio. What we have to do within the committee is work on the calibration and interplay between these three ways of measuring capital. That's a fascinating exercise, but not so easy.

On top of that, we also have to go through a thorough process of revising the standardised approach, as it is now outdated. Part of the standardised approach and the debate around floors comes from Basel I, but this framework was introduced a long time ago. Things simply need to be modernised. Talking about this, we have also recently put out a consultation paper on the structure of a revised standardised approach – without getting into the whole issue of calibration and without dealing with the numbers.

But to answer your question, it's pretty clear there is way too much variation with risk weights, and the whole system has lost a lot of credibility. We need to work on ways to restore credibility, which is why we are considering a capital floors system. Those floors are part of a range of measures the committee is developing to enhance the reliability and comparability of risk-weighted capital ratios. The question is how to construct them and how those floors relate to the standardised approach. Then, of course, we want to put in place a leverage ratio that will be a complement to the floors. In other words, we think an approach based on multiple metrics is superior to a single measure.

Risk: At what level of risk will the floors be aggregated? What are the pros and cons of the different options?

SI: There are a whole lot of issues here, and this is why we launched a consultation on the standardised approach for credit risk in December.

You can do this in many different ways. One is to set up the floor per risk category, in effect setting separate floors on credit risk, operational risk and market risk as a percentage of the respective standardised approaches. Another is to set a floor based on the risk-weighted asset (RWA) total for a bank.

The difference is that a risk category-based approach wouldn't allow any offsetting across various types of risk. With this approach, the floor would simply be the sum of the higher of the capital amounts required under either the floored standardised approach or the internally modelled approach for each risk category. This approach would then be calibrated at a lower level than an aggregate RWA-based floor to deliver the same capital impact.

That being said, it would be premature on my side to say one way is better than the other – the consultation process is running, and we will receive many responses and many different views on the two alternative ways forward.

The truth is that the more granular you are, the more you impose standards that are the same for everybody all over the world. On the other hand, the less granular you are, the easier it is to come up with something that is seen as a reasonable outcome because banks are very different from one jurisdiction to another and their size also differs enormously. We have to bear in mind that even within the Basel Committee itself, there is an enormous difference between – let's say – a G-Sib and a small local bank in whatever country. So it's a matter of judgement to balance this.

Risk: Is there any possibility the floors will be set at 100% or more of the standardised approach?

SI: I am not sure why anyone would want to do that, but it's too early to say where we will end up when it comes to the calibration of the floor. One issue to solve before the floor can be finalised is to see how all these things fit together. It's one thing to produce a standardised approach, where you can use that as a floor for the internal risk-weighted approach. It's a different thing to use internal risk weights the way they are – and use other floors when you use the internal risk-weighted approach. This is precisely the exercise that lies ahead of us, and we need to find out how to balance all of this.

Risk: The US has gone some way beyond the Basel III leverage ratio with its supplementary leverage ratio, taking the compliance level to 5% and 6% in some cases. Do you expect other countries to follow?

SI: We have agreed here at the Swedish central bank that our level should start at 4% and then go to 5% over time. There are some other countries such as the Netherlands and the UK, which have reached similar conclusions. But this is something countries have decided on their own, and it is outside the Basel scope in the sense that the committee has not yet tackled the whole issue of the calibration of the leverage ratio.

Last year, we agreed on a definition of the leverage ratio. That was an achievement, because this compilation of definitions had not existed in the past. Now, when the reporting process starts, it will be possible for the first time to compare leverage ratios in different parts of the world in such a way that you can understand what the numbers are.

What remains to be done within the committee is to get back to the issue of what would be a reasonable minimum leverage ratio number at the global level. That conversation has not happened yet.

Risk: There seems to be a growing consensus – among supervisors as well as market participants – that post-crisis regulation has resulted in markets that are more fragile, by constraining market-makers. Do you agree?

SI: It was very reasonable to put in place the rules and regulations we have been working on after the financial crisis. And given we know what the cost of a crashing financial system is, I think the work that has been done is an investment with very high return. Some things are fundamentally meant to change in the financial sector. That's why we embarked on Basel III. It's not surprising people are claiming there are some negative effects, but I think it's a gain for society to do what we have done.

Risk: So you never worry the regulatory response has gone too far?

SI: No.

Risk: Are you confident everything is in place and will adjust itself naturally over time?

SI: When it comes to regulation, financial markets change over time and so do rules. We can hope something will get done and will stay in place forever, but that's not how things work in the real world.

It was very important to increase the stability of the financial sector. The previous system led us to a global financial crisis, and this really is something we should try to avoid going forward. We should also try to do more than we have done in the past to at least increase the intervals between these difficult events.