UK: Bank Capital Regulation | Where Next For The Good Ship Basel?

Last Updated: 2 December 2015
Article by David Strachan

Most Read Contributor in UK, August 2017

It is striking, and perhaps not entirely coincidental, that since the start of November two very senior regulators have each used examples from maritime history in their speeches about the future of bank capital regulation. Neither example is a happy one. Stefan Ingves, Governor of the Swedish Riksbank and Chair of the Basel Committee on Banking Supervision (BCBS), referred to the fate of the Vasa. The Vasa when it was completed in 1628 was the most impressive vessel in the Swedish navy. But it sank on its maiden voyage, a casualty of significant design flaws. Nobuchika Mori, Commissioner of the Japan Financial Services Agency, drew on another tragic tale. The SS Eastland sank on Lake Michigan in 1915, having overloaded itself with life rafts to meet a regulation that had been introduced after the sinking of the Titanic. 841 lives were lost, more than on the Titanic itself.

It would be wrong to speculate about why Governor Ingves and Commissioner Mori chose these examples. But such cautionary tales indicate that both are contemplating some significant and serious issues ahead of the BCBS meeting at the start of December. What are the prospects for that meeting?

The BCBS is on a long voyage. The first consultation on Basel III was in December 2009. Some six years later huge progress has been made and the BCBS has played a vital role in the post crisis reform process. According to Mark Carney, Governor of the Bank of England and Chair of the Financial Stability Board (FSB), Basel III has increased capital requirements ten-fold while liquid assets on banks' balance sheets have risen four-fold since the crisis. Yet, the list of "open" Basel initiatives remains long. It includes the Fundamental Review of the Trading Book (FRTB), reviews of the standardised and advanced approaches to credit risk, a review of capital for operational risk, capital floors, interest rate risk in the banking book (IRRBB) and the treatment of sovereign exposures. (Governor Carney has also been very clear that this package does not amount to "Basel IV".) Agreeing each of these will be a challenge, both technically and politically. And agreeing the package as a whole will be even more daunting.

The BCBS will have to navigate its way through the following:

  1. The trade-off between speed, certainty and the importance of taking properly considered decisions. This time last year it was clear that the FSB and BCBS wanted the bank capital job largely done by the end of 2015. This has proved unachievable. The BCBS looks set to complete the FRTB by the end of the year, but closing down the rest of the open issues will take another 12-18 months (possibly longer in the case of sovereign risk). Unfortunately, this is at a time when fatigue with the continuous regulatory change agenda appears to have set in among some regulators (Governor Ingves's exasperation with the time taken to complete the FRTB is evident in a speech that he gave in October.) And for the industry (and investors in it) the continuing open-ended nature of the capital agenda means that strategic-planning and decision-taking are subject to significant uncertainty.
  2. The magnitude of any additional capital increase arising from the open items on bank capital. In October Andrew Bailey, the CEO of the UK's Prudential Regulation Authority, set out three reasons why he "disagree[s] with the much more capital school of thought". Moreover, Bill Coen, Secretary General of the BCBS is reported in an interview as saying "There's not a prevailing view among the BCBS that we need more and more capital". The fact that statements such as these are being made indicates that a "much more capital school of thought" exists in some countries, even though a lot of the BCBS's ongoing work is motivated more by concerns about the ways in which risk is managed than by a desire simply to continue to raise capital requirements. In many (but not all) cases the result will be an increase in capital requirements in specific modules of the framework (as highlighted by the recently published interim results of the impact study for the FRTB), even before account is taken of the FSB's recent TLAC standard. The BCBS may need to address the potential disconnect here – if aggregate capital is not actually in shortfall, are amendments which will lead to incremental increases in capital levels strictly necessary? (This question applies equally to the BCBS's review of the calibration of the leverage ratio which is due by end-2017 at the latest.)
  3. The balance between risk sensitivity, simplicity and comparability. Significant time has passed since the BCBS published a discussion paper on this topic in July 2013, but in the meantime the drive for simplicity appears to have become something of a steerage passenger – there is little simplicity in the capital framework, with even the (supposedly simple) leverage ratio retaining some degree of complexity in its calculation. It may be that the ultimate aim of a framework that is both simple and risk sensitive is unachievable, in which case the BCBS will ultimately have to decide on which side of the fence it will fall. (And if simplicity prevails, comparability is a much less relevant consideration.) But given that modern financial services are inherently multifaceted as a result of the many ways in which they seek to serve customer needs, there seems little reason to exempt the capital framework from the maxim that things should be made as simple as possible, but not simpler. Remaining within the boundaries of the risk-weighted framework appears the most sensible route, as other approaches would risk oversimplifying. This is ultimately as much a question about the legitimacy and credibility of the framework as about its technical performance.
  4. The balance between global, regional and national approaches to bank capital. Even if there is no "Basel IV", the EU will have to legislate to reflect the conclusions of outstanding issues in Basel when they emerge, so there will be a CRD5 and/or a CRR2 at some point. But political priorities have changed in the EU, with the emphasis now being much more on jobs and growth and the flagship Capital Markets Union initiative. Against this background, it is not obvious that the EU will feel obliged to copy out every detail of the BCBS's future framework, particularly if elements of it are contrary to the EU's current priorities. For example, changes which result in increases in capital requirements for SME financing are likely to receive short shrift. At the same time, the US has chosen to move beyond the BCBS and the FSB (most recently on TLAC) and appears to regard its CCAR approach as the most appropriate methodology to assess banks' overall capital needs. It is only 18 months ago that Daniel Tarullo, a member of the Federal Reserve Board of Governors noted that ".... I see little reason to maintain the requirements of the IRB approach for our largest banks". Switzerland also has a track record of introducing capital requirements that go beyond Basel and the FSB in the form of "Swiss finishes". The risk here is that further delays and/or compromises around the Basel table lead countries or regions to move away from (or beyond) the agreed BCBS standards, accelerating a trend that is already evident.

In all likelihood the BCBS will stay the course and complete the outstanding items on its agenda in the next 12-18 months. But this outcome isn't without risks, both in terms of global coherence and also the significant residual uncertainty (not to mention the ongoing review and implementation costs) that the industry will face. This is at a time when many policymakers are concerned about banks' ability and willingness to finance economic recovery and to provide liquidity to the capital markets they want to see grow.

But there may be another route. In 2009 when the BCBS issued its first consultation on Basel III, no one envisaged just how long the journey would take and how far-reaching the overhaul would be. Is now the time to reassess the cargo that has been accumulated on the way? The FRTB needs to be completed and the approach to operational risk is in need of review. But why not offload the rest and leave it in storage for the time being? The leverage ratio was always intended as a backstop, so could it take the place of the floors, if not permanently then at least temporarily? Persist with the current standardised approach to credit risk. Use a strengthened Pillar 2 for IRRBB and sovereign risk and look to greater disclosure to drive comparability in these areas. And make further use of cross-industry reviews and supervisory convergence to deal with the worst examples of RWA variability. That way, when it is time to embark on the Basel IV voyage, policymakers can steer their course on the calmer waters of a stable framework which has been operating in practice for a number of years.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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