The recent financial crisis made it clear that the existing regulatory framework was ill-equipped to prevent or mitigate a global financial meltdown. With hindsight, this was hardly a surprise. Over the past decade we have seen dramatic changes in financial markets, financial products and practices. During this period, the expansion of cross-border banking continued apace and increasing interdependencies between banks in different countries intensified vulnerabilities and fuelled contagion risk.
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Many global banks had shifted their financing strategies, relying more heavily on market funding, and the associated liquidity disruptions and shortfalls further amplified financial system fragility. Moreover, a flood of new and very complex financial products was introduced into the markets. In many cases, the originators of these products did not fully understand the inherent risks due to the products’ complexity, or because the regulatory framework necessary to create the incentives for proper risk management were absent. The speed with which the crisis unfolded caught policy-makers by surprise leading to, at times, a fragmented and uncoordinated response.
Basel response
The Basel Committee’s response to the crisis was a bold one. Within a short space of time, the committee developed and agreed upon a global set of rules on capital and liquidity. The 'Basel III' framework, as it is known, was published in December 2010. In one year from now – in January 2013 – these rules are expected to begin taking effect across the countries that are members of the Basel Committee. The new rules require higher levels of common equity – the purest and most loss-absorbing form of capital. Basel III also introduces new global liquidity requirements where none have previously existed.
These are but a couple of the significant measures that comprise Basel III, which we believe is a significant step in establishing a solid foundation for more resilient banks and banking systems. Strong, comprehensive rules are, however, not enough to help ensure that banks and supervisors are better prepared to cope with the next crisis. Implementation is imperative and is therefore a key priority for the committee. We will make sure the rules are implemented and enforced fully and consistently as agreed among the Basel Committee members. This represents a new dimension to the committee’s traditional role as policy-maker and standard setter.
The Basel Committee’s policy work remains a prominent part of our work programme. There are several initiatives under way at the moment, including extensive monitoring of some of the Basel III elements, such as the leverage ratio and the liquidity rules. Our motivation is to make sure that when the policies come into effect, they deliver the results the committee intended. Other current projects include an update and revision of the Core Principles for Effective Banking Supervision – the handbook for bank supervisors globally.
The committee is also undertaking a fundamental review of the trading book rules as well as reviewing the rules for securitisations and large exposures, among other things. It has already begun to explore whether the framework for global systemically important banks should be extended to domestic systemically important banks.
Making the rules work
What, then, will the Basel Committee do to ensure national and regional compliance with the Basel framework? The committee’s Standards Implementation Group has been mandated to closely monitor and coordinate the implementation of the committee’s policy rules and recommendations. Furthermore, the committee recently agreed on an aggressive three-level approach for the implementation assessments process.
At the most basic level, the Basel Committee has begun assessing countries’ progress in adopting the Basel regulatory framework (ie. Basel II, the July 2009 enhancements to Basel II, and Basel III). A first progress report detailing the degree to which national authorities have implemented the Basel rules was published in October and will be updated on a regular basis. The committee anticipates that such transparency will encourage countries to adopt the rules in a timely fashion.
The second level of review is to assess the consistency of national and regional legislations with the agreed Basel III rules text. This work will start early next year and will include both off-site and on-site reviews, with public disclosure of the findings. This work will be carried out by global review teams, which will evaluate how the Basel rules, adopted at a domestic level, compare to the globally agreed framework. Do the local rules meet the spirit and the letter of the Basel framework? What is the nature and material of any differences and do these deviations result in a weakening or dilution of the Basel rules? This again marks a considerable change in the committee’s role and represents for it a completely new way of working.
Finally, the third level of assessment will be to determine whether, in practice, the rules are delivering the anticipated outcomes across different countries and whether the rules result in comparable outcomes at the bank level. While there are a number of practices that impact the overall level of regulatory capital, this work will focus initially on how banks calculate their risk-weighted assets, both in the banking book and in the trading book. There have been troubling reports that average risk weightings have been decreasing and that there are large variations in risk-weighted assets across banks and jurisdictions.
Even though attempts have been made to explain and justify these differences, there is no convergence in views about the materiality and implications of these variances. The intent is not to unduly limit banks’ flexibility to measure and manage risk. Instead, this initiative aims to ensure that risk-weighted assets accurately and consistently reflect the underlying risks.
Concerns remain
There is a closely related issue which concerns me and which underscores the need to take a closer look at banks’ risk weightings. A number of banks have recently publicly signalled their plans to meet the higher capital requirements by changing their risk-weighting models, instead of replenishing capital, or by reducing the risk of their assets. This clearly runs counter to the Basel rules that govern the use of a bank’s models for calculating regulatory capital requirements.
Following a crisis, there is often a tendency for some bankers and supervisors from regions or countries not heavily affected by the crisis to become complacent, based on having escaped relatively unscathed. These days, some argue that Basel III is not relevant in their jurisdiction. This is a very dangerous way of thinking.
This leads me to another observation gained from my experience with the Nordic crisis of the early 1990s and my years working at the International Monetary Fund. Following a crisis, there is often a tendency for some bankers and supervisors from regions or countries not heavily affected by the crisis to become complacent, based on having escaped relatively unscathed. These days, some argue that Basel III is not relevant in their jurisdiction. This is a very dangerous way of thinking. This crisis undeniably had its roots in a limited number of Western countries.
However the factors that led to or amplified the financial crisis – ie. mispriced liquidity, weak bank governance, too much leverage and too little loss-absorbing capital – are not specific to those countries most affected by this crisis but are the common denominators of almost all financial crises, regardless of the jurisdiction. With that in mind, the presumption should always be 'this can also happen to you'.
One would also draw the conclusion that living in a complex, global and interconnected world no doubt requires well-designed global rules and regulations that have global acceptance. This is essential for making the global financial system safe and stable. Any efforts to delay or to water down the agreements will jeopardise financial stability and undermine the long-term robustness of the recovery. I and my colleagues in the Basel Committee are, therefore, committed to ensuring that the new and modified banking rules are implemented by all its members.
Stefan Ingves is governor of Sweden's central bank, the Riksbank, and chairman of the Basel Committee on Banking Supervision
