What's happening?
Among many of the bank trade associations, there was a sigh of relief when on January 3 the Basel Committee on Banking Supervision (BCBS) announced it was unable to finalise its framework of banking reforms on schedule and needed more time.
This buys some temporary relief for banks, which are facing more demands to raise their capital levels as a result of the BCBS fine-tuning the rules. Importantly, it also gives them more time to lobby over the many elements they are unhappy with. All of these tweaks add up to some big chunks of extra capital, hence bankers referring to it as ‘Basel IV.’
However, reversing those tweaks might be a forlorn hope. It looks as if everything is agreed: the leverage ratio, the various liquidity measures, the fundamental review of the trading book, and so on. Committee members will probably not fancy debating those topics again. It has taken years to get this far, after all.
Why is it happening?
The delay is over output floors. These are designed to restrict banks from getting too creative with their internal models and reducing the amount of capital they need to set aside against various exposures relative to what they would otherwise have to do under standardised models. It is a question of capital efficiency.
This is a big deal for European banks, supported by the big European governments, the European Commission and the European Parliament, which are concerned output floors could choke off credit to Europe’s economy.
By contrast, US regulators are deeply sceptical about internal models and prohibit their use for many banking activities. The BCBS is banning their use for a number of lending activities, such as loans to giant corporates, due to a lack of default data, unlike for, say, credit cards, where there is an abundance of it.
In turn, the BCBS says internal models lead to inconsistency, and suspects they are used to lower capital levels excessively in order to drive higher returns, which results in undue risks.
Reports suggest that as a compromise the BCBS is considering limiting banks from calculating their capital needs using internal models to 55% of the amount stipulated under standardised models starting from 2021, rising to 75% by 2025. Previously, the figures 60% and 90% were mooted.
Last year, analysts at Morgan Stanley estimated that the originally proposed floors could result in the risk-weighted assets of non-US banks rising by an average of 18% to 30%, requiring an extra €250bn to €410bn in capital.
What do the banks say?
European banks, joined by their Japanese peers in this case, say that internal models not only drive the efficient allocation of capital, but are more risk-sensitive and therefore help banks make better judgements.
They also argue that using standardised models would result in all banks behaving in the same way; that is, taking the same risks, and any faults in those models would therefore be massively amplified, possibly leading to another financial crisis.
The banks do have a point, despite the BCBS’s reservations. They learned a great deal about risk during the financial crisis, and the advent of big data and more advanced mathematical techniques are helping them to model risk better.
Will it provide the right incentives?
There is a lot at stake here. If BCBS compromises on output floors do not go far enough, the Europeans are threatening to walk away from that part of the Basel accords. This would set an unfortunate precedent, and result in other countries following suit. After all, the political focus is increasingly shifting away from regulatory reform towards rekindling economic growth, and European banks have a big role to play.
The risk is that level playing fields for banks could be further away than ever.
In essence, it looks as if the Basel accords are nearly complete: there is just the output floors element to finalise, and that decision could come as soon as March. But things may not be that straightforward.
The new US administration under president Donald Trump could throw another spanner in the works. Mr Trump has promised financial deregulation. Does that mean abandoning Basel, or watering it down into irrelevance? His appointments to the various US regulatory agencies and their new priorities should provide some clues in the coming months.
