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Analysis & opinionAugust 1 2019

Basel is putting prosperity on the line

The latest Basel regulations will limit business growth with their misguided approach to risk strategies, writes Giampaolo Gabbi of Siena University.
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As the latest iteration of the rules from the Basel Committee on Banking Supervision (BCBS) is developed, not enough attention is being paid to the unintended consequences of new requirements on bank’s risk strategies and, therefore, business prospects. This is a dangerous oversight.

In the months following the most dramatic events of the financial crisis, regulators were faced with a dilemma: redesigning banking supervision to prevent similar catastrophes in the future, or letting financial agents find a new market equilibrium without additional intervention.

The threat of financial contagion drove policy-makers to the former solution. They strengthened the regulatory model that had been approved by the BCBS before the crisis, after identifying its main weaknesses: gradual erosion of the level and quality of the capital base; excessive on- and off-balance-sheet leverage; insufficient liquidity buffers; a procyclical deleveraging process; and interconnectedness of systemic institutions through an array of complex transactions.

With a series of proposals (Basel III) subsequently translated into standards and regulations, the committee sought to reinforce the banking systems in both capital and liquidity. 

Separate goals

Banks, at least the larger ones, were still allowed to develop internal models for calculating capital against possible losses due to credit, market and operational risks. But these exercises often led to solutions that simply minimised the amount of required regulatory capital of a certain business strategy, turning risk management into capital management.

The process of developing internal models involves both risk managers and capital managers, but they should have two distinct goals: the former should optimise the system of risk controls, while the latter should optimise the absorption of the bank’s capital. Due to the high cost of equity, banks may choose the risk solution that more than any other allows the release of regulatory capital.

To solve the problem, at the end of 2017 the BCBS introduced a number of major revisions (often and improperly referred to as Basel IV), which will come into force in June 2021, with the intention of reducing the excessive variability of risk-weighted assets and, regulators hope, decouple risk and capital management.

Under the new rules, internal models will be significantly conditioned by the application of external constraints and reduce individual banks’ discretion over them, which may have micro- and macro-prudential negative effects.

Furthermore, to avoid crises at global systemically important banks, new Basel rules will add a liability requirement that should increase the bank’s loss-absorption capacity. This is done in the form of a total loss absorbing capacity (TLAC) requirement and the minimum capital requirement and eligible liabilities (MREL). TLAC and MREL requirements oblige banks to issue subordinated liabilities that can then be bailed in in the event of a crisis. The cost of raising additional funds to satisfy those requirements can vary significantly across countries, creating competitive biases, which would hinder the creation of a level playing field.

Holding up growth

These new rules may have a positive impact on the safety and soundness of banks, but they could drive regulated agents to decisions that reduce profitability. This may lead to losing about 1 percentage point of European banks’ return on equity, according to a McKinsey study

A bank that is unable to generate adequate return on equity tends to lose shareholders, damaging its market capitalisation, and, over time, tends to suffer reduced solvency too. The new rules also risk hindering growth by lowering bank credit to the economy.

A standardised and interventionist approach by regulators would progressively reduce banks’ incentives to develop internal models for assessing risk and find new business opportunities that fit their risk appetite. 

Little has been done to improve banks’ risk cultures and better understand how risk mechanisms can influence banks’ overall strategies. This is a challenge that should be taken up by all those involved: policy-makers, regulators and bank CEOs. Improving banks’ stability, efficiency and growth should not be conflicting goals. 

Giampaolo Gabbi is professor of risk management at Siena University and SDA Bocconi School of Management

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