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Gleeson on the International Regulation of Banking, 3rd Edition by Gleeson, Simon (30th August 2018)

Part I The Elements of Bank Financial Supervision, 3 Basel and International Bank Regulation

From: Gleeson on the International Regulation of Banking (3rd Edition)

Simon Gleeson

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2015. All Rights Reserved. Subscriber: null; date: 01 April 2020

Subject(s):
Regulation of banks — Basel 1 — Basel 2 — Basel 3 — Risk adjusted assets — Basel committee on Banking Supervision

(p. 33) Basel and International Bank Regulation

A.  The Basel Committee and the Basel Accord

3.01  A historic approach to bank regulation is of little use or relevance,1 but it may be helpful to say a few words about the Basel2 Committee, and how it has come (p. 34) about that an organization with no powers, constitution, or even legal existence has come to be the dominant power in bank regulation.

3.02  As the financial markets internationalized in the 1970s, it became increasingly clear to supervisors that some form of co-operation would be needed between them in order to supervise the larger banks. The failure of Bankhaus Herstatt in 1974—a failure of a German bank which had significant repercussions in the London market—was the event which triggered the establishment of an entity for this purpose. Thus towards the end of 1974 the governors of the central banks of the G10 countries established a committee to discuss international supervision. The Basle (later Basel) Committee on Banking Supervision (BCBS) was afforded a secretariat by the Bank for International Settlements (BIS) (which existed to manage payments between central banks) based in Basel. The key point here is that since the Committee was founded by central bank governors (who at the time were responsible for bank supervision) it could not be given any formal role or status in international law, and remained an entirely informal body. In 1975 the Committee produced its first major document, the Basle Concordat, which laid down a division of responsibilities between the national supervisors of international banks with the aim of ensuring that there were no gaps in the regulatory coverage of such banks.

3.03  Another consequence of the increasing internationalization of the financial markets was that banks established in different countries were beginning to compete head to head in the London syndicated loan markets, and this competition was beginning to highlight the fact that banks from different countries were subject to very different regulatory constraints in terms of the level of capital which they were required to hold. It is generally suggested that the Bank of England’s paper of 1980 entitled ‘The Measurement of Capital’ constituted the first formal imposition by a central bank regulator of a formal capital adequacy regime based on risk-weighted assets, but the US followed almost immediately afterwards, imposing a leverage ratio (a capital requirement not based on the riskiness of assets) by 1985, as did the Japanese regulator. Each jurisdiction had different rules for what counted as capital and what requirement should apply to what type of asset, and many countries (particularly European countries) operated a system whereby the capital requirement imposed on each individual bank was simply a matter for the judgement of the relevant regulator. At the same time banks were increasingly trying to improve their return on equity by financing themselves with a wider range of instruments and by reducing the equity proportion of their balance sheets. Thus there was considerable concern amongst regulators that a ‘race to the bottom’ could only be averted if the regulatory community established and promulgated a common standard.

3.04  The result of this initiative was the Basle Capital Accord of 1988. This set out a simple weighting system for different types of assets, standardized the rules as to (p. 35) what should count as capital, and set out the basic requirement that banks must maintain an amount of Tier 1 (broadly equity) capital equal to at least 4 per cent of their risk-weighted asset value, and an amount of Tier 1 and Tier 2 equal to 8 per cent of their risk-weighted assets. The BCBS designed the 1988 Accord as a simple standard so that it could be applied to many banks in many jurisdictions. It required banks to divide their exposures up into a few broad ‘classes’ reflecting similar types of borrowers. Exposures to the same kind of borrower—such as all exposures to corporate borrowers—were subject to the same capital requirement, regardless of potential differences in the creditworthiness and risk that each individual borrower might pose.

3.05  While the 1988 Accord was applied initially only to internationally active banks in the G10 countries, it quickly became acknowledged as a benchmark measure of a bank’s solvency and is believed to have been adopted in some form by more than 100 countries. The Committee supplemented the 1988 Accord’s original focus on credit risk with requirements for exposures to market risk in 1996.

3.06  In theory no one was (or is) obliged to take any notice of the Basel Committee. However, the Basel Accord was rapidly adopted as the standard bank regulatory approach, both by the G10 banks which composed the Committee but also by almost every other bank supervisor worldwide which supervises international banks. Thus by the time the proposal for an updated Accord was introduced in 1999, the original Accord could justifiably be said to form the basis for global bank supervision. That updated Accord, published in June 2004, is the document commonly referred to as Basel II and whose provisions form the subject of the bulk of this work.

B.  Policy Responses to the Crisis

3.07  One of the primary political responses to the crisis was to maintain that it was ‘caused’ by the banks. The logic of this position is examined in paras 3.38 to 3.53. However, the usefulness of the belief meant that it soon became an assumption rather than a contention, and even in the earliest G20 statements responding to the crash are to be found observations to the effect that banking supervision ‘needed to be tightened’. The difficulty which this posed is that even those who agreed that banks had ‘caused’ the crisis were unable to agree on which aspect of bank behaviour had had the causative connection. However, the common denominator of many of these positions was that because the banks’ problems had resulted in a shortage of capital, requiring them to hold more capital was the answer. The Basel Committee was therefore given a strong mandate to ‘tighten’ bank capital regulation.

3.08  It is important to understand that the Committee’s starting point was that it absolutely did not accept that the crisis had revealed weaknesses in the fundamental (p. 36) basis of the capital regulatory system. Rather, it had demonstrated that the existing system, although coherent, had been incomplete. Basel III is therefore not a rewriting of Basel II, but a development of it. The fundamental Basel II architecture remains in place, and is supplemented rather than restructured by the Basel III changes.

C.  Basel 2.5

Trading book reform

3.09  It may be remembered that in the immediate aftermath of the crisis the products which bore the brunt of public criticism were securitization and repackaging. Much of the public criticism was uninformed to the point of infantilism, arguing that these products were ‘bad’ because they were ‘complex’. However, beneath this lazy populism, regulators knew that a real problem had been revealed. The issue was that trading book risk assessments had, under the Basel II regime, been conducted on the basis that markets would always be liquid—ie that it would always be possible to trade out of any instrument within a reasonably short period at a manageable loss. As a result, the measures of risk applied to instruments held in the trading book did not reflect the underlying credit risk of positions, but only the historical market movements associated with them. In the crisis market liquidity abruptly vanished, and the more structured a security was, the harder it was to value and the less likely it was that a buyer could be found for it at any price. In fact, the post-crisis experience of structured securities suggested that their credit performance had been roughly as expected. However, the fact that they had proved almost completely illiquid during the crisis meant that, at the very least, their treatment as tradable securities required to be reviewed.

3.10  The Committee’s reaction to this was to approach their reforming mandate in two stages. The first stage—known as Basel 2.5—was a response to the specific market issues which had been revealed during the crisis. This was intended to be implemented at the end of 2012. The second stage—a broader review of every aspect of bank capital regulation known as Basel III—is now complete, and will be implemented over the next decade.

3.11  The primary developments implemented by Basel 2.5 were:

  1. (a)  requirements for trading strategies and parameters to be more clearly defined within institutions;

  2. (b)  prohibition on including securitization positions in the trading book (with limited exemption for correlation trading);

  3. (c)  introduction of the incremental risk charge, intended to cover the risk of significant market movement;

  4. (d)  increased risk charge for resecuritizations.

(p. 37) Stress testing

3.12  Stress testing has been part of banks’ risk management processes for many years, and in May 2009 the Basel Committee published a set of ‘Principles for Sound Stress Testing Practices and Supervision’. Banks are encouraged to make greater use of stress testing as part of the pillar 2 assessment. In one of the more telling observations in the Basel 2.5 documents, the Committee notes that ‘[s]tress testing is especially important after long periods of benign risk, when the fading memory of negative economic conditions can lead to complacency and the underpricing of risk, and when innovation leads to the rapid growth of new products for which there is limited or no loss data’. Therefore, a bank’s capital planning process is now required to incorporate rigorous, forward-looking stress testing that identifies possible events or changes in market conditions that could adversely impact the bank.

Pay and bonuses

3.13  The Basel approach to remuneration is that compensation policies must not incentivize individual employees towards generation of short-term accounting profit, but should incentivize longer-term capital preservation and the financial strength of the firm. The Committee takes the view that:

[c]ompensation practices at large financial institutions are one factor among many that contributed to the financial crisis that began in 2007. High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they imposed on their firms. These incentives amplified the excessive risk-taking that has threatened the global financial system and left firms with fewer resources to absorb losses as risks materialised. The lack of attention to risk also contributed to the large, in some cases extreme absolute level of compensation in the industry.

3.14  This of course takes us back to the ‘evil bankers’ debate. There are two poles of opinion about some of the risk decisions taken in the period 2003–7. One—the ‘evil bankers’ position—is that bankers knew perfectly well that they were taking unsustainable risks but did so anyway in order to enrich themselves. The other— the ‘stupid bankers’ position—is that the bankers believed—along with their own senior management, risk professionals, industry analysts, and regulators—that the transactions they were engaging in really were low risk but nonetheless high profit. Those who tend towards the ‘evil bankers’ position believe that remuneration structures created perverse incentives, and that therefore remuneration regulation should be at the core of bank regulation. Those who tend towards the ‘stupid bankers’ position tend to regard incentive regulation as misplaced, on the basis that incentives can only affect deliberate behaviour. Basel seeks to steer a middle way between these positions, but regulators generally (especially in the European Union) have taken strong positions on the ‘evil bankers’ side of the debate.

(p. 38) D.  Basel III Framework

3.15  ‘Basel III’ is a term with a curiously vague meaning. It is best regarded as the name for a process of reform which was commenced with the 2010 document ‘Basel III: A global regulatory framework for more resilient banks and banking systems’3 (Basel III framework) and ended in 2017 with ‘Basel III: Finalising post-crisis reforms’4 (Basel III final). During this period a number of important policy changes were made outside the framework of these documents, and there is now no single document which sets out the Basel consensus.

3.16  The Committee approached the broader Basel III review by trying to identify lacunae in the regulatory system generally, and proposing rules to plug them. It therefore began the Basel III process by setting out in the Basel III framework document an analysis of what it felt were the objectives it had to achieve, and the problems that it had to solve.

Strengthening the global capital framework

3.17  The undoubted facts of the crisis were that banks had had too little capital relative to the risks to which they were exposed, and that much of that capital had proved to be useless for the purpose of absorbing losses. The primary objective was therefore to strengthen banks’ capital. This was achieved by increasing the total amount of capital required by a bank and changing the rules relating to the composition of that capital. The effect of these changes was to eliminate Tier 3 capital, significantly reduce the importance of traditional Tier 2 capital, and provide that the majority of the capital requirement should be satisfied by shareholder funds—ie ordinary shares (or equivalent) and retained profits. The logic behind this was that the experience of the crisis had proved that other forms of capital (notably subordinated debt) were only useful in the insolvency of the institution concerned. Since, during the crisis, practically every financial market institution large or small had been deemed to be too big to fail (at the height of the crisis the UK treasury intervened to guarantee London Scottish Bank, which held £250m of deposits), protection which only took effect in the event of failure had proved to be useless. In particular, so-called ‘hybrid capital’ instruments—ie subordinated debt structured so that the interest payable on the debt increased after a specified date, thereby creating an incentive for the issuer to redeem on that date—were phased out.

3.18  Another issue which had caused great concern was that it was by no means easy to establish the capital position of banks from the published accounts of their (p. 39) holding companies. Banks would therefore in future be required to disclose all items of their capital base along with a detailed reconciliation to the reported accounts.

Enhancing risk coverage

3.19  As noted in the previous section, the Basel 2.5 reforms raised capital requirements for the trading book and complex securitization exposures. Basel III developed this theme further by introducing measures to increase the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo, and securities financing activities. These reforms had a twofold purpose. One aim was to address the problem that, in the view of the Basel Committee, even after the Basel 2.5 reforms counterparty risk was under-recognized in the trading book. Another, however, was that pursuant to the G20 commitment to move more derivative trading onto a cleared basis, these measures provided additional incentives to move over-the-counter (OTC) derivative contracts to central counterparty clearing. The effect of the reforms was that:

  1. (a)  Banks were required to use stressed inputs in calculating capital requirement for counterparty credit risk (CCR). The approach is similar to that introduced for market risk in Basel 2.5.

  2. (b)  Banks were subjected to a capital charge for potential mark-to-market losses (ie credit valuation adjustment (CVA) risk) associated with a deterioration in the creditworthiness of a counterparty.

  3. (c)  Standards were strengthened for collateral management and initial margining. Banks with large and illiquid derivative exposures to a counterparty would be required to apply longer margining periods as a basis for determining the regulatory capital requirement. Additional standards would be adopted to strengthen collateral risk management practices.

  4. (d)  Capital requirements for exposures to central counterparties (CCPs) were increased. This may appear perverse, given that the professed aim of the regulators was to induce derivative trading to move to CCPs. However, it was accepted that the Basel II treatment (0 per cent exposure, leading to 0 per cent risk weighting) was unjustifiably low. The proposal to replace this with a 2 per cent requirement was intended to recognize this risk whilst retaining a significant capital advantage for cleared over uncleared trades.

  5. (e)  Risk weights on exposures to financial institutions generally were raised relative to the non-financial corporate sector. This increase was justified on the basis that failures of financial institutions are more highly correlated both with each other and with the failure of the reporting exposures than with exposures generally, and that this merited an increased risk premium.

  6. (f)  Counterparty credit risk management standards were increased, particularly including for the treatment of so-called ‘wrong-way risk’, ie cases where the exposure increases when the credit quality of the counterparty deteriorates.

(p. 40) 3.20  The Committee did not, however, tackle the important issue of the use of external ratings. External rating agencies were widely blamed for mis-rating senior tranches of securitization and repackaging vehicles, and external ratings also formed the basis of the Basel II approach—a point which critics were swift to develop. In the US, this resulted in section 939A of the Dodd-Frank Act,5 which prohibited the use of credit ratings in the formulation of regulatory capital standards. This well-meaning reform has, at the time of writing, largely broken down due to the absence of any other verifiable external standards (see para 3.33). Basel stopped well before crossing this Rubicon, and contented itself with requirements for banks to perform their own internal assessments of externally rated securitization exposures.

Leverage ratio

3.21  Leverage ratios are simply non-risk-sensitive capital ratios, and had previously been held in low esteem by bank regulators. However, the Committee noted that part of the background to the financial crisis had been the build-up on bank balance sheets of assets which, because they were regarded as low risk, consumed very little capital. Although at the time the cause of this phenomenon was believed to be excess holdings by banks of senior (AAA) tranches of securitizations, it appears in retrospect that a significant cause (at least in Europe) was excessive exposures to high-risk sovereign (particularly EU sovereign) debt. Since these exposures could be treated as risk-free in the Basel II regime, banks could assume very high levels of exposure in this area without affecting their capital position at all. This had allowed high levels of absolute leverage to develop. Although the primary mechanism for dealing with this should have been to improve the quality of risk capital requirements, Basel elected to supplement these with a leverage ratio. The express aims of the leverage ratio were not primarily the protection of individual institutions, but were aimed at reducing the aggregate amount of credit provided by the banking sector to the economy as a whole, thereby constraining overall bank leverage in the economy as a whole. Calculating the leverage ratio has proved particularly challenging due to differing accounting treatments of netting between the EU’s accounting standards6 and their US equivalent.7

Countercyclical buffers

3.22  The Basel system is acknowledged to be procyclical, in that banks will underestimate risk (and therefore requirements for capital) during booms and overestimate (p. 41) it during downturns. This is an inherent problem, not so much with bank regulation as with human nature—in booms over-optimism is the besetting fault, whilst in downturns over-pessimism is equally apparent. As a response, the Basel Committee proposed a countercyclical capital buffer with the aim of dampening this procyclicality. The aim was to create a regime in which the capital requirements imposed upon banks will increase when ‘there are signs that credit has grown to excessive levels’.

3.23  It was often argued that procyclicality in bank balance sheets was increased by the fact that the relevant accounting standards did not permit banks to take provisions for losses in their accounts until they could demonstrate that the loss would actually be incurred. This was an entirely fair criticism, but the accounting principle concerned was not as unreasonable as it was sometimes made out to be. In the aftermath of the Enron collapse, the accounting industry globally moved away from approaches which allowed companies to apply their discretion in valuing assets and towards approaches where valuations were based on empirical evidence. Unfortunately, the only empirical evidence likely to be available of asset valuations is that of the recent past, and this creates a problem for firm management who believe that their assets are overvalued and may decline, but are inhibited from making what they feel to be appropriate provisions for those valuations in their accounts. This pendulum is now swinging back—the new IFRS 9 and the US Current Expected Credit Loss models (see paras 7.38 et seq. below) permit (and in many cases require) management to apply a judgement-based reduction to asset values in their financial accounts. It is hoped that this change will reduce the level of procyclicality in bank balance sheets generally, but this will not obviate the necessity for the countercyclical buffer.

Systematic interconnectedness

3.24  Another major concern for regulators was ‘excessive’ interconnectedness among banks and financial firms. Because banks had large exposures to other banks, a weakness of any one bank transmitted itself throughout the system. It is also the case that exposures amongst banks are generally of the ‘hub and spoke’ variety, with a small number of very large banks acting as an inner ring, and a large number of smaller banks acting as outer rim. Once contagion had hit the inner ring, confidence in the entire system is necessarily shaken. This led to the conclusion that the inner ring of banks should have higher levels of capital than other banks. This led to the idea of the creation of a list of the inner banks (globally systemically important banks or G-SIBs), and the imposition on the banks on that list of higher capital requirements than are applied to other banks. These capital requirements were envisaged as taking the form of capital surcharges, contingent capital, and bail-in debt. Other suggestions included liquidity surcharges, tighter large exposure restrictions, and enhanced supervision.

(p. 42) Systemic risk

3.25  One of the major concerns evinced in the run-up to the crisis was that aspects of the financial system were unnecessarily risky and could be made safer. Interestingly, in this regard the reports of the Counterparty Risk Management Policy Group of 2005 and 2008 identify many of the issues which were to become problematic during the crisis.8 Since the crisis was widely blamed on the complexity and lack of transparency of global financial instruments and settlement systems, these concerns were reflected in the Basel response. Thus several of the capital requirements introduced by the Committee were aimed not at improving the regulatory position of banks per se, but at creating incentives for them to structure their operations in ways which, in the eyes of the Basel Committee, increased systemic safety. These included:

  • •  capital incentives for banks to use central counterparties for OTC derivatives;

  • •  higher capital requirements for trading and derivative activities, as well as complex securitizations and off-balance sheet exposures (for example structured investment vehicles);

  • •  higher capital requirements for inter-financial sector exposures; and

  • •  the introduction of liquidity requirements that penalize excessive reliance on short-term, inter-bank funding to support longer-dated assets.

Introducing a global liquidity standard

3.26  Banks have been subject to liquidity regulation for a very long time. However, although there is a broad consensus as to how credit risk should be quantified, there is no equivalent consensus as to how liquidity risk should be approached. The consensus view prior to the crisis was set out in the IIF report on liquidity,9 which broadly concedes that liquidity management techniques do and should vary significantly according to the nature of the asset book of the institution concerned, and this approach was broadly echoed in the Basel ‘Principles of Sound Liquidity Management’ of 2008. However, by the time of Basel III this approach was not acceptable to the Basel Committee, which had concluded that banks had allowed their liquidity mismatch positions to deteriorate to an unacceptable level, and that they should therefore be subject to formal regulation in order to eliminate this problem.

3.27  Because of the lack of industry consensus on the issue, there were no existing global standards in 2009 when the Basel Committee sat down. It therefore produced a new set of standards of its own.

3.28  It is almost certainly true that in the highly liquid markets of the mid-2000s, many institutions had confused liquidity and credit—their assumption was that (p. 43) any institution would be able to raise short-term liquidity at some price provided that it was sufficiently creditworthy. The crisis revealed this to be an incorrect assumption—in a sufficiently panicked market liquidity was not available at any price save from central banks acting in their capacity as lenders of last resort, regardless of the balance sheet strength of the borrower. Since even central bank liquidity was only available against high-quality collateral, banks who owned portfolios of good-quality assets which were not central bank eligible could find their access to liquidity cut off completely. The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.

3.29  The Committee proposed two liquidity standards. The first of these—the liquidity coverage ratio (LCR)—was a development of existing liquidity supervisory practices. Its aim was to require those institutions subject to it to hold a larger pool of central bank eligible collateral. The basis of the change here was that the bank was no longer required to hold sufficient liquid assets to get it through a probable crisis, but enough to get it through an extreme 30-day market crisis, in which its customers demanded liquidity and the market refused to provide it. The second—the net stable funding ratio (NSFR)—set a time horizon of one year, and was intended to ensure that long-term assets—ie those assets which could only be liquidated with difficulty—should be financed with long-term borrowing.

The first liquidity standard—the liquidity coverage ratio

3.30  The LCR is based on a hypothetical crisis. The question that it poses to banks is how they could respond to a scenario in which:

  • •  the bank was significantly publicly downgraded;

  • •  there was a degree of run on deposits;

  • •  unsecured wholesale funding ceased to be available;

  • •  secured funding was only available with significant haircuts;

  • •  the institution suffered significant collateral calls on derivatives and other financings; and

  • •  the institutions’ clients simultaneously demanded liquidity through contractual and non-contractual financing commitments, including committed credit and liquidity facilities.

The essence of the LCR is to require that banks must hold a pool of cash and liquid assets sufficiently large to enable them to meet their expected liabilities in any foreseeable crisis.

The second liquidity standard—the net stable funding ratio

3.31  The NSFR aims to limit the proportion of the bank’s balance sheet which is financed through short-term funding. For this purpose ‘short-term’ is arbitrarily (p. 44) defined as funding with maturity of one year or less. The effect of the rule is therefore to require banks to fund their ‘long-term’ assets—ie those which are both illiquid and have a maturity of over one year—with ‘long-term’ borrowings—ie those which are not repayable within one year. The NSFR is not a matched funding requirement—it will still be permissible to fund a portfolio of 15-year loans with revolving 13-month funding—but it is intended to inhibit the funding of long-term assets with very short-term borrowings.

Monitoring tools

3.32  One of the consequences of the lack of consensus in analysing liquidity risk in the industry was a corresponding diversity of approaches amongst regulators. Thus, in addition to prescribing liquidity rules, Basel also prescribes a series of metrics that bank regulators should use in order to understand the risks which banks are subject to. The short-term consequences of the application of these metrics are intended to be simply to gain an understanding of the basic aspects of a bank’s liquidity needs, but it seems likely that these identify, at the very least, those areas where banks are most concerned.

  1. (a)  Contractual maturity mismatch assessment. This is a simple baseline of contractual commitments and takes no account of actual probable liquidity risk. It does, however, identify the ‘worst case’ mismatch.

  2. (b)  Concentration of funding. This involves analysis of the sources of wholesale funding, by counterparty, instrument, and currency. This is intended to highlight over-reliance on particular sources.

  3. (c)  Available unencumbered assets. This is an assessment of the bank’s potential ability to raise new funding in the secured market or from central bank facilities. Since the primary relevance of secured funding in a crisis is that if the bank’s credit deteriorates significantly, secured funding is likely to be the only funding available to it, this is an important measure of crisis resilience.

  4. (d)  LCR by currency. Foreign exchange risk is a component of liquidity risk, in that banks may in extremis be unable to access the foreign exchange market. LCR will therefore be monitored on a currency-by-currency basis.

  5. (e)  Market-related monitoring tools. Regulators are instructed to monitor the overall market; the market estimation of the availability of funding (as shown in bond spreads, credit default swap (CDS) prices, etc); and institution-specific information on the institution’s own costs of borrowing.

Addressing reliance on external credit ratings and minimizing cliff effects

3.33  Basel has struggled with ratings. It is an article of faith amongst some commentators (and some regulators) that ‘over-reliance’ on ratings was a cause of the crisis, and the desire of the regulators is therefore to reduce reliance upon them. The difficulty that this creates is that banks have two sources of benchmarks (p. 45) for credit assessment—their own assessments and external credit ratings. In the absence of any third yardstick, the challenge which regulators face is to choose between permitting banks to use their own internal ratings (which runs the risk of lack of clarity) and permitting the use of the external ratings perceived to have caused the crisis. Basel steers a delicate course between these two terrors, seeking to gently disincentivize the use of ratings in some circumstances without significantly affecting their use in other cases. The major change here is a rule which addresses the specific disincentives to obtaining a rating which exist within the standardized approach, the rule being that where a bank has deliberately avoided having an exposure rated in order to obtain the unrated weighting rather than the higher low-rated weighting, this should be reflected through an increase in the pillar 2 charge. In addition, the arbitrary rule that disregarded the credit protection provided by providers rated worse than A is to be abolished. Finally, banks are prohibited from using unsolicited ratings unless they are satisfied that the credit assessment behind the rating is equal in quality to the general quality of solicited ratings.

Enhanced counterparty credit risk management requirements

3.34  The exposure at default (EAD) to be used for a trading book position is, broadly, the effective expected positive exposure (EPE) calculated using models multiplied by a factor (alpha). Banks may model alpha, subject to a floor of 1.2. Basel III increases slightly the regulatory standards which should be met, accompanied by a warning to regulators that they should be sensitive to the likelihood of rapid variations in EAD.

Stress testing

3.35  Banks must have a comprehensive stress-testing programme for counterparty credit risk. The stress-testing programme must include at least monthly exposure stress testing of principal market risk factors (for example interest rates, FX, equities, credit spreads, and commodity prices) in scenarios in which (a) severe economic or market events have occurred; (b) broad market liquidity has decreased significantly; and (c) the market has been impacted by the liquidation of positions in a large financial intermediary. The tests should assess the credit quality of counterparties and groups of counterparties, and consider interrelationships between counterparties.

Implementation and transitional arrangements

3.36  The Basel Committee provided for an extended transitional period for the new higher standards—whereas Basel 2.5 was to be implemented within a few years, Basel III was given more than a decade. The logic behind this appears to have been to give banks the opportunity to build up reserves slowly and over time—the (p. 46) argument being that this would give banks the opportunity to build up their capital to match their asset books rather than shrinking their asset books to meet the new capital requirements. The unspoken premise was that since the aim of the reforms was to reduce bank return on equity, it was therefore unlikely that the markets would be prepared to provide significant new equity in the period. The idea of slow capital improvement through profit retention enabled the authorities to argue—predictably—that their proposed changes would have no significant impact,10 and the industry to argue—equally predictably—that they would have major economic impact.11

3.37  The difficulty with this analysis was, of course, that as soon as the Basel III standards were announced banks were immediately measured against them, and bank management began almost immediately to announce their state of Basel III readiness. Thus even before the European Banking Authority had spoilt the Basel plan for a staged implementation by recommending in December 2011 that European banks move to a 9 per cent Core Tier 1 ratio by June 2012, banks had already begun to shrink their balance sheets. In the same way, the original Basel timetable was for the LCR to be introduced on 1 January 2015 and the NSFR on 1 January 2018, but banks almost immediately began to vie with each other in terms of their proposed time to meet these standards, and significant regulators committed to early implementation.

E.  Other Initiatives

3.38  Between the Basel III framework document of June 2011 and the final Basel III document of December 2017 a great deal was going on in the Basel world. It is unhelpful to think of these developments as extraneous to the Basel III process—they all addressed risk issues relating to banks, and fed to some degree or other into the core Basel calculation—but their development arcs were separate from that of the main Basel III document. The most significant developments were as follows.

3.39 

  • •  The D-SIB framework paper of October 201212 set out a set of mechanisms which could be applied to impose further requirements on institutions which, although not G-SIBs, were unquestionably systemically significant to the domestic economies of the countries in which they operated.

(p. 47) 3.40 

  • •  The January 2013 paper issuing the LCR13 rewrote the original Basel proposal, and made substantial amendments both to the treatment of inflows and outflows and to the definition of high-quality liquid assets (HQLA).

3.41 

  • •  The March 2014 paper on the standardized approach for measuring CCR14 introduced the SA-CCR, a sophisticated approach to CCR which significantly raised the bar for all institutions with non-trivial trading books. The SA-CCR replaced the current exposure method (CEM) of 1995 and the standardized method of 2005. It also replaced a proposed non-investment models method (NIMM) which was put forward by Basel but withdrawn and replaced by the SA-CCR.

3.42 

  • •  The paper on banks’ equity investments in funds of December 201315 created a new look-through regime for investments in funds by banks.

3.43 

  • •  The April 2014 document on capital requirements for bank exposures to central counterparties16 adjusted the capital treatment of banks providing clearing services to clients in order to remove a barrier to the provision of clearing services by banks to clients.

3.44 

  • •  The April 2014 standards on large exposures17 finally introduced a formal large exposures regime into the Basel system. These had been commonplace amongst bank regulators for many years, but for some reason had never been formalized within the Basel process.

3.45 

  • •  The net stable funding ratio paper of October 201418 revived the concept of the NSFR and ensconced it as a liquidity requirement.

3.46 

  • •  The BIS/IOSCO paper on margin requirements for non-centrally cleared derivatives19 of March 2015 created a necessary counterweight to the CCP regime by ensuring that parties could not avoid collateralizing risk exposures simply by avoiding clearing.

3.47 

  • •  The TLAC papers (the FSB Termsheet of November 201520 and the Basel standard relating to the capital treatment of holdings of TLAC of October 201621) together set a benchmark for the TLAC requirement.

3.48 

  • •  The ‘Minimum capital requirements for market risk’ paper of January 201622 (universally referred to as the ‘FRTB initiative’, since the original process was (p. 48) named the Fundamental Review of the Trading Book) ditched and completely replaced the market risk sections of the old Basel Accord.

3.49 

  • •  The standards document ‘Interest Rate Risk in the Banking Book’ of April 201623 pulled back from imposing formal capital requirements, but set out a reporting regime along with pillar 3 disclosure requirements aimed at enabling supervisors and investors to identify this risk.

3.50 

  • •  The July 2016 revisions to the securitization framework24 set a whole new approach to securitization risk.

3.51 

  • •  The March 2017 standards on regulatory treatment of accounting provisions25 created a bridging regime whilst bank standard setters considered the interaction of the new accounting provisioning framework with the existing regulatory expected loss rules.

3.52 

  • •  The pillar 3 disclosure regime of March 201726 updated and systematized the existing reporting frameworks for information about banks. These measures imposed a formal set of templates for these disclosures, thereby significantly facilitating comparability.

3.53 

  • •  The guidelines on the identification of step-in risk of October 201727 expanded the list of entities which could be included in consolidation or in respect of which further capital might be required to cover informal association risks.

F.  Basel III Final

3.54  The Basel III document published in December 2017 may prove to be the last act in the Basel III saga. The bitter disputes which held up its finalization went to the most fundamental disagreements between the various parties, and the current position amongst regulators appears to be that this agreement, having been reached, should never be reopened.

3.55  The essence of the 2017 compromise was the agreement of the collective bank supervisors of the world to a series of amendments to the existing system designed to improve its robustness. The BIS stated that its intention was not to increase overall capital requirements, but simply to recalculate capital requirements to produce greater resilience.

(p. 49) Output floor

3.56  The most important element of the 2017 agreement was the introduction of an output floor for banks using internal models to assess capital—such banks would in future be subject to an alternative minimum capital requirement equal (after an extended lead-in period) to 72.5 per cent of the requirement which they would be subject to if they applied the standardized approach. This places a limit on the regulatory capital benefits that a bank using internal models can derive relative to the standardized approach. It is explicitly intended to maintain a level playing field between banks using internal models and those on the standardized approach.

3.57  Part of the compromise which was required in order to establish the output floor was an extended implementation schedule. Thus Basel provided that national supervisors could cap the increase in a bank’s total risk-weighted assets (RWAs) that results from the application of the output floor during its phase-in period. The cap would apply for the duration of the phase-in period of the output floor (ie the cap would be removed on 1 January 2027).

Changes to capital calculations

3.58  Significant changes were also made to the way in which the standardized approach itself was calculated. In particular, the flat risk weight applied to residential mortgages was replaced by a sliding scale based on the loan-to-value (LTV) ratio of the mortgage. Also, unrated exposures to banks and corporates were made more granular.

3.59  The use of the internal ratings-based (IRB) approach was also restricted. In particular, the option to use the advanced IRB (A-IRB) approach for certain asset classes has been removed for asset classes that Basel did not believe could be modelled in a robust and prudent manner. These include exposures to large and mid-sized corporates, and exposures to banks and other financial institutions. As a result, banks with supervisory approval will use the foundation IRB (F-IRB) approach. In addition, all IRB approaches were removed for exposures to equities. Finally, ‘input’ floors (for metrics such as probability of default (PD) and loss given default (LGD)) were imposed.

CVA risk framework

3.60  The CVA framework has been revised to enhance its risk sensitivity. This involved removing the ability to model CVA risk. This left firms with a set of regulatory rules which were more closely aligned with the market risk architecture.

Operational risk framework

3.61  The advanced measurement approach (AMA) for calculating operational risk capital requirements (which are based on banks’ internal models) and the existing (p. 50) three standardized approaches were all replaced with a single standardized approach, which was based on two factors—the bank’s income from the activity concerned and a measure of its historic losses. Conceptually, it assumes: (i) that operational risk increases at an increasing rate with a bank’s income; and (ii) banks which have experienced greater operational risk losses historically are assumed to be more likely to experience operational risk losses in the future.

Leverage ratio framework

3.62  Basel III introduced a leverage ratio buffer for G-SIBs, set at 3 per cent plus 50 per cent of a G-SIB’s risk-weighted higher-loss absorbency requirements (so a G-SIB subject to a 2 per cent risk-weighted higher-loss absorbency requirement would be subject to a 1 per cent leverage ratio buffer requirement). The calculation of the leverage ratio was also tidied up, modifying the way in which derivatives are reflected in the exposure measure and updating the treatment of off-balance sheet exposures to ensure consistency with their measurement in the standardized approach to credit risk.

G.  Beyond Basel III?

3.63  The very mention of Basel IV is sufficient in some quarters to make strong men weep. However, bank regulation must continue to match the industry, and it is also true that Basel III left some important loose ends untied—of which the issue of risk weighting for sovereign exposures (see paras 8.18 to 8.22) is unquestionably the most important. Also, the experience of operating SA-CCR and FRTB will undoubtedly require adjustment as time goes by. However, even given all this, it is cautiously suggested that we have come to the end of the period of existential change within bank regulation, and the current architecture is likely to remain in place in broadly its current form for at least the next decade or so. This confidence is only partly engendered by the fact that the extended implementation periods provided for in the Basel III compromise mean that a decade from now Basel III will only have been in force for a few years. What is more important is that amongst regulators, emphasis is changing from the measurement of risks using probabilistic mathematics to scenario-based approaches whereby the questions asked of banks are as to the level of capital which they would need to survive a particular shock (or type of shock). This stress test based approach is to a large extent based on the capital measures set out in the Basel accords, but it places less reliance on fine calculations of the probability of remote events, and more on the broad ability of the supervisor to produce extreme yet plausible scenarios against which to assess institutions. It may be remembered that supervisors have not always been completely clairvoyant in this regard (most stress testing in the run-up to the 2008 financial crisis was on the risks posed to the banking system by the (p. 51) hedge fund industry), but stress testing has a powerful after-the-fact effect in providing confidence to users of the system, as was seen by the tests imposed on the EU banking industry by the European Banking Authority in the aftermath of the EU sovereign debt crisis of 2009–12. It is therefore likely that the discussions of the Basel Committee going forward are likely to focus more on stress test design, and less on amending fundamental capital requirements.(p. 52)

Footnotes:

1  For those who disagree, an excellent account of the development of the current bank regulatory model can be found in Goodhart, The Basel Committee on Banking Supervision—A History of the Early Years 1974–1997 (Cambridge University Press, 2011).

2  A note on spelling. The 1988 Accord was referred to as the ‘Basle Accord’, using the French spelling, since this was at the time the working language of the Bank for International Settlements (BIS), which provides the secretariat for the Committee. However, the city itself is in the German-speaking part of Switzerland, and the German spelling is Basel. At some point between the first and second Accords the BIS was prevailed upon to adopt the local variant—hence Basle I but Basel II.

3  BIS, December 2010, revised June 2011.

4  BIS, December 2017.

5  The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub L 111–203, HR 4173.

6  These replicate the International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board and the IFRS foundation with some minor discrepancies.

7  The Generally Accepted Accounting Principles (GAAP) adopted by the US Securities and Exchange Commission. The primary difference between the two is that IFRS generally does not recognize legal netting, whereas US GAAP does—hence US balance sheets are significantly smaller in terms of absolute levels of assets than they would be if they were accounted for under IFRS.

9  ‘Principles of Liquidity Risk Management’, Institute of International Finance, March 2007.

10  ‘An Assessment of the Long-Term Economic Impact of the New Regulatory Framework’, Basel Committee 2010; ‘Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements’, BIS 2010.

11  ‘The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework’, Institute of International Finance, September 2011.