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Newsletter May 2010: Regulators to stand their ground over Basel III

Key July Basel Committee meeting will decide revisions to reform package, and calibration. Bankers may be disappointed over outcome

By Melvyn Westlake

Bank regulators look set to make some revisions to the stringent new capital and liquidity rules that are due to be finalised in the next few months, laying the foundation for a more resilient global banking system. But any such revisions will be far less extensive than the industry wants, despite the barrage of criticism it has unleashed during a four-month public consultation on the proposed regulatory framework.

Although divisions have emerged between regulators in different countries, the Basel Committee, which effectively sets prudential standards for banks around the world, is determined to stick to the mandate given to it by the leaders of the Group of 20 largest economies. It is on course “to deliver a fully calibrated package of global standards for capital and liquidity by the end of this year,” Stefan Walter, the Committee’s secretary general, told lawmakers at the European Parliament in Brussels, during early May, dispelling suggestions that the process was slipping.

Basel Committee chairman, Nout Wellink, who is also head of the Dutch central bank, and other regulators, have indicated that they will look closely at aspects of the proposed reforms that are causing most concern to bankers. But those in the industry expecting a delay in designing the regulatory framework, or that the recently-completed impact study would lead to an extensive re-write of the proposals – described by some bankers as “punitive” and “excessively conservative” – look likely to be disappointed.

A fierce dispute now seems certain, however, over the cumulative impact that the various new rules will have on the banks’ ability to provide sufficient credit to sustain the global economic recovery. A suggestion by Nout Wellink, based on calculations by Dutch central bank economists, that global growth might be reduced by 0.5% to 1.0%, cumulatively, over several years, was instantly challenged by bankers, who believe this is a gross under estimate.

Conversely, some of the estimates that have been bandied around by the industry – economic output declines of as much as 5% – are dismissed by the regulators as wildly exaggerated and “crazy.”

An official macroeconomic impact assessment is being undertaken jointly by the Basel Committee and the Financial Stability Board (FSB), the Basel-based body that is coordinating the international policy response to the 2007-09 financial crisis. The joint study group is chaired by the Bank for International Settlements (BIS), the so-called central bankers’ bank, and working closely with the International Monetary Fund (IMF), the Washington-based agency that monitors the global economy.

This high-powered group has the job of assessing the impact of the reforms over different possible transition periods to ensure that there is no threat to the economic recovery.

But there are also various private sector exercises underway, notably a geographically broad and in-depth assessment by the Institute of International Finance (IIF) in Washington, a trade body representing some 390 financial firms, which is viewed as the voice of global banking. The IIF study is due to be published in June.

This is a month before the crucial mid-July meeting of the Basel Committee, when bank regulators from its 27 member countries are due to consider any revisions to the new capital and liquidity framework, as well as decide on its so-called calibration – the precise minimum capital requirements and liquidity buffers.

The proposed measures – dubbed Basel III – initially issued on December 17, include tighter definitions of Tier 1 capital, the introduction of a leverage ratio, a framework for counter-cyclical capital buffers, measures to limit counterparty credit risk, and short and medium-term quantitative liquidity ratios.

A subsequent public consultation has generated an unprecedented response of almost 300 letters, the majority of them criticising aspects of the reforms (see box below). Regulators have promised to give careful consideration to these comments, which have been allocated to the Basel Committee’s specialist working groups. Particular attention is likely to be given to the proposed liquidity rules and the credit valuation adjustment (a capital add-on to capture mark-to-market valuation losses) because of the large number of comments relating to these elements. Chairman Wellink has also indicated that the Committee will look closely at the industry’s complaints about proposals to exclude tax deferred assets and minority interests from the calculation of banks’ Tier 1 capital.

In addition to the consultation, the Committee has undertaken a quantitative study of the reforms’ impact on individual banks. This mammoth exercise – separate from the macroeconomic impact assessment – has involved two or three hundred banks each completing some 21 pages of spreadsheets, containing thousands of cells, by the end of April. These spreadsheets are now being reviewed by national supervisors before being submitted to the Basel Committee.

Together, this study of the quantitative impact (QIS) on individual banks, together with the macroeconomic assessment, and any revisions to the December reform package, will contribute to the Basel Committee’s calibration. “We want to bring all the elements together to take an integrated, holistic view on where the standard should be set,” says secretary general Walter.

It is a meeting that bankers are awaiting with distinct unease. They have a lot at stake. Some reports have estimated that the reforms will reduce banks’ return on equity by several hundred basis points, and force them to raise billions of dollars and euros of new capital, as well as pushing up the cost of borrowing.

Banking industry representatives, however, tend to emphasis the risk that tough reforms could pose to economic growth and employment, aware that this is a sensitive issue for governments. It could yet divide Basel Committee regulators.

In a policy letter to Group of 20 finance ministers and central bank governors ahead of their late-April meeting in Washington, Charles Dallara, IIF managing director, says it is important to assess not only the benefits of the regulatory reform proposals, but also the overall costs. Such an assessment is needed before the reform package is finalised, he said. Although the IIF’s own impact assessment is not yet complete, the Dallara letter says the initial results are “sobering.” They suggest that, “even in a scenario reflecting only the main proposals emerging so far from the Basel Committee – and not other, national initiatives – there would be a significant adverse impact on employment and growth in the US, extending over several years.” There would be a “more substantial effect in the Euro area,” the policy letter suggests, “reflecting the greater relative importance of banks in the region’s economy. Japan, whose banks were not directly involved in the crisis, would also be materially affected by the proposed changes.”

The impacts worldwide would be exacerbated by regulatory changes that go beyond the core Basel proposals, Dallara adds.

Regulators insist they are every bit as concerned as bankers about how the transition to the new regulatory regime is managed. (On the present timetable, the new rules should be implemented by the end of 2012).

The Basel Committee is “bringing to bear the best thinking, and deploying the best macro models available to central banks to assess the impact of this move,” contends Walter. “That assessment will inform our decision on the appropriate transition to ensure there is no damage to the recovery.”

More modest growth OK

But it is also clear that some modest reduction in growth during upswings in the business cycle would be acceptable to regulators if the proposed capital and liquidity framework also produced greater financial stability. If the cumulative 0.5% to 1.0% reduction in growth estimated by Dutch central bank economists is the price for getting a really resilient banking system, “that price is not too high,” Basel Committee chairman Wellink told the Financial Times newspaper in early May.

Regulators in the US and Britain have expressed similar sentiments.

“None of us wants to take precipitous action on new capital rules or liquidity requirements that might lead to an abrupt reduction of credit to creditworthy borrowers,” John Dugan, US Comptroller of the Currency, recently told bankers.

However, long-term economic growth requires safe, sound, and strong banks that are able to withstand even severe downturns. “If we are going to err,” he added, “I believe we should err on the side of safety and soundness. This bias, over the long run, will help ensure a sustainable level of credit growth that is consistent with our longer term goal of financial stability around the world.”

Says Walter: “If you have a banking system that is so vulnerable whenever you get into bad times, and magnifies the downturn, you are going to have substantially lower overall growth. All in, our goal is to have more sustainable through-the-cycle growth, with a higher set of standards and a more resilient banking sector that is less subject to boom-bust, less prone to excessive leverage, and less likely to under-price credit and liquidity risk,” he explains. “We are saying that, overall, when you look at the whole thing, it is going to be welfare enhancing.”

(Volume:8 Issue: 5)

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