On Thursday December 7, the Basel Committee on Banking Supervision (BCBS) finally agreed the Basel III framework designed to avert another financial crisis and to create a level playing field for global banks. By Justin Pugsley 

It comes a decade after the start of the financial crisis and is not scheduled to be fully implemented until 20 years after that event. 

Given such a long process, it is hardly surprising that a profound sense of regulatory fatigue has gripped the banking industry and even many regulators. 

Striking the agreement was nonetheless a huge achievement. And it was greeted with relief by banks and regulators as it provides a degree of certainty. And the Basel Committee seems to have more or less stuck with its promise to not significantly raise capital levels for most banks. Among the globally systemically important banks (G-SIBs), it identifies four that will be more significantly hit than the rest. 

The BCBS estimates that the capital shortfall for the industry as a result of the final rules will be €90.7bn. This burden mainly falls on the largest banks and is manageable for them, especially given that the estimate is based on two-year old data and banks have mostly improved their robustness since then.  

But there are concerns that it has taken so long to come about that different jurisdictions might now be set on their own particular regulatory journeys. Also, national priorities have moved on from making the banking system safer towards supporting economic growth. 

Long road ahead

It is therefore hardly surprising that during the press conference, Mario Draghi, president of the European Central Bank and chair of the Group of Governors and Heads of Supervision (GHOS) declared that “it was difficult to reach this agreement … it’s equally difficult now that all the jurisdictions would put in place and implement the agreement in a timely and consistent manner.” The GHOS oversees the BCBS. 

Indeed, the current US administration, which is often hostile towards international bodies, wants to pursue a deregulation agenda posing questions over whether that could clash with the new Basel III rules. Over in the EU, the cumbersome legislative process means that it will struggle to implement the Basel revisions into the capital requirements regulation II and capital requirements Directive V and is therefore likely to be late in doing so. 

On areas such as the fundamental review of the trading book (FRTB), jurisdictions from the US through to some in Asia had unilaterally decided to delay its implementation following a strong push back from banks. 

“The focus moves quickly on what happens in the EU and the US translation of Basel. Will it happen on time? Will it happen faithfully or will there be some divergence from it?,” wonders David Strachan, a senior regulatory partner at Deloitte. “I'm somewhat pessimistic. Our view is that is that we are passed the point of peak convergence and that if anything as this next set of elements of the Basel package are transposed into national law, we will see some departures.” 

Molly Preleski, a financial services expert at PA Consulting Group echoes those concerns. “The United States could still unsettle these agreements,” she says. “There’s still a final hurdle to get over in agreeing the rules, as legislators globally must ratify the rules. Given the unpredictability of the US government, and known desire of the Trump administration to limit regulatory changes, it’s not clear how long this part of the process may take.” 

She explains that though concessions were made by the negotiating parties it was not the package the Committee had hoped for.  For instance, it’s been forced to completely abandon plans for risk weights on government bonds, which are usually thought of as risk free, but aren’t necessarily so,” says Ms Preleski.

Nonetheless, agreeing a deal is widely considered to have been a much better outcome than not doing so as it could have opened the door to a regulatory race to the bottom. Also, had the talks dragged on much longer it risked completely exhausting any regulatory reform momentum left. 

Internal models targeted

Getting the deal over the threshold took considerable compromise with the controversial output floor dictating how far bank internal models can diverge from the Committee’s standardised approach being set at 72.5%. Banks will be given five years to implement it from 2022 onwards, starting at 50%. This was the focal point of disagreement between Europe and US.

And even on that figure there is some unhappiness, particularly in Europe where the impact of the floor is most keenly felt. Wim Mijs, CEO of the European Banking Federation, warned that the floor could still do significant harm to the European economy and the competitiveness of European banks.

Valdis Dombrovskis, who heads up the financial services brief at the European Commission, said the Commission will “carefully assess” the Basel rules and how to “appropriately apply” them. He may lend a listening ear to Mr Mijs’ fears. The European Banking Authority estimates the revisions could see a €36.7bn capital shortfall among European banks some of which are still struggling with the aftermath of the financial crisis. 

Sweden’s financial supervisory authority, Finansinspektionen (FI), said in a statement that Sweden will adapt the design and application of the capital requirements for Swedish banks when the Basel standards become binding EU regulations. It’s director general Erik Thedéen added that FI will not allow capital requirements to increase automatically as a result of the Basel floor, while conceding that capital levels at Swedish banks may need to go up once the agreement is implemented. 

The standardised approach will contain more granularity and risk sensitivity, which should help banks using those models to compete more effectively with those employing internal models. 

The Committee’s general suspicions that banks use internal models to game capital levels was evident elsewhere in the framework. 

For example, internal models will no longer be permitted for operational risk. For assessing credit exposures to large corporates and financial institutions, banks will no longer be allowed to use the advanced internal rating based (IRB) approach and will be restricted to the foundation IRB approach and that will be confined to the probability of default for the banks' credit risk exposures as the only parameter that is calculated using internal models.

Also, there is more granularity around risk weights with higher quality credits attracting less capital.  

Meanwhile, revisions to the measurement of the leverage ratio and a leverage ratio buffer for G-SIBs, which will take the form of a Tier 1 capital buffer, will be set at 50% of a G-SIB’s risk-weighted capital buffer. That compares with 35% currently for UK banks.  

More FRTB work

The calibration of the standardised and internal model approaches to FRTB are to be reviewed and the implementation date pushed back from 2019 to 2022 so it aligns with start date of the revisions to the rest of the framework. There is much concern around aspects of FRTB such as non-modellable risk factors and their granularity drilling down to desk level. 

The credit valuation adjustment framework has also been recalibrated and banks will be keen to run tests to see what those changes produce in practice.  

“The finalised rules will result in higher RWA (risk weighted assets) but appear to be a more benign outcome than previously speculated upon — particularly regarding changes to standardised RWA and the internal ratings based (IRB) output floor,” wrote Diarmaid Sheridan, financials analyst at capital markets group J&E Davy.  

He added that the finalisation comes as the target review of internal models (by the ECB) process continues, which is likely to front-run the impact of the introduction of the output floor without the benefit of a phase-in period until 2027.

Though banks were generally relieved that the new measures will not dramatically hike capital requirements, especially compared to what had been suggested in some Basel consultations, there were nonetheless some disappointments for them. 

One highlighted by the International Swaps and Derivatives Association (ISDA) is the requirement for banks to count customer cash collateral held at central counterparties towards their leverage exposure and to ignore the exposure-reducing effect of initial margin. 

“This has a negligible effect on overall bank capital, but it significantly increases the amount needed to support client clearing activities,” the ISDA said in a statement. “Some banks have opted to scale back or withdraw from the client clearing business as a result, which runs counter to the objectives of the Group-of-20 nations to encourage central clearing.”

It acknowledged that the Basel Committee would continue to monitor the impact of the leverage ratio on clearing adding that “it is disappointing that the requirement was left unchanged in the final package”.

Indeed, EU and US policymakers have recognised challenges around clearing with ISDA calling for a globally consistent calibration to prevent regulatory fragmentation. 

Global Risk Regulator will delve further into the details and consequences of the finalised Basel framework in the January issue to be published after January 12.