The fruition of prudential rules first agreed by G20 politicians in the aftermath of the financial crisis took a step closer as the Federal Reserve (Fed) finalised its capital rules on 2 July (see our briefing note here), following the publication of CRD IV in the Official Journal of the European Union on 27 June. Most internationally active banks will be subjected to the Basel III regime from 1 January 2014 at the latest. In the US, smaller community and regional banks have been given an extra year to prepare for not only the higher capital standards that Basel III introduces, but also tighter eligibility criteria for capital instruments. In fact, Basel III will change how banks operate, from the basics, for example capital deductions for unrealised gains, to the fundamentals, such as the viability and profitability of business lines and services.
But Basel III isn’t done and dusted. International regulators must still revise a global leverage ratio, currently fixed at 3% (the Fed has proposed a 4% ratio- see our briefing note here), and finalise the second pillar of the new liquidity provisions: the net stable funding ratio. The latter requires banks to maintain a sustainable maturity structure of assets and liabilities and will provoke a major re-think amid growing concerns about its potential impact on lending to the real economy. We don’t expect the ratio to be calibrated this year and the implementation date could be pushed out beyond 2019 if global growth doesn’t pick-up.
The leverage ratio is designed to constrain the build-up of leverage in the banking system and protect against potential gaming in the risk-based capital requirements framework. From 1 January 2014, EU banks will need to report the leverage ratio and its components to their supervisors; public disclosure, calculated on a common basis, will begin from the start of 2015. Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.
The Basel Committee set-out a supervisory framework associated with the ratio back in 2010. Further revisions were made to this framework recently, as well as details on the public disclosure requirements for the ratio. The changes to the framework relate primarily to the denominator of the ratio, the Exposure Measure, including:
Commenting on the new framework, Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank, said, “The Basel III leverage ratio is a transparent, non-risk based measure that is needed to complement the risk-based capital requirements: used together, the two measures should considerably strengthen the bank capital adequacy framework”.
The idea of a leverage ratio has grown in prominence in recent years. The crisis highlighted that banks had insufficient capital protection in the incumbent capital framework which relied heavily on risk-weighted assets. There is growing empirical evidence that a leverage ratio based on total assets is a better predictor of bank distress than a risk-based capital ratio. Blundell-Wignall and Roulet (2012), studying 94 banks between 2004 and 2011, have shown that the Basel Tier 1 risk-based capital ratio is not a statistically significant indicator of bank default. The leverage ratio, on the other hand, is very statistically significant. Other policymakers and researchers have come to similar conclusions, such as Andy Haldane of the Bank of England and Jeremiah Norton of the Federal Deposit Insurance Corporation.
However, the leverage ratio creates incentives for institutions to raise their overall asset risk while keeping total assets constant (see D’Hulster for the limitations of the leverage ratio). First, such optimizations may have effects on the capital measure. Second, there is considerable evidence that such incentives are also present in risk-based measures. The risk-weighted capital approach also seems to provide banks with the opportunity to optimise/manage/game RWAs to reduce capital requirements. In doing so, “banks may concentrate their balance sheets in certain asset classes that, in aggregate, may expose the institution to more risk than the lower risk weightings would imply” according to Norton. Recent OECD research shows that global banks appear to be increasing their Basel capital levels with a focus on RWA optimisation rather than a renewed emphasis on building up capital through profits or issuing shares. In Europe, several of the largest banks are financed by relatively low levels of common equity, according to Norton, despite reporting very high Tier 1 risk-based capital ratios.
The picture is further clouded by the level of uncertainty that the risk-based approach creates, making it difficult for regulators and the market to gauge the true health of a bank’s balance sheet. Recent research by the Basel Committee points to considerable variation across banks in average RWAs for credit risk in the banking book. Most of the variation is due to differences in the composition of banks’ assets, reflecting differences in risk preferences as intended under the risk-based capital framework (good variation). However, there is also material variation driven by diversity in bank and supervisory practices (bad variation).
The report also includes a preliminary discussion of potential policy options that the Basel Committee could pursue in seeking to minimise excessive practice-based variations. The Basel Committee is conscious of the need to ensure that the capital framework retains its risk sensitivity, while at the same time promoting improved comparability of regulatory capital calculations by banks. This is because the RWA can provide useful insights into banks’ asset structures and lending and investment trends over time. A belts and braces approach of a leverage ratio requirement working alongside the Basel risk-based capital approach appears to be the best solution at this point in time. Absent risk weights, we would be back in Basel I territory where banks would be incentivized to chase higher yields, as there would be no additional capital costs for holding risky assets. But while combining the Basel I and Basel II paradigms might result in better outcomes it might also demonstrate that the Basel approach to prudential regulation doesn’t work and we need to go back to the drawing board. All will be revealed in time.
The RWA study is the most comprehensive to-date and is important reading for regulators and banks alike. It draws on supervisory data from more than 100 major banks and is part of the wider Regulatory Consistency Assessment Programme (RCAP) which is intended to ensure consistent implementation of Basel III.
Rimantas Sadzius, the Lithuania finance minister, set out his priorities in financial services on 9 July to both the European Parliament and the Council. Plans to finalise the Eurozone banking union will consume considerable attention, energy and time over the next six months. Policy makers face significant challenges in erecting its three pillars: the single supervisory mechanism (SSM), a single resolution mechanism (SRM), and a common deposit guarantee scheme.
Working on building SSM is well underway and the Presidency hopes to finalise the text as soon as possible. Political agreement on SRM (a preliminary version of legislative proposals were published on 11 July), the Bank Recovery and Resolution Directive (EU Council agreed a general approach on 19 June) and the Deposit Guarantee Scheme (resurrecting the Council negotiations frozen in early 2012) are also expected before the European Central Bank takes up the mantel as Eurozone prudential supervisor by mid-2014.
Political agreement on MiFID II/MiFIR is a high priority but progress will also be sought on Central Securities Depositories Regulation (CSDR). The European Parliament’s ECON Committee has finalised its negotiating position on the proposal tabled by the Commission in March 2012. An Irish Presidency assessment of progress in Council, dated 20 June 2013, notes that there are five key areas needing political agreement and further work is required on several technical issues before Council can agree its general approach in order to launch trilogue negotiations but nevertheless progress has been made. CSDR introduces an obligation of dematerialisation for most securities, harmonised settlement periods for most transactions in such securities, settlement discipline measures and common rules for central securities depositories. It forms part of the tripartite of reforms (the others being MiFID II/MiFID and EMIR) that will form a framework in which systemically important securities infrastructures (trading venues, central counterparties, trade repositories and central securities depositories) are subject to common rules on a European level.
The Presidency also wants to push forward a comprehensive approach to anti-money laundering measures, the Anti-Money Laundering Directive IV and with negotiations on Omnibus II, with a view to getting political agreement by the end of 2013. The Lithuanians will also look to progress Insurance Mediation Directive 2 and UCITS V, part of the Commission’s ‘retail package’ proposals of 3 July 2012. It will also advance the debate on legislative proposals on financial benchmarks and money market funds which are expected to be tabled soon.
Looking ahead to the next batch of reforms, the European Parliament (EP) outlined its vision for banking reform in a non-legislative resolution on 3 July. The resolution, in a similar vain to a recent UK Parliamentary report on banking standards (see our summary here), makes a number of recommendations, including:
The resolution will feed into the European Commission’s Autumn proposal on bank structure and it will be interesting to see if it takes forward these proposals. As we start implementing big ticket prudential reforms, it is not surprising that the focus will shift towards conduct and competition matters. Holding additional capital or collateral will not necessarily deliver the necessary changes in conduct that we need to see. Arlene McCarthy, MEP believes the next focus should be on “deliver[ing] a change in culture”.
Several macroprudential reports published recently point to improving market conditions in the EU financial system.
On 27 June 2013, the European Systemic Risk Board’s (ESRB) fourth Risk Dashboard indicated an up-swing in the price-to-earnings ratios at banks and stable liquidity conditions in money markets. According to the European Securities Markets Authority’s Risk Dashboard, the overall level of systemic risk in EU securities markets decreased throughout 2012, as conditions in equity and bond markets improved. The same picture is evident in the UK, where systemic risk indicators have fallen to their lowest levels since 2008 according to the Bank of England’s Systemic Risk Survey.
The ESRB suggests that market clustering and fragmentation, funding risk and the low interest rate environment all could be sources of systemic risk. Authorities need to remain vigilant over systemic conditions and active in macroprudential policy as banks, in particular, remain fragile. In the UK, the two main risks to the financial system remain an economic downturn and sovereign — principally euro area — risk, with the proposed FTT a factor which could destabilise markets in the medium term.
In this regard, a recommendation by the ESRB (dated 4 April 2013) on Intermediate objectives and instruments of macro-prudential policy (ESRB/2013/1) was published in the Official Journal on 17 June 2013. The recommendations relate to intermediate objectives of macroprudential authorities, macroprudential instruments, policy setting and policy evaluation.
In reality, the fortunes of the banks are held ransom by the economy (and vice versa) and it looks as though there will be no respite in the coming years. The International Monetary Fund cut global growth forecasts for 2013 and 2014 recently, citing expectations of a more protracted recession in the EU and slower growth in China and Brazil.
The weak macroeconomic environment is so important because it impacts the financial positions of governments, private and commercial borrowers (i.e. bank’s customers and assets), the outlook for property markets (i.e. its collateral), and the profitability and asset quality of banks, insurers and other financial market participants. A strong economy would help banks recover quicker but the economy needs a strong banking system to recover in the first place. So policy makers can’t wait for the economy to lift all banks. Proactive and direct action to buttress banks appears the best routine out of the current quagmire.