On 8 February 2022, the Basel Committee on Banking Supervision (Basel Committee) published a speech by its Chair, Pablo Hernández de Cos, entitled ‘Implementing Basel III’.
Key points in the speech include:
- An open global financial system requires a set of global minimum and consistent prudential standards. A failure to achieve this could result in regulatory fragmentation, regulatory arbitrage, an uneven playing field for internationally active banks, and increased risks to global financial stability.
- The Basel III framework was finalised in 2017 and was endorsed by the G20 Leaders. While much has changed since 2017, the COVID-19 pandemic and other structural trends have only further underlined the importance of a resilient banking system. The Basel III reforms have played a central role in ensuring the banking system has remained operationally and financially resilient during the pandemic.
- While the initial set of Basel III reforms fixed a number of fault lines in the pre-global financial crisis regulatory framework, the way in which banks calculated risk-weighted assets (RWA) – the denominator of banks’ risk-weighted capital ratios – remained largely unchanged. At the peak of the global financial crisis, investors lost faith in banks’ published ratios and placed more weight on other indicators of bank solvency. The outstanding Basel III reforms seek to help restore credibility in the calculation of banks’ RWA in four ways:
- They will enhance the robustness and risk sensitivity of the standardised approaches for credit risk, market risk and operational risk, which will facilitate the comparability of banks’ capital ratios.
- They will constrain the use of internally modelled approaches by ensuring that modelled parameters are subject to greater safeguards and that advanced modelling approaches are not used for portfolios with limited historical data.
- The Basel III reforms will introduce a robust risk-sensitive output floor. The output floor provides a risk-based backstop that limits the extent to which banks can lower their capital requirements relative to the standardised approaches.
- The reforms will complement the risk-weighted framework with a finalised leverage ratio. The leverage ratio provides a safeguard against unsustainable levels of leverage and mitigates gaming and model risk across both internal models and standardised risk measurement approaches.
- The Basel III reforms were extensively consulted on and the finalised standards take on board many of the comments received from stakeholders and reflect the differences in views among Basel Committee members. They include a range of national discretions to provide a degree of flexibility. A back-of-the-envelope estimate suggests that over 35 key adjustments were made to the reforms as they were finalised relative to the original proposals. The majority of these adjustments were made to reflect the views of different European stakeholders.
- Under very conservative assumptions, the reforms are estimated to increase banks’ Tier 1 capital requirements by only 2% if implemented immediately. Some “outlier” banks may face higher requirements, for example as a result of aggressive modelling practices.
- It is clear that the outstanding Basel III reforms will complement the previous reforms in having a positive net impact on the economy. For example, a recent analysis by the European Central Bank suggests that the GDP costs of implementing these reforms in Europe are modest and temporary, whereas their benefits will help permanently strengthen the resilience of the economy to adverse shocks.
- It is critical to implement the full Basel III package in Europe, as its components are complementary in nature and are necessary to safeguard the resilience of the European banking system. The European Commission’s (Commission) proposal covers all the elements included in Basel III. All stakeholders are urged to accelerate work in implementing Basel III in Europe, taking due account of the need to respect the European legislative process. Any further delays could result in the European banking system being insufficiently prepared to face future shocks and could even have undesirable knock-on effects on the implementation process in other jurisdictions.
- Consistency should be a key pillar of the implementation process in Europe. Basel III incorporates enough flexibility through the use of national discretions. For example, the Commission proposes to exercise the discretion to exclude banks’ historical losses when calculating operational risk capital requirements, an option already adopted by other jurisdictions and compliant with Basel III.
- In contrast, pursuing approaches that go beyond the flexibility embedded in Basel III should be minimised. The Commission’s proposal includes additional requirements, including several in the credit risk framework. Such deviations would not be in the best interests of Europe, as they could undermine the credibility and robustness of the bank capital framework and could leave specific risk exposures under-capitalised.
- Another area of concern relates to the output floor, which is a key plank of Basel III to help reduce excessive variability in risk-weighted assets and restore the credibility of banks’ capital ratios. While the “single stack” design in the Commission’s proposal is welcome, the proposal also introduces a range of transitory adjustments when it comes to residential real estate, unrated corporates and derivative exposures. These adjustments should be avoided as, in Mr de Cos’ view, they present a deviation from Basel III, are unfounded from prudential or financial stability grounds, and could trigger a “race-to-the-bottom”.