This post was published by Bruegel and the Peterson Institute, and a bit later by Vox.
On February 14, European Commissioner Michel Barnier and
Federal Reserve Governor Daniel Tarullo both indicated their agreement
to quickly give the Basel III accord binding force over, respectively,
European and American banks. This is welcome. But even more important than the speed
of adoption is that implementation should stay true to what the accord stipulates.
At this point, and contrary to many perceptions in Europe, this goal is more likely
to be reached by the US than the EU.
Basel III is the work of the Basel Committee on Banking
Supervision, which includes 27 countries as its members (plus EU institutions
and the International Monetary Fund as observers) and is hosted by the
Basel-based Bank for International Settlements with a small permanent
secretariat there. It is the crowning achievement of the G-20’s financial
regulatory agenda in the wake of the Lehman Brothers collapse in 2008. Other
prominent initiatives have had only partial or mixed results, including the
centralized clearing of over-the-counter derivatives, accounting standards
convergence, the regulation of rating agencies, or restrictions on compensation
practices or regulatory havens. By contrast, Basel III has moved ahead
quickly and can be labeled a clear success for global financial regulation. It
is already making a difference, and a positive one, in the way the global
banking system operates. Credit for this goes to the Basel Committee’s members and
to its successive chairmen and secretaries-general since 2007.
Without going into all the details of a rather long text, Basel III makes the
definition of regulatory capital much more rigorous; increases minimum capital
requirements dramatically, from 2 percent to 7 percent for the key ratio of
common equity to risk-weighted assets; tightens the methodology to weigh the
risk of assets; introduces a minimum leverage ratio (capital to
non-risk-weighted total assets) to mitigate the risk of manipulation of risk
weights; introduces additional requirements depending on the financial cycle
and the systemic importance of some banks; and introduces regulatory standards
and ratios for banks’ liquidity profile.
The accord has been criticized from all sides of the financial
regulatory debate. Much of the banking community, including the Institute of
International Finance, has argued that the increase in capital requirements
would greatly impede growth and that the liquidity ratios would harm market
functioning. J.P. Morgan Chase’s head, Jamie Dimon, has lambasted
the additional capital requirements for systemically important financial
institutions, including his own, as “anti-American.” But third-party studies suggest
that bankers have been exaggerating the negative impact, and that the
standards’ adverse effects will be more than compensated by the benefits of additional
financial stability for the system.
Conversely, a number of academics and advocates argue that
Basel III is insufficient, or even toothless. The critics call for the need
for even higher
capital requirements (see also here).
They also criticize the widespread gaming of
risk-weighting calculations; the excessively long phasing-in
period for the standards to take full effect; and the recent announcement that
liquidity standards would be less
stringent than initially envisaged. But the authors of these critiques fail
to present an obvious better alternative or address how to avoid banks
circumventing the rules. Pushing minimum capital levels even higher would lead
to widespread migration
of financial intermediation towards the less-regulated shadow banking system. Risk-weighting
is flawed, but the alternative of focusing on a ratio of capital to
non-risk-weighted assets is even easier to game. Furthermore, Basel III’s
leverage ratio creates a backstop against risk-weight manipulation that did not
exist in Basel II. The phasing in now looks rather steep to many banks,
particularly in Europe, and in any case was arguably the most acceptable price
to pay in the compromise to get the accord through in spite of the opposition
of some Basel Committee members. The watering down of liquidity ratios appears
justified by the uncertainties about the impact of this new and untested regulatory
instrument, and the lessons from the euro zone crisis regarding the possible
credit risk and illiquidity of sovereign debt markets. In fairness,
Basel III goes remarkably far
for a consensus-driven Committee that had been much less bold in the past,
especially with the previous comprehensive accord (Basel II), which now
appears to have been embarrassingly complacent.
Beyond the accord itself, the Basel Committee, in an unprecedented
(though arguably long overdue) move, has designed a three-level process to
nudge its members to adopt and implement its standards rapidly and
consistently. Level One checks that each member jurisdiction has adopted rules
that legally mandate the application of Basel III by those for which it
was intended, namely large internationally active banks. Level Two checks
in detail the consistency of the legislation or regulation with all points
covered in the text of Basel III. Level Three assesses how the accord
is implemented in practice. The Basel Committee has published regular short
reports to the G-20 since 2011, scoring countries’ progress on Basel III and
the earlier accords’ adoption (Level One). The Committee also started in
October 2012 to publish detailed reports on the consistency of adopted or
proposed legislation/regulation with Basel III, with the first three
reports devoted to Japan,
the US and the EU (Level Two);
and in January 2013 the Committee published its first study on actual
implementation, devoted to the consistency of risk-weighting across a sample
of banks (Level Three).
The picture that emerges is not uniform, but is encouraging
from a global perspective. Eleven of the Committee’s 27 members (Australia,
Canada, China, Hong Kong, India, Japan, Mexico, Saudi Arabia, Singapore, South
Africa and Switzerland) have adopted
Basel III and started implementing it in time on January 1, 2013
(India has a delay until April 1). In the EU, which includes 9 other
Committee members (Belgium, France, Germany, Italy, Luxembourg, the
Netherlands, Spain, Sweden, and the UK), the implementing legislation, known as
the Capital Requirements Regulation (CRR) and Fourth Capital Requirements
Directive (CRD4), was proposed by the European Commission in July 2011. It is in
a final phase of discussion between the European Commission, Parliament and
Council. (This phase is known as
trilogue in the Brussels jargon.) In the US, the three federal agencies jointly
in charge – the Federal Reserve, Federal Deposit Insurance Corporation (FDIC)
and Office of the Comptroller of the Currency (OCC) – have published a
regulatory proposal in June 2012 and are currently working on a final version. Work
is also in progress in the remaining Basel Committee members, namely Argentina,
Brazil, Indonesia, South Korea, Russia, and Turkey.
Among the three jurisdictions reviewed in more detail under
the Basel Committee’s Level-Two process, Japan gets high marks for essentially
complying with the accord. The US (based on the June 2012 proposal) is
compliant on all areas tested but one: its rejection of any reference to credit
rating agencies’ assessments in bank prudential regulation, enshrined in Section
939A of the Dodd-Frank Act of 2010, creates differences with parts of
Basel III which keep some references to credit ratings (even though the
Basel Committee has also tried to reduce the extent of such references). The EU
is found “materially non-compliant” in two areas: the definition of capital and
an exemption that the review found too broad from one of the risk-weighting
methods. The definition of capital is the more important of the two, as it goes
to the core of capital regulation: it is no good to have high minimum
requirements if the definition includes “funny equity” that is not genuinely
loss-absorbing in a crisis.
These differences are attributable to differences in
financial cycles and local politics. The EU is in a state of banking system fragility that
has not been resolved by the recent improvement in market conditions.
Forbearance is thus a temptation, even though experience suggests that
forbearance is a losing
crisis-management strategy. By contrast, Japan, Mexico and much of Asia have
learned their lessons the hard way during the crises of the 1990s, and their
banks have strong enough balance sheets for the early transition to
Basel III to be an easy one. Banks in Canada and Australia have been
thriving recently. Switzerland and the US, like the EU, have faced severe
banking crises in 2007-08, but unlike the EU, have largely resolved them in
2009-10, which makes their implementation of Basel III requirements less
challenging than in several EU member states.
The delay and spotty compliance in the EU stands in stark
contrast to Europe’s championing and early adoption of Basel II, in the
early 2000s. It is not uncommon for EU financial policy leaders to offer
support for the Basel III process and to criticize it at the same time. In
particular, the European Commissioner in charge of financial services has
reacted angrily
to the Basel Committee’s Level-Two report on the EU, arguing that some of its
findings “do not appear to be supported by rigorous evidence and a well-defined
methodology” while simultaneously affirming his “support [for] the Basel
Committee’s intention to assess consistent implementation.”
The Commissioner implies in his reaction that the EU’s
CRR/CRD4 legislative proposal was assessed unfairly and negatively in
comparison with the reviews of Japan and particularly of the US. However, the Basel
Committee’s Level-Two assessment process has involved Europeans prominently:
they represent no less than half of the respective assessment teams for both
Japan (6-member team led by the Banque de France’s Sylvie Mathérat and also
including members from the German and Swedish central banks) and the US
(6-member team including members from the French and Italian central banks and
from the European Commission). As for the EU, the assessment team was led by
Charles Littrell from the Australian Prudential Regulation Authority. It also included
five other members from prudential authorities in Japan, New Zealand,
Singapore, Switzerland, and the US. (The teams are formed on the principle of
no self-assessment, which is why no EU member state is represented in the EU
assessment team.)
The Basel Committee has put a lot of effort into ensuring
the quality and consistency of its assessment methodology, and there is no
convincing evidence of anti-European bias from a detailed reading of the Level-Two
reports. The Committee’s policy so far has been not to react publicly to the
European Commissioner’s critique. But it is evident from the content of the
Level-Two report on the EU that the same arguments put forward in this critique
have been carefully considered by the assessment team before completion of the
report.
The reaction from many stakeholders in Europe to the US
delay in Basel III adoption has been similarly shrill. The joint press
release of the Fed, the FDIC and the OCC does nothing more than announce
that the deadline of January 1, 2013 will be missed in the finalization of
the rulemaking process, given the large number of written comments received on
the June 2012 proposals that justify in-depth analysis. This has been widely denounced
in continental Europe as a de facto abandonment of the effort, which would justify
significant delaying of the EU’s own decision-making process on grounds of
competitive fairness: the European Banking Federation sent a letter
interpreting the US press release as implying that “our US competitors will not
have matching obligations imposed on them in parallel [with the EU’s CRR/CRD4],
or in a foreseeable future.” The head of the Italian Banking Associated said
that “Basel III must be postponed, full stop.”
In fact, the EU and the US are likely to adopt
Basel III around the same time, probably in both cases in the second
quarter of 2013. As mentioned above, the procedures are different. In the EU,
CRR and CRD4 are produced by a legislative co-decision process that involves
the European Parliament and the Council, involving a degree of politicization. (CRD4,
being a directive, requires further transposition in all member states’
national legislation, while CRR will be directly applicable in all member
states once adopted by the European Parliament and Council.) In the US, the
process is more technocratic. It is in the hands of the three federal agencies
(Fed, FDIC and OCC) but is also subject to the scrutiny of Congress, which may
still impose further delay.
On both sides, there is no indication that the points of
“material non-compliance” found in the Basel Committee Level-Two preliminary
assessments will be corrected in the final version. In the US, Section 939A of
the Dodd-Frank Act prohibits reference to credit ratings in the prudential
regulation of banks and is unlikely to be abrogated by Congress any time soon.
The EU is ill-placed to criticize the US on this, as it has itself put much
blame on credit rating agencies in the crisis context and submitted them to
increasingly stringent regulation. In the EU, there is no indication that the
revision of the non-compliant parts of CRR are among the points that the
co-legislators in the European Parliament and Council intend to revise in the
current final phase of legislative “trilogue.”
There would be sound justifications, however, for a second
look in the EU that would enable the adoption of a Capital Requirements
Regulation that would be fully compliant with the Basel III accord.
- First, the direct economic impact of the
necessary changes would be limited, especially if the changes only apply to the
large internationally active banks for which the Basel Committee’s standards
are intended. In his response to the Basel Committee’s Level-Two report on the
EU, the European Commissioner argues that the report’s reservations on the definition
of capital of non-joint stock companies (presumably referring to so-called
“silent participations” in some public banks in Germany) “concerns a single
internationally active bank,” and that the other material issue about the
treatment of insurance subsidiaries “can arise only in very few banks.” These
points are designed to argue that the non-compliance with Basel III is not
material. But the argument can be reversed in the sense that correcting the
non-compliance would not have a systemically detrimental effect on the EU
economy.
- Second, full compliance with Basel III
would enhance trust in European banks. The EU’s deviations from the
international accord feeds the widespread presumption in the investor community
that at least some supervisory authorities in the EU tend to apply a high
degree of forbearance to banks within their remit and are reluctant to force
them to apply high and consistent capital standards. This market sentiment is
detrimental to all EU banks, including those (presumably many) that are
sufficiently capitalized, and thus puts a drag on the European economy as a
whole. The cost-benefit balance is without a doubt favorable to bringing CRR to
full compliance with Basel III.
- Third, the EU’s incomplete adoption of
Basel III undermines the global authority of the Basel Committee,
encourages other jurisdictions to introduce exceptions of their own, and
diminishes the EU’s own moral stature in the global financial regulatory
debate. In the past two decades, the EU has been a champion of global financial
regulatory convergence, in particular with its endorsement of International
Financial Reporting Standards in the early 2000s and support of Basel II
and Basel 2.5 throughout the 2000s. The calculation was that global financial convergence
and integration would support an agenda of harmonization and integration within
the EU itself. This calculation remains relevant, even after the shift from a
G-7 to a G-20 global framework in which the EU member states’ relative
influence is less than it used to be. The European Union’s co-legislators
should revisit their stance and make the Capital Requirements Regulation fully
compliant with Basel III before they put their final stamp on it.