Tag: Basel III

Applying Basel III to small banks

Dr Andreas Dombret Member of the Executive Board of the Deutsche Bundesbank spoke on the finalisation of Basel III  – “One size fits all? Applying Basel III to small banks and savings banks in Germany“.

A demanding 2017 lies ahead of banks and savings banks: While the sector is witnessing a structural scale-back of sorts, low interest rates and competition from digital service providers are weighing on profit opportunities. At the same time, the risks that need to be managed have not got any smaller – no, the challenges posed by the low-interest-rate environment are, together with mounting interest rate risks, making them even more demanding.

Many institutions are therefore seeking new strategies and rethinking their business models. To make matters more difficult, a raft of further regulatory reforms is just around the corner.

2 Basel III and the completion of regulatory reform

I’m talking, first and foremost, about the finalisation of Basel III in the Basel Committee on Banking Supervision and its transposition into EU law by way of CRR II and CRD V.

The finalisation of Basel III is the topic of much discussion at the moment, which centres specifically around approaches for calculating risk-weighted assets (RWA). Although many parts of this last package of reforms are already done and dusted – primarily the fundamental revamping of trading-book approaches – some final parts are still being debated in the Basel Committee. This is the case with respect to reforms concerning the treatment of credit risk and operational risk, for instance.

Many banking industry representatives are afraid that this last package of reforms will create a new set of burdens. I see it the other way around: these reforms are necessary, as they complement and round out the Basel reform process. What we saw during the financial crisis was that the approaches to calculating RWA produced capital requirements that were too low in some cases, and a response is urgently needed.

That is why the Basel III package will not be complete until these further reforms have been implemented, and that is why we are referring to the process as the finalisation of Basel III. What I want, here and now, is to clearly disabuse people of the notion that a completely new standard is being introduced.

Of course, what is being asked of institutions is significant and by no means negligible. However, all outstanding reforms are based on the existing regulatory framework and take it a step further. I therefore believe that they should be easier to implement than many fear.

That said, I do understand why banks and savings banks would be jittery at the prospect of a further increase in capital requirements. That is why, in the Basel III finalisation process, the Bundesbank has come out strongly against a further increase in capital requirements. Our motto must therefore be that no agreement in Basel is better than a bad agreement. At the same time, though, an international standard has a very high value that must not be underestimated. This is all the more true in a time in which more and more countries are turning inwards. The Bundesbank will also continue to work towards a compromise on Basel III – one that benefits Germany.

3 Reforms and smaller institutions: a one-size-fits-all solution or graduated rules?

Let me turn now to a second, different topic. In talks with smaller banks and savings banks about the post-crisis reforms, I hear one concern being echoed time and again: that smaller institutions perceive the operational burdens of regulation as being particularly overwhelming. As they put it, a burden that is much more onerous on small banks and savings banks than on their much larger competitors. This is an issue I take very seriously, for the banks and savings banks are right.

Therefore, for the next few minutes I will discuss the question as to whether banking regulation should be offered only as a one-size-fits-all solution for all banks and savings banks – or whether multiple different regulatory regimes should be created to fit different sizes of institutions.

Ladies and gentlemen, it is my firm view that there is absolutely no way a one-size-fits-all approach can do justice to today’s banking landscape – with its very large and complex institutions, its numerous smaller and regional institutions, and the wide expanse of medium-sized institutions! It will positively damage the structure of our banking system – a structure that gave us stability during the financial crisis.

You may well all be familiar with the allegation that the purpose of the new regulatory regime is to encourage more and more consolidation in the industry – including Germany’s banking industry. Of course, mergers among banks and savings banks must not be a taboo topic – but, by the same token, they must not be a regulatory objective, either. I admit to being a fan and proponent of diversity in terms of bank size and business model, as this makes our banking system more stable. Supervisors are not supposed to be making structural policy; rather, they ought to be actively working towards proportionality in regulation.

This is precisely why banking regulation and banking supervision are already designed with a large degree of proportionality. However, the ambitious reforms following the financial crisis have made the rulebook more complex, particularly because the rules were oriented to the epicentre of the financial crisis: large and medium-sized institutions with risky business models.

This new regime has made compliance a much more difficult and time-consuming affair. This overhead is high for each and every institution – regardless of its size. However, small banks and savings banks, owing to their smaller staff sizes, are far less able to spread the costs of compliance across their employees and have to either hire additional staff or enlist external aid. This leads to comparatively higher burdens.

For that reason – and because smaller institutions pose less of a threat to financial stability than medium-sized to large institutions – I think that offering relief to small banks and savings banks is the right thing to do.

One thing that is of paramount importance to me, however, is this: any relief measures being discussed here have to solve the actual problem – which is not, first and foremost, the minimum capital requirements, but primarily the operational burdens imposed by the need to comply with complex rules.

What this means specifically is that any relief for smaller banks and savings banks must be about removing operational burdens – and of this I am firmly convinced. On the other hand, there cannot and must not be any easing of capital and liquidity requirements.

Moreover, no relief should be permitted to jeopardise financial stability. Medium-sized, highly systemically interconnected institutions – those referred to as “too interconnected to fail” – and those institutions with risky business models should not be provided any relief. The recent financial crisis, during which many insolvent institutions had to be bailed out, is still fresh in all of our minds. We also need to be careful not to create any loopholes that end up being used by so many small institutions that a situation of general distress results.

I am therefore firmly convinced that institutions need to be regulated with a sense of proportionality without diluting the new regulatory regime. I am committed to ensuring that the debate on greater proportionality is not used as a pretext for reducing capital and liquidity requirements but that it instead results in an actual reduction in operational burdens on smaller banks and savings banks.

4 Greater proportionality – but how?

How can the goal of regulatory proportionality be achieved in a reasonable manner without any side effects?

There are two conceivable approaches. The first is a details-driven approach that involves introducing special exceptions or adjustments to individual rules.

The second is the creation of separate regulatory frameworks for smaller institutions, on the one hand, and large multinational institutions, on the other.

The details-driven approach has already been pursued as part of the EU reforms I explained earlier, with the Commission emphasising a reduction in the burden on smaller institutions in all reform areas. In its draft consultative document, it has proposed a variety of relief measures and de minimis thresholds, such as in disclosure and reporting requirements. Institutions below these thresholds will be subject to considerably simplified rules, with some requirements even being abolished altogether, which is something I can only welcome.

We just need to be careful not to set the de minimis thresholds too high, as otherwise there would be considerable risks that were inadequately regulated.

With that in mind, I would like to return to the conviction I expressed earlier on: relief measures that reduce capital and liquidity requirements need extremely careful consideration. Examples include some of the exemptions to the leverage ratio (LR) and the net stable funding ratio (NSFR). Another is the considerable enlargement of the SME factor. Whereas real economic growth is unlikely to receive any boost, the minimum requirements for institutions’ risk provisioning could be weakened.

Let me come to the second approach: the two-tiered system. The fact that work is being done on a details-driven approach doesn’t mean at all that this fundamental approach cannot be pursued as well.

Specifically, we are talking about a fundamental approach that envisages a dedicated rulebook for smaller institutions – an approach that would systematically address the excess burden placed on smaller institutions’ operational capacities.

In this scenario, only banking multinationals would be subject to the fully loaded Basel III requirements in the EU. This would be appropriate from a risk perspective: we would be regulating global banking institutions under a harmonised set of global rules, while smaller institutions and those operating within a certain region would be governed by graduated rules that do justice to their different business models and risk profiles by setting less complex requirements.

The Basel Committee would also benefit from such a dedicated rulebook for banks operating internationally. If the 28 member states knew that the fully loaded Basel standards were only applicable to large, internationally active banks, we wouldn’t have to worry any more about detailed national exemptions, but could instead devote our entire energy to the key task: standards for large, internationally active banks.

I feel very much that Brussels and Basel should examine this approach with an open mind. Such a systematic approach to relieving the burden on smaller institutions, to the extent that it is deliverable, is generally superior to a patchwork of exemptions. In this connection, I am very eager to open up a dialogue with the banking community. To this end, a joint working group was recently established, comprising delegates from the Federal Ministry of Finance, the Bundesbank, BaFin and the central associations of the German banking industry, in order to develop proposals along these lines.

5 Conclusion

Ladies and gentlemen, the implementation of Basel III will impose further demands on banks and savings banks – but I think that less time and effort will be required than many currently fear.

With regard to the implementation of reforms, two things are of paramount importance to me. Under no circumstances must we water down what has been achieved since the financial crisis; rather, we must maintain a robust regime of rules.

That said, a one-size-fits-all approach will not do justice to the banking landscape. One of the objectives guiding the actions taken to finalise the agenda of reforms in Europe should therefore be to lessen the operational burdens on small, low-risk institutions – ie to make the final regulatory regime more granular.

The objective must not be to erode minimum capital requirements and thereby open a new gateway for stability problems. Instead, it is about reducing operational burdens on small institutions without hollowing out capital and liquidity requirements.

This, ladies and gentlemen, is how we can secure a diverse, successful and, above all, stable financial sector – to serve the German economy.

More On Rental Yields – It Matters Where You Buy

We continue our update on our rental yield modelling, using data from our household surveys. Last time we looked across the average gross and net yields (in cash-flow terms) by state, and also at average capital gains. Today we drill into the location specific analysis and also look at our master household segmentation.

But before we look at the data specifically, it is worth reflecting on why we show the data the way we do. New rules from Basel will require banks to hold more capital against loans which are required to be serviced from income other than rent. As a result, the question of net yield – meaning rental income, less loan repayments and other costs before tax suddenly become more important. Whilst the Basel rules are yet to be finalised (there are internal squabbles between members as to where to set the limits), this data is significant – and needs to be separated from any equity held in the property – as equity is no guide to loan serviceability, only an indicator of potential risk should a sale be forced.

So now we turn to our household master segments. We find a startling truth. Most affluent households seem to be able to hold investment property where net yields are still positive, whereas less affluent households – those on the urban fringe, battlers, stressed older households and multicultural segments, as well as young growing families; on average have net yields in negative territory. Whilst there are a smaller number of these households, compared with the number of more affluent households who hold investment property, it is telling. In addition – and no surprise – more affluent households on average have more equity in the property (and more properties per household).

Another way to look at the investment portfolio is by regions and locations. We use a list of 50 or so, which cover the country. There are variations across these.  On average households in Horsham, Ballarat and Wangaratta have little equity in their investment properties, and are well underwater in terms of net rental yields.

At the other end of the spectrum, investment properties in Darwin, Tasmania and areas of Queensland are in much more positive territory.

Investors in Warnambool, Canberra and in the Central Coast have the highest average paper capital profits (current property value less outstanding mortgage). But of course many investment households have large mortgages so they can offset interest against other income thanks to negative gearing.

The pressure of rising investment loan interest rates, low rental income growth, and in some cases, vacant property are all having an impact. But the fallout is not equally spread across the country, or across households.

APRA On The Countercyclical Capital Buffer

APRA released a brief update to support their zero Countercylical Capital Buffer setting. As they say “the countercyclical capital buffer is designed to be used to raise banking sector capital requirements in periods where excess credit growth is judged to be associated with the build-up of systemic risk. This additional buffer can then be reduced or removed during subsequent periods of stress, to reduce the risk of the supply of credit being impacted by regulatory capital requirements”.

APRA may set a countercyclical capital buffer within a range of 0 to 2.5 per cent of risk weighted assets. On 17 December 2015, APRA announced that the countercyclical capital buffer applying to the Australian exposures of authorised deposit-taking institutions (ADIs) from 1 January 2016 would be set at zero per cent. An announcement to increase the buffer may have up to 12 months’ notice before the new buffer comes into effect; a decision to reduce the buffer will generally be effective immediately.

APRA reviews the level of the countercyclical capital buffer on a quarterly basis, based on forward looking judgements around credit growth, asset price growth, and lending conditions, as well as evidence of financial stress. APRA takes into consideration the levels of a set of core financial indicators, prudential measures in place, and a range of other supplementary metrics and information, including findings from its supervisory activities. APRA also seeks input on the level of the buffer from other agencies on the Council of Financial Regulators.

A range of core indicators are used to justify their position. Here are their main data-points.

Credit growth

Credit-to-GDP ratio (level, trend and gap)

The credit-to-GDP gap is defined as the difference between the credit-to-GDP ratio and its long-run trend. The long-run trend is calculated using a one sided Hodrick-Prescott filter, a tool used in macroeconomics to establish the trend of a variable over time. The credit-to-GDP gap for Australia is currently negative at -3.9. The Basel Committee suggests that a gap level between 2 and 10 percentage points could equate to a countercyclical capital buffer of between 0 and 2.5 percent of risk-weighted assets.

Housing credit growth

The pace of housing credit growth has slowed this year, growing at 6.4 per cent year on year as at September 2016, down from 7.5 per cent at the time the buffer was initially set. Investor housing credit growth fell from 10 per cent to 4.9 per cent over the same period, however the pace of growth has been increasing again more recently. APRA has identified strong growth in lending to property investors (portfolio growth above a threshold of 10 per cent) as an important risk indicator for APRA supervisors.

Business credit growth

Business credit growth increased marginally in the first half of 2016. However, business credit growth has fallen over recent quarters; annual growth in business credit was 4.8 per cent over the year to end September 2016, down from 6.3 per cent as at September 2015. Notwithstanding the lower overall rate of growth, commercial property lending growth (not shown) has remained strong, growing 10.5 per cent year on year as at September 2016.

Asset Prices

National housing price growth remains strong, but has slowed relative to 2015 peaks, growing nationally at around 3.5 per cent over the 12 months to September 2016. However, over a shorter horizon, prices have been reaccelerating recently with six month-ended annualised price growth of 7.2 per cent nationally as at September 2016 (albeit still a slower pace than 2015 peaks). Conversely, rental growth and household income growth have been relatively weak. Looking beyond the national averages, conditions vary significantly across individual cities and regions. In particular, housing price growth has strengthened in Sydney and Melbourne over recent months with six month-ended annualised growth rates of 11.4 per cent and 9.0 per cent respectively.

Non-residential commercial property has also been exhibiting strong price growth, though this has moderated somewhat in recent months (not shown).

Lending indicators

APRA monitors a range of data and qualitative information on lending standards. For residential mortgages, the proportion of higher-risk lending is a key metric. Over the past few years, APRA has heightened its regulatory focus on the mortgage lending practices of ADIs in order to reinforce sound lending practices. This has included, but not been limited to, the introduction of benchmarks on loan serviceability and investor lending growth, and the issuance of a prudential practice guide on sound risk management practices for residential mortgage lending.

In general, higher-risk mortgage lending has been falling recently with the share of new lending at loan-to-valuation ratios greater than 90 per cent falling from 9.5 per cent to 8.1 per cent over the year to September 2016. Other forms of higher-risk mortgage lending including high loan-to-income and interest-only lending (not shown) have also moderated from 2015 peaks, although there has been some pick-up in the share of interest-only lending recently.

In business lending, banks have showed some evidence of tightening lending standards more recently, in particular for commercial property lending, with the lowering of loan-to-valuation and loan-to-cost ratios on certain development transactions (not shown).

Lending rates had been steadily falling for both housing and business lending to historical lows. More recently however, lending rates have fallen by less than the cash rate, with banks passing on around half of the August cash rate reduction. Lending rates have also risen in recent weeks in response to higher costs in wholesale funding markets. In particular, a number of ADIs have recently announced increases to their mortgage lending rates with some ADIs specifically targeting investor and interest-only loans.

APRA’s confidential quarterly survey of credit conditions and lending standards provides qualitative information on whether conditions are tightening or loosening in the industry.

Financial Stress

Indicators of financial stress are used in informing decisions to release any countercyclical capital buffer. While a wide range of indicators could signify a deterioration in conditions, APRA has identified non-performing loans as its core indicator of financial stress.

The share of non-performing loans remains low, though it has increased moderately over 2016, to 0.93 per cent as at September 2016, largely driven by increases in regions and sectors with exposures to mining.

So, everything is looking rosy, in their view. However, the high household debt to income ratio and the fact that debt servicing is supported by ultra low interest rates is not included adequately in their assessment – seems myopic in my view, but then this continues the regulatory group-think.  In addition the use of “confidential quarterly survey data” highlights the lack of industry disclosure.

Delayed Completion of Basel 3 Reform Is Credit Negative for Banks

According to Moody’s the 3rd January announcement from the Basel Committee on Banking Supervision (BCBS) that the final decision on the completion of the Basel 3 reform (also referred to as Basel 4) has been postponed, is credit negative for Banks. The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

The scheduled January meeting of the Group of Central Bank Governors and Heads of Supervision (GHOS) to agree on final capital regulations was postponed because of the lack of agreement on calibrating parameters for the use of internal capital models. The protracted process is credit negative for banks and signals the supervisors’ difficult reach for a consensus on adopting rules for a common/global capital framework, which is critical to preserve a level playing field.

The delay could also dent investors’ confidence in banks’ capital ratios and result in higher cost of funding.

GHOS’ decision to postpone the meeting is unsurprising given differing views among BCBS members. The BCBS is striving to define a revised framework that fairly reflects risks and does not result in “significant” capital increases. Officials from EU countries including France and Germany and the European Commission are worried about choking off bank lending to economies where loans are the primary form of corporate finance. Although what would constitute a significant capital increase has not been quantified, BCBS Chairman Stefan Ingves last month acknowledged that this objective does not mean avoiding any increase for any bank and it may result in significant increases at some banks.

BCBS members agree on the overarching objective, which is to restore confidence in banks’ calculation of their risk-weighted assets (RWAs). That means achieving greater consistency and reducing variability in the calculation methodology for RWAs. The BCBS seeks to constrain the benefit of modelling techniques: in some cases, supervisors consider that the models too frequently result in low capital requirements and the BCBS is specifically targeting banks that have developed aggressive modelling techniques. However, defining the threshold at which such capital benefits become unacceptable is proving thorny for BCBS.

BCBS has a consensus on the need to get rid of unjustified variability, yet lacks a consensus on the acceptable level of difference between the “standardized” measure of risks and banks’ internal model estimates. Banks will be required to assess their risks under both methods and the general floor, which will be set between 60% and 90% of standardized risk weights, will determine the benefits risk modelling could bring: the lower the floor, the greater banks can benefit from models’ outcomes. Those regulators who place greater trust in banks’ internal models favor a lower floor while others, based on well-documented failures that occurred during the financial crisis, argue the standardized approach should drive the outcome, and therefore prefer a higher floor. The more intensive use of models by EU banks makes them sensitive to the floor.

The final decision on the general floor will attract a lot of attention from investors. If the general floor is set at a high level (close to 90%), the GHOS will have been relatively conservative; even more so if the implementation period is short. Were the floor to be set closer to 60% with a long transition phase, it would indicate a more permissive stance. However there are also many technical parameters that are critical to form a view on the framework’s toughness (or lack thereof); for example, floors could be imposed at the model level (setting a minimum level of probability of default or loss given default).

For now, the absence of an agreement and the BCBS’ difficulties in clinching a deal continue to fuel investors’ lack of confidence in RWAs and hence in capital ratios and skepticism towards the adoption of harmonized rules.

Basel III Reforms Delayed

The finalisation of the Basel III reforms has been delayed, according to a press release today.  No details were given of which issues remain to be resolved, nor a revised time frame.

The Group of Central Bank Governors and Heads of Supervision (GHOS), the oversight body of the Basel Committee on Banking Supervision, welcomes the progress made towards completing the Basel Committee’s post-crisis regulatory reforms.

However, more time is needed to finalise some work, including ensuring the framework’s final calibration, before the GHOS can review the package of proposals. A meeting of the GHOS, originally planned for early January, has therefore been postponed. The Committee is expected to complete this work in the near future.

“Completing Basel III is an important step towards restoring confidence in banks’ risk-weighted capital ratios, and we remain committed to that goal,” said Mario Draghi, Chairman of the GHOS and President of the European Central Bank.

Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank, said that the Committee will continue to work on outstanding details. “The Committee will keep working to finalise its reforms aimed at fixing shortcomings highlighted by the financial crisis to make banks safer and more resilient,” he stated.

About the Basel Committee and the GHOS

The Basel Committee comprises 45 members from 28 jurisdictions, consisting of central banks and authorities with formal responsibility for the supervision of banking business. The Committee reports to the central bank Governors and (non-central bank) heads of supervision from the Committee’s members

APRA releases final standard on the Net Stable Funding Ratio

The Australian Prudential Regulation Authority (APRA) has today released the final revised Prudential Standard APS 210 Liquidity (APS 210) and Prudential Practice Guide APG 210 Liquidity (APG 210) which incorporates, among other things, the Net Stable Funding Ratio (NSFR) requirements for some authorised deposit-taking institutions (ADIs).

APRA’s objective in implementing the NSFR in Australia for ADIs that are subject to the Liquidity Coverage Ratio (LCR), implemented in 2015, is to strengthen the funding and liquidity resilience of these ADIs.

The NSFR encourages ADIs to fund their activities with more stable sources of funding on an ongoing basis, and thereby promotes greater balance sheet resilience. In particular, the NSFR should lead to reduced reliance on less-stable sources of funding, such as short-term wholesale funding, that proved problematic during the global financial crisis.

The release of the final prudential standard and prudential practice guide on liquidity follows submissions received on APRA’s September response paper: Basel III liquidity – the Net Stable Funding Ratio and the liquid assets requirement for foreign ADIs. APRA has released today a letter addressing the issues raised in these submissions, while APRA’s final position also takes account of comments received in submissions to the initial March 2016 discussion paper on these matters.

APRA Chairman Wayne Byres said ‘the final policy settings will reinforce the steps that ADIs have taken to strengthen their funding profiles in recent years, and ensure that strengthening is sustained over the long term.’

In addition to addressing the Net Stable Funding Ratio requirements, the final APS and APG 210 released today also address a number of other changes noted in the September response paper. The new APS 210 will commence on 1 January 2018, while the new APG 210 replaces the existing APG 210 from today.

Liquid assets requirement for foreign ADIs
As noted in the September 2016 response paper, APRA will retain the 40 per cent LCR as the default liquid assets requirement for foreign ADIs, but allow foreign ADIs with simpler business activities to apply to use the alternative Minimum Liquidity Holdings (MLH) approach.

Background information

Q: What is the Net Stable Funding Ratio (NSFR)?
A: The NSFR is a quantitative global liquidity standard established by the Basel Committee on Banking Supervision that seeks to promote more stable funding of banks’ balance sheets. The standard establishes a minimum stable funding requirement based on the liquidity characteristics of an ADI’s assets and off-balance sheet activities over a one-year time horizon, and aims to ensure that long-term assets are financed with at least a minimum amount of stable funding.

Q: Why is APRA introducing the NSFR?
A: The NSFR seeks to promote more stable funding of banks’ balance sheets. As the Basel Committee on Banking Supervision noted, when announcing its new international liquidity framework in 2009, throughout the global financial crisis many banks had failed to operate with adequate liquidity and unprecedented levels of liquidity support were required in order to sustain the financial system. The crisis illustrated how quickly and severely liquidity risks can crystallise and certain unstable sources of funding can evaporate, compounding concerns related to the valuation of assets and capital adequacy.

Q: Which ADIs will the NSFR apply to?
A: The NSFR will apply to those locally-incorporated ADIs that are also subject to the Liquidity Coverage Ratio (LCR). There are currently 15 LCR ADIs:  AMP Bank; Arab Bank; Australia and New Zealand Banking Group; Bendigo and Adelaide Bank; Bank of China; Bank of Queensland; Citigroup; Commonwealth Bank of Australia; HSBC Bank; ING Bank; Macquarie Bank; National Australia Bank; Rabobank Australia; Suncorp-Metway; and Westpac Banking Corporation.

Q: Why is APRA only applying the NSFR to ADIs with the Liquidity Coverage Ratio (LCR)?
A: Non-LCR ADIs typically have simpler funding models with most of their balance sheet funded by their deposit base which is considered to be a more stable source of funding. Given the balance sheets of these ADIs will already be financed with significant amounts of stable funding, APRA does not consider there would be any additional benefits from the imposition of the formal NSFR framework for these ADIs.

A Reminder Of The Basel III Logic

To many, the required changes to capital under Basel III may seem obtuse and overly complex. So the timely speech given by Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision is worth reading. He gives a clear articulation of why Basel III exists. Crises are expensive and should be avoided, he says.

When financial crises afflict us it becomes obvious to all how much damage they cause. Unfortunately, this insight is often temporary, as it is easy – even a human survival instinct – to forget problems and leave them behind us. As a representative of the Basel Committee I therefore see it as an important task to remind you of how costly financial crises are to the national economy and how important it is that we have robust regulatory frameworks that reduce both the cost of crises and the probability that they will occur.

He showed this chart as a reminder of what happened after the GFC, as numerous and well know banks were bailed out.

why-basel-iiiHe also discussed the core assumption that increasing capital protects society, as well as the banks themselves.

why-basel-iii-1

A crucial cause of the most recent financial crisis was that banks around the world had taken on too much risk. This was possible for two reasons. Firstly, the regulatory framework applying at the time did not sufficiently influence the banks’ risk taking. Secondly, the banks themselves evidently did not have the will or ability to manage their risks on their own. The answer was the Basel III Agreement – a comprehensive package of reforms with the main purpose of strengthening the banks’ capital base to ensure that they can manage losses in a better way and improve the banks’ liquidity management.

In 2013, the Basel Committee therefore published a number of reports analysing what capital requirements the banks’ internal models generated. The reports show that there are major differences in the banks’ capital requirements. They also show that these differences cannot be explained by the differences in the underlying risk in their assets, but are instead due to the way the banks measure risk. The fact that this is so not only makes it difficult to compare capital requirements between the banks, it also reduces the credibility of the international capital regulations. The Committee’s current work therefore concerns to a large extent ensuring that the models used by the banks are reliable and reflect the risks in their operations in a correct manner.

This work includes revising and to some extent limiting the banks’ scope to use internal models to calculate their risk-weighted assets and thereby their capital requirements. For instance, the Basel Committee is planning to introduce floors for a number of the parameters the banks estimate themselves. The result of this is that we will see less difference in the banks’ capital requirements for assets with similar risk profiles. Let me make myself clear: The idea is not that we shall return to Basel I. The banks will be able to continue using internal models in their risk management. What the Committee’s current work concerns is instead bringing order to the risk-based system to increase the credibility of the capital requirements the banks have and to make it easier to compare them. Without this work, there is a risk of further erosion of confidence in the regulations.

Another important part of the Committee’s work involves modernising and developing standard methods so that they become more risk sensitive and thereby better adapted to banks with international operations. For many types of exposure, such as lending with property as collateral, the current standard measures often give the same risk weight regardless of the loan-to-value ratio. This will probably be changed so that the capital requirement varies according to the loan-to-value ratio. This work also covers trying to reduce the mechanical dependence on external credit ratings, which is in line with the objectives stated by G20.

Critics have expressed fears that the reforms I am talking about now will lead to minimum capital for certain banks increasing radically, which in turn risks resulting in a real economic decline. Here I would like to point out that the Basel Committee’s ongoing reform work does not aim to significantly increase the total global capital requirements.

Instead, it concerns ensuring that all banks around the world have adequate resilience to manage financial crises and that risks are covered by capital in a uniform way in all banks and all countries. One result of this exercise is that banks that currently have very low risk weights will probably face higher capital requirements, while banks with very high risk weights may face lower capital requirements. Designing a uniform global regulatory framework is not an easy task, particularly as banking systems differ from country to country, but also because we are living in a changing world. The Basel Committee’s work is therefore largely a question of finding compromises that all member countries can support and which will stand the test of time.

APRA Re-Calibrates IRB Bank Capital

Wayne Byres APRA Chairman spoke at Finsia’s ‘The Regulators’ event, Melbourne. He discussed risk culture, profitability and returns in the financial system, and Basel risk capital. We focus on the capital discussion, because he warned that the IRB banks are re-calibrating their models to get closer to the 25% risk weighting. As a result there could be some “noise in the system”. Also it appears Basel III won’t really be complete in 2017.

risk-pic-2

The Basel Committee needs to complete the final work on Basel III. All the key components of the capital framework are still under review in one way or other, with the ambitious goal to:

  • improve the risk sensitivity of some parts of the framework;
  • reduce excessive variability in others; and
  • not significantly increase capital requirements overall.

If the Committee achieves all these things to everyone’s satisfaction, it will be a miracle!

I’ll be happy to just get some finality to the deliberations. The Committee meets again in a couple of weeks, and hopefully an agreement will be reached that will allow the complete package of reforms to be endorsed by the Governors and Heads of Supervision of Basel Committee member countries in January. If that happens, our return to work in the New Year should be accompanied by the revised international capital framework. That process sounds relatively orderly, but behind the scenes there is still much horse trading to do.

However, the Basel framework doesn’t purport to deliver ‘unquestionably strong’ capital. It is simply the minimum international standard. In Australia, we have long applied more robust requirements1 – an approach that has stood us in good stead. Even without the reinforcing view of the FSI, there’s no reason why we would take a different path now. I mention this to dampen any enthusiasm that might be generated when the new rules are released, by calculating what would happen if APRA was to simply apply the new Basel framework to Australian ADIs. I can tell you the answer now – it would produce a material reduction in capital requirements. Before anyone gets too excited by that, I can also tell you we won’t be pursuing that course.

Once the Basel Committee has set out the minimum requirements, the task for APRA is to think through how and where we build further resilience into the new Basel framework to deliver ‘unquestionably strong’ capital ratios. But that’s not our sole objective. As we make policy choices, we’ll also be considering:

  • how we make the framework more flexible, so that it is better able to respond to business and financial cycles;
  • how to improve transparency, so that investor understanding of capital strength is enhanced; and
  • heeding the message of the FSI, how to take account of the competitive impacts of differing approaches (albeit that any differentiated approach will inevitably lead to different capital requirements at a product level).

The key issue, of course, is how we might calibrate the new requirements. The FSI gave us one guidepost – top quartile positioning relative to international peers – but we’ll also use others. For example, we’ll assess capital positions against rating agency measures of capital strength. The results of stress tests are also informative: banks that have difficulty demonstrating their ability to survive plausible adverse scenarios without severely curtailing lending and/or emergency capital raisings are unlikely to be seen as unquestionably strong. As with top quartile positioning, none of these are intended to be definitive benchmarks, but they do give some useful guidance against which to calibrate the final requirements.

I’ll just say a quick word on timing. Given the number and potential impact of the changes that will be proposed, 2017 will be a year of consultation. We don’t expect to have final standards before this time next year. And even if that is the case, they would not take effect until at least a year after that. But while there’s time for the changes to be worked through, that shouldn’t lead to complacency in the current environment. In that sense, the message I’ve given previously still holds: capital accumulation remains the appropriate course for most ADIs, but with sensible capital planning the actual implementation of any changes should be able to be managed in an orderly fashion.

Before I conclude on capital altogether, I want to say a few words on the FSI recommendation regarding mortgage risk weights. In July 2015, we announced higher mortgage risk weights for banks using internal model-based approach to capital. This was an interim step, but a step we were comfortable we wouldn’t need or want to materially unwind, regardless of the outcomes in Basel.

All other things being equal, we expected to raise the average mortgage risk weights for banks using internal models from around 16 per cent to at least 25 per cent. Unfortunately, in the world of internal models, all other things are rarely equal. Banks constantly refine their models, often at their own initiative but also sometimes at the request of APRA. We noted earlier this year that the impact of a range of modelling changes in the pipeline, when combined with the adjustment proposed in July 2015, would have produced an average risk weight well in excess of our interim objective of 25 per cent. So we’ve had to slightly recalibrate the adjustment, with a view to ensuring the outcomes were broadly consistent with the target we announced.

I mention this because, for those who follow these numbers closely, there will be some noise in the system over the next few quarters. As various modelling changes come on stream, the average risk weight across all IRB banks will fluctuate somewhat, and will impact different banks at different times. But these differences will narrow over time.

Update On Basel Regulatory Framework

The Basel Committee on Banking Supervision has issued the Eleventh progress report on adoption of the Basel regulatory framework. It includes a status update for each country, including Australia, where progress continues, based on self-reporting made to the committee in March 2016.

Pillar 3 disclosures appear to be the main area of slippage. In January 2015, the Basel Committee issued the final standard for revised Pillar 3 disclosure requirements, which will take effect from end-2016 (ie banks will be required to publish their first Pillar 3 report under the revised framework concurrently with their year-end 2016 financial report). The standard supersedes the existing Pillar 3 disclosure requirements first issued as part of the Basel II framework in 2004 and the Basel 2.5 revisions and enhancements introduced in 2009.

aus-basel-status-sept-2016More broadly, the Committee’s latest report as of end-September 2016 shows that:

all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force;

26 member jurisdictions have issued final rules for the countercyclical capital buffers;

25 have issued final or draft rules for their domestic SIBs framework; and
18 have issued final or draft rules for margin requirements for non-centrally cleared derivatives.

With regard to the global SIBs framework, all members that are home jurisdictions to G-SIBs have the final framework in force. While members are now turning to the implementation of other Basel III standards, including the leverage ratio and the net stable funding ratio (NSFR), some member jurisdictions report challenges in meeting the agreed implementation deadlines for some standards. These include the revised Pillar 3 framework (by end-2016), the standardised approach for measuring counterparty credit risk (by January 2017), capital requirements for central counterparty (CCP) exposures (by January 2017) and capital requirements for equity investments in funds (by January 2017).

This report sets out the adoption status of Basel III standards for each member jurisdiction of the Basel Committee as of end-September 2016. It updates the Committee’s previous progress reports which have been published on a semiannual basis since October 2011 under the Committee’s Regulatory Consistency Assessment Programme (RCAP).

Since it introduced the RCAP in 2011, the Committee has periodically monitored the adoption status of the risk-based capital requirements. From 2013, the Committee expanded its coverage to monitor its members’ adoption of the requirements for systemically important banks (SIBs), the liquidity coverage ratio (LCR) and the leverage ratio. In 2015, the Committee extended its monitoring of the adoption progress to all Basel III standards, which will become effective by 2019.

Methodology

The information contained in the following table is based on responses from Basel Committee member jurisdictions, and reports the status as of end-September 2016.

The following classification is used for the adoption status of Basel regulatory rules:

1. Draft regulation not published: no draft law, regulation or other official document has been made public to detail the planned content of the domestic regulatory rules. This status includes cases where a jurisdiction has communicated high-level information about its implementation plans but not detailed rules.
2. Draft regulation published: a draft law, regulation or other official document is already publicly available, for example for public consultation or legislative deliberations. The content of the document has to be specific enough to be implemented when adopted.
3. Final rule published: the domestic legal or regulatory framework has been finalised and approved but is still not implemented by banks.
4. Final rule in force: the domestic legal and regulatory framework has been published and is implemented by banks.
In order to support and supplement the status reported, summary information about the next steps and the adoption plans being considered are also provided for each jurisdiction.
In addition to the status classification, a colour code is used to indicate the adoption status of each jurisdiction. The colour code is used for those Basel components for which the agreed adoption deadline has passed.

Green = adoption completed; yellow = adoption in process (draft regulation published); red = adoption not started (draft regulation not published). N/A: Not applicable.

 

A Revised Basel Framework – State of Play

We have an update on the Basel Committee’s work to finalise the global regulatory framework from William Coen, Secretary General. He spoke on “Bank capital: a revised Basel framework” at a panel discussion at the 2016 Annual Membership Meeting of the Institute of International Finance, Washington DC, 7 October.  The objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks.

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Our goal is to finish by the end of the year. The Committee’s post-crisis reforms have been comprehensive and wide-ranging. I am pleased to say that we are close to finalising these reforms, which will provide clarity and certainty to supervisors and market participants.

Second, the bulk of the outstanding reforms relate to reducing excessive variability in risk-weighted assets. A high degree of variability in capital ratios has been demonstrated across a number of empirical studies by the Committee, academics and analysts. The Committee’s objective is to restore the credibility of the risk-based capital framework, which is an integral element of the Committee’s post-crisis reforms.

This is not an exercise in increasing regulatory capital requirements, although I do not rule this out as a possible outcome for outlier banks.

Finally, maintaining a risk-sensitive framework is an important objective, but this has to be carefully balanced with the need for simplicity and comparability.

Progress in finalising the Basel Committee’s reform agenda

The Basel Committee’s policy development process

So where do we stand and what remains to be done? Since late last year, we have published four consultative documents that would revise the current standards for: (i) the standardised approach for credit risk; (ii) operational risk; (iii) the internal ratings-based (IRB) approaches for credit risk, including a potential “output floor”; and (iv) the leverage ratio. The Committee received and analysed comments from a wide range of stakeholders. In parallel with the consultative process, we launched a comprehensive cumulative quantitative impact study (QIS). This allows us to test different scenarios and combinations of scenarios.

The comments we review and the results of our QIS are important inputs to this process – we spend a considerable amount of time assessing these inputs. But we are also aware of their limitations and bias. Data quality, in particular, is a challenge and, even under the best of circumstances, there will always be an element of bias in the data. This is understandable: our exercises often require data that are not readily accessible, and banks must therefore estimate certain outcomes based on the data that are available. In short, QIS exercises are a labour-intensive, painstaking process for banks and for bank supervisors but an essential part of our policy development process. The cumulative QIS exercise will allow the Committee to make a well informed judgment on the overall impact of its remaining reforms and on the component pieces of that package.

A package of proposals

Let me say a few words about each part of the package we will finalise by year-end. I stress the word “package” since there are clearly trade-offs associated with the various policy levers. For example, the more weight that is placed on using standardised approaches to calculating risk-weighted assets, the less weight that is needed on other policy levers, such as input and output floors.

  • Standardised approach for credit risk1 – In the two consultations the Committee conducted on this topic, we explicitly noted that our intention was to improve the standard’s risk sensitivity. The intention was not to increase overall regulatory capital requirements. The Committee intends to adhere to this objective. This does not mean that there will be no changes in capital requirements. Indeed, if we achieve our objective, then capital requirements on riskier exposures should increase, while decreasing for lower risk exposures.
  • Internal ratings-based approaches2 – Our March consultative paper expressed concern about banks’ modelling practices and the degrees of freedom in estimating risk components such as probably of default, loss-given-default and exposure at default. The Committee proposed to remove the option to use the IRB approaches for certain exposures, where it is judged that the model parameters cannot be estimated sufficiently reliably for regulatory capital purposes. This objective can be achieved through various combinations of approaches, which the Committee is still assessing.
  • At the aggregate level, credit risk accounts for on average three quarters of a bank’s minimum capital requirements. Operational risk,3 on the other hand, accounts for an average of around 15% of minimum capital requirements. The Committee is considering adjustments to the March consultation paper on operational risk. I expect that the fundamental elements of the revised operational risk framework will be maintained (ie combining a simple accounting proxy of operational risk with a bank’s internal loss data). Nevertheless, the Committee is considering refinements to the methodology that go in the direction of simplifying the framework and enhancing its robustness.
  • Output floor – Discussions are still under way to replace the existing transitional capital floor based on the Basel I framework that the Committee, in 2009, agreed to keep in place.4 The floor is meant to mitigate model risk and measurement error stemming from internally modelled approaches and would place a limit on the benefit a bank derives from using its internal models for estimating regulatory capital.

There are several other elements of the Basel III package that the Committee will finalise by year-end, including the leverage ratio exposure measure and a surcharge for global systemically important banks.5 The Committee is also finalising the treatment of credit valuation adjustment (CVA) risk. CVA risk is complex but on average accounts for only 2% of minimum capital requirements and is significant for a relatively small number of banks. We are carefully weighing the benefits of a risk sensitive treatment for this risk with the associated complexity and global applicability.

I would also like to say a few words about the Committee’s market risk rules as, similar to CVA, the contribution of market risk to minimum capital requirements is relatively low (ie on average less than 5%) and of particular relevance for a small number of large banks. The Committee has compiled frequently asked questions and is developing responses to these FAQs to provide greater clarity on how the standard is expected to work in practice. The Committee is considering the impact of the new market risk rules as part of its regular QIS monitoring exercises, and is continuing its work on the P&L attribution test, which is a key determinant of whether a bank can use internal models for market risk or is required to apply the standardised approach.

Impact of the final reforms

So what will be the cumulative impact of these reforms? The answer, of course, depends on the final package of proposals that the Committee agrees to, and which is ultimately endorsed by Governors and Heads of Supervision (GHOS). I can reiterate that the objective is to reduce risk-weighted asset variability with a focus on outliers, while not significantly increasing overall capital requirements. However, this does not mean that the minimum capital requirement for all banks will remain the same – variability in risk-weighted assets can only be reduced if there is some impact on the outlier banks. So some banks which are genuinely outliers may face a significant increase in requirements as a result. We are studying the impact taking account of all the moving parts and (i) a variety of policy scenarios, (ii) different bank sizes and (iii) various business models.