Tag: BIS

Five Critical Risks in an Era of Negative Interest Rates

A speech by Professor John Iannis Mourmouras, Deputy Governor of the Bank of Greece, examines the impact of low and negative interest rates on economies. He starts by stating that this unconventional monetary policy is not temporary. Rates will be ultra low for a long time. As a result, bank profits will be eroded; financial market will be negatively impacted; investors will be forced to take higher risks so creating stability risks; governments will not be under pressure to reduce debt; and operational risks increase.  He concludes that the time has come for other policy tools, including fiscal and structural ones.

After nine years of low interest rates and large-scale market interventions, the consensus is that this unconventional monetary policy is not temporary, while in most advanced economies the prospect for normalisation seems rather remote. Indeed, most of continental Europe (the euro area, Denmark, Sweden and Switzerland) and, as of last January, also Japan have moved towards a much more accommodative monetary policy by introducing negative policy interest rates, and/or negative central bank deposit rates. Together with forward guidance and quantitative easing, such measures have created an unprecedented situation, in which nominal interest rates are negative in a number of European countries across a range of maturities in the benchmark yield curve, from overnight to even five- or ten year maturities! Indeed, 88 of the 346 securities in the Bloomberg Eurozone Sovereign Bond Index have negative yields, thus nearly $2 trillion of debt issued by European governments is currently trading at negative yields. Illustrative examples are those of Switzerland and Germany, in which 18 out of 19 bond issues and 14 out of 18 bond issues respectively are priced with negative yields. As a result, almost one quarter of the world’s GDP is produced in countries with negative interest rates.

There are, however, a number of concerns associated with the use of negative interest rates, each of which is considered in turn.

I. Erosion of bank profitability: As negative deposit rates impose a cost on banks with excess reserves, there is a higher probability that the banks’ net interest margins (the gap between commercial banks’ lending and deposit rates) will shrink, since banks may be unwilling to pass negative deposit rates onto their customers to avoid an erosion of their customer base and subsequent reduced profitability. The extent of the decline in profitability will depend on the degree to which banks’ funding costs also fall. The central bank could reduce concerns about bank profitability by raising the threshold at which the negative central bank deposit rate applies, as the Bank of Japan recently introduced a three-tier system, a different way from the ECB’s negative interest rate policy. Doing so, however, it could reduce the transmission of negative deposit rates to market rates, namely the power of negative interest rate policy transmission through the credit and portfolio rebalancing channel. Moreover, compressed long-term interest rates also reduce profit margins on the standard banking maturity transformation of short-term borrowing and lending at a somewhat longer term. So far, lenders have been reluctant to pass on the costs of negative rates to customers and have taken almost all of the burden. But, as recent research by the BIS
shows, the impact on profitability becomes more drastic over time, as short-term benefits such as lower rates of loan defaults diminish.

II. Negative effects on financial markets: Money market funds make conservative investments in cash-equivalent assets, such as highly-rated short-term corporate or government debt, to provide liquidity to investors and help them preserve capital by paying a modest positive return. While these funds aim to avoid reductions in net asset values, this objective may not be attainable if rates in the market are negative for a considerable period of time, prompting large outflows and closures and reducing liquidity in a key segment of the financial system. For insurance and pension funds, a low-for-long interest rate environment poses challenges, which may even be exacerbated if rates enter into negative territory. They may find themselves unable to meet fixed long-term obligations. Life insurance companies will also be less able to meet guaranteed returns.

III. Excessive risk-taking: Increased financial stability risks, stemming from search for yield and higher leverage. Keeping interest rates at negative levels for a long time increases borrowing attractiveness in key sectors of the economy and the risk of bubbles. This can not only lead to an inefficient allocation of capital, but leave certain investors with more risk than they appreciate, as investors in search of higher yields necessarily turn to excessive risky assets.

IV. Disincentive for government debt reduction: With interest rates at negative levels, governments are under no pressure to reduce their debt. Negative rates actually encourage them to borrow more. And if government borrowing becomes a sort of free lunch, there is a clear disincentive for fiscal discipline. Ultra-low interest rates flatter the debt service ratio, painting a misleading picture of debt sustainability. For instance, persistent negative rates may potentially act as an “anaesthetic” to governments of eurozone countries, especially in the europeriphery, meaning that they will proceed only slowly with fiscal and structural reforms, given the fiscal space that they gain from lower debt servicing costs.

V. Operational risks: The issuance of interest-bearing securities at negative yields may face design challenges. Areas that are commonly mentioned as sources of concern are interest bearing securities, particularly floating-rate notes (renegotiating, collecting interest, use as collateral) in the context of negative interest rates. More generally, if negative rates were to prevail for long, they may entail the need to redesign debt securities, certain operations of financial institutions, the recalculation of payment of interest among financial agents, and other operational innovations, the costs of which may offset negative rate benefits. For instance, most option-pricing models either do not work or do not work well with negative interest rates, particularly entailing risks for the compatibility of trading systems and other market infrastructure.

In brief, persistent negative rates may change expectations and create distortions (for instance, in terms of saving habits and, in that sense, they may be a topic for behavioural economists to look at). It is still unknown what their long-term effects will be (e.g. on the erosion of bank profitability). In contrast, QE has been tested successfully in the US and the UK and I would also like to remind you that monetary policy– conventional or unconventional – entails considerable time lags. It takes time to see the results at full length. However, there is definitely something positive about negative interest rates: it is a strong reminder that the time has come for other policy tools, including fiscal and structural ones.

BIS Updates Standards For Interest Rate Risk In The Banking Book

The Basel Committee on Banking Supervision has today issued standards for Interest Rate Risk in the Banking Book (IRRBB). The key enhancements to the 2004 Principles include:

  • More extensive guidance on the expectations for a bank’s IRRBB management process in areas such as the development of interest rate shock scenarios, as well as key behavioural and modelling assumptions to be considered by banks in their measurement of IRRBB;
  • Enhanced disclosure requirements to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. This includes quantitative disclosure requirements based on common interest rate shock scenarios;
  • An updated standardised framework, which supervisors could mandate their banks to follow or banks could choose to adopt; and
  • A stricter threshold for identifying outlier banks, which is has been reduced from 20% of a bank’s total capital to 15% of a bank’s Tier 1 capital.

The document runs to 50 pages but here is a summary of the main points:

  1. Interest rate risk in the banking book (IRRBB) is part of the Basel capital framework’s Pillar 2 (Supervisory Review Process) and subject to the Committee’s guidance set out in the 2004 Principles for the management and supervision of interest rate risk (henceforth, the IRR Principles). The IRR Principles lay out the Committee’s expectations for banks’ identification, measurement, monitoring and control of IRRBB as well as its supervision.

  2. IRRBB refers to the current or prospective risk to the bank’s capital and earnings arising from adverse movements in interest rates that affect the bank’s banking book positions. When interest rates change, the present value and timing of future cash flows change. This in turn changes the underlying value of a bank’s assets, liabilities and off-balance sheet items and hence its economic value. Changes in interest rates also affect a bank’s earnings by altering interest rate-sensitive income and expenses, affecting its net interest income (NII). Excessive IRRBB can pose a significant threat to a bank’s current capital base and/or future earnings if not managed appropriately.

  3. Three main sub-types of IRRBB are defined for the purposes of these Principles:

    • Gap risk arises from the term structure of banking book instruments, and describes the risk arising from the timing of instruments’ rate changes. The extent of gap risk depends on whether changes to the term structure of interest rates occur consistently across the yield curve (parallel risk) or differentially by period (non-parallel risk).
    • Basis risk describes the impact of relative changes in interest rates for financial instruments that have similar tenors but are priced using different interest rate indices.
    • Option risk arises from option derivative positions or from optional elements embedded in a bank’s assets, liabilities and/or off-balance sheet items, where the bank or its customer can alter the level and timing of their cash flows. Option risk can be further characterised into automatic option risk and behavioural option risk.

    All three sub-types of IRRBB potentially change the price/value or earnings/costs of interest rate-sensitive assets, liabilities and/or off-balance sheet items in a way, or at a time, that can adversely affect a bank’s financial condition

  4. The Committee has decided that the IRR Principles need to be updated to reflect changes in market and supervisory practices since they were first published, and this document contains an updated version that revises both the Principles and the methods expected to be used by banks for measuring, managing, monitoring and controlling such risks.

  5. These updated Principles were the subject of consultation in 2015, when the Committee presented two options for the regulatory treatments of IRRBB: a standardised Pillar 1 (Minimum Capital Requirements) approach and an enhanced Pillar 2 approach (which also included elements of Pillar 3 – Market Discipline). The Committee noted the industry’s feedback on the feasibility of a Pillar 1 approach to IRRBB, in particular the complexities involved in formulating a standardised measure of IRRBB which would be both sufficiently accurate and risk-sensitive to allow it to act as a means of setting regulatory capital requirements. The Committee concludes that the heterogeneous nature of IRRBB would be more appropriately captured in Pillar 2.

  6. Nonetheless, the Committee considers IRRBB to be material, particularly at a time when interest rates may normalise from historically low levels. The key updates to the Principles under an enhanced Pillar 2 approach are as follows:

  • Greater guidance has been provided on the expectations for a bank’s IRRBB management process, in particular the development of shock and stress scenarios (Principle 4) to be applied to the measurement of IRRBB, the key behavioural and modelling assumptions which banks should consider in their measurement of IRRBB (Principle 5) and the internal validation process which banks should apply for their internal measurement systems (IMS) and models used for IRRBB (Principle 6).
  • The disclosure requirements under Principle 8 have been updated to promote greater consistency, transparency and comparability in the measurement and management of IRRBB. Banks must disclose, among other requirements, the impact of interest rate shocks on their change in economic value of equity (∆EVE) and net interest income (∆NII), computed based on a set of prescribed interest rate shock scenarios.
  • The supervisory review process under Principle 11 has been updated to elaborate on the factors which supervisors should consider when assessing the banks’ level and management of IRRBB exposures. Supervisors could also mandate the banks under their respective jurisdictions to follow the standardised framework for IRRBB (eg if they find that the bank’s IMS does not adequately capture IRRBB). The standardised framework has been updated to enhance risk capture.
  • Supervisors must publish their criteria for identifying outlier banks under Principle 12. The threshold for the identification of an “outlier bank” has also been tightened, where the outlier/materiality test(s) applied by supervisors should at least include one which compares the bank’s ∆EVE with 15% of its Tier 1 capital, under a set of prescribed interest rate shock scenarios. Supervisors may implement additional outlier/materiality tests with their own specific measures. There is a strong presumption for supervisory and/or regulatory capital consequences, when a review of a bank’s IRRBB exposure reveals inadequate management or excessive risk relative to a bank’s capital, earnings or general risk profile.

  1. Consistent with the scope of application of the Basel II framework, the proposed framework would be applied to large internationally active banks on a consolidated basis. Supervisors have national discretion to apply the IRRBB framework to other non-internationally active institutions.

  2. The document is structured as follows. Section I provides an introduction to IRRBB. Section II presents the revised Principles, which replace the 2004 IRR Principles for defining supervisory expectations on the management of IRRBB. Principles 1 to 7 are of general application for the management of IRRBB, covering expectations for a bank’s IRRBB management process, in particular the need for effective IRRBB identification, measurement, monitoring and control activities. Principles 8 and 9 set out the expectations for market disclosures and banks’ internal assessment of capital adequacy for IRRBB respectively. Principles 10 to 12 address the supervisory approach to banks’ IRRBB management framework and capital adequacy. Section III states the scope of application and Section IV sets out the standardised framework which supervisors could mandate their banks to follow, or a bank could choose to adopt. The Annexes provide a set of terminology and definitions that will provide a better understanding of IRRBB to both banks and supervisors and further details on the standardised interest rate shocks.

  3. The banks are expected to implement the standards by 2018.

Why more finance is the wrong medicine for our growth problem

More finance is not the answer to driving growth harder. This was the essence of a striking keynote by Dr Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank, at the Harvard Law School Symposium on Building the Financial System of the 21st Century: An Agenda for Europe and the US. He argues that new approaches to monetary policy are required and we need to move beyond finance-led growth emerged as the dominant political strategy in the 1980s.

2016 marks the 30th anniversary of the Program on International Financial Systems. That’s about the age when young people begin to realise that smoking, drinking and working late hours won’t leave their physique unscathed. Bad habits, happily ignored in younger years, catch up with them eventually. Some of us probably know what I am talking about.

You could say that today’s global economy has reached a similar point in its life. But it would be 38 today, having turned 30 back in 2008 when the financial crisis was raging. At that time, the global economy did realise that excess was detrimental to its long-term health. Now the world economy is eight years older – but is it also eight years wiser? In other words, have we cut back enough on our bad habits to thrive for another four or five decades? Or are we still leading a life of excess that will prove costly for tomorrow’s financial health?

In my remarks today, I will argue that we have not yet done enough to adapt. For the global economy to become healthy and prosperous again – and to stay that way – we need to adapt our policy habits. We have to move towards a more sustainable mix: fewer painkillers, less wine, more healing and greater abstinence.

2. Stricken by two illnesses at once

Our subject, the world economy, is still struggling to adapt to the new realities of being “thirtysomething”. It is stricken by two illnesses simultaneously.

The first is the result of the excessive lifestyle it led before the crisis. I’m referring to the overblown financial system and the extreme leveraging, which created a lasting liability in the shape of mountains of debt. It was this excessive leveraging which paved the way to the financial crisis. During the crisis itself, it was plain to see that leverage levels needed to be lowered, especially in the financial sector. But precious little headway has been made in this regard, leaving us with an unstable financial system.1

The second ailment is that global economic growth has been stubbornly stagnant over the past seven years.2 Most policy responses to the crisis have sought to put output levels and growth back on track. Yet growth has been stuck in the doldrums in most advanced countries.

Thus, the global economy has been stricken by both stagnating growth and excessive levels of debt. These twin illnesses are very difficult to treat – especially so given that it is not entirely clear what exactly is behind the growth problem. Is it the unhealthy lifestyle of excessive finance, or is it another, more fundamental condition? Or could it be a more complex complaint in which stifling debt and low growth fuel each other in a vicious circle?

3. Financial painkillers aren’t the cure

How are we supposed to treat these twin illnesses? Finance-led growth emerged as the dominant political strategy in the 1980s. That meant financial deregulation was high on the agenda to foster financial development, and monetary policy was used to counter financial turmoil.

In fact, monetary policy created a high degree of stability during the spell known as the “Great Moderation”, which ran from the 1980s until 2007. This episode was characterised by gratifyingly low volatility in growth and inflation rates. That outcome can still be regarded as a good thing. And many attribute it, at least in part, to systematic monetary policymaking by central banks. This, however, came at a price. Monetary expansion drove liquidity levels higher, which in turn facilitated balance sheet expansion and excessive risk-taking.

In the words of Ben Bernanke, “for the most part, financial stability did not figure prominently in monetary policy discussions during [the Great Moderation].”

Given this experience, a doctor treating a patient with these symptoms would stop prescribing painkillers. But as it turned out, the monetary “medication” actually started to be expanded in 2008. First via ultra-low interest rates, then through quantitative easing, followed, more recently, by even more monetary measures aimed at kick-starting inflation and the economy.

The liquidity provided stabilised the financial system, but it also inflated asset prices. The aftermath of the expansionary monetary policymaking before the crisis should serve as a reminder not to make the same mistake twice. Providing an endless flow of liquidity as a kind of painkiller does nothing to tackle the root cause of the economic challenges we are facing.

The second painkiller frequently administered to support financial development in the pre-crisis era was deregulation and a “light touch” in regulation and supervision. The idea behind this approach was that lenience would fuel increased investment. Unfortunately, it inflated the credit bubble.

Solid regulation and responsible supervision is the key to limiting future bubbles. Yes, we’ve already achieved a great deal since the crisis – Basel III and TLAC at the global level; Dodd-Frank in the US; the banking union in the euro area. And some are saying we’ve already gone too far. The evidence, however, tells a different story: it is higher standards that strengthen credit intermediation and economic development. That’s something worth remembering in the face of what are, intuitively, compelling claims about capital costs. These claims have been discredited by the experience gained during the crisis and by empirical evidence.

In sum, these policies did not constitute a sustainable lifestyle, nor did they deliver a systematic cure. Rather, they turned out to be painkillers. So the big question I’m asking myself is this: should we carry on treating the symptoms by taking more and more painkillers – or should we look for a fundamental change of lifestyle that might cure the underlying problems?

4. Finance is no panacea for growth

Put differently, do we need to treat the global economy with more monetary and financial stimulus? And, more fundamentally, do we need more finance to fix our economy?

For over three decades, the simple answer was “the more, the better”. And scientific evidence supported this intuition. Studies showed that financial development corresponded strongly with economic growth. Politically, there was a clear preference for finance-led growth. Thus, deregulation was high on the agenda.

I won’t remind you where all this led. We just need to remember the tremendous costs for banks and for society at large that followed the burst of the last credit bubble.

Moreover, recent scientific evidence based on historical data reveals that there is indeed such a thing as too much finance. Financial depth starts having a negative effect on output growth when credit to the private sector reaches 100 per cent of GDP. Most advanced countries far exceeded this level prior to the financial crisis – and continue to do so.

Thus, the diagnosis for advanced economies like the EU und the US is that increasing financial intermediation is beneficial, but only up to a point. This point has been exceeded in most developed economies.

5. What’s the right medicine? Fewer painkillers, a better cure

What’s the takeaway from all this? It’s that more finance is not the solution to our current problems.

Sticking to the simple “more finance, more growth” trajectory isn’t a sustainable solution. That would run the risk of focusing on what is currently our most pressing problem – lifting growth expectations – at the expense of our long-term – and fundamental – goal of achieving a stable financial system. And by doing that, we would also sacrifice sustainable growth.

Most doctors would probably agree that a sophisticated course of treatment aimed at the patient’s long-term wellbeing is better than a box of painkillers every week. But ask them what exactly they would prescribe, and the result will probably be rather like asking several economists for macroeconomic policy advice. You might end up with more treatment plans than you have doctors – or patients for that matter.

What we need is less, and better finance – finance that serves the real economy and sustainable development. How do we achieve that? There are several angles to that question, but the ones I would like to emphasise are financial regulation and supervision, and monetary policy.

As I said earlier, providing a flow of liquidity as a monetary painkiller does nothing to tackle the root causes of the economic challenges we are facing. In the absence of economic progress on the structural front, monetary easing is not the key to a sustainable economy. It does, however, affect financial stability, given that it can fuel bubbles. Therefore, we need to look for an exit strategy. It is important for central banks to think hard about how they intend to achieve an exit as soon as economic conditions make it viable to do so.

From a more general angle, integrating financial stability considerations into monetary policy while maintaining the primacy of the price stability goal will be a key challenge for the future. I welcome the fact that central banks are moving in that direction.

Rock-solid regulation and responsible supervision is likewise indispensable for a stable financial system. Over and above the progress we have made since the crisis erupted, there are three more steps we need to take. First, we must credibly implement the agreed reforms – for example, the new bail-in instruments need to be credible so that politicians do not pre-empt the bail-in during times of crisis. Zombie banks should not be kept alive for political reasons. Uncertainty over the bail-in instruments will only exacerbate market uncertainty.

Second, supervision must be steadfast. Either banks are capable of managing their risks adequately, or supervisors must force them to do so – or, ultimately, they must take disciplinary measures. As such, it is up to a supervisor to increase an individual institution’s capital requirements, if need be. At the same time, however, we must be careful that risky activities do not move to unregulated areas.

Finally, we must not discontinue our reform efforts prematurely. We need to put an end to the privileged treatment of sovereign exposures. We must regulate shadow banking. And we must finalise Basel III in a sound manner. Yes, there has been a commitment to not raise capital requirements significantly on average, as the Basel Committee and the G20 have clarified. But several German banks, for example, have already lifted their regulatory equity by more than 100 per cent between December 2010 and June 2015 – that’s an increase from 58 billion to 118 billion euros. So we have already achieved a substantial increase in capital. But make no mistake: high-risk portfolios will end up with higher requirements. Moreover, a pledge to not significantly increase capital requirements certainly doesn’t mean that requirements will fall back to their low pre-crisis levels.

The bottom line is this: we must not lapse back into bad old habits when we’re finalising, implementing and enforcing the reforms aimed at restoring financial stability. Financial intermediation is important for our advanced economies. But if it’s not or insufficiently regulated, it can do more harm than good. That should be borne in mind in each and every decision we take.

But talking about rules and their enforcement is one thing – they will only lead to better finance if banks and investors change their behaviour accordingly. Banks, especially European ones, have to adapt their business models. They need to set themselves sustainable profit targets which do not undermine ethical behaviour.

Without a doubt, such financial policies need to be complemented by fundamental economic policy reforms. But I’m certain that sound financial and monetary policy will be a cornerstone of a stable financial system that serves the development of the real economy over the long term.

6. Conclusion

Esteemed colleagues

We are facing two challenges simultaneously: to reanimate economic growth, and to build a sustainable financial system that is fit for the 21st century.

I am convinced that our policies need to set their sights on a long-term solution – a lasting cure, if you will, not an endless supply of painkillers. We should not turn a blind eye to the short-term challenges we face, of course. But what we must do is refrain from solutions that encourage excessive indebtedness. Finance will be an important ingredient in the cure for growth – but it will need to be of a better quality, not a greater quantity.

Basel III Progress Assessment Published

The Bank for International Settlements (BIS) has released the 10th status report on the adoption of the Basel regulatory framework. We summarise the elements within Basel III and their target dates, and the status of Basel III in Australia. The complexity of the overall approach is highlighted. It also shows the journey to Basel III is far from complete. Today the IMF Working Paper highlighted the deficiency in the approach in connection with mortgage finance.  We are not convinced more complexity is necessarily better.

As of March 2016, all 27 member jurisdictions have final risk-based capital rules, LCR regulations and capital conservation buffers in force, 24 have issued final rules for the countercyclical capital buffers and 23 have issued final or draft rules for their domestic SIBs framework. With regard to the global SIBs framework, all members that are home jurisdictions to G-SIBs have the final framework in force. Members are now turning to the implementation of other Basel III standards, including the leverage ratio and the net stable funding ratio (NSFR).

Regarding the consistency of regulatory implementation, the Committee has published its assessment reports on 24 members – Australia, Brazil, Canada, China, nine members of the European Union, Hong Kong SAR, India, Japan, Saudi Arabia, Mexico, Russia, Singapore, South Africa, Switzerland, Turkey and the United States – regarding their implementation of Basel risk-based capital regulations.

The Basel III framework builds on and enhances the regulatory framework set out under Basel II and Basel 2.5.

• Basel III Capital: In December 2010, the Committee released Basel III, which set higher levels for capital requirements and introduced a new global liquidity framework. Committee members agreed to implement Basel III from 1 January 2013, subject to transitional and phase-in arrangements.

  • Capital conservation buffer: The capital conservation buffer is phased in between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
  • Countercyclical buffer: The countercyclical buffer is phased in parallel to the capital conservation buffer between 1 January 2016 and year-end 2018, becoming fully effective on 1 January 2019.
  • Capital requirements for equity investment in funds: In December 2013, the Committee issued the final standard for the treatment of banks’ investments in the equity of funds that are held in the banking book, which will take effect from 1 January 2017.
  • Standardised approach for measuring counterparty credit risk exposures (SA-CCR): In March 2014, the Committee issued the final standard on SA-CCR, which will take effect from 1 January 2017. It will replace both the Current Exposure Method (CEM) and the Standardised Method (SM) in the capital adequacy framework, while the IMM (Internal Model Method) shortcut method will be eliminated from the framework.
  • Securitisation framework: The Committee issued revisions to the securitisation framework in December 2014 to strengthen the capital standards for securitisation exposures held in the banking book, which will come into effect in January 2018.
  • Capital requirements for bank exposures to central counterparties: In April 2014, the Committee issued the final standard for the capital treatment of bank exposures to central counterparties, which will come into effect on 1 January 2017.

• Basel III leverage ratio: In January 2014, the Basel Committee issued the Basel III leverage ratio framework and disclosure requirements. Implementation of the leverage ratio requirements began with bank-level reporting to national supervisors until 1 January 2015, while public disclosure started on 1 January 2015. The Committee will carefully monitor the impact of these disclosure requirements. 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 (minimum capital requirements) treatment on 1 January 2018 based on appropriate review and calibration.
• Basel III liquidity coverage ratio (LCR): In January 2013, the Basel Committee issued the revised LCR. It came into effect on 1 January 2015 and is subject to a transitional arrangement before reaching full implementation on 1 January 2019.7
• Basel III net stable funding ratio (NSFR): In October 2014, the Basel Committee issued the final standard for the NSFR. In line with the timeline specified in the 2010 publication of the liquidity risk framework, the NSFR will become a minimum standard by 1 January 2018.
• G-SIB framework: In July 2013, the Committee published an updated framework for the assessment methodology and higher loss absorbency requirements for G-SIBs. The requirements came into effect on 1 January 2016 and become fully effective on 1 January 2019. To enable their timely implementation, national jurisdictions agreed to implement by 1 January 2014 the official regulations/legislation that establish the reporting and disclosure requirements.
• D-SIB framework: In October 2012, the Committee issued a set of principles on the assessment methodology and the higher loss absorbency requirement for domestic systemically important banks (D-SIBs). Given that the D-SIB framework complements the G-SIB framework, the Committee believes it would be appropriate if banks identified as D-SIBs by their national authorities were required to comply with the principles in line with the phase-in arrangements for the G-SIB framework, ie from January 2016.
• Pillar 3 disclosure requirements: 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.
• Large exposures framework: In April 2014, the Committee issued the final standard that sets out a supervisory framework for measuring and controlling large exposures, which will take effect from 1 January 2019.

The structure of the attached table has been revamped (effective from October 2015) to monitor the adoption progress of all Basel III standards, which will come into effect by 2019.

Australian-Basel-2016

 

Payments and Financial Inclusion

In recent years, a number of reports have been prepared by organisations on financial inclusion, a topic whose importance is increasingly being recognised. However, few of these reports have addressed what may be called the “payment aspects” of financial inclusion. In cases where the topics of payment systems and payment services have been raised in the context of financial inclusion, discussion has focused only on specific aspects of payments, such as mobile payments, rather than on the payment system in its entirety. Understanding payments in a holistic sense, including how individual elements relate to one other, is crucial to an understanding of financial inclusion and to promoting broader access to and usage of financial services.

The report, published today, provides an analysis of the payment aspects of financial inclusion, on the basis of which it sets out guiding principles designed to assist countries that seek to advance financial inclusion in their markets through payments. The report was first issued in September 2015 as a consultation document. As a result of the comments, we have made changes to the report to strengthen the analysis and sharpen the message. The report has been prepared for the Committee on Payments and Market Infrastructures (CPMI) and the World Bank Group by a task force consisting of representatives from CPMI central banks, non-CPMI central banks active in the area of financial inclusion and international financial institutions.

This report is premised on two key points: (i) efficient, accessible and safe retail payment systems and services are critical for greater financial inclusion; and (ii) a transaction account is an essential financial service in its own right and can also serve as a gateway to other financial services. For the purposes of this report, transaction accounts are defined as accounts (including e-money/prepaid accounts) held with banks or other authorised and/or regulated payment service providers (PSPs), which can be used to make and receive payments and to store value.

The report is structured into five chapters. The first chapter provides an introduction and general overview, including a description of the PAFI Task Force and its mandate, a brief discussion of transaction accounts, and the barriers to the access and usage of such accounts. The second chapter gives an overview of the retail payments landscape from a financial inclusion perspective. The third chapter forms the core analytical portion of the report and outlines a framework for enabling access and usage of payment services by the financially excluded. Each component of this framework is discussed in detail in the report. The fourth chapter of the report describes the key policy objectives when looking at financial inclusion from a payments perspective, and formulates a number of suggestions in the form of guiding principles and key actions for consideration.

In this context, financial inclusion efforts undertaken from a payments angle should be aimed at achieving a number of objectives. Ideally, all individuals and businesses – in particular, micro-sized and small businesses – which are more likely to lack some of the basic financial services or be financially excluded than larger businesses – should be able to have access to and use at least one transaction account operated by a regulated payment service provider:

(i) to perform most, if not all, of their payment needs;
(ii) to safely store some value; and
(iii) to serve as a gateway to other financial services.

The guiding principles for achieving these objectives of improved access to and usage of transaction
accounts are the following:

  1. Commitment from public and private sector organisations to broaden financial inclusion is explicit, strong and sustained over time.
  2. The legal and regulatory framework underpins financial inclusion by effectively addressing all relevant risks and by protecting consumers, while at the same time fostering innovation and competition.
  3. Robust, safe, efficient and widely reachable financial and ICT infrastructures are effective for the provision of transaction accounts services, and also support the provision of broader financial services.
  4.  The transaction account and payment product offerings effectively meet a broad range of transaction needs of the target population, at little or no cost.
  5. The usefulness of transaction accounts is augmented with a broad network of access points that also achieves wide geographical coverage, and by offering a variety of interoperable access channels.
  6. Individuals gain knowledge, through awareness and financial literacy efforts, of the benefits of adopting transaction accounts, how to use those accounts effectively for payment and store-of-value purposes, and how to access other financial services.
  7. Large-volume and recurrent payment streams, including remittances, are leveraged to advance financial inclusion objectives, namely by increasing the number of transaction accounts and stimulating the frequent usage of these accounts.

Finally, the fifth chapter of the report addresses a number of issues in connection with measuring the effectiveness of financial inclusion efforts in the context of payments and payment services, with a particular emphasis on transaction account adoption and usage.

Revisions to the Basel III leverage ratio framework

The Basel III framework introduced a simple, transparent, non-risk based leverage ratio to act as a credible supplementary measure to the risk-based capital requirements. The Basel Committee is of the view that a simple leverage ratio framework is critical and complementary to the risk-based capital framework and that a credible leverage ratio is one that ensures broad and adequate capture of both the on- and off-balance sheet sources of banks’ leverage.

The latest document sets out the Committee’s proposed revisions to the design and calibration of the Basel III leverage ratio framework. The proposed changes have been informed by the monitoring process in the parallel run period since 2013, by feedback from market participants and stakeholders and by the frequently asked questions process since the January 2014 release of the standard Basel III leverage ratio framework and disclosure requirements.

Among the areas subject to proposed revision in this consultative document are:

  • measurement of derivative exposures;
  • treatment of regular-way purchases and sales of financial assets;
  • treatment of provisions;
  • credit conversion factors for off-balance sheet items; and
  • additional requirements for global systemically important banks.

The final design and calibration of the proposals will be informed by a comprehensive quantitative impact study.

The Committee welcomes comments on all aspects of this consultative document and the proposed standards text. The deadline for submissions is Wednesday 6 July 2016.

APRA, Basel Committee: Another GFC is coming

From Australian Broker.

Both the global banking regulator and Australia’s banking regulator have warned another financial crisis is imminent.

Speaking at the Australian Financial Review (AFR) Banking and Wealth Summit in Sydney yesterday, Bill Coen, the secretary-general the Basel Committee on Banking Supervision, the global banking regulator, said another global financial crisis is “statistically certain”.

“As regulators, our focus is invariably on the downside risks rather than the upside. I’m an optimist by nature but maybe a pessimist by fact and experience. We know with statistical certainty there will be another financial crisis,” Coen said.

Echoing Coen’s warning, Wayne Byres, the chairman of Australian banking regulator APRA, said it is not a matter of “if” but “when”.

“When adversity arrives – and it will, it is not ‘if’, it will – to the extent possible we want the banking system to help alleviate rather than exacerbate problems. Ideally act as shock absorber not an amplifier.”

Byres said this is why it is important to build strength and resilience now.

“The main message I want to talk about today is that it is better we continue to invest in building resilience now when it can be done in an orderly manner from a position of relative strength than try to do so in more difficult times.”

Last year, the regulator announced an increase in the amount of capital required to be held by lenders against residential mortgages. This resulted in the big four banks raising more than $18 billion combined in new equity from shareholders.

APRA also enforced a limit on investment lending and warned it would be keeping a close watch on credit asessments.

Byres said capital requirements were likely to continue to move higher in 2016, amongst other regulatory work, to ensure our Australian banks are “unquestionably strong”, as recommended by the Murray Financial System Inquiry (FSI).

“Achieving this objective will involve work in four broad areas, and take the next several years to fully implement,” Byres told the summit.

“The four areas I have highlighted are: reinforcing capital strength; improving the stability of liquidity and funding profiles; enhancing both the public and private sectors’ readiness for adversity; and strengthening the risk culture within the financial system.”

According to Coen, increasing bank resilience in good times is the “most efficient and effective” way of dealing with periods of stress.

“The message here is caution against complacency,” Coen said.

The global policy reform agenda: completing the job

Global keynote spreech by William Coen, Secretary General of the Basel Committee, at the Australian Financial Review’s Banking and Wealth Summit, Sydney, 5 April 2016.

Introduction

Good morning, and thank you for the opportunity to participate in this summit. It is a pleasure to be in Sydney. I would like to thank the Financial Review for inviting me to be part of this event, which is indeed timely, since the Basel Committee aims to finalise a number of important regulatory reforms this year.

This morning I will say a few words about our recent proposals and outstanding reforms. I will describe the approach we are taking towards finalising the global regulatory framework. Our goal, as always, is to promote a safe and sound banking system, which is critical to ensuring sustainable economic growth. Australia’s economic growth record over the past two decades is the envy of many. As is the stability of its banking system. But, as regulators, our focus is invariably on the downside risks rather than the upside. And as we have learned from the all-too-frequent episodes of banking distress that have occurred throughout the world – increasing bank resilience in good times is the most efficient and effective way of dealing with periods of stress, which inevitably occur.

Building bank resilience is of course linked to the issue of capital. I will therefore offer a few thoughts on the subject of the level of bank capital. While critically important, regulatory capital is not, however, the sole focus of regulators. Strong supervision is essential and, above all, bank’s internal risk measurement and management are paramount. I will conclude with a look at some other areas where we need to bridge gaps to ensure resilience and profitability over the long term.

The Basel framework as a bridge

A bridge is an apt metaphor for the Basel framework, especially here in Sydney, with the celebrated Harbour Bridge only a few hundred metres away. Bridges must be safe and sound. A safe and sound banking system is exactly what the Basel framework aims to support. Bridges facilitate movement, commerce and trade. The financial system plays a crucial role in directing investment and funds between individuals and businesses. Bridges are complex to design and build. They must be sympathetic to their surroundings and their design and construction rely on the expertise of many parties. Global cooperation between regulators, duly recognising individual circumstances, is the Basel Committee’s tried and tested way of working. And, once complete, international prudential frameworks for banksdeliver benefits for all, as do strong bridges.

As strong bridges bring prosperity, weak bridges can undermine it. A weak bridge jeopardises the safety of those crossing it, and may create wider problems for society at large. A loss of confidence in a structure or its builders shakes confidence in every similar structure. These knock-on effects can be severe and persistent. So it is essential that a bridge, like the Basel framework, is built to last.

We must also not forget the importance of regular maintenance. The Harbour Bridge opened with four traffic lanes but now has eight, together with a complementary tunnel. Some parts are repainted every five years, while others last as long as 30 years. We face the same imperatives with the Basel framework. Maintenance does not imply re-opening every previous decision; we understand the importance of stability and certainty. But it does mean staying vigilant to market developments and keeping in mind the increasingly widespread use of the Basel framework.

Finalising global regulatory reform

The major outstanding topics that we will finalise this year relate to credit risk and operational risk. The Basel Committee recently published proposals on revising these two areas of the regulatory framework. Earlier this year, we finalised the regulatory capital framework for market risk.

One of our main goals this year is to address excessive variability in risk-weighted assets modelled by banks. Some – not us – have already dubbed these reforms “Basel IV”. I do not think the title in itself is important but I note that each moniker bestowed on the global regulatory framework was characterised by a substantial change from the earlier version. Basel II was a significant departure from the Basel I framework; while Basel III was a vastly different set of rules again. The current set of proposed reforms are meant to revise elements of the existing framework rather than introduce new ones. As such, I would not refer to these revisions as constituting “Basel IV”.

At the end of last year, the Committee consulted on proposals to revise the standardised approach for credit risk. This is the approach used by the vast majority of banks around the world. The Committee’s objective was to promote, as much as possible, the standardised approach as a suitable alternative to the modelled approaches. The standardised approach is of course also relevant for banks using internal models, as it may form the basis for an “output floor”, should the Committee decide to adopt such a floor. An output floor would cap the amount of capital benefit a bank using an internally-modelled approach would receive vis-à-vis the standardised approach. The Committee is still considering the specific design and calibration of an output floor.

The Committee recently consulted on revisions to operational risk and the internal ratings-based approaches for credit risk. For operational risk, our proposal did not include a modelled approach. While internal models are an essential part of risk management for many banks, the question is what role they should play in prudential rules. This is particularly relevant for operational risk. The Committee’s recent proposals to calculate capital for credit risk do not eliminate the use of models but place additional constraints around their use for regulatory purposes. I would emphasise the word “additional” – the kinds of constraint that have been proposed already exist in some form in the capital framework. Before we finalise the standards by the end of this year, we will analyse comments and conduct comprehensive quantitative impact studies (QIS).

The resources required to conduct these QIS exercises at banks and supervisory authorities are extensive. The appropriate level of minimum regulatory capital is a central question and we have a dedicated task force that is looking specifically at the calibration of the capital framework. We are tackling this question from the perspective of each individual policy on the table this year but are also taking an aggregate, overall view.

What is the right amount of capital?

Many people think that the Basel framework is all about capital. In many ways, they are right. For the past 25 years, the foundation of the international approach to the prudential regulation of banks has been a risk-based capital ratio. With respect to regulatory capital adequacy, there are two factors to consider: first, what counts as capital; and, second, how much of it do you need.

With Basel III’s definition of capital reforms, the Basel Committee took a great stride towards answering the first question. There is now, I think, a consensus that Common Equity Tier 1 is the most important component of capital, though with an acknowledgement that some other financial instruments may have a role to play in certain circumstances. Charts 1 and 2 show that banks have made very good progress in adjusting and increasing their core capital base. Banks’ leverage ratios and risk-weighted ratios have increased since the global financial crisis, with most of this increase stemming from banks augmenting their capital resources.

The level of capital is a more difficult question. There are many views on what the “right amount” should be. Banks, investors, rating agencies, depositors and regulators all have a different perspective on what is optimal. Even within groups there are different perspectives. Inside banks, loan officers, traders, risk managers and senior management may respond to capital requirements in different ways. And different regulators have different views on the question of how much capital is the right amount.

At the Committee, we work hard to bridge these different perspectives and to come to a consensus on a prudential framework of minimum standards that support a level-playing field for internationally active banks while also ensuring their resilience across financial cycles.

The Basel Committee’s view of capital

From the Basel Committee’s viewpoint, we define minimum requirements and do not try to answer the question of what is the optimal level of capital. Instead, we try to answer a slightly different question: “Is bank capital enough to ensure safe, resilient banks that perform better in the longer term?”

The banking sector has raised capital levels significantly. But there are still some gaps in the framework, which we will bridge by year-end. Some stakeholders seek short-term fixes, with some investors (and perhaps others) taking an unhealthy, if understandably myopic, view of bank performance and resilience. Our focus is on a far longer term. The process of devising international regulations is not well suited to delivering the quick fixes that are sometimes sought. Basel standards are minimum standards that support a sound banking system at all stages of the financial cycle. There will be circumstances, related to an individual bank, jurisdiction or financial cycle, that warrant having more capital than the minimum. For example, Australia has signalled its desire for its banks to be “unquestionably strong”, with Common Equity Tier 1 ratios in the top quartile of the benchmark set by peers. Other jurisdictions have also adopted regulations that are more stringent than the Basel standards. While we do not intend to significantly increase overall capital requirements, this does not mean avoiding any increase for any bank. And, as I said, it does not preclude individual jurisdictions from imposing higher standards.

I noted earlier that a risk-based capital ratio has underpinned our framework for a quarter of a century. This is, at heart, a simple concept: the amount of capital needed for a given activity should reflect the risk of that activity. The higher the risk, the higher the capital. This principle of risk-sensitivity is still very important to the Committee but it is not the only consideration.

The 1988 Basel I framework had limited risk-sensitivity. This sensitivity increased over time. Basel II allowed considerable use of internal models to determine capital requirements. In principle, internal models permit more accurate risk measurement. But, if they are used to set minimum requirements, banks have incentives to underestimate risk. Several studies have found substantial variation in risk-weighted assets across banks. For example, Charts 3 and 4 show the range of risk weights estimated by banks in hypothetical portfolio exercises we conducted on the banking and trading books. Complexity in internal models, banks’ choices in modelling risk parameters and national discretions in the framework have all contributed to this variation. However, I think it’s fair to say that the wide discretion provided to banks in the current framework is likely a major driver of this high degree of variability.

Such variation makes it difficult to compare capital ratios. Basel’s Pillar 3 framework – in its original form – failed to provide sufficiently granular, and sufficiently comparable, information to enable market participants to assess a bank’s overall capital adequacy and to compare it with its peers. The Committee has since addressed some of these disclosure deficiencies. Furthermore, some asset classes are inherently difficult to model. Together, this suggests that the use of internal models to cover all risks does not strike the right balance between simplicity, comparability and risk-sensitivity in the regulatory framework. I think it is not only regulators who feel that the balance between these objectives has been skewed too far towards risk-sensitivity and complexity. I know that, in many cases, academics, analysts, investors and perhaps even bank managers and board members would agree that the benefits of simplicity and comparability have been undervalued.

The Committee is therefore proposing greater restrictions on the use of internal models. This includes removing the option of using internal models to determine risk parameters for certain exposure categories. These categories are typically characterised by a scarcity of default data and/or model complexity. Specifically, we have recently proposed to:

  • remove the advanced measurement approaches for operational risk, where the inherent complexity and the lack of comparability arising from a wide range of internal modelling practices have exacerbated variability in capital calculations and contributed to an erosion of confidence in capital ratios;
  • remove the internal modelling approaches for exposures to banks, other financial institutions and large corporates, where it is judged that the model inputs cannot be estimated sufficiently reliably for regulatory capital purposes;
  • adopt floors for exposures to ensure a minimum level of conservatism where internal models remain available. These floors would be applied at the exposure – rather than portfolio – level; and
  • limit the range of practices regarding the estimation of model parameters under the IRB approaches.

Strong capital, narrowly defined, is not enough

The design of the overall regulatory framework has evolved significantly following the financial crisis. The foundation of the risk-based capital ratio is still in place, albeit strengthened with tougher materials, in the shape of higher-quality capital. But we have made many changes around it. The framework has been improved to catch up with modern traffic flows, particularly complex or illiquid trading activities and off-balance sheet exposures. Layers of capital buffers provide extra resilience.

The biggest change has been the introduction of multiple regulatory metrics. The revised framework complements the risk-based capital ratio with (i) a leverage ratio, (ii) standards for short-term and long-term liquidity management, (iii) large exposure limits, (iv) margin requirements and (v) additional going- and gone-concern requirements for the world’s most systemically important banks. Overall, this approach is more robust to arbitrage and erosion over time, as each measure mitigates the weaknesses of the others (Table 1). A number of empirical studies have suggested that simpler metrics are at times more robust than complex ones. We have kept this in mind when developing the leverage ratio, among other measures.

An appropriate level of resilience, in our view, is that implied by the combination of metrics that now comprise the Basel III framework.

But have we done enough? From a supervisor’s perspective, completing the regulatory standards is a critical step, but not the whole story. The financial crisis revealed, among other things, that implementation of the agreed standards was remiss. There were also weaknesses in banks’ internal controls. Also, incentive structures were not always aligned with the banks’ long-term soundness.

We have spent several years developing a framework to make sure that banks’ capital and liquidity buffers are strong enough to keep the system safe and sound. But these buffers can only be as reliable as the underlying risk measurement and management. No matter what standards the Basel Committee and national supervisors set to safeguard the system, it is ultimately banks themselves that determine their risk-taking, risk controls, business incentives and, ultimately, success or failure. These factors determine the way people ultimately behave. And we all know that in our current global financial system, much like a failed beam or girder, the failure of an individual bank is likely to have wider repercussions.

What else is needed?

So what else is needed? There are three areas that I would like to note: improved corporate governance and culture, better IT systems and effective stress-testing.

Let’s start with corporate governance. As noted by the Dutch central bank, “today’s undesirable behaviour in financial institutions is at the root of tomorrow’s solvency and liquidity problems”.1 The Basel Committee published Principles for enhancing corporate governance in 2006. They were revised in 2010, then again last year. The Committee has emphasised the need for more effective board oversight, with a focus on the skills and qualifications of individual board members as well as the collective board. The Principles also reinforce the imperative of rigorous risk management, appropriate resources and unfettered board access for the chief risk officer, as well as call for better discussions between a board’s audit and risk committees. Corporate culture has been an oft-publicised topic, with many senior management teams reinforcing appropriate norms for responsible and ethical behaviour. These norms are especially critical in terms of a bank’s risk awareness, risk-taking behaviour and risk management.

Next, IT systems. Many in the banking industry recognise the benefits of improving IT infrastructure. Banks’ risk data aggregation capabilities have been a source of concern for the Committee for some time now. The global financial crisis showed IT systems failed to support the broad management of financial risks. Many banks could not properly measure risk exposures and identify concentrations quickly and accurately, especially across business lines and legal entities. Risk reporting practices were also weak.

In 2013, the Basel Committee set out its Principles for effective risk data aggregation and risk reporting. We are monitoring their implementation. Though progress is being made, there is still a considerable way to go.

Finally, stress testing. Although not part of the Pillar 1 framework, stress testing plays an increasingly important role in a number of jurisdictions. In some countries, stress testing is an integral part of the assessment process. In others, it is used for contingency planning and communication. For some banks, supervisory stress testing has proven to be the binding regulatory constraint. Stress testing is also used by banks as a risk management tool and by macroprudential authorities for policy analysis. Over all these areas, stress testing has demanded more resources in both banks and supervisors. The Committee is monitoring these developments closely. I should also recognise here that APRA has used stress testing as part of their supervisory framework for many years now – long before it became fashionable.

Conclusion

In conclusion, I hope I have given you a flavour of the Committee’s perspectives and priorities as we embark on the final parts of our post-crisis policy reforms. High-quality capital and robust capital ratios have always been, and will remain, the keystone in the Basel framework. But high-quality capital must be complemented with effective governance and appropriate culture; strong risk management processes and internal controls; and a broad view of risk that encompasses all of a bank’s activities.

Here in Sydney, you have one of the world’s most iconic bridges, which has served the city well for more than 80 years. During the eight years of its construction, between 2,500 and 4,000 workers were employed in various aspects of its building. Since it opened, it has been continuously maintained to keep it safe for the public and to protect it from corrosion. This is the eighth, and we hope the final, year of the construction of Basel III. While it might not appear on as many picture postcards, I hope that Basel III will also serve as a model of safety and soundness for many years to come. Thank you.

How Does Bank Capital Affect the Supply of Mortgages?

The Bank for International Settlements just released a working paper – “How Does Bank Capital Affect the Supply of Mortgages? Evidence from a Randomized Experiment.” Given the intense focus on banks lifting capital ratios, this is an important question.  They conclude that higher bank capital is associated with a higher likelihood of application acceptance and lower offered interest rates, whilst banks with lower capital reject applications by riskier borrowers and offer lower rates to safer ones. In other words, changing capital ratios directly and indirectly impact lending policy, but not necessarily in a linear or expect way.

The recent financial crisis refocused the attention on how the health of banks affects financial stability and macroeconomic growth. In particular, the academic and policy debates currently center on the effects of bank capital on lending and risk-taking. Indeed, both macroprudential and the microprudential regulatory reforms propose to raise bank capital ratios and strengthen bank capital buffers, with the aim of preventing “excessive” lending growth and increasing the system’s resilience to adverse shocks.

Yet, there is only a limited degree of consensus on the effect of higher bank capital on lending. On the one hand, higher bank capital increases both the risk-bearing capacity of banks and incentives to screen and monitor borrowers, in this way boosting lending. On the other hand, as debt creates the right incentives for bankers to collect payments from borrowers, lower debt and higher capital may reduce banks’ lending and liquidity creation.

In this paper we study the effect of bank capital on banks’ propensity to grant mortgages and on their pricing. We also explore how bank capital affects the selection of borrowers and the characteristics of offered mortgages, deriving implications for risk-taking. Finally, to detect possible non-linearities, we provide nonparametric estimates.

We focus on mortgages, whose relevance for both macroeconomics and financial stability has been unquestionable following the 2007-2008 financial crisis. In the first half of the 2000s, a strong increase in mortgage originations fueled a housing boom in several countries (US, UK, Spain, Ireland). That boom in turn led to a high accumulation of risks, which subsequently materialized causing the failure of several banks and a large drop in house prices. Understanding how bank capital affects mortgage originations and the way banks select the risk profiles of borrowers is thus critical to evaluate developments in the mortgage market and the potential accumulation of both idiosyncratic and systemic risks.

We use a new and unique dataset of mortgage applications and contract offers obtained through a randomized experiment. In particular, we post randomized mortgage applications to the major online mortgage broker in Italy (MutuiOn-line) in two dates (October 16, 2014, and January 12, 2015). Upon submitting any application, the online broker requires prospective borrowers to list both their demographic characteristics (income, age, job type) and the main features of the contract requested (amount, duration, rate type). By varying those characteristics, we create profiles of several “typical” borrowers who are submitting distinct applications for first home mortgages. Crucially, through the online broker all participating banks (which include the 10 largest banks in the country accounting for over 70% of the market for mortgage originations) receive the same mortgage applications, defined by the same borrower and loan characteristics. Hence, our estimates are not biased by the endogenous selection of borrowers into contracts or banks and, furthermore, there are no missing data due to discouraged potential borrowers not submitting applications. We then merge those data with the banks’ characteristics from the supervisory reports and, in our empirical analysis, we include several bank-level controls to reduce concerns about omitted variable bias; we exploit the time dimension of our data and we include bank fixed effects to control for unobserved determinants of bank capital in the cross-section; finally, in some specifications, we include bank*time fixed effects, to fully account for all bank specific, time-varying characteristics.

On the one hand, we find that banks with higher capital ratios are more likely to accept mortgage applications and to offer lower APRs. On the other hand, banks with lower capital ratios accept less risky borrowers. However, we cannot rule out that less well-capitalized banks take more risk on other assets (business loans, securities).

We also provide a quantitative estimate of the effect of bank capital ratio on the supply of mortgages, using a nonparametric approach. We find that the capital ratio has a non-linear effect on the probability of acceptance, stronger at low values of the ratio, almost zero for higher values. This non-linearity is more pronounced when the borrower or the contract are riskier.

Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

Basel Committee proposes measures to reduce the variation in credit risk-weighted assets

The Basel Committee on Banking Supervision today released a consultative document entitled Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches.

The consultative document sets out a proposed set of changes to the Basel framework’s advanced internal ratings-based approach and the foundation internal ratings-based approach. The IRB approaches permit banks to use internal models as inputs for determining their regulatory capital requirements for credit risk, subject to certain constraints. The proposed changes to the IRB approaches are a key element of the regulatory reform programme that the Basel Committee has committed to finalise by end-2016.

The proposed changes to the IRB approaches set out in this consultative document include a number of complementary measures that aim to: (i) reduce the complexity of the regulatory framework and improve comparability; and (ii) address excessive variability in the capital requirements for credit risk. Specifically, the Basel Committee proposes to:

  • remove the option to use the IRB approaches for certain exposure categories, such as loans to financial institutions, since – in the Committee’s view – the model inputs required to calculate regulatory capital for such exposures cannot be estimated with sufficient reliability;
  • adopt exposure-level, model-parameter floors to ensure a minimum level of conservatism for portfolios where the IRB approaches remain available; and
  • provide greater specification of parameter estimation practices to reduce variability in risk-weighted assets for portfolios where the IRB approaches remain available.

The Committee has previously consulted on the design of capital floors based on standardised approaches and is still considering the design and calibration. This would complement the proposed constraints discussed in this consultation paper. The final design and calibration of the proposals will be informed by a comprehensive quantitative impact study and by the Committee’s aim to not significantly increase overall capital requirements.

As set out in its work programme and in its reports to G20 leaders, the Committee is today releasing proposed measures to reduce excessive variability in credit risk-weighted assets. With the release of these proposals, the Committee has now consulted on all key elements of its post-crisis regulatory reform programme. Stefan Ingves, Chairman of the Basel Committee on Banking Supervision and Governor of Sveriges Riksbank said “Addressing the issue of excessive variability in risk-weighted assets is fundamental to restoring market confidence in risk-based capital ratios”. He added that “the measures announced today largely retain the use of internal models for the determination of credit risk weighted assets, but with important safeguards that will promote sound levels of capital and comparability across banks”.

The Committee welcomes comments from the public on all aspects of the proposals described in this document by Friday 24 June 2016. All comments will be published on the Bank for International Settlements website unless a respondent specifically requests confidential treatment.