The BIS published an interesting report on how financial regulation is evolving. In short, significantly more capital will be required as the screws are tightened, or in other words capital rules have been too lax. These changes will have an impact on monetary policy; sometimes limiting credit availability; it will impact asset prices; weaken the relationship between policy rates and real-life interest rates; and make the banks reliance on the central bank stronger. It also provided a good summary of changes proposed under Basel III.
Financial regulation is evolving, as policymakers seek to strengthen the financial system in order to make it more robust and resilient. Changes in the regulatory environment are likely to have an impact on financial system structure and on the behaviour of financial intermediaries that central banks will need to take into account in how they implement monetary policy. Against this background, in February 2014, the Committee on the Global Financial System (CGFS) and Markets Committee (MC) jointly established a Working Group – co-chaired by Ulrich Bindseil (European Central Bank) and William Nelson (Federal Reserve Board) – to assess the combined impact of key new regulations on monetary policy.
The BIS has now released their report which presents the Group’s findings. It is based on information from a range of sources, including central bank case studies as well as structured interviews with private sector market participants. It argues that the likely impacts of the new financial regulations on financial institutions and markets should have only limited and manageable effects on monetary policy operations and transmission. Hence, as necessary, central banks should be able to make adjustments within their existing policy frameworks and in ways that preserve policy effectiveness. These adjustments will tend to differ across jurisdictions according to the financial systems and policy frameworks in place. Specific implications, and examples of potential policy responses, are set out and elaborated in the report.
The report’s findings can be characterised in terms of five distinct sets of implications. In addition, more general effects of the emerging regulatory environment that are independent of specific macroeconomic conditions can be differentiated from those that pertain in the context of the current environment of low policy rates. All of these, and examples of potential policy responses. In brief, they are as follows:
Safer financial systems and their implications for policymaking. The emerging regulatory environment will contribute to enhanced bank resilience, reducing the risk of spillovers from the banking sector to the real economy, and is expected to limit the extent of liquidity and maturity transformation undertaken at banks. Therefore, if the regulations are effective, bank credit will be more stable on average, because credit cycles will be less severe and less frequent. At the same time, at some points of the credit cycle, the supply of bank credit for the non-financial sector will tend to be lower than it would be in the absence of the new regulations (and with everything else unchanged). Thus, to achieve the same economic outcomes, central banks may end up adopting a policy stance that is somewhat more accommodating during some parts of the cycle than would otherwise be the case.
Shifting asset price relationships and their implications for policy targets. As markets adjust to the new regulatory requirements, the equilibrium relationships between financial asset prices and central bank policy rates will shift, adding to the existing uncertainty around these relationships – at least during the transition period. As a result, central banks may need to adjust the settings of their policy instruments to achieve the same stance of monetary policy. A complicating factor is that different regulations, considered in isolation, can have consequences that go in opposite directions. Moreover, the interaction of these regulations could add to the difficulties in predicting their overall impact. As a result, central banks will need to monitor these changes and respond to them as they manifest themselves.
Reduced arbitrage activity and its impact on policy implementation. New regulations, such as the leverage ratio, may disincentivise certain low-margin arbitrage activities, such as banks’ matched repo book business. This reduction would tend to weaken, and make more uncertain, the links between policy rates and other interest rates, weakening the transmission of monetary policy impulses along the yield curve as well as to other asset prices relevant for economic activity. More difficult reserve demand forecasting. For central banks with an operational target of steering a short-term interest rate within a corridor system, if the rate paid on reserve balances is close to the interest rate on other types of high quality liquid assets (HQLA Level 1), small changes in interest rates could result in relatively large swings in reserve demand as banks substitute freely between reserves and these other assets. Additionally, new limits on counterparty concentration may mean that forecasts of the level of reserve balances will depend more strongly than in the past on the distribution of those reserves across counterparties. Similarly, with periodic calculation of regulatory ratios (such as at year- or quarter-ends), window dressing behaviour and associated movements in short-term interest rates are likely to intensify.
More central bank intermediation. Many of the new regulations will increase the tendency of banks to take recourse to the central bank as an intermediary in financial markets – a trend that the central bank can either accommodate or resist. Weakened incentives for arbitrage and greater difficulty of forecasting the level of reserve balances, for example, may lead central banks to decide to interact with a wider set of counterparties or in a wider set of markets. In addition, in a number of instances, the regulations treat transactions with the central bank more favourably than those with private counterparties. For example, Liquidity Coverage Ratio rollover rates on a maturing loan from a central bank, depending on the collateral provided, can be much higher than those for loans from private counterparties.
Effects specific to the current low interest rate environment. In addition to these more general implications, there are a number of effects for monetary policy that are specific to the current environment of low policy rates in the major advanced economies. For example, effects that tend to lower market interest rates relative to policy rates will support monetary policy in jurisdictions at the zero lower bound, but may hinder efforts to normalise the stance of policy. Effects that tend to raise market rates relative to policy rates will have the opposite consequence. Moreover, any temporary reduction of credit supply resulting from the new regulations and their phasing-in may imply the need for additional unconventional measures for central banks operating at the zero lower bound, with the added complication that some unconventional measures may make the new regulations more binding.
The four key regulations identified by the Working Group as being the most likely ones to significantly affect monetary policy implementation:
Liquidity Coverage Ratio. The stated objective of the LCR is to ensure that banks maintain an adequate level of unencumbered, high-quality liquid assets (HQLA) that can be converted into cash to meet their liquidity needs under a 30-day scenario of severe funding stress. It is defined as the ratio of the stock of HQLA (numerator) to net cash outflows expected over the stress period (denominator). The initial minimum requirement of 60%, effective January 2015, will be increased in a stepwise fashion to 100% by 2019. The HQLA definition groups eligible assets into two discrete categories (Level 1 and Level 2). Level 1 assets, which can be included without limit, are those with 0% risk weights for Basel II capital calculations, such as cash, central bank reserves and sovereign debt (which may be subject to haircuts). Level 2 assets, which can make up no more than 40% of the buffer, include assets with low capital risk weights as well as highly rated non-financial corporate and covered bonds, subject to a 15% haircut. (Under certain conditions, supervisors may choose to include additional asset types, termed Level 2B, up to a limit of 15% of the total HQLA stock and carrying haircuts of 25% or higher.) Net cash outflows, in turn, are calculated on the basis of agreed run-off and inflow rates that are applied to different sources of cash out- and inflows (with an aggregate cap of 75% of total cash outflows).
Net Stable Funding Ratio. The aim of the NSFR, which will be introduced as of January 2018, is to (i) limit overreliance on short-term wholesale funding, (ii) encourage better assessment of funding risk across all on-and offbalance sheet items, and (iii) promote funding from stable sources on a structural basis. The NSFR is defined as the ratio of available stable funding (ASF) to required stable funding (RSF), which needs to be equal to at least 100% on an ongoing basis. The numerator is determined by applying ASF factors to a bank’s liability positions, with higher factors assigned for longer maturities (according to pre-defined buckets: less than six months, between six and 12 months, and higher), and more stable funding sources. The denominator reflects the product of RSF factors and the bank’s assets, differentiated according to HQLA/non-HQLA definitions and by counterparty (financial/non-financial). Asset encumbrance generally results in higher RSF factors, especially for longer encumbrance periods (eg assets encumbered for a period of one year or more receive the maximum RSF factor of 100%, while central bank reserves have a factor of 0% (with discretion to apply a higher rate) and other Level 1 assets a factor of 5%). Differentiated RSF factors also apply according to whether assets are secured against Level 1 assets or not.
Leverage ratio. The Basel III minimum leverage ratio is intended to restrict the build-up of leverage in the banking sector, and to backstop the risk-based capital requirements with a simple, non-risk-based measure. Public disclosure of the regulatory LR by banks commenced on 1 January 2015. The final calibration and any further adjustments to the definition will be completed by 2017 with a view to migrating to a binding Pillar 1 requirement on 1 January 2018. The LR is defined as the ratio of Tier 1 capital to total exposures. The denominator consists of the sum of all onbalance sheet exposures, derivative positions, securities financing transactions and off-balance sheet items. As such, the total exposure measure includes central bank reserves and repo positions. Netting of cash legs (ie of receivables and payables) of repo exposures (with the same counterparty) is permitted under certain conditions, but netting across counterparties or of cash positions against collateral is not.
Large exposure limits. The large exposures (LE) framework of the Basel Committee on Banking Supervision (BCBS) is a set of rules for internationally active banks aimed at reducing system-wide contagion risk. It imposes limits on banks’ exposures to single counterparties in order to constrain the maximum loss a bank could face in the event of sudden counterparty failure. The framework is due to be fully implemented on 1 January 2019. Under the LE framework, a bank’s exposure to any single counterparty or group of connected counterparties cannot exceed 25% of the bank’s Tier 1 capital. A tighter limit of 15% is set for exposures between banks that have been designated as globally systemically important. While exposure measurement is aligned with the standardised approach under risk-based capital rules, exposures to sovereigns and central banks, as well as intraday interbankexposures, are exempt from the limit.
Basel III capital regulation includes a number of new elements to boost banks’ capital base. First, it incorporates a significant expansion in risk coverage, which increases risk-weighted assets. Specifically, it targets the instruments and markets that were deemed most problematic during the crisis – that is, trading book exposures, counterparty credit risk and securitised assets. This builds on the earlier approach under Basel II, which introduced differentiated risk weights (which are either internal model-based or set by regulation). A key differentiation from the perspective of monetary policy is that central bank reserves carry a zero risk weight under the risk-weighted standard, whereas the leverage ratio introduces an implied capital charge that is equal for all assets. Riskweighted capital charges also differ according to whether a transaction is secured or unsecured. Second, and critically, Basel III tightens the definition of eligible capital, with a strong focus on common equity. This represents a
move away from complex hybrid capital instruments that proved incapable of absorbing losses in periods of stress. A unique feature of Basel III is the introduction of capital buffers that banks can use without compromising their solvency, and surcharges, which counter individual banks’ contribution to systemic risk.
First, a conservation buffer is designed to help preserve a bank as a going concern by restricting discretionary distributions (such as dividends and bonus payments) when the bank’s capital ratio deteriorates. Second, a countercyclical buffer – capital that accumulates in good times and that can be drawn down in periods of stress – will help protect banks against risks that evolve over the financial cycle. Finally, a capital surcharge will be applied to global systemically important banks (G-SIBs), or banks with large, highly interconnected and complex operations, in order to discourage the concentration of risk. These international standards impose lower bounds on regulators: countries may choose to implement higher standards to address particular risks in their national contexts. Combining these elements will significantly increase banks’ capital requirements.
