Basel III: Satisfying regulatory objectives?

1. Basel III: Satisfying regulatory objectives? Kern Alexander Professor of Law and Finance, University of Zurich & Special Adviser to the European Parliament on Financial Services Department of Economics, University of Warwick 25 January 2011

2. Main points • The economic v legal concept of bank capital • Does Basel III excessively focus on micro-prudential risks? • How does Basel III affect Pillar 2 assessment of risk management? • How to enhance Basel III’s macro-prudential focus?

3. Lessons from the crisis • Institutions and market structures • Market-based models of measuring risk provide inadequate safeguards against systemic risk. Power of financial contagion in integrated financial markets • Policy analysis • Market-based regulatory models do not adequately incentivise banks to monitor and control systemic risks

4. Financial Supervision and Crisis Management in the EU (2007) Financial markets have moved increasingly away from bank-based to capital market-based models of finance (facilitated by structured finance & securitisation). Originate rate and relocate model (ORR) of securitised debt finance led to increased complexity and higher leverage for the financial system. Financial regulation generally failed to address the changing nature of systemic risk in wholesale capital markets and market-based regulatory models increased pro-cyclicality. Basel II’s reliance on model-based approaches to measuring risk will lead to under-capitalised banks which are more vulnerable to systemic shocks. Systemic risk is global in reach and cannot be regulated efficiently at the national level – the externality is cross-border and therefore law and regulation must be cross-border in its application and more durably linked to national supervisory authorities and their practices. K. Alexander, J. Eatwell, A. Persaud & R. Reoch (2007) ‘Financial Supervision and Crisis Management in the EU’ (Brussels) http://www-cfap.jbs.cam.ac.uk/publications/downloads/financial_supervision_and_crisis_management_in_the_eu.pdf 4

5. Capital adequacy – economic theory • Economic capital. ‘the methods or practices that allow banks to consistently assess risk and attribute capital to cover the economic effects of risk-taking activities.’ Bank for International settlements 2009. Economic capital derived from banks’ models & data. • Regulatory capital. Should be calculated mainly as a charge (not a ‘reserve’ or buffer) on bank risk-taking. A second (or third)-best approach atapproximating the social costs of bank risk-taking; aims to reduce the negative externality; not merely to absorb losses to pay creditor claims

6. The role of regulatory capital ‘The Basel Committee . . . promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers’ Alan Greenspan, FT, 26 March 2009

7. Recent history - 1988 Basel Accord • A common capital adequacy standard • Defines capital as equity and subordinated debt • Defined a measure of credit risk called risk-weighted assets (RWAs) • Banks required to operate with minimum ratio of capital to RWAs of 8%

8. LIABILITIES ASSETS 8%

9. Basel II 3 Pillars • Rules should be more ‘risk-sensitive’ and regulatory capital should approximate economic capital • Less regulation, more supervision • ‘disclosure as an aid to market discipline’

10. Basel II – general critique before crisis • Pro-cyclical • Supervisory discretion – regulatory capture • Inadequate capital for trading book • Focuses on individual bank’s risk, not aggregate risk for financial system • Capital formulae too prescriptive & complex See Alexander, Dhumale and Eatwell (2005), Global Governance of Financial Systems http://ukcatalogue.oup.com/p2p/endecaSearch.do

11. Basel III 11 11 • Amendments to Basel II (Basel III) • Tighter definition of tier 1 capital (common equity) and increased to 7% • Less reliance on bank models, but bank models remain the basis for regulatory capital determination • Limits on maturity mismatches in wholesale funding (NSFR, 2019) • Liquidity coverage ratios (LCRs, 2018) – buffers focus more on ‘loss absorbency’ Not yet finalized • Counter-cyclical capital ‘buffer’ (up to 2.5%) – guidance for supervisors: ‘protecting banking sector from periods of excess aggregate credit growth’ • Capital surcharge for systemically-important financial institutions (SIFIs) • Contingent convertible capital instruments (Cocos) • Does Basel III achieve macro-prudentialaims of regulatoryreform?

12. U.S. and European Bank Tier 1 capital & leverage ratiosat 3Q09. Source: Company reports, SNL, CreditSights

13. IMF Estimate of Bank Capital Needs. Source: IMF staff estimates

14. Basel III on Liquidity Risk (2016 and beyond) • Liquidity coverage ratio – measures the ability of a bank to meet all its required cash outflows during an acute funding stress lasting a month. Liquid assets = cash and unencumbered government securities. • Net stable funding ratio – measures the “stickiness” of funding sources; funding that isn’t prone to flight in a crisis. Fed funds, commercial paper, and repo are not considered stable funding sources. • Stable funding = retail deposits, long-term debt, and equity capital. • US banks are not compliant with either the liquidity coverage or net stable funding ratios. Estimates of either gap depend on a number of key assumptions regarding the timing of any adjustment, as well as future bank asset (and liability) composition and growth.

15. Barclay’s Estimates of Impact on US Banks • To meet their liquidity coverage ratio, US banks would need increase their liquid holdings by about $900bn • Purchase US Treasuries • Hold cash at the Federal Reserve • Reduce the amount of debt/obligations that mature within 1m –repo, commercial paper, and fed funds • To meet stable funding ratio requirement, US banks would need to alter the composition of their liabilities and liabilities to close current gap in stable funding of $1.7trn • Raise retail deposits • Reduce reliance on repo, commercial paper, and fed funds (wholesale funding still accounts for more than 20% of large bank liabilities) • Alter the composition of their assets • Securities holdings require lower net stable funding than loans • Required funding for Treasuries, agencies, and MBS = 5-20% • Long-term loans = 100% • Unused commitments = 10%

16. Nevertheless, Basel III has inadequate macro-prudential focus almost exclusively micro-prudential in its focus: Focusing on solvency of individual banks, rather than on the resilience of the financial system Text uses phrase such as ‘loss absorbency’ of bank capital: treats capital as a ‘buffer’ not a ‘charge’ Treating bank capital as a buffer ignores the ‘liability-side of the balance sheet’ (ie., unstable short-term funding and forex exposures), and excess asset growth in the boom period

17. Enhancing Basel III’s macro-prudential role – how to control credit booms Assessing vulnerabilities • Monitor ratio of total credit to GDP • Ratio of non-core to core liabilities in the banking sector Core: retail deposits & equity; Non-core: wholesale deposits, bonds, securitization and forex borrowing & repos) • Ratio of financial liabilities (repos & financial commercial paper) to monetary aggregates – (M2) Macro-prudential role of monetary aggregates should focus on the behaviour and stability properties of these measures

18. Enhanced regulatory capital and liquidity ratios are not enough Perhaps a more holistic regulatory approach is needed: • most stringent and enhanced capital levels • Liquidity requirements (ie., leverage ratios), • Counter-cyclical capital and/or dynamic provisioning, But also enhanced macro-prudential tools needed • Address credits booms: loan to value ratios (LTVs) and loan to income ratios (strictly enforced) • Bank liabilities should consist mainly of retail deposits, followed by equity, with smaller % from securitised finance & repos • Leverage caps – linking asset growth to equity growth (Morris & Shin 2008) (bank capital should be a constraint on balance sheet growth) • Financial stability tax on bank’s non-core liabilities (IMF 2010 FSC proposal, a balance sheet tax)

19. How will Basel III affect robust Pillar 2 implementation? • Regulators now focus on risk management and corporate governance • Institutions that fail to demonstrate this can be subject to discretionary Pillar 2 capital charges • Regulators should anticipate financial innovation and demand robust tests to support lower capital charges for new instruments • Will supervisors be using an adequate macro-prudential approach for robust Pillar 2 assessment? • Basel II should require a more robust ‘structural approach’ to risk management (ie., stress testing)

20. A structural approach to risk management • Financial crises occur because market underestimate the risk beforehand. Using models based on market estimates will do more harm than good. • Models should be linked to both internal risk measures for the firm (prices & past volatilities) but also to external factors such as the behaviour of other banks and investors. • Structural view of risk, rather than statistical view. • Concentration risks. To monitor, use common stress tests across all banks at once (Alexander, Eatwell, Persaud & Reoch, 2010)

21. Basel III and risk management  Enhanced Pillar 2 assessment should involve (1) more robust stress testing – a structural approach, (2) risk management committee at board level, (3) diversity of risk management approaches (no one size fits all), and (4) enhanced host country testing of risk models – the role of the colleges 21

22. Implications for European Systemic Risk Board • ESRB monitoring macro-prudential risk and issuing recommendations and warnings • How to monitor for excessive credit booms – what is ‘excessive’? ratio of total credit to GDP, but also focus on liabilities ratio of non-core to core liabilities of banks (to determine stage of cycle) ratio of financial liabilities of banks to monetary aggregates (‘M2’) (to identify vulnerabilities) recommend macro-prudential policy tools • Also,ESAs – harmonised rulebook and technical guidance standards for CRD implementation – possibility for ‘gold-plating’ above Basel III?

23. Conclusions • Financial crisis demonstrates inadequacy of bank risk models and market-based regulatory models • What is the main objective of regulatory capital: is it a charge? Or a buffer? • Does Basel III have an adequate macro-prudential focus? • Risk management models will need to incorporate macro-prudential components – structural approach to risk management • The challenge for the EU/ESRB

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