The benefits of being good

Lately, they have not been welcome: higher levels of capital, more onerous leverage and risk measures. When it comes to seasonal gift giving, will the gnomes at the Basel-based Bank for International Settlements, the global regulator, become elves or grinches this year?

" When it comes to seasonal gift giving, will [Basel regulators] become elves or grinches this year?"
Andrew Cornell, BlueNotes managing editor

Over 2016 there has been considerable debate around the ongoing benefits of the regulatory agenda rolled out since the financial crisis of 2008, designed to make the financial system more resilient and protect taxpayers from bank failures.

According to the BIS, the project is on track: In a speech last week, Claudio Borio, head of the BIS’s monetary and economic department, urged global bank regulators to hold strong, dismissing arguments regulation was doing more harm than good by constraining economic activity.

“Finalising the reforms should provide much needed clarity for the sector, helping to dispel any uncertainty that could hold back planning. Not diluting the standards is equally important,” he said.

“It should be recalled, in particular, that even based on very conservative assumptions there appears to be room to raise capital further while generating net benefits for the economy.”

Not everyone agrees.  In US president-elect Donald Trump’s spray of policies is a stream to wind back the American regulatory response to the crisis, the Dodd-Frank Act. And, particularly in Europe, banks have argued higher capital and lower leverage ratios effectively act as a credit squeeze on the real economy because financial institutions can’t lend so much.

The global bank lobby, the Institute of International Finance, has argued specifically against BIS measures on the risk weighting of loans, on the basis the – desirable – shift towards simplicity and comparability has had the unintended consequence of obscuring actual risk.

“Frankly, the industry viewed the original set of Basel Capital reform proposals (on Risk Weight Assets) as highly imbalanced,” IIF chief executive Tim Adams said last week. “Risk sensitivity had been sacrificed for a more pronounced role of simplicity and comparability.”

COMMON GROUND

There is common ground on the regulatory agenda. Everyone, apart from perhaps lawyers and accountants, is keen for the process to be completed and uncertainty removed.

The recent Basel committee-sponsored International Conference of Banking Supervisors in Chile acknowledged that.

“Discussions focused on the adjustments necessary to adapt to the new global regulatory framework, the revised standardised approach for credit risk, and the growing and important role of supervisory stress testing,” the conference communique said.

“The ICBS was held following a meeting of the Basel Committee on Banking Supervision, where very good progress was made towards finalising the Basel III post-crisis reforms. The package of reforms under review includes a revised standardised approach for credit risk, revisions to the internal ratings-based approach, a revised operational risk framework, a leverage ratio surcharge for global systemically-important banks and an aggregate output floor.”

The details of this package are what financial institutions – and national regulators – will wait with trepidation, unsure whether they will be judged naughty or nice.

The challenge – as it has been since the crisis – is recognising financial services are fundamental to healthy economies but very complex eco-systems. Simple answers are usually wrong even if superficially appealing.

Take the US desire to dismantle Dodd-Frank and impose a simple leverage ratio – total assets (un-risk weighted) to total debt. Sounds straightforward.

But as US Federal Reserve Governor Daniel Tarullo pointed out on the weekend, such a step is short sighted. He warned adopting such a plan would push banks into riskier assets – which would then lead to a stricter leverage ratio which could see financial intermediation become unprofitable.

“The imposition of, say, a 10 per cent leverage ratio on the current balance sheets of large banks would yield a very well-capitalised set of banks. But one needs to look at the dynamic effects of such a requirement," Tarullo said.

"We should remember that it was because of the limitations of a stand-alone leverage ratio that risk-based capital requirements were introduced in the 1980s."

Tarullo outlined some of the balancing acts required, noting capital levels alone don’t make banks or financial systems safe. Consideration also needs to be given to liquidity and stable sources of funds.

The ratings agency Standard & Poor’s drew attention to other paradoxes. In a recent report Most Banks Don’t Need More Capital But The Flexibility To Use It In Times Of Stress, the firm concluded:

• Regulators have been successful in pushing banking systems to build much stronger capital bases than before the 2007 financial crisis.

• Banks' limited capacity to use their enhanced capital bases without breaching much stricter minimum regulatory requirements undermines the benefits of having a stronger capital base.

• As a result, we believe that banks' pro-cyclical behaviours and exposure to confidence shocks might not have improved as significantly as could have been expected.

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SIMPLE

The answer to these challenges is not simple, it requires judgement as well as rules. Clearly not all loans carry the same risk, hence the IIF is right to point to the benefits of using risk weighting for assets (RWA). However, under current modelling nearly half banking system assets in Europe attract a zero weighting – which is clearly ridiculous.

Healthy banks are essential for a functioning economy but returns can’t be excessive or under-written by taxpayers as they were before the crisis. Trump’s Treasury Secretary nominee Steven Mnuchin, an ex investment banker, was guilty of oversimplification when he claimed lending to business was being restricted by complicated regulation. 

Yes, certainty around the regulatory timetable, particularly in relation to capital requirements – quantum and quality – and leverage would be a very welcome end of year gift.

But not if it comes with the sort of bluntness that undoes international consistency – which leads to regulatory arbitrage – or naivety around risk – of which standardised measures are too frequently guilty.

On that front, the Basel gnomes seem quite pragmatic – sophisticated internal models of risk will be allowed but with a floor and limits.

Basel Committee chairman Stefan Ingves said there would be modifications to the regime – now popularly known as ‘Basel IV’ - to reduce the variability in risk-weighted assets.

“Capital requirements may go down for some banks and go up for others,” he said. “At the global, aggregate level, the impact is not significant, but it may well be significant for some banks.”

It was interesting to see reports of a speech by Minouche Shafik, deputy governor of the Bank of England, suggest he was arguing regulation and conduct fines had cut banks' lending capacity to the tune of over $US5 trillion.

In fact, Shafik was outlining the BoE’s approach to improving standards in the industry and blamed the high fines, and resulting costs to the economy, on "the wave of misconduct which has emerged in the aftermath of the financial crisis".

Cures can be worse than the disease but often it’s easy to blame the cure.

Andrew Cornell is managing editor at BlueNotes