Monitoring of Basel Rules will be Critical

Publication of the latest package of capital requirements – often dubbed Basel IV – has been a long time coming. A year later than expected after a disagreement between European and US regulators over the level of an output floor, banks finally have clarity on the detail of the final framework.

There was little surprise about the output floor compromise – the 72.5% level was widely flagged in the media in advance. It remains to be seen whether this figure will ultimately mitigate the concerns of those European regulators who were worried about a reduction in risk sensitivity in the framework.

An impact study from the European Banking Authority (based on end-2015 data) indicated total Tier 1 minimum required capital would increase by 15.2% for European Union global systemically important banks (G-SIBs) on a weighted average basis. That compares with an average drop of 1.4% for G-SIBs globally, according to figures from the Basel Committee on Banking Supervision. However, that global figure masks a wide variation in impact, meaning there will be winners and losers. The Basel Committee estimates the total capital shortfall for G-SIBs is €85.7 billion.

Fortunately, there’s time to drill down closer into the impact, and to ensure those banks most active as intermediaries aren’t forced to pull back from providing liquidity. The Basel Committee has set out transitional arrangements that will enable the floor to be phased in over five years, and the clock starts counting down in 2022. Implementation of other parts of the framework will also occur in 2022.

This timing is important. Since the crisis, the largest global banks have raised over $1.5 trillion in new common equity Tier 1 capital. Further changes need to be very carefully monitored during the period until implementation to ensure capital levels don’t rise significantly and become out of synch with risks and returns. That would impact the ability of banks to provide financing, investment and risk management services to the real economy. Where anomalies are spotted, regulators must act to adjust the framework to the extent necessary.

This monitoring should also drill down to the business and product level. While a specific change may have a relatively muted effect on overall bank capital, the impact on a particular business can be much more severe. As a result, banks are more likely to pull out those businesses that are deemed uneconomic.

Take the leverage ratio as an example. Banks are required to count customer cash collateral held at central counterparties towards their leverage exposure and to ignore the exposure-reducing effect of initial margin. This has a negligible effect on overall bank capital, but it significantly increases the amount needed to support client clearing activities. Some banks have opted to scale back or withdraw from the client clearing business as a result, which runs counter to the objectives of the Group-of-20 nations to encourage central clearing.

While the Basel Committee has said it will continue to monitor the impact of the leverage ratio on client clearing, it is disappointing that the requirement has been left unchanged in the final package. National regulators and policy-makers such as the US Treasury and the European Commission have recognized this as an issue, and have already proposed alternative treatments. We think it’s important for the calibration to be globally consistent to prevent regulatory fragmentation and an unlevel playing field.

There were some welcome inclusions. There is a commitment to review the calibration of both the standardized and internal model approaches of the Fundamental Review of the Trading Book, and the implementation date is being extended to 2022. This will give regulators and the industry time to further develop new and largely untested elements, like the new eligibility test for trading desks to use internal models and the non-modellable risk factors framework, and to ensure the calibrations are appropriate. The credit valuation adjustment framework has also been recalibrated – although the new requirements should be fully tested before implementation to ensure the rules are proportionate and sensitive to risk.

Over the coming weeks, ISDA will work with members to review the entire text in detail. In the coming year, we will also provide input and impact analysis as national authorities look to transpose the rules into local regulation. ISDA is committed to ensuring we have a capital framework that is both safe and efficient.

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