Basel III and Financial Stability

Speech by Stefan Walter, Secretary General, Basel Committee on Banking Supervision, at the 5th Biennial Conference on Risk Management and Supervision, Financial Stability Institute, Bank for International Settlements, Basel, 3-4 November 2010.

I would like to welcome all of you to Basel. I would also like to thank Josef, Roland and the Financial Stability Institute for the opportunity to present to you the work of the Basel Committee. Basel is most known for three things: its pharmaceutical industry, its Fasnacht (or carnival), and the Capital Accords named after this city. Today, I would like to discuss the key elements of the Basel III framework, and how it promotes broader financial stability.

There is a wide body of evidence that banking crises are associated with much deeper economic and financial downturns. The reason is obvious: banks are at the centre of the credit intermediation process, both directly and indirectly through their role as lenders, market makers, providers of backstop liquidity, and payment services.

Moreover, banking crises have been much more frequent than we would like, occurring on average about every 20 to 25 years in both industrial and emerging market countries. That is an annual probability of about 4-5%, which is simply unacceptable.

There are many factors that led to the build up of the crisis. At the top of the list is excess liquidity, resulting in too much credit and weak underwriting standards. The vulnerability of the banking sector to this build up of risk in the system was primarily due to excess leverage, too little capital of insufficient quality, and inadequate liquidity buffers. For example, the amount of tangible common equity of many banks, when measured against risk weighted assets, was as low as 1-3% before the crisis. That's risk based leverage of between 33 to 1 and 100 to 1.

The crisis was exacerbated by a procyclical deleveraging process and the interconnectedness of systemically important, too-big-to fail financial institutions. Finally, there were major shortcomings around risk management, corporate governance, market transparency, and the quality of supervision. When it comes to both risk management and supervision, there was too much of a firm-specific focus and an insufficient understanding of how broader system-wide risks could play out under stress.

The Basel Committee reforms address these weaknesses through both micro prudential and macro prudential measures. Clearly, micro and macro prudential reforms are closely related, as greater resilience at the individual bank level reduces the risk of system wide shocks. 

Let me begin with the micro, institution-specific reforms and how they promote greater financial system resilience.

First, we have substantially raised the quality of capital, especially a much greater focus on common equity to absorb losses. Credit and market value losses come directly out of retained earnings and therefore common equity. During the crisis, it was the tangible common equity ratio that market participants focused on to assess bank resilience. This is also the reason why regulatory deductions are taken from this common equity component of capital. We also have fully harmonised all aspects of the definition of capital and these must be fully disclosed in the financial statements.

Second, we have substantially improved the coverage of the risks, especially related to capital markets activities. Trading book exposures will be subject to a stressed value at risk requirement. Banks must hold appropriate capital for less liquid, credit sensitive assets with much longer holding periods. Securitisation exposures will be subject to capital charges more consistent with those for the banking book. These measures will become effective at the end of next year and result in about a 4-fold increase in  trading book capital requirements. We also are strengthening the capital requirements for counterparty credit risk by requiring that these exposures be measured using stressed inputs. Banks also must hold capital for mark-to-market losses associated with the deterioration of a counterparty's credit quality. The monoline insurers were a prime example of this type of exposure building up.  Finally, the higher capital requirements for OTC activities will increase incentives to use central counterparties and exchanges. However, we also are working to ensure that these are appropriately managed and capitalised, so that we do not create a new concentrations of systemic risk.

Third, we are requiring much higher levels of capital to absorb the types of losses associated with crises like the previous one. This includes an increase in the minimum common equity requirement from 2% to 4.5% and a capital conservation buffer of 2.5%, bringing the total common equity requirement to 7%. If one also factors in the tougher definition of capital and the better risk coverage, we are talking about around a seven-fold increase in the common equity requirement.

Fourth, we have introduced a global liquidity standard to supplement the capital regulation. While capital is a necessary condition for bank resilience, it of course is not sufficient. Northern Rock had one of the highest capital ratios in the UK when it failed. There were extremely high levels of liquidity across asset markets, even in the first half of 2007. Liquidity risk was not priced into many banking activities or even considered to be a key risk at the system level. That of course all changed and the public sector had to step in to provide massive liquidity support to financial institutions and markets, producing major distortions and costs. We therefore will require banks to be able to withstand a 30 day system-wide liquidity shock as well as maintain a more robust structural liquidity profile. No doubt, this will raise the cost of funding in normal times and have an impact on business models. Banks will have to do more to self ensure against periods of stressed liquidity, just as they need to hold capital to absorb unexpected losses. Going forward, liquidity should not be viewed as a free good and therefore needs to be priced appropriately.

And finally, we are introducing stronger supervision, risk management and disclosure standards. The Committee has strengthened the Pillar 2 supervisory review process of the Basel capital framework, including in the areas of corporate governance, risk appetite, risk aggregation, and stress testing. We also have increased Pillar 3 transparency requirements for more complex capital markets activities.

Let me now turn to the macro prudential elements of the package. These are critical if we are to create a system that does justice to the shortcomings revealed by the crisis.

First, there is the introduction of a leverage ratio. As I said, the lines between micro and macro reforms are blurry. The leverage ratio has the role of helping to contain the compression of the risk based requirement. A recent study of the Basel Committee's Top-down Capital Calibration Group showed that the leverage ratio did the best job in discriminating between banks that ultimately required official sector support and those that did not. The only risk based ratio that performed well was tangible common equity to risk-based assets, which is precisely the measure we are now emphasising.  However, the leverage ratio also has a macro prudential role. It prevents the build up of excess leverage in good times and thus reduces the deleveraging dynamic in periods of stress. In addition, the leverage ratio protects the system against unintended consequences of the risk weighting regime. Many asset classes may appear to be low risk when seen from a firm specific perspective. But we have seen that the system-wide build up of seemingly low risk exposures can pose substantial threats to broader financial stability. Before the recent crisis, the list of apparently low risk assets included highly rated sovereigns, AAA structured products, collateralised repo and derivative exposures, to name just a few. The leverage ratio will help ensure that we do not lose sight of the fact that there are broader system wide risks that need to be underpinned by capital. Having said all this, we will cautiously phase in the leverage ratio, making sure we understand its interaction with the risk-based requirement over the cycle, and how it affects different business models.

Second, we have introduced measures to raise capital levels in good times so that they can be drawn down in periods of stress to reduce procyclicality. If a bank's capital falls below the 2.5% conservation buffer, supervisors will constrain distributions and bonuses, addressing the collective action problem that prevailed before the crisis, namely market pressure to keep paying out dividends. This will ensure that capital is conserved in a downturn and rebuilt during the upswing. In addition, we have introduced a countercyclical capital buffer to protect the system against excess credit growth. We have seen over and over again that the most severe crises are preceded by credit bubbles. When these bubbles burst, the banking sector is the first casualty. While we may not always be able to prevent such bubbles, we can at least make banks more resilient to the inevitable fall-out. 

Third, globally systemic banks will be required to have additional loss absorbency capacity beyond the Basel III requirements. As the Committee's Cross-Border Resolution Group observed, "there is no international insolvency framework for financial firms and a limited prospect of one being created in the near future." Thus, if we cannot fully eliminate the impact of problems at a global bank, we must do more to reduce the probability. The Basel Committee, in cooperation with the Financial Stability Board, is developing a methodology comprising both quantitative and qualitative indicators to assess the systemic importance of global financial institutions. It also is assessing the magnitude of loss absorbency that global systemic banks should have. Finally, we expect that this additional loss absorbing capacity will be met through some combination of common equity, contingent capital and bail-in debt. The Basel III reforms, as I mentioned before, also substantially raise capital and liquidity requirements for trading, derivatives and funding activities most associated with systemic risk and interconnectedness.

Higher levels of capital, combined with a global liquidity framework, will significantly reduce the probability and severity of banking crises in the future. This protects financial stability and economic growth, and reduces the exposure of the public sector and tax payers. For example, our studies suggest that an increase in the banking sector's common equity ratio from 7% to 8% reduces the annual probability of a banking crisis by at least one percentage point. A one percentage point reduction in the probability of a crisis in turn produces an expected annual output benefit of between 0.2% and 0.6%. These are admittedly rough estimates but it is clear that there are substantial economic benefits associated with a better capitalised banking sector.

Moreover, the introduction of the new standards is expected to have only a modest impact on economic growth over the transition period. Our Macroeconomic Assessment Group estimated that if higher requirements are phased in over four years, the level of GDP would decline by about 0.2% for each percentage point increase in a bank's actual common equity capital ratio once the new rules are in place. This estimate does not assume credit rationing, as the rules are to be phased in over a transition period. The estimate is conservative in that it assumes that banks fully pass on the higher cost of capital, and that they make no changes to their portfolio composition or their efficiency, and that ROEs are fully maintained. 

The standards will be increased gradually between now and 2018. The transition period ensures the higher standards can be achieved through earnings retention, de-risking of certain capital markets exposures and appropriate capital raising. Banks that are close to meeting the new standards should move more quickly while maintaining sound credit and lending activities. Those that have a longer way to go can use the full transition period.

Standards where we have less experience, such as the liquidity and leverage ratios, will be phased in gradually. This will enable us to address any unintended consequences.

Looking to the future, I would like to emphasise the following initiatives that will be particularly important for banking system resilience in the face of continued financial innovation.

We need to continue our efforts to ensure banks capture all the risks in a prudent manner. With a tougher definition and level of capital, there will be pressure for banks to understate their risk-weighted assets. The leverage ratio will help contain some of this behaviour. We also are conducting a fundamental review of the market risk framework rules to address arbitrage between the banking book and trading book. Moreover, we will be taking a very close look at how banks arrive at their measures of exposure, how they go about risk-weighting their assets, and how they engage in risk mitigation activities. The focus should be on building sound business models underpinned by adequate capital and liquidity, not on making capital arbitrage the business model. Those banks that refrained from these activities before the crisis, ensuring that they actually had strong capital and liquidity, and not just the appearance thereof, are the ones now reaping the benefits at the expense of their weakened competitors.

We are also working to reduce the reliance on external ratings in the regulatory capital framework. This includes addressing cliff effects from ratings downgrades, reviewing the treatment of securitisations, and strengthening independent due diligence standards.  

However, it is not enough to develop new regulations and standards. We also must put in place stronger mechanisms to ensure that our regulations and standards are fully implemented. In particular, we have established the Standards Implementation Group which will conduct follow up and thematic peer reviews. All member countries need to fully implement all aspects of Basel II and III. We also will be following up to review implementation by banks and supervisors in areas like stress testing and sound liquidity risk management.  

Finally, we will monitor financial developments and risks and update our standards on a more regular basis. We need to be particularly vigilant about shifts in the perimeter of regulation and the growth of bank-like activities in the shadow banking sector. In particular, these includes activities which combine leverage, maturity transformation, and a call on liquidity. This is one of the key lessons of the crisis and we must do a much better job ensuring that we understand these system-wide developments and that regulation keeps up. Systemic risk boards will play an important role in this respect, both nationally and internationally. 

Let me conclude, Basel III represents a fundamental shift in how we will be conducting banking regulation and supervision in the future. It fixes many of the shortcomings of micro-level supervision. But it also incorporates the broader system wide lessons and introduces a macro-prudential overlay to the regulatory framework. Taken together, these measures should make the system more stable over the long run, thus raising economic growth over the cycle.