Basel III implementation: Progress, pitfalls, and prospects

Keynote speech by Mr Stefan Ingves, Chairman, Basel Committee on Banking Supervision and Governor, Sveriges Riksbank at the High-Level Meeting for the Americas, Lima, Peru, 3-5 November 2014.

As prepared for delivery

Introduction

It is a pleasure to speak to you here today. The Basel Committee attaches great value to these high-level discussions at the regional level. They help deepen the Committee's engagement with regulators and supervisors around the world.

As it happens, the Committee has recently welcomed Chile as an observer member to the Basel Committee meetings. The Basel Consultative Group1 includes representatives from Chile, Peru, the Association of Supervisors of Banks of the Americas, and the Caribbean Group of Banking Supervisors. The engagement with the region thus continues to grow. I sincerely hope for a further strengthening in the relationships we are seeking to build between South American and Latin American banking regulators and the Basel Committee.

In the four decades of the Committee's existence, Latin America's banks and banking regulators have witnessed their fair share of financial and macroeconomic stress. In meeting those challenges, they have provided several important policy and practical lessons for their fellow regulators and supervisors around the world. We all have learnt from them. But the Global Financial Crisis of 2008 - which is still unfolding - has provided a painful reminder that financial sector strains bear close monitoring and that no region can insulate itself from a fragile, uneven global economic recovery and the attendant downside risks.

It is therefore incumbent on each of us to remain cautious and vigilant while keeping in mind our respective socioeconomic imperatives. Collectively, we still face considerable challenges on the macrofinancial front. Sound, resilient, and well regulated and supervised banks will help us deal with the unexpected. I sincerely hope that our dialogue will advance our understanding and provide some practical solutions on matters of banking regulation and supervision.

Today, I want to talk about "implementation" - a term that has gained even more attention as the policy design phase draws to a close. Regulators as well as supervisors are now accountable for the outcomes produced by the raft of new rules.

At the Basel Committee, we have largely completed our post-crisis reform agenda. These include major improvements to the risk-based capital standards; requirements for global and domestic systemically relevant banks; prudential buffers; liquidity risk regulation; a leverage ratio; and new disclosure standards.

Several areas of the Basel framework will remain as work in progress as we review some of its fundamental aspects to enhance the framework's purpose and assure its continued relevance. These include revisions to Pillar 3 disclosures, the securitisation framework, operational risk framework, and the market risk framework. The Committee is also considering whether the substantial national discretions of the Basel framework are still necessary. Of particular interest to several of you will be our ongoing work on revising the standardised approach for credit risk. We expect to publish proposed revisions later this year and we look forward to your feedback during the consultative process.

All these efforts on the policy side aim to strengthen the banking system's resilience, improve market confidence in regulatory ratios and promote a level playing field internationally. But, how will this happen? Regulators should regulate; supervisors should supervise. But who takes responsibility for proper implementation and ensuring the desired or intended outcomes? Times are changing, as are the incentives for effective implementation. The triptych of regulation-implementation-supervision is becoming the way of life for those charged with ensuring banking system stability.

Importance of implementation and progress made

It goes without saying that consistency in implementation is imperative. It ensures a level playing field for banks and supports comparability of regulatory ratios, which are both essential if confidence in banks is to be restored. Yet achieving that consistency is a huge challenge and must be reflective of domestic factors. As a colourful palette of countries with many differences, the Basel Committee's membership spans a great variety of legal systems, accounting regimes, supervisory practices, banking structures and economic conditions.

Consistent implementation of the global standards is key to realising the outcomes intended for international standards and also to supporting effective supervision. Supervision is handicapped by faulty implementation. We need to bring the focus on implementation closer to good supervision. Only then will the full benefits of Basel III be realised.

Writing the Basel III requirements into domestic regulations brings little benefit by itself. Of central importance is the way in which the Basel standards are adopted, applied, enforced, and monitored at the local level. Implementation is a continuum and not a one-off event. To realise the full benefits, implementation requires a rigorous system of monitoring and analysis. To this end, the Basel Committee has initiated the regulatory consistency assessment programme ("RCAP" in short). Initiated in 2012, the programme consists of two distinct but complementary workstreams. The first monitors the timely adoption of Basel III standards and the progress made by banks in improving their capital and liquidity positions. The second assesses the consistency and completeness of the adopted standards, including the significance of any deviations in the regulatory framework. The assessment work is carried out on a jurisdictional as well as on a thematic basis.

Regarding the monitoring work, the Basel Committee regularly issues reports on the adoption status of Basel standards by member jurisdictions and large banks. These reports are publicly available on the Committee's website, creating some peer pressure on members to align their domestic implementation with the agreed timelines. Adding to this incentive, we include numerical scores and colour codes in the reports. Just like a traffic light, "green" acknowledges jurisdictions that have issued final rules and have put them into effect; while "red" indicates that more work needs to be done. These reports are also regularly shared with G20 leaders and the broader public.

The latest monitoring report was issued in October.2 It shows that member jurisdictions are making good progress in the adoption of the Basel III standards. By end-2013, all Committee members had implemented Basel III risk-based capital regulations. As of September 2014, 26 of the 27 Committee members had issued final or draft rules for the liquidity coverage ratio; 23 had issued final or draft rules on the leverage ratio; and 23 had issued final or draft rules on their G-SIB or D-SIB frameworks.

Non-Basel Committee jurisdictions also report substantial progress in adopting Basel III standards. The Financial Stability Institute (FSI) - the co-hosts of this High-Level Meeting - publishes a yearly overview of that progress.3 Among the 109 surveyed jurisdictions, 94 have either implemented Basel II or are in the process of doing so. With respect to Basel III, 89 have implemented the framework or are in the process of doing so. It is good to see that many South American and Latin American countries are participating in the FSI survey and report progress in adopting the Basel standards. Often specific adaptations to local circumstances are made. Being transparent about these local adaptations helps to clarify how the standards are applied, which is important for markets and investors.

The Basel Committee also regularly monitors the progress made by banks as they apply the rules. While a number of banks still need to improve their capital and liquidity positions, the latest numbers suggest that most banks already meet the fully phased-in Basel III minimum requirements. By the end of 2013, the average Common Equity Tier 1 capital ratio of large internationally active banks rose to above 10% and the capital shortfall declined to €15 billion, from €400 billion in 2012. The weighted average Basel III leverage ratio for large internationally active banks was 4.4% and the weighted average liquidity coverage ratio was 119%.

Assessing implementation and addressing pitfalls

Regarding the assessment work, the Committee conducts two types of assessments: (i) jurisdictional assessments and (ii) RWA assessments. The Committee has completed seven jurisdictional assessments, which are a close-up review of the domestic regulations that implement the Basel capital standards. A team of experts reviews the consistency of the local regulations and identifies any deviations from the Basel standards. We also assess the potential impact of any deviations on banks' prudential ratios. At the end of the assessment, the country receives a grade that summarises the view of the assessment team.

By the end of this year, we expect to have completed all assessments for those jurisdictions with global systemically important banks. By 2016 we will have completed all other Basel Committee member jurisdictions. Note, however, that the assessments have thus far focused only on Basel III's risk-based capital standards. The scope of the assessments is expanding and will soon cover the liquidity coverage ratio and SIB requirements from 2015 onwards.

The standard-setting process requires well informed, transparent development of policies followed by a thorough assessment of implementation. This is the first time that the Committee has taken this essential second step, and pointing out inadequacies is never easy. A parallel may be drawn with the early country assessments of the Basel Core Principles (BCP). Today, countries are undergoing a second and, in many instances, a third round of such reviews.4 Many are also opting to publish these assessments. Over time, these assessments have helped improve the quality of supervision, thus helping to mitigate specific banking system risks. Almost all of you present here today have undergone formal BCP assessments.

Similarly, the RCAP assessments are continuing to evolve in scope and purpose. Like a BCP assessment, an RCAP also requires time and thoroughness. The discussions can be intense. But their value cannot be underestimated. Regulation is about details and that means that attention to narrow issues of implementation is vital. Banks and supervisors need to be able to determine how a regulation is meant to be applied and what the prudential expectations are. Governor Daniel Tarullo of the Federal Reserve Board has recently rightly said that what matters is not "mere" compliance but "good" compliance.5

The RCAP's focus on regulatory consistency takes on even greater significance, and this for several reasons. First, the Basel standards are only "soft law", not legally binding. As pointed out recently by Sir Jon Cunliffe - the Bank of England's Deputy Governor for Financial Stability - this soft law is powerful because it is grounded in the recognition that we can only have a globally integrated capital market if we can agree and implement key common minimum standards.6 To ensure consistent implementation a transparent review process is necessary. Members need to be willing to give and receive critical peer reviews, and to act when potential gaps are discovered.

Second, the RCAPs offer a "quality certificate" for members that have been assessed as "compliant". This is good for fostering public trust and confidence. Third, the assessments can generate the needed pressure within the jurisdiction for a full implementation of the Basel rules, counterbalancing pressures from local banks or interest groups.

In sum, the assessments provide discipline and address some of the pitfalls of implementation. For example, the bolthole of wording regulations vaguely is often tempting when there is pressure to assuage certain stakeholders. Another pitfall is to adopt the rules through inappropriate regulatory instruments that have no binding force in practice. Or there is the temptation to hope that deviations from the internationally agreed standards will go unnoticed or remain immaterial in practice. Loosely written standards or regulations will always provide an alluring but specious opportunity to "game" the rules.

So far, the assessments have contributed demonstrably to improved consistency. Over 200 rectifications have been made by member jurisdictions in response to findings raised by the assessment teams. In addition, there is much more transparency about local implementation. We learn from each other, harmonise supervisory practices, including for model validations, and we draw the lessons for better drafting of standards. The assessments also increasingly feature in private sector analyses.

In this context, I would like to remind you that the Basel framework is a minimum standard and members are free to go beyond the minimum. We actually encourage that, and most jurisdictions have adopted minimum requirements that exceed the global standard. Super-equivalences are often found in developing and emerging market economies, where banks have a higher risk profile. The local regulators therefore set higher minimum requirements.

RCAP assessments help to identify areas where jurisdictions are super-equivalent and these areas are also explicitly noted in the assessment reports. So far, no elements of the Basel framework have been identified where all members are super-equivalent. This tentatively suggests there are no Basel capital standards that generally lack conservatism or that are calibrated too weakly in the collective judgment of the implementing authorities.

Another positive side effect of these assessments is their contribution to Basel literacy. The detailed interaction between subject-area experts on the Basel framework is formative. In addition, topics are uncovered that might be subject to differences in interpretation. The Committee now has a process to examine and clarify such issues. The assessments are thus more than a double-edged sword: they train members in the Basel framework, help jurisdictions to bring domestic regulations into line with Basel standards, and spotlight areas that require cleaning up by the Basel Committee.

Assessing risk-weighted assets and reducing variability

Let me turn to the assessments of risk-weighted assets. Through the RCAP programme, the Committee has completed three studies that focus on banks' risk-weighting of banking and trading book assets. These studies have confirmed that material variances exist in banks' regulatory capital ratios arising from factors other than differences in the riskiness of banks' portfolios. These variances undermine confidence in capital ratios.

Supported by its governing body, the Group of Central Bank Governors and Heads of Supervision (GHOS), the Committee is taking steps to reduce the level of observed variation in RWA measurement across banks. The Committee's response thus far has centred on the three areas: policies, disclosure and monitoring. On the policy front, we are developing prudential proposals related to the use of floors and benchmarks; providing additional guidance on those aspects of the Basel framework that are ambiguous or require clarity; and undertaking a more fundamental review of modelling practices. When it comes to disclosure, requirements related to risk weights are being strengthened by amending Pillar 3 of the Basel framework. And, finally, on the monitoring side, we are working to ensure proper implementation by reviewing the outcomes of risk-weighted asset variability through Hypothetical Portfolio Exercises under the Committee's RCAPs.

The policy proposals will be presented in greater detail to the G20 Leaders for their upcoming summit in Brisbane later in November. However, I would like to give you a preview of the key measures that the Committee is taking with regard to standardised approaches.

Standardised approaches are widely used by banks around the world. As I mentioned earlier, later this year we expect to publish a revised Standardised Approach for credit risk. Earlier, we published for consultation a revised Standardised Approach for operational risk; this followed the Committee's earlier consultations on the Standardised Approach for market risk, and the recent finalisation of the Standardised Approach for counterparty credit risk.7 These revisions and ongoing work in this area aim to improve the way all banks calculate risk-weighted assets. Moreover, the greater risk sensitivity embedded in the revised approaches will improve their use as a basis for the implementation of a capital floor.

Regarding the advanced approaches for credit, market and operational risk that are based on banks' models, the Committee is developing specific policy proposals to reduce excessive variability. These will be further detailed in the paper to the G20.

Prospects of implementation

Let me look briefly ahead. The Committee will continue its programme of hypothetical portfolio exercises, and complete the analysis of material asset classes in the banking and trading book. The Committee will also expand the scope of its jurisdictional assessments, including liquidity and SIB standards from 2015 onwards. Further off, assessments of the leverage ratio and the NSFR are envisaged. These efforts will help promote convergence across member states, both in regulations and in practices relating to risk-weighting of assets in the banking and trading books.

Today, implementation is the key challenge for standard setters. The Basel Committee's RCAP programme has already made substantial headway, and the initial results have been very strong. Nevertheless, good implementation has to be a loop: the lessons learned must feed back into better policymaking. For this reason, it is my firm expectation that the implementation agenda will become a core component of the Basel Committee's work. Thank you for your attention.



1 The Basel Consultative Group facilitates broad supervisory dialogue with non-member countries on new Committee initiatives early in the process by gathering senior representatives from various countries, international institutions and regional groups of banking supervisors that are not members of the Committee.

2 See www.bis.org/publ/bcbs290.htm.

3 See www.bis.org/fsi/fsiop2014.htm.

4 The Basel Committee revised the supervisory principles in 2012 (www.bis.org/publ/bcbs230.htm). A third party assessment of supervisory compliance with the full set of Basel Core Principles has thus far been carried out under the joint IMF-World Bank Financial Sector Assessment Program (FSAP).

5 See speech by Governor Daniel K Tarullo at the Federal Reserve Bank of New York Conference, "Reforming Culture and Behavior in the Financial Services Industry", New York, www.federalreserve.gov/newsevents/speech/tarullo20141020a.htm.

6 See speech by Sir Jon Cunliffe at Chatham House, London, "Regulatory reform and returns in banking", 20 October 2014, www.bankofengland.co.uk/publications/Pages/speeches/default.aspx.

7 See Basel Committee for Banking Supervision, Operational risk - Revisions to the simpler approaches, October 2014, www.bis.org/publ/bcbs291.htm; Fundamental review of the trading book - second consultative document, October 2013, www.bis.org/publ/bcbs265.htm; and The standardised approach for measuring counterparty credit risk exposures, March 2014, www.bis.org/publ/bcbs279.htm.