Strengthening the resilience of the banking sector

The Basel Committee on Banking Supervision has issued for consultation a package of proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector.

The Committee welcomes comments on all aspects of this consultative document by 16 April 2010. Comments should be submitted by post (Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, CH-4002 Basel, Switzerland) or email (baselcommittee@bis.org). All comments will be published on the Bank for International Settlements' website unless a commenter specifically requests anonymity.

Executive summary: Overview of the Basel Committee's reform programme and the market failures it addresses

This consultative document presents the Basel Committee's proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.

The proposals set out in this paper are a key element of the Committee's comprehensive reform package to address the lessons of the crisis. Through its reform package, the Committee also aims to improve risk management and governance as well as strengthen banks' transparency and disclosures. Moreover, the reform package includes the Committee's efforts to strengthen the resolution of systemically significant cross-border banks. The Committee's reforms are part of the global initiatives to strengthen the financial regulatory system that have been endorsed by the Financial Stability Board (FSB) and the G20 Leaders.

A strong and resilient banking system is the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors. Moreover, banks provide critical services to consumers, small and medium-sized enterprises, large corporate firms and governments who rely on them to conduct their daily business, both at a domestic and international level.

One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing the taxpayer to large losses.

The effect on banks, financial systems and economies at the epicentre of the crisis was immediate. However, the crisis also spread to a wider circle of countries around the globe. For these countries the transmission channels were less direct, resulting from a severe contraction in global liquidity, cross border credit availability and demand for exports. Given the scope and speed with which the current and previous crises have been transmitted around the globe, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks.

To address the market failures revealed by the crisis, the Committee is introducing a number of fundamental reforms to the international regulatory framework. The reforms strengthen bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress. The reforms also have a macroprudential focus, addressing system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time. Clearly these two micro and macroprudential approaches to supervision are interrelated, as greater resilience at the individual bank level reduces the risk of system wide shocks.

Building on the agreements reached at the 6 September 2009 meeting of the Basel Committee's governing body, the key elements of the proposals the Committee is issuing for consultation are the following:

• First, the quality, consistency, and transparency of the capital base will be raised. This will ensure that large, internationally active banks are in a better position to absorb losses on both a going concern and gone concern basis. For example, under the current Basel Committee standard, banks could hold as little as 2% common equity to risk-based assets, before the application of key regulatory adjustments.
• Second, the risk coverage of the capital framework will be strengthened. In addition to the trading book and securitisation reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos, and securities financing activities. These enhancements will strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the next through the derivatives and financing channel. The strengthened counterparty capital requirements also will increase incentives to move OTC derivative exposures to central counterparties and exchanges.
• Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. This will help contain the build up of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk based requirements, and help address model risk. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting. The ratio will be calibrated so that it serves as a credible supplementary measure to the riskbased requirements, taking into account the forthcoming changes to the Basel II framework.
• Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress. A countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks. In addition, the Committee is promoting more forward looking provisioning based on expected losses, which captures actual losses more transparently and is also less procyclical than the current "incurred loss" provisioning model.
• Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. The framework also includes a common set of monitoring metrics to assist supervisors in identifying  and analysing liquidity risk trends at both the bank and system wide level. These standards and monitoring metrics complement the Committee's Principles for Sound Liquidity Risk Management and Supervision issued in September 2008.

The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

Market pressure has already forced the banking system to raise the level and quality of the capital and liquidity base. The proposed changes will ensure that these gains are maintained over the long run, resulting in a banking sector that is less leveraged, less procyclical and more resilient to system wide stress.

As announced in the 7 September 2009 press release, the Committee is initiating a comprehensive impact assessment of the capital and liquidity standards proposed in this consultative document. The impact assessment will be carried out in the first half of 2010. On the basis of this assessment, the Committee will then review the regulatory minimum level of capital in the second half of 2010, taking into account the reforms proposed in this document to arrive at an appropriately calibrated total level and quality of capital. The calibration will  consider all the elements of the Committee's reform package and will not be conducted on a piecemeal basis. The fully calibrated set of standards will be developed by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured, with the aim of implementation by end-2012. Within this context, the Committee also will consider appropriate transition and grandfathering arrangements. Taken together, these measures will promote a better balance between financial innovation, economic efficiency, and sustainable growth over the long run.