“Basel IV” – turning our backs on a risk-weighted paradigm · Some Studies of Economics...
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Some Studies of Economics Changes, ISBN 978-80-89691-27-2 152 “Basel IV” – turning our backs on a risk-weighted paradigm Sven Hansen DZ BANK, Frankfurt am Main, Germany Slovenskej poľnohospodárskej univerzity v Nitre, Nitre, Slovakia [email protected] Abstract. The term Basel IV is not an official label, but the sum total of recommendations, discussion and consultation papers by various institutions involved in banking supervision (Basel Committee of Banking Supervision, European Banking Authority, etc.) is tantamount to an amendment to the regulations to date that are summarized under Basel III. Even if most of the regulations in Basel III have not yet been implemented, Basel IV involves a further tightening of European banking law. All the activities are evidence of an over-arching goal. The intention is to strike a better balance between risk sensitivity, straightforward standards and comparability of information. Thus, in many countries the regulations for banks already exceed the requirements given in Basel III. The essence of all these stipulations is to attach greater importance to the capital regulations that are not risk- weighted. This constitutes a turn around on the watchdogs’ previous focus on risk. The prior intention of strengthening internal bank risk management processes has also given way to a strict adherence of a non-risk-oriented leverage ratio (LR). Keywords: Basel IV, institutions, banking Simplicity - Leverage ratio Individual EMU member states are already planning to go beyond the Basel III requirement of a three-percent ceiling for the LR (Basel Committee of Banking Supervision, 2014 LR, page 1). This highest debt ratio - ratio of a bank’s equity capital to its non-risk-weighted assets - of well over three percent would thus amount basically to a “front stop” solution for capital requirements as per Pillar I and no longer accord with the “back-stop” role it was originally intended to have. While in Germany the introduction of the LR is still a matter of controversy, in the United States some public authorities are already advocating a five-percent limit for systemically important banks and six percent for retail banks (Federal Reserve Board, 2013). 1 For large Swiss banks there will be a LR about four point three- percent (Swiss National Bank, 2013:20). In its guideline on the leverage ratio the Basel Committee proposes that during a “parallel phase” - 2013 to 2017 - the three-percent limit be “tested” and during this time the effect of different capital volumes be established. Over and above this, several supervisory bodies have already advocated a stronger weighting of the LR. The reasons for this are above all that unforeseeable risks and financial market uncertainty can better be managed using simple and comparable rules than by trying 1 A critical appraisal in: PwC Financial Services, 2013, page 7.
Transcript of “Basel IV” – turning our backs on a risk-weighted paradigm · Some Studies of Economics...
Some Studies of Economics Changes, ISBN 978-80-89691-27-2
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“Basel IV” – turning our backs on a risk-weighted paradigm Sven Hansen
DZ BANK, Frankfurt am Main, Germany Slovenskej poľnohospodárskej univerzity v Nitre, Nitre, Slovakia
Abstract. The term Basel IV is not an official label, but the sum total of
recommendations, discussion and consultation papers by various institutions involved in banking supervision (Basel Committee of Banking Supervision, European
Banking Authority, etc.) is tantamount to an amendment to the regulations to date that are summarized under Basel III. Even if most of the regulations in Basel III have
not yet been implemented, Basel IV involves a further tightening of European banking law. All the activities are evidence of an over-arching goal. The intention is to
strike a better balance between risk sensitivity, straightforward standards and comparability of information. Thus, in many countries the regulations for banks already exceed the requirements given in Basel III. The essence of all these
stipulations is to attach greater importance to the capital regulations that are not risk-weighted. This constitutes a turn around on the watchdogs’ previous focus on risk. The prior intention of strengthening internal bank risk management processes has
also given way to a strict adherence of a non-risk-oriented leverage ratio (LR).
Keywords: Basel IV, institutions, banking
Simplicity - Leverage ratio Individual EMU member states are already planning to go beyond the Basel III requirement of a three-percent ceiling for the LR (Basel Committee of Banking Supervision, 2014 LR, page 1). This highest debt ratio - ratio of a bank’s equity capital to its non-risk-weighted assets - of well over three percent would thus amount basically to a “front stop” solution for capital requirements as per Pillar I and no longer accord with the “back-stop” role it was originally intended to have. While in Germany the introduction of the LR is still a matter of controversy, in the United States some public authorities are already advocating a five-percent limit for systemically important banks and six percent for retail banks (Federal Reserve Board, 2013).1 For large Swiss banks there will be a LR about four point three-percent (Swiss National Bank, 2013:20).
In its guideline on the leverage ratio the Basel Committee proposes that during a “parallel phase” - 2013 to 2017 - the three-percent limit be “tested” and during this time the effect of different capital volumes be established. Over and above this, several supervisory bodies have already advocated a stronger weighting of the LR. The reasons for this are above all that unforeseeable risks and financial market uncertainty can better be managed using simple and comparable rules than by trying
1 A critical appraisal in: PwC Financial Services, 2013, page 7.
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to apply probability-based statistical models. Indeed, the financial crisis provided empirical evidence that simple rules, such as precisely the LR, can better predict which banks are likely to get into difficulties.
However, precisely this turn away from risk-based approaches is not without dangers. Banks could try exclusively to take on receivables with a higher risk or to expand business with higher-risk client groups. The costs of portfolios with lower risk would become far higher. Assets with little risk would become less appealing for banks and therefore mortgage loans or loans to public bodies might be burdened down with a higher credit costs. Precisely such financing provided stability during the financial crisis. The problem of cross-border comparability is also not solved by different accounting standards (PwC Financial Services, 2014:5).
Specifically non-consideration of internal models and loan collateral to measure risk denies that banks’ core competence is managing risk by the transformation of maturities and interest, and also negates the advantages of higher risk sensitivity. Thus, all the achievements of risk evaluation are ignored and there is absolutely no consideration of diversification through a portfolio approach. Furthermore, the efforts to conduct internal risk assessments would be cut back and the possible dependence on outside parameters - ratings - could rise. This in turn is at loggerheads with the express intention of the G20 heads of state and government, who stated that they wished in future to initiate measures to counteract any over-great reliance on external ratings.
Simplicity - Internal models In the past, the supervisory authorities have increasingly focused on the risk weighting of internal models. After the introduction of Basel II in 2007 (Basel Committee of Banking Supervision, 2006), some even thought we would see the admissibility of internal models for equity cover for credit risk. At present, the focus is on the complexity and lack of transparency of internal bank models for measuring risk, and they are also the butt of criticism. Specifically, there was no empirical evidence for the long period of low interest rates enabling the weak debtors to delay loan defaults over a long phase and this thus sufficiently being factored into banks’ internal models. Another empirical observation: the valuation banks give for their interbank receivables are too low and these systemic risks are therefore not adequately considered. The watchdogs try to take these recurrent doubts in the validity of internal models into account be jacking the disclosure standards ever upward.
However risk sensitivity must be a central goal of a (bank) management approach even if we can assume that the complexity of internal models to calculate Pillar I and II equity capital will decrease owing to the supervisory requirements. These doubts as regards internal models can be equated with the doubt that banks are able to measure and manage their own risk sensitivity. This opinion places all banks in the same bad light. Such an approach obstructs risk management by banks that conduct their modelling based on conservative parameters and possibly emerged from the financial crisis unscathed. That said, one result of this mistrust in internal models is that complexity is reduced in the comparability of banks, something that gradually disappeared under Basel II.
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Pillar II and Liquidity Although in the Basel Committee published its revisions to the liquidity coverage ratio (LCR), European supervisory bodies are busy working on further liquidity variables (Basel Committee of Banking Supervision, 2013, Liquidity). While the EU has resolved adherence to a defined 60-percent LCR from 2015 onwards, other variables such as the net stable funding ratio (NSFR) remain the subject of debate at the European level (European Commission, 2013, CRR). For the first time, the Basel Committee has issued concrete requirements for managing liquidity risk on the basis of defined key ratios. Banks have to compute these new variables at least once a month and then report them.
The LCR is meant to ensure the bank’s short-term solvency in a stress scenario of 30 days and serve as the limit for the cumulative liquidity gap. The net payment outflows under stress conditions are to covered by a liquidity cushion in the form of a non-encumbered, first-class and highly liquid asset (= a so-called liquidity cushion). The introduction of the LCR was originally set for January 1, 2015. The Basel Committee for Banking Supervision decided against this schedule on January 6, 2013. Instead of 2015 being the year when the LCR has to be completely met, as at this date 60 % of the reserve suffices. Through 2019 the level is raised in annual increments to 100 % (PwC Financial Services, 2013:1).
The NSFR is a new variable introduced as part of the Basel III guideline with a view to measuring a bank’s structural financing (Basel Committee of Banking Supervision, 2014, NSFR). The NSFR regulation is meant to ensure sustainable, stress-resistance financing of a bank’s lending transactions and its off-balance-sheet activities. The ratio corresponds to that between the factual, stable i.e. durably available financing and the required stable refinancing weighted in terms of the liquidity tied down. Those liabilities count as durably stable financing as given the contractual maturities or the underlying behavioral assumptions will be available for at least 6 months and/or one year. The minimum ratio here is 100%. The NSFR regulation is expected to come into force in 2018. Should the NSFR of 100% come into effect, then the Bundesbank expects additional refinancing means will be required (core capital). Banks would for example be forced to raise additional core capital or reduce the volume of long-term loans on their books. This could not only constitute a major challenge for the financial industry, but also strain the macro-economic financing requirement (investments in long-term ventures such as infrastructure projects).
The literature tends to assign such ratios to Basel III, but in the transition to Basel IV they will become ever more important (KPMG Financial Services, 2014). And they characterize the transition to (liquidity) risk management based not on models but on key balance-sheet ratios. In particular the consideration of stress scenarios in these ratios indicates that under Basel IV we can expect to see further stipulations as regards so-called stress tests that banks will have to conduct to prove their risk-bearing capacity. While only a few years ago banks were called on to develop their own stress scenarios, supervisory regulations are becoming ever tighter and increasingly influencing the ratios in question.
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Capital Add-Ons Pillar II According to the greater requirements set by Basel III as regards the quantity and quality of capital coverage banks must provide for their assets, we can expect that in Basel IV there will also be detailed adjustments to the Pillar II capital adequacy regulations (European Banking Authority, 2015). The objective will be to develop these on the basis of the same regulations issued for Pillar I. This likewise stands in the way of the path toward qualitative supervision advocated by Basel. Thus, some European countries tend to insist that economic capital under Pillar II must exclusively be covered by hard core capital and may no longer consist of a combination of core and supplementary capital. In Germany, a guideline was published on the supervisory assessment of economic risk-bearing capacity concepts as a result of which the MaRisk amendments (Pillar II) now also address interpretations of Pillar I. Thus, economic capital planning must be in line with the regulatory regime for the Pillar (Deutsche Bundesbank, 2013).
In some European countries, the focus is also on so-called “pillar one plus”. According to this, the regulatory capital adequacy requirements form a kind of minimum requirement when calculating the economic capital adequacy ratios (Pillar II). The issue was tabled because in the countries in question the banks’ Pillar II equity coverage as calculated by economic models was far too low compared to the regulatory levels set. Factoring in other types of risk, such as business risk, for example, into the calculation of risk-bearing capacity for Pillar II, also meant that economic capital was not the scarce resource used to manage banks and instead the regulatory regime of Pillar I took pride of place. With this “pillar one plus” approach, the regulators are now giving a greater weighting to Pillar I when calculating economic capital (ICCAP) than to Pillar II (Die Deutsche Kreditwirtschaft, 2014:2).
Figure 1. “Pillar one plus”
Credit risk
Market price risk
Op. risk
Credit risk
Market price risk
Op. risk
Other risks
Pillar I Pillar II
Capital-requirements
Addi onal capitall requirements under „pillar one plus“
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Disclosure In July 2013, the Basel Committee published its discussion paper on “balancing risk sensitivity, simplicity and comparability” (Basel Committee of Banking Supervision, 2013, Framework). Among other things, it outlines how and why the level of complexity and the lack of comparability may have arisen. It in particular points to the lack of comparability of internal bank models used to calculate the capital of the institutions in question. The paper calls not just for a future reduction in complexity, but also for expanded disclosure by banks (Pillar III). Thus, not only the results of internal models will have to be disclosed and juxtaposed to the key financial ratios arrived at by standard processes, but also additional capital ratios and financials that provide useful information for investors and describe a bank’s “health”. Capital ratios that consider market values or risk variables that factor in equity volatility are foregrounded in this context.
In general, the goal of simplification can be considered a good one. However, the number and scale of the regulations for banks is now somewhat opaque and itself now constitutes a regulatory risk. However, no distinction is made between whether the complexity was actually desirable or simply arose as a result of inconsistencies and disproportionality. While the latter need not be discussed here, one should consider that the financial industry is highly complex and that complex processes and models are required to describe bank products adequately. Disclosure as per Pillar III already entails a volume that it would be hard to top. All this information is already providing market players with a surfeit of data that makes it hard for the addressees to decide which items are relevant to them and which are not. This filtering of key information translates into high transaction costs that cannot be justified in terms of the goal of simplification and improved legibility. Moreover, the Basel Committee seeks to supervise large banks that are active internationally. But precisely in Europe with its plethora of banks, these regulations must also make sense for banks operating only regionally. In particular, given the decidedly cost-intensive provision of information, disclosure should only be expanded from the perspective of the latter banks if this spells a guaranteed increase in the addressees’ knowledge and there is a healthy balance struck between this and the additional expenses involved.2
Conclusion The discussion here shows there has been a clear change in bank supervision. While Basel II still indicated that mathematically ever more refined models for calculating risk would determine the future of capital adequacy, today norms and the debate on future trends show that a bank’s risk-bearing capacity can be determined by less quantitative aspects, too. Here we are seeing a change in the approach taken by the supervisory authorities. It can be read as a concession to the fact that a highly complex decree such as Basel II and its structure of three pillars did not prevent the financial crisis. Indeed, the highly complex supervisory regulations did not ensure that banks did not get into difficulties. However, the goal remains of using supervisory requirements to create a stable financial system at the European level. It would seem, though, that the qualitative and economic approach the supervisory authorities took up to the financial crisis will be revised with the transition to Basel IV. This 2 A first step could be made by the EU: European Commission, 2013, Disclosure
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reversal has at present sparked a change in banks’ organizational and workflow processes. Whether this reversal in bank supervisory law will suffice to prevent a future financial crisis remains to be seen and will only emerge in a future crisis. The microeconomic methodologies underpinning the regulation of individual banks neglect the need for a macroeconomic approach for the financial system as a whole. These methodologies, for example, do not factor in the banking world in the respective country or currency area. Yet diversification in the banking world has proved to create resilience to crisis. Efforts to regulate and restrict individual banks should not get in the way of strengthening the financial industry as a whole. A healthy mix of private banks, cooperative banks and banks incorporate under public law could constitute a better counterbalance to a potential crisis, irrespective of the strengths of each individual bank.
Figure 2. The road to Basel IV (KPMG Financial Services, 2014)
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Capital-requirement
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Liquidity-requirement
• Short term (LCR) • Long term (NSFR)
Basel IV
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Disclosure • Comparability
Implica ons
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Risk sensi vity
Internal modles
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