Being Basel Ready:

Anticipating the Strategic Impact of the Global Capital and Liquidity Standards

Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Remarks Prepared for the

Institute of International Bankers

Washington, D.C.

March 7, 2011

 

I have been asked today to discuss the new Basel III capital and liquidity regime.  So, let’s start with the new standards for the equity tranche of a mortgage-backed security when you hold a correlation-trading position in it and consider the credit-risk capital, the operational-capital requirements, market-risk capital and the liquidity standards applicable to this position under both the liquidity coverage ratio and the net stable funding ratio.  OK, never mind.  I suspect you’ll be happy to hear that I plan today to step back from Basel III’s manifold minutiae to focus on the future of the global Accord and its impact on each of your banks back home and here in the United States.

I last spoke to the Institute a few years ago when my topic was Basel II.  Those of you with endurance may even recall the several presentations I’ve given to IIB on Basel I.  Each time, I said what I’ll emphasize again today: the Basel rules are daunting, but franchise defining.  As a result, understanding them, at least in bottom-line terms, is a critical strategic challenge.

What I’ll do this morning is briefly summarize key provisions first in the Basel III capital standards and then do the same for the liquidity rules.  I’ll focus on both the global standards and outstanding U.S. issues.  Then, I’ll turn to perhaps the most critical question here:  will the U.S. in fact belly up to Basel III?  If it doesn’t, the U.S. strategic outlook changes dramatically and the global Accord – already fragile – could come unglued.  To cut to the chase, I think the U.S. will comply with Basel III, but we’ll do it our own way and create some significant asymmetries between the U.S. and other major financial markets.  Basel III isn’t the only rule on which the U.S. will go its own way, so I’ll also briefly address some other major variations emerging between U.S. bank regulation and the new global framework.

Keys to the Capital Standards

As my little excerpt from the Basel III rules made clear, delving into the details of Basel III will quickly drive us to distraction.  So, what I’d like to do today is highlight several critical facets of the capital standards, including those still in the works for systemically-important financial institutions.  These firms are commonly called SIFIs.  Since almost every bank here today is a SIFI, these are also a critical part of the strategic Basel III framework.

  • Quantity and Quality:  The Basel III rules require a seven percent common Equity Tier 1 target, not counting some of the other charges that build atop this basic standard.  To be sure, banks don’t need to have all this high-quality capital until 2019, but markets are pushing banks to show their ability to meet the rules on a far quicker pace, as are several nations.  The U.S. has demanded that the largest banks lay out a Basel III compliance plan in last quarter’s stress test, making it a lot harder for big firms to pay dividends or undertake other capital distributions if they aren’t Basel ready.  And, of course, Switzerland has upped the Basel III ante even as the U.K.’s chief regulator is talking about how much more capital he thinks banks need to hold to prevent future crises.
  • Leverage:  A key component of Basel III is a new minimum capital requirement of three percent against most on- and off-balance sheet assets.  This phases in as a supervisory standard, but it’s still stringent.  For most global banks, the leverage rules are actually the hardest part of Basel III.  How it will work here is uncertain.  U.S. banks already need to meet a five percent leverage rule to be well-capitalized, but this is assessed only against on-balance sheet assets.  How off-balance sheet assets are incorporated into the U.S. leverage rule and where the bar is set will drive the cost of this part of the capital requirements.
  • What’s Risky:  Critics of Basel III have argued that it leaves risk-weighted assets (RWAs) largely as set under Basel II.  This is only sort of right.  Wherever regulators thought Basel II went too light on RWAs, especially for complex products, the Basel III rules toughen them up.  Stiff new stress tests also up the capital ante, even where RWAs are left from before.

And, while I’m on the subject of risk, it’s worth a moment to focus on ratings.  The Basel III rules remain reliant on ratings because the RWAs are largely the same as the ratings-based ones in Basel II.  Regulators are thinking hard about this and Basel II.5’s market-risk rules hedge this ratings bet a bit.  But, for now, global risk-based capital rises or falls at the behest of the credit rating agencies.  Not so in the U.S., where the Dodd-Frank Act mandates that any vestige of a reference to a ratings agency be struck from federal regulation.  This is posing profound problems in figuring out an alternative approach to objective measurement of creditworthiness, hampering U.S. efforts to advance the global standards.

Importantly, the new seven percent Tier 1 tangible common equity requirement is only one part of a panoply of new capital requirements.  There’s good old Tier 2, of course, but now also a “capital-conservation buffer.”  This is included in the seven percent minimum charge to force banks to make unpleasant decisions if capital comes under stress. Above the seven percent standard, there’s also a “counter-cyclical” capital requirement that kicks in if GDP goes gaga and a “loss-absorbent” requirement.  The latter is among the most problematic in Basel III.  Is it “bail-in debt?”  “Contingent capital?” Something else?  Does it apply to all banks or just SIFIs?  And, since it’s supposed to be mandated only when nations lack a statutory resolution regime, does it count in the U.S.?

Loving that Liquidity

Having softened you up with a summary of Basel III’s capital standards, let me turn to the liquidity rules.  These are often overlooked – probably because everyone’s just too darn tired to think after reading the capital standards.  But, I think the liquidity rules are actually even more important than the new capital standards.  Too high or too low and with or without all the nuances I’ve noted, all of the banks here have long been subject to capital rules.  That isn’t true for liquidity requirements.  No one’s ever done this before, but Basel’s doing it anyway.  To be sure, they’re easing it in a bit, with “observation periods” over the next few years to spot “unintended consequences.”

In the run-up to liquidity rules, global bankers argued that they will cost well over $1 trillion in added liquidity, but Basel marched on.  As a result, I don’t think the sheer magnitude of the impact of the liquidity rules will deter regulators.  It will take demonstrated effects such as a flight to sovereign obligations – a strong prospect given the incentives in the liquidity standards – to cause a rethink.

If that doesn’t happen, here’s what the Basel III liquidity rules require:

  • A liquidity coverage ratio, which requires banks to show they can withstand run-off of retail deposits and wholesale funding sources over a stressed month; and
  • a net stable funding ratio, which forces a similar calculation over the course of a year.

What this means is that, under various measures and at these different points in time, banks will need to do a lot better job of matching high-quality liquid holdings against their assets.  No more boosting yield by funding short at lower rates to lend or bet long.  Of course, how well this works depends on all of the assumptions built into these ratios, which are premised on run-off rates under stress scenarios.  Many analysts – me very much included – challenge these run-offs.  Not only were they often not experienced in the crisis, but regulators also shouldn’t use crisis scenarios to set day-in, day-out liquidity standards.  Reasonable market conditions should be specified and then stressed to establish reasonable liquidity rules, not set the basic bar at the worst of the worst. I’m not arguing with the need for liquidity rules – we’ve learned all too many times about the risks of borrowing short to lend long.  But, much in the details here needs another, hard look during the observation periods.

Basel III in the U.S.

I’ve briefly mentioned a few U.S.-specific issues, but let me now turn to a threshold and very hard questions confronting the U.S. as it takes on the President’s commitment to comply with Basel III.  Regulators can make all the promises they want, but they can’t keep them if Congress begs to differ.  Does it?  So far, it has.

A critical provision of the Dodd-Frank Act is section 171, often called the Collins Amendment.  It stipulates that banks in the U.S. can hold no less capital than that required under Basel I, essentially setting the old rules in stone as a floor for U.S. regulatory capital.  Going forward, banks will need to figure out how much capital they would hold under Basel I and then compare this to Basel II now and Basel III to come.

This raises an array of questions, almost none of them addressed in the recent inter-agency proposal to implement the Collins Amendment.  For example, how to calculate the Collins comparison?  If it’s all-in Basel II – credit, operational, market and related risk – then Basel II and III will come in above Basel I and the global rules can be implemented here with little change.  If, though, it’s a calculation based only on credit-risk capital, then the Collins Amendment could force banks to hold as much credit-risk based capital as Basel I demands under its crude risk weightings and then top this up with all the other capital charges required in the later standards, additional buffers included.

For foreign banks doing business in the U.S., the Collins Amendment is particularly problematic.  Regulators have proposed to apply the standards even to branched operations here, essentially making Basel I compliance the price of a ticket to do business.  This is raising considerable concern, and rightly so, about the ability of banks in compliance with Basel II and III at home to expand in the U.S.

One Global Size Isn’t Fitting All

Let me conclude by putting the conundrum of U.S. capital rules into a broader context.  Despite the best will of top U.S. regulators and Treasury officials to bring America into the global framework, U.S. law is driving U.S. rules in a different direction.  This is true not only with regard to the Collins Amendment.  It also pervades many other vital facets of the emerging rewrite of global bank regulation.

Take the critical question of systemic regulation.  Will there be global SIFI surcharges?  Maybe so – we’re still awaiting word from the Financial Stability Board on whose systemic and what might happen to designated firms.  But, Dodd-Frank requires systemic surcharges in the U.S., along with tough prudential, capital and liquidity rules. So, even if the global standards go light on systemic rules, U.S. law dictates tough add-on requirements, including for foreign financial firms whose parents are global SIFIs.

What about cross-border resolution, especially for systemic firms?  Again, global regulators are thinking hard, but have announced little to address the problem of perceived taxpayer support for too-big-to-fail banks.  In fact, some regulators – most notably in the EU – are proposing to immortalize TBTF by mandating “bail-in debt” or similar insulation between a TBTF bank and taxpayers in hopes of reducing loss next time around.  As I mentioned, Basel III has mandated a “loss-absorbent” capital charge comparable to the bail-in proposal, but provides an exemption for nations with statutory resolution regimes.  The U.S. has this in spades with Title II of Dodd-Frank, the “orderly liquidation” provisions of the new law that essentially doom a systemic firm once an immediate panic subsides.  Do U.S. banks need to bear the cost of counterparty demands in anticipation of loss in a systemic situation and, at the same time, global charges based on taxpayer rescue?  How will foreign banks under contradictory regimes here and at home be treated?

What about the Volcker Rule? Time doesn’t permit delving into this major part of Dodd-Frank, so suffice it to say that it’s yet another asymmetric standard.  U.S. banks and foreign ones here can’t do proprietary trading or make hedge-fund or private-equity investments.  Offshore, you can, although U.S. banks remain barred from doing so. Living wills are another major issue – will some nations like the U.S. force subsidiarization while others – the EU – foster branching and resulting efficiencies?  Given the power of the credit rating agencies, different standards here mean more than the asymmetry in the Basel III standards I mentioned earlier.  Asset securitization in the U.S.?  Its fate depends on Dodd-Frank too.  And, there’s the very different framework for derivatives regulation likely as Dodd-Frank is implemented here and rules take a different tack in other major regimes.

Conclusion

Let me conclude with an over-arching suggestion.  Although Basel III is seemingly final, much in it remains in doubt, especially as implementation gets under way in the U.S.  And, these vital rules are coming into effect in tandem with debate over all of the other principle tenets of strategic bank regulation.

I’ve told you today what I know about Basel III, but I know one other thing:  uncertainty is the watchword for bank strategic planning.  Banks that look for the final rulebook to guide them will be waiting a long, long time.  Banks and competing institutions that anticipate the rules to come and shape them to desired business and policy goals will thus gain a critical competitive edge.  One more consequence of the global financial crisis is that the critical defining factor for success at each of your banks is what legislators and regulators do.  Policy risk – one still unfamiliar to all too many banks – now has become the inflection point for key line-of-business and corporate decisions.

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