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The 'Basel 4' reviews – storm in teacup or end of the world?

Every now and again you will read some press comment about bad things expected to result from the current set of “Basel reviews”. A good example – a real corker – was this from early 2015: “Secretive bank watchdog could slam door on first-time buyers” and referenced a “secretive Swiss committee” as the fount of all evil. So what is this all about – what is Basel and what is being reviewed? and is it a storm in a teacup (or, being Swiss, in a fondue pot – remember those?)

The Basel Committee for Banking Supervision is the international forum for setting common standards in banking regulation – originally for capital adequacy, but now lots of other stuff as well. It’s a committee hosted and supported by the Bank for International Settlements in Basel. The current Basel framework determines how much capital major internationally active banks in different countries hold, based on the size and make-up of their banking book. Low risk assets have low “risk weights”, higher risk stuff has higher “risk weights”. So far, so sensible – what’s not to like?magnifying-glass-on-graph.jpg

The problem goes back at least to the financial crisis, which blew up just as the previous Basel review was bedding down (no causal connection, of course!). Way back there was Basel 1, which was simple and rough and ready and everyone understood. But clever people – experts - thought it just wasn’t clever enough, so we had to have Basel 2, which introduced the idea that instead of a simple tariff of risk weights by broad asset categories, big banks would make up their own black-box “internal ratings” models, and that would tell them what the risk weights should be. Then there was “Pillar 2” – supervisory review – to fine tune the result, and also “Pillar 3” – transparency – necessitating hundreds of pages of extra disclosures that hardly anyone ever reads. None of this prevented the financial crisis and after the crisis, a further Review was inescapable.
Eight years later, we’ve already had Basel 3 – implemented in 2013 – but even that hadn’t covered everything, so we’re now in the middle of what some people call “Basel 4”. And this is where the shouting begins.

Basel 3 already raised the bar a long way post-crisis, requiring banks (and building societies) to hold more, and better, capital so as to be more resilient in a downturn. Building societies generally met the Basel 3 standards without any difficulty.  After the crisis some banks had to go out and raise significant amounts of new capital.
The “Basel 4” reviews cover three parts of the capital calculation – revisions to the “standardised approach” for credit risk – i.e. the successor to the simple Basel 1 tariff, but not so simple anymore; revisions to the Internal Ratings Based approaches for credit risk – to rein in the wilder excesses of the “black boxes” ; and changes to the capital required for operational risk – the risk of failures of people, processes etc. aka cock-up risk – where Basel doesn’t like what came out of the “black boxes” either.

From 2014 onwards, Basel has been consulting on these. The first CPs were quite scary– giving rise to comments like the one mentioned at the beginning. Although the name of the game was not supposed to be yet another upward jump in overall capital requirements, that’s exactly what all the early CPs would have done. Even for the standardised approach, which in the BSA’s view was mostly “not broke and didn’t need fixing”, and was generally agreed to require ample capital to support normal mortgage books, Basel proposed measures which would have pushed up capital requirements further. This was compounded by the CP on the internal ratings approaches, which proposed to apply a floor of between 60% and 90% of the standardised calculation (itself now going way OTT in some areas). And the CP on operational risk, by over-egging the impact of past conduct losses, looked likely to send major banks’ capital requirements off the dial.

However, some common sense solutions began to break out in other parts of the forest. As the BSA has been saying for years, a further jacking-up of capital requirements risks setting off a new round of deleveraging and contraction in bank credit as some institutions struggle to meet the new bar. Is that we want at this point? Now some important people seem to have realised this. The oversight body for the Basel Committee - the Group of Governors and Heads of Supervision (GHOS) - said this in January 2016: “The GHOS will review the Committee's proposals on the risk-weighted framework and the design and calibration of capital floors at or around the end of 2016. The Committee will conduct a quantitative impact assessment during the year. As a result of this assessment, the Committee will focus on not significantly increasing overall capital requirements.” Moreover, the word on the street is that the outcomes of the latest proposals (as measured by the impact assessment) would be especially penal for banks in Europe. Cue ECOFIN – the council of EU finance ministers - riding to the rescue, and saying in July (in polite Euro-code) to Basel – don’t you dare stuff European banks in the final calibration.

So where are we now? In a nutshell, the Basel Committee is trying to square the circle and avoid losing face. They have to scale back the impact of each of the individual reviews – standardised credit risk, IRB credit risk, and operational risk, so that the overall level of capital required doesn’t rise by more than say 10%-15% (that’s what “significantly” is being taken to mean) – but without creating the appearance of a full scale retreat or U-turn.

We are told that the final rules in these three areas will be out by about the end of 2016 – there’s a key meeting of the GHOSts in January which should sign it off. Then a long period for implementation, to give banks time to adjust to the new requirements, hopefully without drawing in vital business and household lending. Who knows – maybe with hindsight, this will be seen as the high water mark of the influence of the capital hawks, and the tide will turn. Here’s hoping…….
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Jeremy Palmer

Head of Financial Policy

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