The Basel Committee have finalised reforms that aim to enhance the resilience and consistency of large banks’ internal models last week – almost a decade since the inception of the global financial crisis.
Key to reaching a final agreement on the Basel reforms have been compromises on two key issues that divided regulators across the Atlantic: when banks would have to increase capital on their trading books and how large lenders self-assess the risks they take.
The finalised rules allow both capital market participants and loan makers to breathe a sigh of relief. Banks have been granted an extended deadline to adopt the previously-agreed Fundamental Review of the Trading Book (FRTB), with full implementation put back to 2022 from an original date of 2017. The agreed “output floor”, which limits the degree to which large lenders’ internal models could diverge from regulators’ standard and more conservative calculation, has also been more lenient than expected. This floor was agreed at 72.5%, a mid-point between EU and US regulators’ proposals, and banks will have until 2027 to complete implementing the new rules (see below).
The new “output floor” rules create winners and losers. And the decade-long implementation window adds further uncertainty around Basel standards becoming binding in national laws. While some US banks have “gold-plated” Basel capital requirements and UBS and Credit Suisse have applied a “Swiss finish” of holding double the required amounts of capital, EU-based banks will likely feel the pinch from the finalised ruling.
An impact study carried out by the European Banking Authority shows that banks in the EU face a capital shortfall of €40 billion on the new “output floor”. The most systemically important banks in the EU would be most affected and will see their capital requirements rise, on average, by 15% – indeed, 60% of CET-1 shortfall globally would be attributable to European G-SIBs under the new capital rules.
EU and national regulators are also sympathetic about the EU banking sector’s dependence on loans and tendency to keep risky mortgages on balance sheets (rather than on those of government agencies, as in the case of the US). Indeed, following the announcement of the Basel III finalisation, Valdis Dombrovskis, the European Commission vice president for financial services, highlighted the need “to consider the specificities of the European economy in terms of the banking sector and its role in financing the economy.”
Uncertainty over completing Basel III implementation aside, the finalised rules also left areas of financial stability risks unaddressed. One relates to the prudential resilience of the wider financial system, including asset management and insurance firms. These organisations have taken on more shadow banking activities as banks shore up capital after the global financial crisis. It is key that the prudential playingfield is level not just between banks of different sizes and geographies, but also between various types of players in the financial system.
Another key concern is around the rise of non-financial risks, such as cyber security, technology risk, and data privacy, which fall under the umbrella of “operational risk”. The finalised Basel III reforms propose that the Advanced Measurement Approach (AMA) approach to operational risk to be replaced by a standard measurement approach (SMA) after 2022. This begs the question over whether a standardised approach is conceptually appropriate to capture the operational complexity of global banks, the increasingly dynamic nature of the risk taxonomy, and whether it is sufficiently forward-looking to keep up with the rapid growth of digital finance and the adoption of new technologies.
As the latest reports by the Financial Stability Board (FSB) pointed out, the speed of technology advancement and the market concentration among technology providers pose stability concerns to the financial system. Such systemic risks may be difficult for financial firms and their regulators to foresee, detect and quantify.
The finalisation of Basel III is a welcomed milestone – but the journey to safeguarding financial stability is far from over. Financial firms and regulators need to shift emphasis to new risks emerging in the financial system, including resilience issues of the shadow banking sector, and the risks residing in the increasingly symbiotic relationship between the financial and technology sectors.
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