Banks should know what Basel regulatory framework is all about — it is aimed at strengthening banking regulation, supervision and risk management. Before, we had the Basel I and II accords, but they failed to prevent the 2008 Global Financial Crisis (GFC). Quite a number of banks proved undercapitalized and overleveraged. Basel III was therefore an imperative of the times; it was necessary to enhance the banks’ ability to manage shocks from financial stress and fortify their transparency and disclosure. While preventing banks from taking on more risks than they could handle is sustained, the Basel III accord could only be as effective as the banks’ willingness to comply and the bank regulators’ eagle eyes to ensure their compliance. Market discipline is also a must.
Both household and business clients of the banks will do well to familiarize themselves with the regulatory standards that govern their banks and their ability to absorb potential losses during turbulent times.
It was in 1974 that the Basel Committee on Banking Supervision (BCBS) was organized to develop the Basel accords following a series of disruptive financial market activities. As early as that time, financial stability was already a buzzword, with the Committee serving as a forum where member countries could deliberate on banking supervisory issues. As of last year, 45 institutions in 28 jurisdictions were represented in the Committee, composed of central banks and authorities with formal responsibility for the supervision of banking institutions. Recall that in some countries, two institutions supervise and regulate the banking industry. In Australia for instance, both the Reserve Bank of Australia and the Prudential Regulatory Authority are in charge. This structure is also true in China, the European Union, Germany, Indonesia, and Japan, among others.
The BCBS is just one of the many committees under the umbrella of the Bank for International Settlements (BIS) which hosts and supports them. The others are the Committee on the Global Financial System, Committee on Payments and Market Infrastructures, Markets Committee, Central Bank Governance Forum, and the Irving Fisher Committee on Central Bank Statistics. Based on this broad spectrum of surveillance and standards setting alone, one would find it strange that financial crises continue to assault us with dire consequences. Of course, it could also be the financial institutions’ half-hearted adherence to the accords as well as the markets’ irrational exuberance that make financial crises unavoidable.
But for banking, it is the Financial Stability Board that coordinates the work of national central banks and prudential bodies as well as international standards setters in developing and promoting the implementation of effective regulation and supervision to achieve global financial stability. Its secretariat is also at the BIS although it maintains its legal identity and governance structure.
What is the Basel process?
This is the mode of promoting international cooperation among monetary authorities and prudential bodies. The BIS talks about two main axes for such global collaboration. One is the regular high-level meetings of senior monetary and financial officials in Basel. The other is the BIS’ support for and collaboration with international groups pursuing financial stability. Based on the discussions in these fora, committee reports are produced, analyzing specific topics and international standards. For the accords to be binding on the authorities for compliance, the agreements reached in Basel have to be approved and implemented at the national level.
It was from these processes that the various Basel accords were introduced, deliberated upon, and finalized. There are three key principles of Basel III: minimum capital requirements, leverage ratio, and liquidity requirements.
In the face of many undercapitalized banks during the GFC, Basel III further raised the minimum capital requirements for banks. More adjustments in minimum capital requirements were instituted in 2015 and 2022. The idea is to ensure that if banks were to do more banking activities involving higher risk exposure, their capital base should be strong.
The accord also introduced a non-risk-based leverage ratio to support risk-based capital requirements. Such a leverage ratio is intended to reduce the risk of deleveraging in the future and the damage they could inflict on the broader financial system and the macroeconomy. Overborrowed banks during the GFC were the most vulnerable, and they were the ones who mostly closed shops because they had overextended their borrowings. A rapid deleveraging, on the other hand, could be as destabilizing.
To deter potential banking stress, Basel III requires the banks to keep a certain level of liquidity through the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The GFC proved in no uncertain terms that even if banks were properly capitalized, if they were not liquid enough, their liquidity problems could blow up into a solvency issue.
As expected, not everyone is happy about Basel III and its key principles.
If the GFC unmasked improprieties in compliance by banks, it also showed the other side of the Basel accord. For instance, some claim that banks challenged by high capital requirements could end up less profitable. Compliance with these equity requirements means the banks would have less funds to lend to borrowers. Holding more capital against their assets will reduce the size of the banks’ balance sheets.
A higher leverage ratio, while covering possible significant deleveraging, could also hit the banks’ financial health by either holding higher Tier 1 capital or reducing their consolidated assets.
The new liquidity requirements could also affect the operations of the bond market. Compliance with LCR could push the banks away from holding high run-off assets like special purpose vehicles. The bias will move in favor of banks holding government bonds. Banks would hold more liquid assets and increase the share of long-term debts if only to address the issue of maturity mismatch.
To the point, some regulators find the Basel III framework inordinately complex, its continuing reliance on the so-called internal model-based regulations to calculate capital requirements difficult to police and its seeming myopia to some off-balance sheet risks a clear impediment to better results. If Basel I capital requirements were limited only to the banks’ credit exposure, Basel III seems to have failed to recognize the increasing concentration of the banking industry.
In the US, the Institute of International Finance opposed the Basel III implementation on the grounds that it could potentially hurt banks and slow down economic growth. The Organization for Economic Cooperation and Development (OECD) estimated that the medium-term effect of Basel III on total output could range from -0.05% to -0.15%. To mitigate the additional cost of the accord on their profitability, banks would have to increase their lending spreads to pass it on to their customers. Some quarters in the US went as far as saying the accord could cripple small US banks by requiring them to have higher capital holdings especially on mortgage and small business loans.
On the other hand, the BIS, in its December 2022 “Evaluation of the impact and efficacy of the Basel III reforms,” noted some “evidence that the overall resilience of the banking sector has increased since the implementation of the Basel reforms.” Greater improvements for financial institutions have been reported that is suggestive of the positive implications of the Basel reforms on resilience. More specifically, the BIS noted that banks’ capital has risen but its loss-absorption capacity was not exactly conclusive. Leverage ratios and liquidity have also improved, with liquidity coming more from high-quality liquid assets and short-term funding sources minimized.
The other key finding of BIS is that “market-based measures of banking sector systemic risk have improved…” thus rendering the financial system less vulnerable to individual banks’ distress. Even market perception of global systemically important banks (G-SIBs) has declined as to their level of systemic risk. The BIS did not find ample evidence of negative side effects of Basel III reforms. The BIS agreed that higher capitalization could reduce the banks’ loan growth although the evidence was considered non-robust. It also admitted to the resulting regulatory complexity although it also argued that such complexity might be difficult to reduce without affecting the banks’ resilience.
But while all these regulatory innovations and reforms were forged in Switzerland, the latest financial shock in the US, definitely much tamer than the GFC, was enough to collapse Credit Suisse and force it to go under the umbrella of the Swiss UBS.
(To be concluded next week.)
Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.