As European countries prepare to introduce Basel III, concerns are mounting that its implementation will highlight a chasm between different countries in terms of bank capital levels. Is the banking sector about to see a new era of regulatory arbitrage?
Part of the living will exercise involves an examination of the loss-absorbing capital held by any bank. Clearly equity is loss-absorbing, but also to be considered are contingent convertible securities and the distribution of losses against a wider range of creditors, including subordinated and possibly senior unsecured bondholders.
The IMF, in its regional economic outlook published in May, urged European countries to push ahead with unified action on a common resolution regime.
“Moving toward a robust and flexible framework for crisis management and resolution…is equally urgent,” the IMF said. “The EU proposal to harmonize these tools across countries is the right step toward ensuring more orderly ex-ante solutions. But more needs to be done to progress from a setting structured along national lines to an integrated EU framework…”
Europe’s next top model
Another illustration of the potential for nationally based solutions in Europe is the lack of a standardised approach to measuring risk-weighted assets.
“As banks calculate their capital requirements they can use either point-in-time models or through-the-cycle models,” says Patricia Jackson, a partner in the risk management group at Ernst & Young. “The Basel Committee has not standardised the measure, meaning that a bank using a point-in-time model for its mortgage book could pick a moment with a low default rate, while a through-the-cycle model would produce a much higher number.”
Under Basel III, it is estimated that banks will need to raise up to €1 trillion of additional common equity, not including the additional capital required for systemically important financial institutions, recommended by the Basel Committee to be set at 3%.
“It will be the responsibility of national regulators to decide which firms in their jurisdictions are systemically important,” says Jackson. “While the big international firms are obviously going to be included, there may be differences over some of the local ones. It is extremely important that there is a level playing field, because otherwise the distortions are going to be huge.”
While Pillar II of the Basel rules expressly allows for national regulators to impose local rules, there is also a surprising level of flexibility in the requirements laid out in Pillar I, particularly on the various buffers designed to embellish the basic requirements for common equity and tier 1 capital.
The countercyclical buffer, set between 0% and 2.5% of total risk-weighted assets, is one area in which national authorities have the power to dictate the regulatory landscape; determining when excess credit growth poses a risk to the stability of the financial system. The Basel governors set no deadline for meeting the requirement.
Local interests may also find some wiggle room on the proposed leverage ratio, the level of which is left up to each member country to determine, although a tentative minimum has been set at 3%. The ratio will be tested in a parallel run, from 2013 to 2015, with a view to it being incorporated into Pillar I requirements by 2018.
“The unspoken message in the wording of the leverage ratio is that there is enormous scope for negotiation,” says Adrian Blundell-Wignall, special advisor to the secretary-general on financial markets at the Organisation for Economic Co-operation and Development. “All we know at the moment is that there is a fair amount of prevarication and the banks don’t like it.”
As regulators ponder their options, what is certain over the coming years is that behind the scenes the bank lobbyists will be working hard to press the case for a lighter touch, with the threat of a move abroad their most powerful weapon. As was shown in 2010, when several Irish banks passed stress tests but required bailouts just two months later, the ability to clear hurdles can very much depend on the power of interpretation.
“It may be the position of the Basel Committee that a safe banking system should be more attractive for stakeholders,” says Richard Barfield, a director at PricewaterhouseCoopers. “But many national regulators will be tempted to think the jury is still out on that. We may well see a greater emphasis on Pillar II emerging, where, currently, without common global standards, national regulators decide for themselves what they mean by strong risk management and supervision.”