Basel III: New Bank Capital Regime Likely

[real6]

http://mlgcap.blogspot.com/2009/09/basel-iii-new-bank-capital-regime.html

Treasury wants global agreement on increased capital cushions
In a statement of principles, the Treasury said it wants regulators worldwide to agree by the end of next year on increased capital cushions for financial institutions. The Treasury is also seeking consensus on liquidity rules by the end of next year and for them to be implemented by the end of 2012. The Treasury's statement said the rules need to be "as uniform as possible across countries to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy."
- Bloomberg
----------

Capital standards must be stronger:
Treasury Secretary Timothy Geithner writes that as leaders from the Group of 20 nations gather this week in London, a main priority must be to strengthen capital standards for financial institutions. Geithner says he explained his views on a global agreement on capital standards in a paper sent to G-20 finance ministers. "The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions," Geithner writes.








http://www.bloomberg.com/apps/news?pid=20601208&sid=aQsIccRJHA2s

U.S. Treasury Seeks Global Accord on Bank Capital Before 2011
Share | Email | Print | A A A

By Robert Schmidt

Sept. 4 (Bloomberg) -- The U.S. Treasury Department said it wants a global agreement requiring banks to increase their capital cushions to be reached by the end of next year.

In a statement of principles, issued yesterday in Washington, the department said that an accord on capital and liquidity rules should be reached by the end of 2010 and be in place by the end of 2012.

The rules must be “as uniform as possible across countries,” the statement said, “to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy.”

Treasury Secretary Timothy Geithner left yesterday for meetings in London with finance ministers and central bankers from the Group of 20 nations. He sent a letter to his counterparts seeking to hammer out the stricter rules as they lay the groundwork for a G-20 summit in Pittsburgh later this month.

Regulators are calling for tougher supervision of banks, saying they contributed to the global financial crisis by investing in risky assets without setting aside adequate reserves. The U.S. was forced to pass a $700 billion package last year to bail out companies including Citigroup Inc. and Bank of America Corp.

“Strengthening capital requirements is an essential part of a broader effort to modernize our regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions,” Geithner wrote in an op-ed piece on the Web site of the Financial Times.

Higher Standard

The Treasury statement didn’t offer specifics on how much extra money banks should be required to keep on hand. It said that capital requirements should be boosted for all banks, while firms posing the biggest threat to the financial system should have an even higher standard.

The department also called for banks to be subject to “simple, non-risk-based leverage constraint” and a “conservative, explicit liquidity standard.”

President Barack Obama in June proposed the most sweeping overhaul of the U.S. financial-regulatory system in 75 years, calling for the creation of an agency to monitor mortgages and other consumer products and tighter oversight of the country’s biggest banks and institutions.

In a briefing two days ago, Geithner said curtailing executive-compensation is “a critical part of our broader reform agenda.” He said the U.S. has proposed “pretty comprehensive reforms” to give shareholders more control over pay policies and also give managers better incentives to act in the best long-term interests of their banks.











http://www.ft.com/cms/s/0/638b9eb2-98ba-11de-aa1b-00144feabdc0.html?nclick_check=1

Financial stability depends on more capital

By Timothy Geithner

Published: September 3 2009 20:00 | Last updated: September 3 2009 20:00

A year ago, deep concerns about excessive leverage almost brought down the global financial system. The resulting panic severely damaged economies across the world and wiped out trillions of dollars in savings. Since at least the Great Depression, governments have recognised that financial breakdowns have devastating effects, and have put in place safety nets to limit the fall-out from instability.

These safety nets have a cost, because they insulate financial institutions from the full consequences of their actions and can diminish market discipline. We have sought to contain this moral hazard through regulation. We require financial institutions to maintain reserves and capital buffers in proportion to their risk so that they can absorb losses at their own expense, not at the taxpayer’s.

That regulatory framework failed last year. In the benign atmosphere before the crisis, government supervisors and those in the market underestimated risks building in the system. Major global financial institutions maintained capital levels that were too low, relied too heavily on unstable short-term funding, and their compensation plans rewarded excessive risk-taking. Larger banks often held less capital relative to their risks and used more leverage than smaller banks.

The resulting distortions helped make our global financial system dangerously fragile. As that system grew in size and complexity, it became more interconnected and vulnerable to contagion when trouble occurred.

This weekend, the Group of 20 will gather in London to move forward on reforms to put our global financial system on firmer ground. President Barack Obama has outlined a new regulatory framework that promotes stronger protections for consumers and investors and greater financial stability. Making the system safer requires a comprehensive approach including tougher regulation of derivatives, securitisation markets and credit rating agencies, new executive compensation standards and, critically, more powerful tools for governments to wind down firms that fail. We are working with our partners to ensure similar reforms are put in place around the world.

But at the core of our endeavour must be making capital standards for financial institutions stronger. In a recent paper sent to G20 finance ministers, I laid out my views on the principles that should shape a new international accord on capital standards. The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions. Such an approach requires a broad shift in the way capital and related regulations are designed.

First, capital requirements for banks simply must be higher across the board. Bringing more capital into the banking system is vital. It is equally crucial to hold the largest, most interconnected institutions, whether or not they own banks, to tougher standards than others.

Second, the regulatory framework also should put a greater emphasis on higher-quality forms of capital that best enable financial groups to absorb losses. Consistent with this principle, during good economic times, common equity should constitute a large majority of a bank’s Tier 1 capital.

Third, capital requirements and accounting rules should be more forward-looking and should reduce the system’s pro-cyclicality. The capital regime should require banks to hold a larger buffer over their minimum capital requirements during good times, to be available in bad times.

Fourth, banks should be subject to explicit liquidity standards designed to improve their resilience in the face of runs by creditors and prevent the build-up of liquidity risk in the financial system as a whole.

Finally, we need to improve the rules used to measure risks embedded in banks’ portfolios and the capital required to protect against them, and put greater constraints on banks’ use of leverage to dampen volatility.

Strengthening capital requirements is an essential part of a broader effort to modernise our regulatory framework so that the financial system is strong enough to withstand the failure of large, complex institutions. That is the most effective way to prevent the world from re-living the events of last autumn. And that is the challenge we must tackle in London, Pittsburgh and beyond.

[real6]

http://www.asbaweb.org/E-News/enews-7/PDF_enews/0607_RR_08_EN.pdf

Towards Basel III - Emerging
Andrew Powell, IDB1
Given recent petitions by large US banks to have greater flexibility in implementing Basel II, this new agreement to regulate banks’ minimum capital has received considerable press attention of late.2 Basel II raises these implementation issues as arguably it is primarily focused on the largest 100 or so international banks incorporated in G10+ countries. However, 100+ countries may well implement the Accord for their top 10+ banks. Implementation issues are then even more fraught for other countries and the “fit” could be substantially improved. Indeed, countries will adapt the Accord to implement it and this implies the essence of a standard may be lost. I propose the development of a standard adaptation, Basel III – Emerging, for emerging countries.
Basel II’s first words suggest the Accord is to be applied on a consolidated basis to “internationally active” banks. There are two fundamental objectives: financial soundness and ensuring a level playing field for competition in international markets. G10 may be focused more on the latter, but emerging countries may be more concerned with the former. This suggests that an Accord for emerging economies should state and be applicable to all major banks in a financial system (whether they are internationally active or not), or even all banks.3
Basel II takes consolidated supervision to a higher level. Banking regulators are asked to consider the holding company of a banking group and then consolidate. However many emerging economies have yet to introduce “traditional” consolidated banking supervision – from the banking group down. The Accord also states that consolidation is not always feasible or desirable; this wording is confusing. Considering emerging economies, consolidated banking supervision should be a clear aim. But if infeasible this should not be an impediment to Basel II implementation at the level of consolidation available.
1 The views expressed here are strictly the views of the author and do not necessarily represent the views of the IDB, the board of that institution or the countries they represent, or any other institution.
2 Members of the BCBS are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. Member countries are expected to implement Basel II by the end of 2006 except for those adopting the most advanced approaches where the expected implementation date is end 2007. See www.bis.org
3 This tension is evident in how some countries have stated they will apply Basel II. The US will only apply Basel II to a handful of banks whereas in Europe it will be written into EU legislation. Most emerging countries applied Basel I to all banks and it is likely they will do the same for Basel II. It appears emerging market regulators seek a standard to implement across the board, not just for a section of the market.
Related lending has been a problem in many emerging economies and indeed has been a root of crisis in several. Basel II includes rules regarding deductions from
capital for investments in commercial entities but many emerging economies already have much more aggressive rules regarding such investments and related lending more generally.4 An Accord for emerging economies should have stronger minimum rules.
Turning to the quantitative requirements (so-called, Pillar 1), Basel II suggests two main approaches for the analysis of credit risk: the standardized approach (SA) and the internal rating based approach (IRB). The former uses external credit ratings to judge the risk of a company, bank or country and the latter uses internal ratings of a bank given each bank’s rating methodology. A third methodology also discussed (the Simplified Standardized Approach) collects the simplest sub-options within the SA.
Many emerging economies (and smaller banks in some industrialized ones) may find themselves between two stools. On the one hand the SA will not result in aligning regulatory capital to risk (perhaps the single most important objective of Basel II relative to Basel I) due to a lack of rating penetration.5 On the other hand, the IRB approach is complex, gives banks a great deal of autonomy and will be difficult to supervise. There is also a serious concern that the IRB approach may not be calibrated correctly for an emerging economy.6 While more information has now been published, the IRB remains something of a black box and difficult to adapt to countries’ circumstances.
I propose an intermediate Centralized Rating Based (CRB) approach.7 The CRB is designed to build on the kinds of information systems and methodologies used in some emerging countries to determine and monitor provisions. The idea is that the bank would rate clients (as in IRB) but according to a standardized scale set by the regulator. The mapping from the rating to the capital requirement could then take the form of a table (rather than the IRB formula) to be calibrated by the local regulator according to specified guidelines.
4 Ecuador has the toughest rules I have encountered, essentially allowing no related lending.
5 This refers to the ratings of rating agencies such as Standard and Poor’s, Moody’s and Fitch. The Accord also allows for the use of Export Credit Agencies (especially for sovereign exposures). There is a second danger which is that the use of the SA will provoke a rush to be rated and a decrease in the quality of such ratings.
6 On calibration, see Majnoni,G. and A. Powell “Reforming Bank Capital Requirements: Implications of Basel II for Latin American Countries” ECONOMIA, Spring 2005, pp.105-140.
7 See Powell, A. “Basel II and developing countries : Sailing through the sea of standards," Policy Research Working Paper Series 3387, The World Bank and Majnoni,G. and A. Powell “Reforming Bank Capital Requirements: Implications of Basel II for Latin American Countries” ECONOMIA, Spring 2005, pp105-140.
The appropriate calibration for an emerging economy would consider the tradeoff between the prudential concern for the financial system, the feasibility of increasing capital requirements and the danger of additional pro-cyclicality. Given higher economic volatility one would expect default probabilities to be higher and in fact if Basel II’s, IRB approach is implemented as calibrated, this might result in high capital requirements (perhaps unrealistically high) in some countries. Moreover, if credit cycles have greater amplitude this may induce significant pro-cyclicality. These arguments suggest the trade-offs are different for an emerging country8.
While those countries where the risks are greatest are unlikely to implement the IRB approach (and in the SA some of these concerns are diminished), international banks may be asked to implement an IRB approach on a consistent basis in all countries. This may place international banks at a disadvantage in lending to SME’s in some emerging countries, and may restrict credit and invoke pro-cyclicality in countries where foreign banks are a significant part of the financial system. I suggest a solution to this below.
The greater amplitude of credit cycles in emerging countries suggests regulators may wish to limit credit growth in the good times when banks tend to lend too much or in too a risky a fashion due to competitive pressures. Counter-cyclical provisioning is one mechanism to achieve this aim and ideally an Accord for emerging economies would include guidelines for such a scheme consistent to complement risk-aligned capital.
Basel II’s SA may well be implemented by several emerging economies. And yet there is little discussion on what ratings will be used. Rating agencies publish ratings according to the currency of a claim AND on local and international scales. The latter distinction is not considered in the Accord and yet emerging regulators face the choice of using international ratings, favoring homogeneity but further limiting the availability of ratings OR using the local scale, but then the essence of a standard across countries is lost as local ratings are not comparable internationally. Calibration issues for emerging economies also abound in the SA. Mortgages and retail lending are two examples. Again, the CRB may be an attractive alternative offering a consistent framework to resolve these issues.
Basel II includes a new capital requirement for Operational Risk. There are different approaches including advanced, standardized and basic-indicator. On the one hand the advanced approaches, which call for the validation of a banks’ internal methodology, again give too much autonomy to a bank given the current culture of supervision in many emerging countries and are difficult to supervise. On the other hand, there are doubts regarding the calibration of the standardized
8 One view would be to have a common calibration for emerging economies, a second would be to allow flexibility. The former would be closer to Basel I in setting a standard in terms of a level of capital or the standard might be in terms of the level of protection – Basel II is 99.9%, but for emerging economies the appropriate level might be 99% or 95%.
approach and concerns that it is easy to game. The basic indicator approach may be the best alternative on offer but the calibration is also questionable. This is an area where further work is urgently required.
A second area where further work is required is the treatment of public sector assets. Basel II calls for capital requirements on these assets using an external or an internal rating. However, if the asset is denominated and funded in local currency then a special regime may result in zero capital requirements. Many emerging regulators apply capital requirements on public sector assets but others find it difficult to resist political pressure to allow banks to fund cheaply, in one way or another, budget deficits. Useful guidelines on capital and what constitutes a safe level of public asset holdings would be desirable.
A further emerging economy issue is the credit risk involved in lending in foreign currency, especially for dollarized or euroized financial systems. Basel II considers the market risk inherent in foreign currency lending and while in the advanced approaches a higher default probability might be assumed, there is no explicit treatment. A clear methodology to consider explicitly the credit risks of lending in foreign currency is a must for emerging countries.
Basel II also includes new techniques to analyze securitization risks and credit risk mitigation techniques. These are important issues for emerging economies where
giving the right incentives for banks to securitize may help develop capital markets. The use of guarantees and market instruments as collateral is common in many emerging economies to reduce the often high levels of perceived counterparty risk. Any Accord for Emerging Economies would need to incorporate appropriate treatments.
Pillar 2 considers what banks should do and what banking supervisors should be doing to assess banking risks and monitor them effectively and to act when required. Much of this is a very useful restatement of the Basel Core Principals for Banking Supervision with more succinct and precise language. However, it is ironic that in this international Accord, there is little regarding how supervisors should coordinate. Indeed, while comments and contributions were received across the globe, the spirit of the Accord as written is that there is a consolidated entity with a single regulator.
Given current trends, it seems likely large international banking groups will have multiple regulators applying different approaches within Basel II. Host regulators would no doubt have the responsibility of supervising local institutions whether they be subsidiaries or branches that count on local deposit insurance and depending on local legal requirements. In some cases where a branch (or perhaps even a subsidiary) counts on a wide and transparent guarantee from the parent, this responsibility might be delegated to a home regulator. It would then be useful to state explicitly in Pillar 2 and in some detail what mechanisms for supervisory cooperation and information sharing should be adopted.
An ideal might be the joint supervision of foreign branches and subsidiaries. This implies the home and host supervisor agreeing with the relevant entity the appropriate approach (SA, IRB or CRB) to be adopted, how that would be calibrated and then jointly supervise with joint inspections. This means both regulators have responsibilities and the process would be designed to enhance supervisory cooperation, information-flow and supervisory knowledge transfer with obvious wider benefits.9
Basel II’s Pillar 3 is entitled market discipline and focuses on the disclosure of risk and disclosure of bank capital. Several emerging economies have adopted other mechanisms to enhance market discipline including a) publishing bank balance sheets and performance ratios (including non performing loans and other indicators of portfolio quality) according to a standardized format b) asking banks to obtain at least one credit rating and c) asking banks to issue a non-insured debt instrument subordinate to insured deposits. For emerging economies where supervisory discipline may be weaker, market discipline may be even more important, although the lack of liquidity in domestic capital markets is often seen as a constraint.
9 Naturally a local regulator will be more considered with the integrity of the stand-alone subsidiary while a home regulator will be concerned about the consolidated entity. There is the potential for conflict in that a host regulator would wish wide guarantees for the subsidiary whereas the home regulator may wish to limit the exposure to a subsidiary, especially in a risky environment – see Powell, A and G. Majnoni, “International Banks, Cross Border Guarantees and Regulation” mimeo IDB.
Discussions towards Basel III, Emerging might consider whether these techniques (or others) would be useful ways to promote market discipline in the context of an emerging economy.
Taking Pillar 3 as it stands, a bank is asked to publish indicators of credit risk according to the Pillar 1 alternative adopted. This yields a lot of information in the case of the IRB but little information in the case of a bank on SA. Again, an advantage of an intermediate CRB approach would be to elicit greater information from banks regarding their risk profile in a more standardized format.
A particular concern also relates to the subsidiaries of foreign banks in emerging economies. Frequently, foreign bank entry has occurred with the purchase of a domestic bank that results in delisting on local stock markets and, depending on the internal funding strategy of the bank, potentially no local uninsured debt instruments outstanding. Market information regarding risk is then replaced with what is frequently a non-transparent guarantee from the parent. Under these circumstances having some non-insured debt instrument issued by the local subsidiary might give information on the risk and the market’s expectations regarding a guarantee. Also, ensuring that the local subsidiary must disclose its risk according to Basel II’s Pillar 3 (especially if it was working under an IRB approach) would yield greater information to the market.
To conclude, there are many instances where the fit of Basel II for emerging economies can be improved. The current policy is to consider these topics as “implementation issues.” The IMF, the World Bank and the Regional Development Banks will surely assist emerging economies through technical assistance. But the danger is that countries will adapt the Accord in their own ways and through this process (coupled with the many sub-alternatives on offer), the essence of a standard will be lost. A committee of emerging economies could develop a more explicit adaptation, Basel III – Emerging, focusing on emerging country issues and enhancing the ownership of the standard developed.