Basel III Point Man Answers Critics of the Capital Rules

Perhaps no one in the world knows international capital rules better than Stefan Walter, the secretary general of the Basel Committee on Banking Supervision. The former New York Fed official took Basel's lead staff job five years ago and has played a key role in shaping the Basel III rules.

After my July 28 column suggesting the U.S. might want to quit the Basel process and simply write our own capital rules, the committee's press office suggested I might want to talk with Walter. I agreed. Who better to explain the rule's expected impact, detail its implementation hurdles and defend it against criticism?

Walter is wrapping up his work in Basel and plans to leave the job in late October. The committee is currently looking for his successor and he has yet to reveal his next move. What follows are excerpts from our interview this week.

Let's start broadly — how much progress have international supervisors made on capital standards?
Nothing is ever perfect, but I think overall, the Basel III international capital standards represent a major achievement in global cooperation. And they are a fundamental improvement over what we had before the crisis. Remember, too, that in the middle of developing Basel III, we also doubled our membership to 27 countries. We thought it made sense to align our membership with the G-20. [Among the new members are China, India, Russia, Singapore and Hong Kong.]

How about liquidity standards. A lot of bankers are hoping there will be some big changes.
We've had decades of experience with capital regulation and we are for the first time putting in place a global liquidity standard. So that's obviously a more difficult process. But we are not debating whether there is going to be a standard or not. The standard is already in place and we are debating the details. Most of the concerns relate to calibration as opposed to the design or the concept. The main issues that have been raised about the liquidity coverage ratio is whether the definition of liquid assets is too narrow and, second, when it comes to the stress liquidity shocks, are those too stressful or not. That's really where the dialogue is happening. We have put out a very concrete rule, but we built in an observation period so we can make sure that the final calibration produces the incentives and results we intended and doesn't cross the line in terms of destroying viable and sustainable business models.

When do you anticipate the liquidity standards will be finished?
The liquidity coverage ratio takes effect Jan. 1, 2015, and we are committed to finalizing any changes by mid-2013 so the industry will have 18 months to prepare. We are definitely going to try to frontload the work and get as much of it done by the end of next year. We have a bit more time for the net stable funding ratio.

What else are regulators doing to control systemic risk?
So much of addressing systemic risk deals with capital and liquidity reforms. At the highest level we've pretty much completed the policymaking side on the capital and to a significant extent on liquidity. We're close to completing the work for the systemic banks on the capital surcharge. We've gone out with a proposal and the comments were due Aug. 26 and we plan to finalize the framework in time for the G-20 leaders summit in November. With the recommendations we made on how to improve cross-border resolution, we have laid out the road we want to travel on the recovery and resolution work in the international context. There is a lot of work still to be done to flesh that out. Then I think the big thing is moving all this from policymaking to implementation. We want to see as consistent implementation of the global minimum standards as possible and we have put in place all kinds of processes to try and make that happen. This is very different from what was in place after Basel I and Basel II.

What about the consistency of application? The U.S. has Dodd-Frank, the U.K. is taking a tough approach, the EU is prohibiting its members from doing anything more stringent than Basel. Can we ever have a truly international standard?
Harmonization will never be perfect, but our efforts are a major step forward. When it comes to Dodd-Frank, this legislation mentions the need for better and higher capital and liquidity standards, but it defers to the Basel Committee to flesh out these requirements. Thus Basel III and Dodd-Frank complement each other nicely.

When it comes to structural issues, be it the Volcker Rule or the treatment of UK retail banking, these issues have always been subject to national treatment under Basel I and II, and it remains the case under Basel III. For example, Basel I was agreed to in an environment where Europe had universal banking and the United States was subject to Glass-Steagall.

Finally, the Basel Committee has always focused on minimum standards. Countries are free to set higher standards to reflect national circumstances.

How about banks. Have they done enough to improve their risk management systems?
I don't think that they are there yet. It's really about the governance process at the top of the firm, the composition of the board, its expertise, its mandates. They have to define the firm's risk appetite and then push that down into the organization in an effective way. And then you need to have the information and the data and be able to aggregate it in a consistent way to support this process. So it really starts from very basic strategic issues, governance issues and then you drill down into the infrastructure and investments that have to be made. That is a multiyear process that the industry still has to go through. The challenge of course is that the world doesn't stand still and these reforms need to be robust over time in an environment of rapid financial innovation and drift in business models.

Is that why capital requirements need to be tougher?
I think that's why we don't want to put all of our eggs in the basket of just risk management and supervision because history has shown over and over things can and do go wrong. Going into the last crisis the level and quality of capital was inadequate and there was just way too much leverage in the banking and financial system. This didn't provide the margin for error for the situations where risk management failed and supervision didn't pick up on it. That's not to say we shouldn't do everything we can to push for better risk management and supervision. We are doing that. That's also part of our agenda in the Basel Committee. It's not as sexy; it doesn't get reported on as much as capital or liquidity regulation, but it is something we are working on quite heavily. As things heat up again, memories of the crisis fade and firms focus on growth and market share, there is again the risk that these basic governance and control issues are neglected.

How worried about that are you?
Very worried. It's human. It's just what happens over and over again in a rapidly changing, complex world — the basic mistakes of risk governance seem to repeat themselves in new contexts as financial innovation progresses. But again that's why I think we need to build in more safeguards through more robust capital and liquidity standards. Moreover, it's not enough for us to just come out with supervisory practice papers. Supervisors and the industry need to follow up on them and make sure they are being implemented by member countries. And that's something we didn't do enough before the crisis. It's something we are going to do in a much more systemic way going forward. We will be asking: Are countries actually implementing this and are banks actually implementing it on the ground?

How will the Basel Committee do that?
This is an area where there is going to be quite a bit of innovation and change. We will put in place stronger peer-review processes where we will be looking at how countries and their banks are actually implementing Basel III in practice. We need to develop stronger tools to do that. There needs to be more centralization of that process at the global level. Obviously it is never going to be a formal, legal power. But if you do have a very strong peer-review process then you can get a virtuous circle to participate. There needs to be a cultural change among supervisors, where critical reviews are welcomed and not viewed in a defensive way. I think that is something that both the Basel Committee and the Financial Stability Board, buttressed by more transparency, will be doing. This process can also be reinforced through the Basel Core Principles for Effective Banking Supervision (which are currently being updated), and through IMF/World Bank country reviews.

Some U.S. banks fear Asian countries will be looser in their implementation of Basel III and they will lose business to companies based in, say, Singapore.
When it comes to Basel III, I would say that is completely unfounded. If anything, countries in Asia have had much higher standards than your traditional Basel Committee member countries. They haven't had as much innovation in capital instruments and hybrid products and they don't have as much leverage. So I would expect that these countries will have at least as tough standards and in some cases they are going to be tougher because certain elements of Basel III would actually be a weakening of existing standards for some of these countries.

What do you say to critics who claim Basel III with its core rule and its three surcharges is just too complicated?
I think Basel III really is about addressing the things that are most important for banking system stability. It raised the level and quality of capital. It strengthened risk-weighted assets for trading and counterparty risk. That is the first piece. While it's important to have a risk-sensitive regulatory capital framework, you also need simple, easy-to-understand, high-quality capital behind it. Second, I think this crisis was humbling for all of us in terms of being able to identify in advance what is going to be the most risky thing, especially at the systemwide level, whether it is triple-A securitizations, repos and derivatives, sovereigns, whatever, versus say hedge funds, which maybe were the dog that didn't bark. That's why we have a reinforcing leverage ratio as a simple backstop to the risk-weighting regime.

The other basic concept enshrined in Basel III is capital conservation. We want to avoid another instance in which institutions are distributing capital via dividends and share buybacks at the same time their capital base is deteriorating because of losses. So that's the role of the capital conservation buffer. A credit boom leads to the most severe banking busts, so that's where we can require more capital through the countercyclical charge. And for systemically important financial institutions (SIFIs), operating across multiple jurisdictions, if they go down, they are going to have a bigger impact than a purely domestic community or regional bank. So we deal with that through the SIFI surcharge.

That's really the essence of what we are doing. It is an integrated framework and it is relatively straightforward.

But what about the impact on economic growth? Critics claim higher capital requirements impede lending, which in turn chills growth?
Our work as well as that of independent academic studies all show the impact is relatively minimal, especially in relation to the benefits that we are going to get.

We've concluded that even when you factor in the SIFI surcharge you are talking about 5 to 10 basis points off annual GDP during the phase-in period, so it's relatively minor. On the other hand you have huge benefits in bringing down the potential downside risks to growth over the cycle. I think the studies we conducted focus on both sides of the equation — the costs and benefits — while many other studies have highlighted only the costs.

One of the reasons the last downturn was so bad was because banks were so undercapitalized. That substantially amplified the depth and severity of this crisis on so many dimensions, including its extension to the fiscal concerns that so many countries are now facing. The benefits of raising the capital in the banking system, especially for the most systemic globally active institutions, are very large.

How much progress do you think has been made on getting capital levels to the proper level?
I think we are quite far down the road in aggregate. We will get a better read when we do our next Quantitative Impact Study. We should have the results by the first half of next year as to where the industry is. Many banks are there and other banks will be there sooner than the timeline we are giving them. We feel quite confident that the industry will be able to meet the Basel III standards.

It's not like we aren't still living in a dangerous world. We want to keep moving the industry along in building its buttresses against potential stress down the road.

But do you ever worry that regulators, through capital rules, have an outsized influence over business decisions?
Any regulation is going to change behavior, that's just by definition what regulation is about. It is forcing the individual institution to internalize the cost that it could present to society more broadly. When it comes to capital adequacy, there was a lot of catching up to do.

But even you admitted it's hard for regulators to figure out what assets pose the biggest risks.
We can only do our best and that's why we want to have checks and balances there through both risk weighting and a leverage ratio backstop.

Why is it taking so long to identify which firms are systemically important?
Our goal is to develop an assessment framework by the G-20 meeting in November as opposed to a fixed list. We will identify the criteria for assessing whether an institution is systemic using five factors: size, complexity, substitutability, interconnectedness and global activity.

Will there be an actual list?
Those five indicators will produce a score, and if a company is above a certain cutoff point, it will be deemed systemic. Right now we think the methodology would produce 28 institutions globally. But that will evolve because by the time this is implemented institutions will have a chance to adapt their business models (in ways that could bring their score down). So we don't know how many it will be in the end.

If there are less than 30 systemic institutions in the world, wouldn't it be more efficient for national regulators to cede oversight of them to some international organization?
If you were to defer that regulation in a legal sense to a global body then that global body would have to have the resources to resolve institutions. So as long as resolution authority and deposit insurance is at the national level you are still going to have regulation at the national level. The best you can do is to improve global consistency and coordination. And there is much, much more coordination now happening for these systemic institutions. For example we have supervisory colleges (teams of regulators from various countries where a bank operates) and crisis resolution groups that discuss if an institution were to get into serious difficulty how would we resolve it? If that institution is not resolvable, what changes might have to be made to make it more resolvable? So those discussions are getting much more specific. There is a lot more focus on these institutions in a coordinated way, but yes it falls short of a global Federal Reserve or a Bundesbank.

Do you think nations should take steps to reduce the size or complexity of their largest financial institutions?
Speaking personally, I think that should be an option on a case-by-case basis. If an entity is organized and structured in a way that is so complex that it seems completely unresolvable, then supervisors should have the ability to force changes in its structure.

Isn't that what living wills will do?
They are part of this process. Moreover, I would expect that where recovery and resolution plans are weak, supervisors could place restrictions on the bank's expansion of certain activities or on mergers.

How worried are you that individual countries will try to protect some bank assets from regulators in other countries?
The degree of ring fencing will be a function of how successful we are in implementing all these standards we've agreed on. If a bunch of counties water down Basel III, if we don't make a lot of progress to improve cross-border resolution, then individual nations will do what they need to do to protect themselves. I really think we are at a critical juncture on all this implementation work because that is going to determine the nature of global banking going forward. I would also say it is not in the interest of the banking industry to lobby to water down the globally harmonized agreements at the national level. Such efforts will increase the risk of balkanization and in the end amount to shooting yourself in the foot.

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.