New Guidance Shows Basel Committee Means Business

First in a nine-part series

In over a decade of consulting and training on the Basel accords, I have never seen anything like what has transpired in the last two weeks. The Basel Committee on Banking Supervision released five new financial regulatory guidelines and published three updated methodology documents. With these eight documents, the Basel Committee is reasserting its role as the key global standards-setting body on all aspects of banking supervision.

The five proposed guidelines, known as consultative documents and open for public comment until the fall, address: revised Basel III leverage ratio framework and disclosure requirements; sound management of risks related to money laundering and financing of terrorism; capital treatment of bank exposures to central counterparties; the non-internal model method for capitalizing counterparty credit risk exposures; and capital requirements for banks' equity investments in funds.

The three discussion documents are an assessment methodology for global systemically important banks; the first report on the regulatory consistency of risk-weighted assets for credit risk in the banking book; and the regulatory framework for balancing risk sensitivity, simplicity and comparability.

Individually, but especially collectively, these guidelines and discussion papers demonstrate, that while the 27 members of the Basel Committee may seem at times to work in slow, mysterious ways, they have not given up on their core mission of establishing uniform international capital standards to improve the safety and soundness of large, interconnected banks.

In particular, I have long waited for the revised Basel III leverage ratio framework and disclosure requirements, because a strong, transparent leverage ratio could be a very useful and credible supplement to the polarizing risk-weighted asset credit risk measure under Pillar I. The changes the committee has proposed to the exposure measure, the leverage ratio's denominator, will impact banks significantly, because it includes a broader scope of consolidation for the inclusion of exposures, clarification on the general treatment of derivatives and related collateral, and enhanced treatment of both written credit derivatives and securities financing transactions (i.e., repos).

In addition to the expansion of what has to be covered by a bank's capital, the new guidelines can be very useful to the market as a whole, because they require banks' disclose what is included in their leverage ratio. The potential, significant changes in the leverage ratio guidelines are likely to reinvigorate global regulators, academics, politicians and practitioners such as myself, who feel that a leverage ratio of 3% is too low for GSIBs. U.S. bank regulators just proposed requiring a higher leverage ratio for the largest U.S. banks.

I will discuss the leverage ratio framework, as well as the other eight recently released documents, in more detail during this series, but here is a quick overview of how each illustrate that the Basel Committee is taking its mission seriously:

• The money laundering guidelines, which are not part of Basel III, but certainly critical to improving banks' risk management, particularly operational risk, should be an important tool in encouraging banks to include the definition, identification and control of money laundering and financing of terrorism risks within their overall risk management philosophy, policies and procedures.
• The guidelines on capital treatment of bank exposures to central counterparties pave the way for changing the capital treatment of exposures to qualifying CCPs, following additional work undertaken by the Basel Committee, the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions.  Having a well-calculated and transparent capital charge for transactions with CCPs is important, particularly in light of the influence that Dodd-Frank and European Market Infrastructure Regulation are having on the migration of over-the-counter derivatives to CCPs.
• The guidance on capitalizing counterparty credit risk exposures is essential as the most recent financial crisis certainly proved that sometimes the credit quality of a derivatives' counterparty can deteriorate before your underlying asset.
• Guidelines on capital requirements for banks' equity investments in funds signal the Basel Committee's and the Financial Stability Oversight Council's continued interest in the role shadow financial institutions play in the global economy and how banks interact with them. Because the committee admitted that there are shortcomings in Basel II's current treatment of banks' equity investments in funds, it decided to review the prudential treatment of these investments by developing a revised capital regime. When finalized, the new standards would be incorporated to Basel III's Pillar I and banks would have to increase capital for this class of assets.
• An updated assessment methodology for what constitutes a GSIB and what additional capital measures are necessary will reignite the desire by many regulators around the world to finalize the Basel surcharge for large systemically important banks. The committee demonstrated that it is listening to strong criticism about low capital requirements for megabanks by stating "the negative externalities associated with institutions that are perceived as not being allowed to fail due to their size, interconnectedness, complexity, lack of substitutability or global scope are well recognized."
• The committee's report on risk-weighted assets reveal the worst kept secret in the banking regulatory world: that there is no uniformity in how banks calculate RWAs for credit risk. Given that in January of this year, the Basel Committee also found great differences in market-risk RWAs, there is no doubt that regulators and financial reform groups will renew their criticism of the way that RWAs are currently calculated and that there is very little public disclosure on the calculations' inputs.
• Finally, the Basel Committee very unexpectedly published what could end up being the most significant bank regulatory topic this year: an admission that Basel III may indeed have become too complex for banks, investors and, even, most bank supervisors. The Basel Committee may come to regret releasing this discussion paper, especially as it indicates a willingness to rethink the risk-weighted-asset methodology for risk measurement. By the time all comments are handed in on October 11 and vociferously debated, the committee may well be underway to crafting Basel IV.

Next: An analysis of Basel's revised Basel III leverage ratio framework and disclosure requirements.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.