Basel, a policy choice …

Last week, the Basel Committee on Banking Supervision (BCBS) held an important meeting in Santiago de Chile to finalise the « Basel III » post-crisis reforms. The package of reforms under review includes a revised standardised approach for credit risk, revisions to the internal ratings-based approach, a revised operational risk framework, a leverage ratio surcharge for global systemically important banks and an aggregate output floor. They will have so huge impacts on capital requirements for banks that the industry refers to it as « Basel IV ».

After this first paragraph, I already lost 90% of my readers.

Let me pursue however ! In Europe, 75% of the financing of the economy comes from banks after all, whether people and policy makers like them or not : it’s worth to try to understand what is at stake.

The BCBS is the primary global standard-setter for the prudential regulation of banks. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability. The Basel Committee works in close collaboration with the Financial Stability Board (FSB) given the FSB’s role in coordinating the monitoring of implementation of regulatory reforms.

The Committee’s Secretariat is located at the Bank for International Settlements in Basel, Switzerland, and is staffed mainly by professional supervisors on temporary secondment from member institutions.

The Committee reports to the Group of Governors and Heads of Supervision (GHOS). The GHOS will meet on January 8th to endorse – its’s the most likely scenario – Basel Committee proposals. At the end of the meeting, we will have a delicious presss release explaining how the compromise is good for our economies.

In a working paper published in march 2016, the European Central Bank explores how higher bank capital ratio, via its impact on bank credit supply conditions, influences business cycle dynamics both at the domestic level and across borders in the EU.

Beyond the complexity of the model, and to make a long story short, the paper distinguishes between three types of behaviour of banks in response to higher required capital ratios. The first of two polar cases assumes that banks approach a higher capital ratio by reducing the size of their balance sheet while not raising capital. Under this scenario (the paper calls it « contractionary deleveraging »), economic activity can drop materially. The opposite polar case assumes that banks raise equity capital or build up capital in a gradual manner by retaining earnings, to invest the additional funds in new assets (« expansionary deleveraging »). Under this capital raising scenario (an unlikely one when the cost of fresh equity is far above its return), some mild upside potential for growth can be measured.

Along with the two polar cases, an unconstrained capital ratio shock scenario is meant to reveal how banks have been moving toward higher capital ratios on average historically. Depending on how the shocks are designed, this scenario tend to produce mixed, though on average somewhat negative, responses of real activity across countries. The simulation results suggest, moreover, that cross-border and cross-bank/banking-system effects are sizable in many cases.

If definitly adopted, Basel decisions will have to be transposed into the european legislation through the normal european legislative process, which involves the Commission, the Council and the Parliament. In practice, two texts will have to be amended : the Capital Requirement Directive and the Capital Requirement Regulation (respectively called « CRD » and « CRR »).

The irony is that, at the very same time, the European Commission just launched a legislative process to transpose into these two texts the preceding set of decisions of Basel Committee : in 2017, and maybe 2018, European legislative bodies will then discuss the fifth version of CRD and the second one of CRR, not taking into account Santiago decisions yet.

As I wrote in my post dated August 4th, « … at the end of the day, in a modern economy, all is about a question of policy choice between resilience of the financial system and dynamism of the economy. And this choice materializes in the level of leverage you are ready to collectively accept in a society. »

Santiago decisions will have a very significant impact on capital requirements of european banks. The adjustment needed will be done partly by reducing the amount of loans to the economy, and partly by freezing in banks the capital that Europe needs for long term projects, corporates, infrastructures …

History will remember that this policy choice will have been done by professional supervisors, whose mandate is to enhance financial stability, not to favor growth and jobs. And that these people told wrongly to stakeholders that the impact of their decisions on capital requirements would be not significant, which was the original mandate given to them by the G20.

Hopefully, european legislator will try to correct the most dramatic effects of Santiago decisions for Europe, but it will be very marginally.

Not only a complicated story : a very sad one for Europe !

Iconography : Quentin Metsys, The Moneylender and His Wife, 1514, oil on panel, 70 x 67 cm. © Musée du Louvre, Paris, France. Post originally published on LinkedIn.

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One Comment on “Basel, a policy choice …”

  1. How much CRAR are we talking about? Of course small sized banks would be forced to reduce balance sheet instead of raising capital, but performing medium sized banks shall raise capital with the promise of increasing ROE to investors, however I am of the opinion that with growing market risk there must be regulations put in place, however Basel4 shall just be guidelines, following them is up to the institutions management

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