Stefan Ingves: From ideas to implementation
Remarks by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the
Basel Committee on Banking Supervision, at the 8th High Level Meeting organised by the
Basel Committee on Banking Supervision and the Financial Stability Institute and hosted by
the South African Reserve Bank, Cape Town, 24 January 2013.
As prepared for delivery.
* * *
Introduction
Let me begin today by thanking Josef Tošovský, Chairman of the Financial Stability Institute,
for organising the latest in its series of High Level Meetings. The Basel Committee continues
to view these events as extremely important, as they bring together senior policymakers and
supervisors in a forum in which we can share thoughts on critical issues of the moment and
reflect on long term challenges. Let me also extend my thanks to the South African Reserve
Bank for its superb hospitality as the annual host of this High Level Meeting.
Change and reform - new ideas and new ways of doing things - can be challenging in good
times. When all is well, the perceived need is low and the costs - including opportunity costs
- are difficult to justify. Even small ideas can be difficult to implement. Crises, on the other
hand, provide a catalyst for fundamentally rethinking past practices. Many banks have learnt
this as a painful lesson in recent years: when times were good, potential operational, risk
management and cultural deficiencies were not examined closely enough. When serious
problems emerge, however, there is a demand for new ideas and new ways of doing things:
the status quo becomes unacceptable.
Of course, the same scenario has applied to the regulatory framework more broadly.
Precrisis, any call for stronger capital and liquidity rules was generally howled down as
burdensome and unnecessary. Post-2008, the costs of a weak regulatory framework have
been all too obvious and painful for the banking sector, and as a result the demand for new
ideas was immediate and forceful.
My theme for today is that successful regulatory reform is about ideas and implementation.
Certainly, we needed to rethink the regulatory framework in light of what we have learnt from
the past five years - the status quo was not acceptable. But if we want to be successful, the
Committee also needs to make sure that the ideas we developed into Basel III are truly put
into practice.
From ideas ....
The Basel Committee's response to the financial crisis was to recognise that policy
weaknesses contributed to the excesses that built up in the financial sector. A substantial
overhaul was necessary: minor adjustments to the framework were not going to be enough.
We needed some big, new far-reaching ideas. In summary, we decided that it was necessary
to:
•
require banks to maintain substantially higher levels of capital, with the minimum
common equity requirement increasing from 2% to 7% of risk weighted assets;
•
require banks to hold higher quality forms of capital, with common equity at the core
of the requirements, and standards to ensure other types of capital instruments are
truly loss-absorbing. It is worthwhile emphasising that these reforms also go a long
way to simplifying banks' capital structures, as well as making them more
transparent and comparable;
•
introduce an additional capital buffer (the capital conservation buffer) designed to
enforce corrective action when a bank's capital ratio deteriorates. The capital
conservation buffer allows banks to dip into their capital reserves, while at the same
time providing disincentives for banks to do so due to the restrictions it imposes on
dividend and bonus payments;
•
add a macroprudential element in the form of the countercyclical buffer, which
requires banks to hold more capital in good times to prepare for inevitable
downturns in the economy;
•
supplement the risk-based regime with a simple backstop in the form of a
(non-riskbased) leverage ratio;
•
impose additional capital requirements on systemically important banks - both
global and domestic - to take account of the externalities their failure would impose
on society; and
• international standards for bank liquidity and
introduce the first funding, designed to
promote the resilience of a bank's liquidity risk profile to both short term liquidity
shocks (the Liquidity Coverage Ratio - LCR) and longer-term mismatches in funding
(the Net Stable Funding Ratio - NSFR).
Of course, there are plenty of other big ideas being floated on how the banking industry
should be restructured in the aftermath of the crisis, particularly those related to varying
models of structural separation (eg the ideas of Volker, Vickers and Liikanen). But for those
that fall within the mandate of the Basel Committee, we believe that the ideas produced by
Basel Committee thinking - translated into the Basel III reforms, and subsequently endorsed
by the G20 and Financial Stability Board - provide a substantial foundation on which the
banking system can be rebuilt to be much more robust and resilient in the future.
Basel III capital requirements are probably well known to all of you, so I do not propose to
say much more about them today. What I would instead like to focus on is our thinking in
relation to liquidity, and particularly the LCR. As an idea, it is simple: a bank should have
enough liquid assets to survive a 30-day period of stress. And perhaps to some, it might
seem underwhelming. If you tell your spouse that we have implemented a reform that
requires banks to have enough cash to last 30 days, more than likely you will get the same
only
response I did when I tried to explain it to my wife: "what do you mean, 30 days?"
Yet this idea has been one of the most fundamental reforms of the crisis. It also is a classic
example of an idea that had been toyed with for a long time, but took a crisis to bring to
fruition. A study of Basel Committee history shows liquidity to have been on the agenda
almost for the entire existence of the Committee, but we have never come close to an
international standard. Basel III has changed that. So even though the LCR is "only 30 days
of cash", its significance should not be underestimated.
As you would be aware, the focus of the Committee over the past two years has been on
refining the formulation of the LCR announced in 2010. Given this is the first time the
international community had developed a global liquidity standard, it was agreed that it
should be subject to an observation period, during which it could be adjusted as a result of
further analysis and assessment. The aim of the observation process was not to further
tighten or weaken the standard: the goal was purely to ensure the calibration was more
reflective of empirical evidence and appropriate for implementation as a minimum standard,
across the Committee's 27 member countries and more broadly.
The changes agreed to by the Committee focus on three main areas:
•
High quality liquid assets (HQLA): A diverse and sufficiently large stock of HQLA is
essential to help banks withstand liquidity stress. The revised definition now
provides limited recognition of additional assets such as a broader range of
corporate bonds, a selection of listed equities, and some highly-rated residential
mortgage backed securities (RMBS). Recognising the greater price volatility
associated with such assets, their inclusion in the stock of HQLA is subject to a
relatively low limit as well as significant "haircuts". The Committee has tried to
balance the benefits of greater diversification of the liquidity pool against the cost of
including slightly lower quality assets.
•
We have also changed some of the assumed inflow and outflow rates that
determine the size of the pool of liquid assets that a bank is required to hold.
• As in the case of the capital conservation buffer, the standards now make very clear
that liquidity is to be built up and maintained in good times so that it can be used in
times of need. In other words, liquidity is not useful if it is frozen.
In addition, in light of the considerable stress facing banking systems in some regions of the
world, the Committee revised the implementation plan of the LCR by introducing a phase-in
arrangement. The LCR will come into force as planned in 2015, although banks now will
have until 1 January 2019 to meet the standard in full. Nevertheless, I expect many banks
will choose to move to the higher standard more quickly.
In announcing the revisions to the LCR, many headline writers categorised it as some kind of
win for the banking industry over the regulators. This is simplistic. We had an observation
period for good reason: to make sure we got the settings right. There was, I think, legitimate
minimum
concern that, as a standard, the 2010 formulation of the LCR may have been
calibrated too conservatively overall. For example, the treatment of traditional retail and
commercial banking was probably too harsh, and this has been adjusted. Equally the
treatment of derivative-related risks was probably too weak, and so that has been adjusted
too. Much has been made of the inclusion of RMBS in the definition of high quality liquid
assets, but the eligibility criteria are tight and the initial perception that the Committee had
granted carte blanche to the securitisation sector is well wide of the mark. As the Chairman
of the Basel Committee's governing body, Governor King of the Bank of England, said when
announcing the full set of changes, they are designed to make the LCR "more realistic". I
think this sums it up very well.
Of course, the overall impact of the changes is to improve the reported LCR of the banking
system. Based on our most recent data (end June 2012), we estimate that the weighted
average LCR for a sample of roughly 200 of the world's largest banks is around 125%,
compared with a little over 100% for the previous calibration. This does not mean, however,
that all banks are ready and able to meet the standard today. Even though the industry
average is well above the minimum, our estimates suggest that roughly one-quarter of our
sample could still have an LCR below 100% even with the latest policy changes. So there
remains a significant liquidity shortfall that will need to be addressed by a number of banks.
One also has to bear in mind that favourable terms from central banks have helped to
improve bank funding. Central banks serve as lenders of last resort and, as economic
conditions improve, banks will need to become more self-reliant. However, the timetable for
the gradual introduction of the ratio ensures that the new liquidity standard will in no way
hinder the ability of the global banking system to finance a recovery.
It has taken a lot of time and effort to reach agreement on the LCR. It is, as I said, a
deceptively simple idea, but its implications are big and far-reaching. Unsurprisingly, there is
much in the detail that required a lot of careful analysis and thought, not to mention a
willingness to find a way through differing national perspectives. It is, however, critical that
the new ideas such as the LCR (and the other new features of Basel III such as the capital
conservation buffer, countercyclical buffer, leverage ratio and NSFR) are implemented if their
benefits are to be realised. Against that background, let me now turn to the work we have
started to ensure that the Basel III framework is implemented as intended.
.... to implementation
Steady progress is being made. As of January 2013, 11 out of 19 Basel Committee
jurisdictions have final Basel III rules in place, including our hosts today, South Africa. A
number of non-member countries also implemented Basel III at the beginning of the year,
further expanding its coverage. While it would be ideal to have much broader coverage at
this time (as at today, around one-third of global banking assets are officially subject to the
Basel III requirements), the delays should not be interpreted as any lack of commitment by
global regulators to implement the agreed reforms. At recent international gatherings, all
members have been asked to reaffirm their commitment to implementing the agreed reforms
as soon as possible. And they have given that commitment (subject, of course, to the
vagaries of domestic rule-making processes that each must follow). Nevertheless, let me be
clear: the question being discussed is when the reforms will be implemented, not if.
Any setback to implementation is undesirable, since Basel III is a key platform on which to
rebuild a stronger global banking system. But the delays are not critical at this point, for two
reasons. First, the Basel III capital rules contain a lengthy phase-in period, meaning that in
2013 the new requirements should not be particularly burdensome for banks (eg none of the
new deductions from capital are applied this year). Second, many regulators who have been
unable to implement the new standards by the beginning of this year are still measuring and
monitoring their banks' capacity to meet the new requirements. And, of course, markets are
applying similar pressure. In other words, the "force" of the new capital regime is much
broader than just those countries that have implemented their domestic regulations.
Nevertheless, to ensure visibility of the implementation of reforms, the Basel Committee has
been regularly publishing information about members' adoption of Basel III. We will continue
to do this so as to keep all stakeholders and the markets informed, and to maintain peer
pressure where necessary. It is especially important that jurisdictions that are home to global
systemically important banks (G-SIBs) make every effort to issue final regulations at the
earliest possible opportunity.
But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for:
full, timely and consistent implementation of Basel III. In response to this call, in 2012 the
Committee initiated what has become known as the Regulatory Consistency Assessment
Programme (RCAP). The regular progress reports are simply one part of this programme,
which assesses domestic regulations' compliance with the Basel standards, and examines
the outcomes at individual banks. The RCAP process will be fundamental to ensuring
confidence in regulatory ratios and promoting a level playing field for internationally-operating
banks.
It is inevitable that, as the Committee begins to review aspects of the regulatory framework in
far more detail than it (or anyone else) has ever done in the past, we will find aspects of
implementation that do not meet the G20's aspiration: full, timely and consistent. We are
going to find parts of the framework that have been implemented only in part, or late, or
inconsistently. The financial crisis identified that, like the standards themselves,
implementation of global standards was not as robust as it should have been.
This could be classed as a failure by global standard setters. To some extent, the criticism
can be justified - not enough has been done in the past to ensure global agreements have
been truly implemented by national authorities. However, just as the Committee has been
determined to revise the Basel framework to fix the problems that emerged from the lessons
of the crisis, the RCAP should be seen as demonstrating the Committee's determination to
also find implementation problems and fix them.
It would be easy to continue to ignore any problems. A fascinating1 history of the Basel
Committee published recently by Professor Charles Goodhart2 notes that the Committee has
on more than one occasion over the past 35 years considered undertaking more detailed
analysis of domestic implementation of global standards, but shied away from this as being
"too intrusive". However, we have now taken that step, since if we are serious about fixing
the problems of the past, then we need to not just look at the policy settings, but also their
application. Our efforts on implementation should therefore be seen as an integral part of the
reform agenda - not just an adjunct to it.
When it comes to our country-by-country assessments, thus far the Committee has
conducted detailed assessments of the final regulations adopted in Japan, and the draft
regulations in the European Union and the United States.3 Follow-up assessments in the
European Union and United States will be conducted once final regulations are available.
Assessments under the RCAP are currently underway for Singapore and Switzerland. Later
this year will follow China, Australia, Brazil and Canada. As with all of the RCAP work,
transparency is critical to success - all of these reports will, of course, be published in full
when complete.
It is important to note that, in undertaking this work, the Basel Committee has no
enforcement power, so it would be meaningless to think we can force jurisdictions to change
their local regulations if we find gaps. Our goal is therefore framed more positively: to deepen
the implementation process and to help jurisdictions identify the gaps and address them.
Ideally, the assessments provide a roadmap by which identified gaps can be closed. They
also provide stakeholders and markets with a much higher degree of transparency about the
extent of any local divergence from agreed international standards, and the importance of
these. In this way, we believe we will establish the appropriate incentives for local
rulemakers to apply the global standards, and for markets and others to apply appropriate
pressure where banks may be subject to weaker-then-expected prudential requirements.
More consistent domestic regulations will be an improvement. But beyond looking at how
local regulators have transposed Basel agreements into domestic regulations, the Committee
has also begun examining whether the framework(s) are producing consistent outcomes.
Ultimately, what counts is that the capital ratio calculated and reported by individual banks
provides a meaningful and comparable representation of their capital strength. Differences in
regulation, or their application, can undermine the regulatory framework by making it more
difficult for bank depositors, counterparties, investors, shareholders and supervisors to have
confidence that reported capital ratios serve their intended purpose.
In this context, some concerns have been recently voiced that banks are not calculating risk
weighted assets consistently. The Committee has, in fact, been investigating this issue for
much of the past year. This work has examined the calculation of risk weights in both the
banking and the trading books. As with our country assessments, we will publish the results
of both studies.
The preliminary results of the trading book are most advanced, and will be published very
shortly. The analysis is based on two sources of data: public disclosures by banks and a
hypothetical test portfolio exercise in which 15 large, internationally active banks have
participated from nine Basel Committee jurisdictions. I will not pre-release the detailed results
today, but the headline messages are that:
•
there is a material variation in risk weights for trading assets across banks (after
adjusting for accounting differences and for differences in the riskiness of different
bank portfolios);
•
certain modelling choices seem to be major drivers of the variation in risk weights;
and
•
the quality of existing public disclosure is generally insufficient to allow users to
determine how much of the variation in reported risk weights is a reflection of
underlying risk taking, and how much stems from other factors (eg modelling
choices, supervisory discretions).
In thinking about these results, it needs to be borne in mind that the objective is not to
achieve zero variation. If we wished to achieve that outcome, we could simply force all banks
onto the standardised approach to capital adequacy and remove any modelling options. But
the standardised approach - while an ostensibly consistent methodology - would not
necessarily guarantee a meaningful measure of risk when applied to the world's largest
banks with the biggest and most complex trading portfolios. Modelling necessarily introduces
a degree of variability, since Basel standards deliberately allow banks and supervisors
flexibility in order to accommodate for differences in risk appetite and local practices, but with
the goal of also providing greater accuracy. Further, from a financial stability perspective, it is
desirable to have some diversity in risk management practices so as to avoid that all banks
act in a similar way. When banks would have identical response functions, economic
cyclicality would increase, potentially creating additional instability.
At the same time, excessive variation in risk measurement is clearly undesirable. Finding the
right balance is the key. The preliminary work suggests we may not have the balance right in
the current set-up. But as with all of our work on implementation, it is necessary to identify
problems before we can set about correcting them.
The on-going analysis has generated a wealth of information about risk modelling by banks.
This is useful for international policymakers. The Committee has not yet decided what
actions it might take in response to the analysis, but some of the possible policy options
could comprise improvements in public disclosure practices, limitations in the modelling
choices for banks, and further harmonisation of supervisory practices. These ideas will also
feed into the current fundamental review of the trading book. In addition, our international
study provides national supervisors with a much clearer understanding of how the risk
models of their banks compare to those of international peers. This means that national
supervisors are much better equipped to discuss the results with their banks and take action
where needed.
The Committee will be doing further work on the trading book, in addition to the banking book
work, to explore the outcomes in more depth. I am confident that it will generate additional
insights in the modelling of risk-weighted assets and to explain better why modelling results
differ across banks. It will also allow building quantitative benchmarks against which
supervisors can test their banks.
The Committee's work on how banks calculate risk weighted assets also feeds into a broader
concern that, in pursuit of risk sensitivity, the Basel III framework has grown too complex.
There are many contributory factors to the build-up of complexity, including developments in
the financial markets and adoption of sophisticated risk management practices by banks. It is
naïve to think banks utilising complex trading strategies and products, across global markets,
can be supervised using simple rules (even if calibrated to penal settings). Indeed, an
important driver has been the necessity to address perverse incentives that are created by
simple rules.
So while seeking appropriate risk sensitivity, care is also being taken to ensure that
complexity does not undermine the very benefits it offers. The Basel Committee has also
been working during 2012 to review possible areas for simplification, aiming to strike a
careful balance between risk sensitivity/complexity, comparability and simplicity. In the near
term, the Committee intends to publish a paper to explain its thinking on the trade-offs that
need to be made, and identifying potential ways to make the framework simpler and more
comparable.
Conclusion
If there is one message I would like to leave you with it is that, when it comes to reform,
ideas and implementation go together.
Much of the Basel Committee's work on big "ideas" that respond to the shortcomings in the
regulatory framework identified by the financial crisis is reaching the end stage. The capital
rules are set (and, in an increasing number of jurisdictions, coming into force), and the
revisions to the LCR have recently been agreed. In 2013, we will seek to set out the
specification of the backstop leverage ratio, and the NSFR will be refined between now and
the end of 2014. Clearly, we still have work to do, but increasingly it is about getting the
technical details correct rather than new far-reaching ideas.
Even when the Committee's policy response to the crisis is complete, much more work will
still be needed. Implementation needs to be seen as an integral part of the reform agenda,
not a sideline activity. As we examine this issue to a depth that it has not previously been
examined, we will inevitably find things that need improvement. Turning a blind eye to these,
as may have occurred in the past, is not an option - we need to persevere and find those
areas where additional modifications to the regulatory framework are needed to ensure it is
effective. If we do not work to improve implementation, we will not embed the reforms into
domestic banking systems in the full, timely and consistent manner that is in everyone's
interests.