Luigi Federico Signorini: Banks and the years of Basel III
Speech by Mr Luigi Federico Signorini, Senior Deputy Governor of the Bank of Italy and President
of the Insurance Supervisory Authority (IVASS), at a conference to mark the 53rd edition of Credit
Day, organized by the Associazione Nazionale per lo Studio dei Problemi del Credito (National
Association for the Study of Credit Problems), Rome, 4 November 2021.
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1. Banks and the crisis
Overall, the Italian banking system coped well with the pandemic shock- as did those of many
other countries. This is different from what happened during the great financial crisis, when the
financial turmoil spilt over into the real economy almost everywhere in the world, mostly through
the banking channel, highlighting the fact that global prudential standards had not kept up with
developments in finance. In contrast, in the last eighteen months, banks have managed to
continue supporting the productive system and have helped to mitigate the very severe effects of
the crisis.
Fears of a credit crunch which, based on the experience of the last crisis, were widespread at
the start of the pandemic, proved groundless. Banks were able to satisfy the increased demand
for funds stemming from firms' greater liquidity needs, especially in the sectors hardest hit by the
measures restricting mobility and productive activities. Since the start of the pandemic, loans to
firms increased constantly up to March of this year, for a total amount of €70 billion;
subsequently, as activities began to recover more generally, lending naturally declined by around
€7 billion.
The countercyclical role of the banks has been supported by the actions of governments as well
as monetary and supervisory authorities. Immediately after the onset of the pandemic, the
adoption of generous and effective credit support measures - mainly in the form of government
guarantees with high coverage ratios for new loans and generalised moratoriums on existing
loans - allowed firms to benefit from favourable credit conditions and enabled banks to limit the
capital absorption of new loans. The scope for flexibility agreed by European and national
regulatory and supervisory authorities further facilitated banks' action during the crisis.
The ample liquidity of banks, facilitated by exceptionally expansive monetary policy, also allowed
them to support the economy, both in the most difficult months, during the initial acute phase of
the pandemic, and when the recovery finally began. The liquidity coverage ratio and the net stable
funding ratio, the two measures introduced by Basel III, were, on average, well above the
regulatory minimums and they have remained so. Bank funding, more than 60 per cent of which
is made up of deposits by resident customers (and which grew significantly as a result of the
pandemic) has been more than sufficient to finance loans. Market funding, while limited in volume
terms, has continued to be available at very low interest rates.
In the face of a dramatically worsened economic outlook, which suddenly heightened the risk of
insolvency for firms, the banking system quickly increased its loan loss provisions, although with
some differences between banks. Profits in 2020 were inevitably affected, though capital ratios
were not. Dividend distribution was very prudent, mainly owing to the recommendations issued
by the European Systemic Risk Board, the Single Supervisory Mechanism and the Bank of Italy,
supported by granular supervisory action. Public loan guarantees contributed to limiting
riskweighted assets. At the end of June this year, the CET1 ratio was 15.2 per cent on average,
more than one percentage point higher than at the end of 2019.
In the first half of 2021, banks' profits returned to growth, both because the cost of credit risk
went down considerably, mainly thanks to the sizeable provisions made in 2020, and as a result
of the positive trend in trading profits. Average ROE reached 8.9 per cent on an annualised basis.
Some improvements are probably transitory and, as a result, overall profitability in 2021 could be
lower than in the first half of the year. The ROE expected by financial analysts for the main Italian
banks stands at around 6 per cent, a similar level to that recorded in 2019.
The gradual phasing out of the support measures, moratoriums and guarantees will surely bring
to light cases of repayment difficulties. However, it is to be expected that the deterioration in
credit quality will be much less marked than it was in previous crises. Banks have started paying
out dividends again since the supervisory authorities, having carefully assessed the improving
economic outlook, withdrew the exceptional restrictions they had previously recommended. In
any case, we expect the banks to preserve adequate capital in relation to risks; it is essential that
they continue to adopt a prudent approach to loan loss provisions.
2. The Basel reforms
The regulatory reforms introduced in recent years by the Basel Committee - known collectively
as Basel III - contributed to the capacity of Italian and international banks to tackle the crisis of
2020. These reforms led to a significant strengthening of banks' capital and liquidity, increasing
market confidence in their soundness and their capacity to absorb unexpected large-scale
shocks. The work is not over. Mainly because of the massive interventions of the central banks,
the resistance of banks' balance sheets to severe market turmoil has not been fully put to the
test. It will be necessary to complete the implementation of Basel III with the last remaining
measures, including the crucial revision of the prudential treatment of the trading book.
The Committee's recently published preliminary analyses confirm that the banks have continued
to carry out their role of providing support to the real economy during the most acute phases of
the crisis, not least thanks to the reforms.
It seems natural at this point to look back at the path taken over the years in establishing
international prudential standards. This is particularly important at a time when Europe is getting
ready to launch the last piece of those reforms.
On a more personal note, doing so gives me the opportunity to give an account of my
participation in the Basel Committee, which lasted a good 13 years. In fact, I became a member
in the summer of 2008, on the very eve of the collapse of Lehman Brothers. I left it just a few
weeks ago.
2.1 From the first Concordat to Basel III
The Basel Committee was established in 1974 at the initiative of the Group of Ten, at a time -
unsurprisingly - of a crisis: that of a German bank, the Herstatt Bank, which involved banks in
many countries and exposed the risks connected with international banking activity conducted
without common rules. Since the first Concordat was issued in 1975, the Committee -
comprising representatives of central banks and banking supervision institutions - has
introduced the international standards in progressive steps. Initially, the aim was managing the
risks incurred in cross-border banking activity; then it increasingly extended to spreading
regulatory best practices and ensuring minimum regulatory standards at global level. Basel rules
are not binding within a jurisdiction until they are transposed into national law; their effectiveness
therefore essentially rests on the Committee's reputation and on market and peer pressure on
national parliaments. The successive agreements (Basel I in 1988; Basel II in 2004; and Basel III
between 2010 and 2017) changed in line with developments in banking activity and with the
mounting complexity of the financial world; they have also become increasingly broad in scope
and prescriptive in content. This was probably inevitable, but it has made the process of
implementing the standards at national level more complex and sometimes open to question. It is
likely that the expansion of the Committee to the leading emerging economies, which was also
inevitable, had a similar effect. Today there are about 30 member countries, and they differ from
each other much more than the initial group of countries did.
The first agreement, implemented in the main jurisdictions in 1992, marked a shift from
'structural' supervision, in many countries (including Italy) based on authorisations and
administrative controls, to the 'prudential' kind. Since then, the aim of ensuring the sound and
prudent management of banks has mainly been pursued by requiring bank to maintain a
minimum ratio of capital to risk-weighted exposures, rather than through direct and discretionary
action by the authority. Basel I divided credit exposures into four broad classes, with coefficients
increasing as the counterparty's theoretical riskiness rose. This was meant to provide banks with
sufficient resources to withstand unexpected losses, and discourage excessive risk-taking. In
Italy, the transition from structural to prudential supervision was marked by the new Consolidated
Law on Banking.
There were two main shortcomings to Basel I: (i) it only covered credit risk; and (ii) the weighting
scheme was insufficiently granular, as it was based merely on the legal nature of the
counterparty and made no attempt at approximating borrowers' risk at the individual level. In
order to surmount the first shortcoming, the Market Risk Amendment was adopted in 1996. It
introduced minimum requirements for market risks and included a new class of capital
instruments for coverage ('Tier 3'). The MRA also marked a conceptual turning point: faced with
the variety and complexity of the statistical and mathematical tools needed to assess market
risk, banks were allowed for the first time to use their own internal models to calculate their
capital requirements, subject to validation by the supervisory authority.
Basel II sought to remedy the second shortcoming by introducing the three-pillar framework of
rules that is still in place. The first pillar provides for quantitative capital requirements in relation to
three risk categories (credit, market and operational risk); banks can compute the requirements
using either a standardised approach or their own internal models. The second pillar, which is of
a more qualitative nature, requires banks to have their own risk assessment and capital
adequacy control process, and entrusts the supervisory authority with the task of verifying that
this process is satisfactory. The third pillar leverages market discipline, with stringent public
disclosure requirements for capital, risk exposure, and management and control systems.
In the process of defining more risk-sensitive requirements, Basel II also sought a better
alignment of objectives between banks and supervisors, creating incentives to refine internal risk
management procedures. At that time, I was not working in supervision. However, it seemed to
me from the outset that, given the innumerable and complex modelling choices to be made by
the banks, each one reasonable and plausible in itself, these incentives could yield to the more
powerful one of saving capital, thus leading to a potential systematic bias. I do not want to be
misunderstood: I am not talking here about breaking the rules, but only about the incentive, when
faced with technically justified alternatives, to choose the less capital-expensive option. The bias
could be more or less marked depending on the bank's larger or smaller risk appetite, possibly
also on the prudence of the supervisor. The latter could, in any case, only devote to the validation
of the banks' extensive and complicated internal models resources that, while highly qualified,
were much more limited than those employed by the banks themselves. Despite the safeguards
that were put in place, therefore, the possibility of an inadequate evaluation of risks was not to be
underestimated, especially with reference to the most advanced and often opaque models, those
relating to trading activities or complex financial products.
It is not clear whether the weaknesses of the Basel II rules contributed to causing the global
financial crisis: at its onset, the rules had only recently been approved and their transposition into
the different legal systems was at best partial. However, the same issues would come to the fore
in the subsequent discussion of Basel III, as we shall see presently. In any case, the crisis clearly
signalled the existence of certain significant gaps in the standards.
The first was the quantity and quality of capital requirements, which proved to be insufficient. For
example, during the crisis it became clear that some of the liabilities included in the regulatory
definition of capital - such as hybrid instruments - were only capable of absorbing losses in the
event of default, and that they could trigger contagion. Neither of these facts would be helpful
from the point of view of protecting stability. The market itself immediately began to refer to
stricter definitions of capital, focusing on equity capital alone.
The second gap was the imbalance in prudential treatment between credit and financial risks,
especially striking as the latter were at the root of the crisis.
There were also no liquidity requirements, nor any limits to concentration risk.
In some cases, such as in Italy, the effects of those gaps were mitigated by stricter supervisory
practices and approaches. For example, we placed more stringent limits than elsewhere on the
capital savings that could be achieved through the application of internal models. Experience has
given us no reason to regret those choices. While a full analysis of all the direct and indirect
causes of the crisis is complex and certainly beyond the scope of this speech, it is a fact that the
sparks that ignited the crisis appeared in places where the supervisory 'touch' had, in the end,
become too 'light'.
Given the traumatic experience of the crisis, the Committee started to work on the development
of new standards and the first Basel III text was published in 2010. The key elements of the
reform were the following: (i) more capital, including through additional buffers, graduated
according to the systemic importance of the bank, and also targeted at macroprudential risks; (ii)
capital of a better quality, i.e., made up of instruments that would effectively be able to absorb
unexpected losses without triggering a default; (iii) new requirements for risks that had previously
been ignored, such as the Credit Valuation Adjustment for derivative transactions; (iv) liquidity
requirements; and (v) limits on leverage.
I would like to say a little more on the last two aspects, namely liquidity and leverage.
Liquidity transformation is as intrinsic to banking as leverage, yet liquidity risk had been left out of
international standards up until the great crisis. The safeguards introduced with Basel III ensure
both greater short-term resilience (through the liquidity coverage ratio, LCR) and a better balance
of maturities over the medium term (through the net stable funding ratio, NSFR). Based on the
experience of the old Italian rules on maturity transformation, we had argued for a more
structured NSFR requirement, that would cover maturities of more than one year more precisely,
but we were unable to gain enough support. The two requirements, as approved, were
nevertheless a decisive step forward.
The leverage ratio, i.e., a minimum ratio between equity capital and non-weighted assets, was
introduced as a backstop to risk-sensitive requirements. It is by definition a rough measure, as it
is not calibrated to the riskiness of assets, and is not therefore expected to be binding on banks'
operations in most circumstances. Its function is to act as a safeguard of last resort, obviously in
relation to overly aggressive internal models as well.
I have already spoken about the logical possibility of bias in internal models; its actual relevance
is borne out by the benchmarking exercises that have been conducted over the years at various
levels, both in Europe and worldwide. They have revealed considerable and hard-to-justify
differences in the capital requirements obtained by applying the internal models of different banks
to an identical portfolio. I would add here that the problem of supervising models could become
even more complex in the future with the spread of techniques for measuring credit risk based
on artificial intelligence and machine learning, which may be effective for the purpose of practical
operations, but whose internal logic is often opaque.
Basel III essentially recognises, and with good reason in my opinion, that no model, however
granular and technically advanced, and regardless of any bias, can fully account for the
complexity of banking risks; that some form of model risk is therefore fundamentally unavoidable;
and that if we accept the existence of such limits to knowledge, it is better to use several
measures, each one imperfect, than to strive for an impossible perfection.
Hence the need to make use of various measures that complement one another and offset one
another's limitations; hence the Committee's choice to add the Leverage Ratio to the risk-based
metrics and then an output floor, as we shall see shortly.
2.2 The completion of Basel III
The final version of Basel III, adopted at the end of 2017, concluded the post-crisis review
process. It dealt with 'model risk', reviewed the standardised treatment for credit risk and
finetuned the rules on securitizations. At the same time, completely new and stricter rules were
adopted for market risks, and those for operational risks were simplified. Let me now list the
main elements of this set of innovations.
1. The final set of Basel III rules does not allow internal models to apply to loan portfolios for
which the use of statistical criteria is problematic because of too few observations, series
that are too short or distributions that are hard to characterise. It sets input floors for key
parameters and it introduces an output floor, that is, a limit on the capital savings that banks
can attain by using internal models with respect to the requirements based on the
standardised method. (I add here that, in the discussion on this, we would have preferred the
output floor to be more rigorously calibrated, in light of the experience of Italian supervision,
which had always discouraged particularly aggressive modelling in banking system
practices).
2. It increases the robustness of the standardised method for credit risk and its sensitivity to
risk. This is intended to make it, on the one hand, a sufficiently risk-sensitive alternative to
internal models, and on the other hand, a credible parameter for calibrating the output floor.
3. It strengthens the requirements associated with less transparent securitisations,
encouraging simple, transparent and comparable ones.
4. As regards market risk, Basel III completes a process that began immediately after the
financial crisis with temporary regulatory interventions ('Basel 2.5'). The trading-book rules
have now been entirely rewritten ('fundamental review'). It took ten years to define this
revision, which may seem too long, and perhaps it is; yet the discussion of this part of the
standards proved to be particularly difficult, both in technical terms and in terms of
negotiation. This was the case because banks' activities in this sector are complex, opaque
and often idiosyncratic, given the increasingly fast (and not always beneficial) progress in
financial engineering; and because, allow me to say this, different national experiences,
needs and priorities clashed. Unlike credit risk (where, for all innovations, the basic
conceptual framework has remained unchanged), there is a radically new approach to
market risks. This makes it hard to express a fully informed opinion, which will require more
time. Yet the criteria inspiring the new rules, namely (i) stricter limits on the use of internal
models and (ii) greater sensitivity to risk, appear to be eminently reasonable.
5. Finally, there has also been a thorough overhaul of the prudential treatment of operational
risk. The new approach simplifies the prudential rules by means of a unique, standardised
method that links the capital requirement to the size of operations and to the past history of
each bank's op-risk losses. The use of internal models has rightly been discontinued, as
experience has shown that such models are not very robust. It should, however, be
recognised that using capital requirements alone to cover op-risk remains a rather
unsatisfactory choice. Exposure to this type of risk depends a great deal on the organisation
of processes and on the business culture, and no model can easily convert these facts into
quantitative requirements. There is therefore no alternative to using supervisory instruments
to pursue further strengthening of the ability of banks to control and manage the relative
risks. Given the progress of technology and the ever-greater recourse to outsourcing, these
risks are highly likely to increase in the near future. There is reflection at all levels on how to
tackle them; I doubt whether further tightening capital requirements would be the most
efficient response.
2.3 Changes to the Committee's modus operandi
The way the Committee operates and interacts with the market has also changed over time. As I
have said, its participation base was broadened to include the big emerging economies. Its
activities became more transparent, and the market was afforded many opportunities for making
comments while the Basel III rules were being drawn up. Many consultation documents and
impact studies have been published: for banks and supervisors alike, the Quantitative Impact
Studies have in fact become valuable tools for measuring the effects, intended or otherwise, of
the proposed prudential rules.
Alongside the drawing up of standards, a considerable amount of the Committee's work now
involves verifying their application, country by country, by means of peer reviews. This makes it
possible to disseminate best practices and contributes to a more level playing field across
different legal systems and banks, by limiting, for the latter, the margins for circumventing
regulations and, for the former, the possibilities for using regulatory leverage to attract business
and defend national flagship companies, as has happened in the past. There are, however, some
drawbacks. The monitoring procedure, and specifically the fact that it includes attributing an
overall final score (to sovereign jurisdictions), may give the false impression that the Committee,
which is simply a producer of technical standards and counts on voluntary participation, wishes
de facto to impose its choices. It appears, in other words, to assume a role as global legislator
on banking issues but with no mandate to do so. We have sometimes made the proposal, as yet
unheeded, to use a grading system only for the assessment of technical aspects, individually
considered, based on objective and quantitative evidence. This would increase the usefulness of
peer reviews, making their technical and impartial nature clearer to everyone (the public, political
entities and the media) and reducing the risk of prompting reactions that bear little relation to
prudential issues.
3. Completing Basel III in Europe
A few days ago, the European Commission published its proposal (known as the 'CRR3-CRD6
package'), which formally starts the process of transposing the final version of the agreement
into EU law.
For the most part, the proposal transposes the new standards into European legislation, although
some European 'specificities' remain. The output floor is introduced, as expected; at the same
time, the main existing deviations from the Basel standards are confirmed, including preferential
treatment for exposures towards SMEs and for funding infrastructure projects.
To guard against the unwanted effects of unilateral decisions on the competitive position of
European banks, the Commission's proposal expressly provides for a review of European rules
in some areas (for example, market and counterparty risk) over the next few years, to be
conducted also in light of the actual degree of global convergence. For other areas where the
Basel III rules allow for different options (operational risks), choices are proposed that take
account of the stance that the other main jurisdictions are expected to adopt.
On the subject of 'adjustments' with respect to the Basel III standard, however, the
Commission's proposal goes further. For example, it has a mechanism that would allow banks
that adopt internal models for credit risk to alleviate the impact of the output floor on a temporary
basis. There is also a proposal to postpone the deadline for applying the new rules for another
two years, even though it had already been delayed by the Committee owing to the effects of the
pandemic. Some additional mechanisms for gradual change would mean that certain rules
would not be fully implemented until 2032, some 24 years since the Lehman crisis.
The negotiation that will lead to the definitive European rules is beginning now. Let me recall the
statement issued in September by the vast majority of governors and heads of supervision in EU
Member States, which urged EU institutions to uphold the letter and spirit of the agreements:
'The EU should stick to the Basel Agreement', just as the title of the message says. Except,
perhaps, for safeguard clauses in the event of blatant non-compliance on the part of others,
which should, however, be verified using reasonable criteria, as not even the European Union will
fully apply these standards.
I hope that the discussions over the next few months will not be an occasion for reopening the
debate on the prudential treatment of individual risks. The pandemic crisis has confirmed what
the great financial crisis had already taught us, namely how important it is to have a financial
system that is robust, adequately capitalised and fully aware of the complexity of the risks.
* * *
To sum up, let me say that the 13 years I spent on the Basel Committee, which coincided with
the lengthy gestation and then the birth of Basel III, were a testing experience for me
professionally, but at the same time an extremely rewarding one.
That the previous system of standards had serious shortcomings I believe was, and is, clear to
everyone. Correctly identifying these shortcomings and finding remedies for them has not been
easy: there are no exact sciences in this field. Despite the support provided by the specialists'
careful technical work on each risk individually considered, the overall assessment can never be
simply the sum of individual analyses: not even in a formal sense, as no risk is independent of
any other. We can only count on experience, on reasoned discussion, on an open dialogue with
industry and with the market, and on real or hypothetical tests.
The difficulty was exacerbated by the presence on the Committee of countries with very different
priorities and banking systems, different supervisory practices and a different degree of
openness, both domestically and abroad. I benefited from the old tradition of Italian supervision,
which instilled in me a scepticism of solutions that are too mechanical, a rationally limited faith in
the capacity of the financial market to correct itself, perseverance in examining all risks, and a
cautiousness that makes it unadvisable to put one's faith in just one methodology, however
elegant and intellectually attractive, and preferable to use several imperfect yet complementary
instruments instead. For instance, in the discussions about the output floor, liquidity
requirements and the quality of core capital, Italy's experience was invaluable, and I believe I can
say that in some way, whether big or small, it contributed to the collective outcome.
The discussions have often been tough, and compromises have sometimes only been achieved
after exhausting negotiations. Interaction with industry, which is indispensable if we want to
devise rules that are realistic and robust, has nevertheless sometimes had to contend with
selfinterested resistance and exaggerated fears. The result is arguably not ideal, and I have given a
couple of examples where we would have liked more far-reaching solutions; on the whole,
however, it is a fundamental step forward. History teaches us that nothing is final; those who
come after us will surely have to grapple with new problems and devise solutions that we have
not been able to look for or find. Nevertheless, the fact that the banking system was 'part of the
solution and not part of the problem' in 2020, as has been endlessly repeated over the last few
months, suggests that that some good has come of it.
One last word on the Italian banking system. At the Basel negotiating table, we never forgot its
peculiarities. This was not to play advocate for Italian banks, as that is a job for others. It is rather
so that the actual features of risk incurred by the banking system in each country were
considered in an even-handed and balanced way, even when they were so specific, as in the
DTA case, as to make it difficult sometimes for us to explain and for others to understand them.
Some significant results have been achieved, though not everything we would have wished for.
Yet the most important message I wish to convey is a different one. Italian banks, too,
sometimes complain about the additional requirements that Basel III has entailed and still entails.
However, Basel III did correct two distortions that were clearly to their relative disadvantage: the
imbalance between credit risk and trading risk requirements, and an excessive tolerance of
aggressive models.
This is one more reason for me to conclude by saying that I believe it is in the common interest
to proceed, hopefully on a global level too, with transposing the Basel rules into law as swiftly and
faithfully as possible.