Stefan Ingves: Basel III - much-needed regulations for a safer banking
sector
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Swedish Society of
Financial Analysts, Stockholm, 1 February 2011.
* * *
More than two years have passed since the collapse of the major US bank Lehman Brothers
triggered panic on the global financial markets and we were close to a widespread financial
meltdown. We will never know what would have happened if the authorities had prevented
Lehman Brothers from going bankrupt. We do know, however, that financial turbulence
spread like wildfire throughout the world. Market agents lost confidence in each other and
liquidity on the funding market was severely impaired. Many banks therefore found it difficult
to fund their operations and suffered an acute liquidity shortage.
In order to stabilise the situation on the financial markets, governments and central banks
around the world were forced to take exceptional measures. By offering loans on favourable
terms, providing capital injections and setting exceptionally low policy rates, they managed to
prevent a total collapse. But this has not been free, and it is not over yet. To date, the
Federal Reserve and the European Central Bank have lent millions of dollars and euros to
the banking system to stop the crisis. In addition to this there have been a great number of
national rescue measures. These have largely been funded by governments borrowing
money. In this way, debts in the financial system have been converted into
centralgovernment debts. For some countries, not least Ireland, the debt mountain has grown to
unmanageable heights and the financial crisis has changed form to become a sovereign debt
crisis.
Sweden has also been affected by the financial crisis. But, unlike many other countries, we
have emerged from the crisis in fairly good shape. Growth in the Swedish economy is back
to pre-crisis levels and other indicators, such as the level of investment and household
consumption, are also positive. I would say that this is mainly due to two factors. First, the
Swedish banks, with the crisis of the 1990s fresh in their minds, have been less risk-inclined
than many international banks, although of course with the exception of their operations in
the Baltic countries. Second, the unusually sound condition of the Swedish economy has
made it possible for Swedish authorities to take extraordinary measures without putting our
public finances at risk.
However, even if Sweden has coped relatively well with the crisis this time, we should
remember that as a small, open economy Sweden is highly dependent on what happens in
the rest of the world. This also applies to the Swedish banks as a considerable part of their
funding comes from international financial markets. The international operations of the
Swedish banks have also increased significantly over the last ten years. This means that
events abroad have an increasing impact here in Sweden. This is also the case for most
other countries. The collapse of Lehman Brothers is just one of many examples of how a
bank with problems in one country can constitute a threat to banks all over the world.
The crisis revealed the lack of effective regulations
In an increasingly globalised world it is important to have well-designed global rules and
regulations that contribute to stable financial sectors in all countries. It has been obvious for
quite some time that this is not the case. But a crisis was required to eradicate any doubts
that reforms are necessary. This is a good aspect of crises. They have the capacity to unite
decision-makers and to provide an impulse to processes for change.
Consequently, over the last two years, considerable resources have been devoted to
determining why the crisis arose and how we can reduce the likelihood of a similar crisis
occurring in the future. Politicians and decisions-makers have left almost no stone unturned.
They have discussed everything from bonus systems and the role of accounting in the
financial crisis to shortcomings in financial supervision and weaknesses in derivatives
trading. Above all, however, they have discussed bank regulation. As a result they have
realised that the current regulatory framework has a number of fundamental weaknesses that
must be dealt with. The Basel Committee1 has therefore drawn up new, revised regulations
for capital and liquidity, the so-called Basel III regulations. I intend to devote today's speech
to describing what the new regulations entail, explaining the effects we can expect them to
have in Sweden and presenting my view of the regulations. This means that several parts of
the speech will be rather technical, but a thorough review is necessary to clarify what the
new regulations actually entail.2
Before I begin I would like to point out that although there has been a great focus on drawing
up regulations that promote a more stable financial sector it is important to remember that
the sector must be effective so that it can continue to manage deposits, provide loans and
conduct payments. Finding a good balance between stability and effectiveness is always an
important task. In my view, we have managed to achieve this balance.
Why we must develop Basel II
Capital inadequate in terms of quantity and quality
A basic problem with the current regulations is that they allow the banks to hold far too little
risk-bearing capital, and in many cases capital that is of far too poor quality.
According to the Basel II regulations the capital base consists of two parts: Tier 1 (or primary)
capital and Tier 2 (or supplementary) capital. Together, these should correspond to at least
eight per cent of the banks' risk-weighted assets, of which Tier 1 capital must constitute at
least four per cent. In addition, the regulations state that share capital and retained earnings,
so-called Core Tier 1 capital, should make up the main part of the Tier 1 capital as it is these
types of capital that can best cover losses.
This vague ruling on how much Core Tier 1 capital a bank must have has led to a number of
problems. Not least, it has enabled regulatory bodies around the world to stretch the rules to
satisfy the banks and has thus started a race to the bottom - that is a race to low capital
levels. Many countries have accepted Core Tier 1 capital levels as low as two per cent. This
means that it has been possible to make up the remaining six per cent with cheaper capital
instruments of poorer quality. Unlike ordinary share capital and retained earnings, these
socalled hybrid instruments have debt-like properties which mean that they can only be used to
cover losses when a bank has failed. Core Tier 1 capital, on the other hand, can be used to
cover losses under normal circumstances when a bank survives.
Not only have the generous capital requirements helped to undermine the ability of the banks
to absorb losses, they have also made it possible for banks to substantially expand their
balance sheets by borrowing. Before the crisis began, no one raised their eyebrows at banks
with debt levels of more than 30 times their equity. However, as you well know, low levels of
capital and high levels of debt turned out to be a catastrophic combination. When the crisis
broke out and it was realised that the ability of hybrid capital to cover losses was extremely
limited, the highly leveraged banks were left more or less defenceless. It was not long before
many of them were forced to turn to the governments and the taxpayers who had to inject
capital and become part-owners. The rest is history.
Basel II underestimates the risks in banking operations
Another weakness of the current Basel II regulations is that they do not sufficiently capture
the banks' risks. There are many examples of this. One is that the regulations and
supervision have focused too much on risks in individual banks and too little on risks in the
system as a whole. We refer to this as the lack of a macroprudential perspective.3 In general,
we have not taken enough account of systemic risks; that is risk that can spread throughout
the financial system. In a capital adequacy context, the lack of a macroprudential perspective
is reflected in the fact that the banks have calculated their capital adequacy requirements on
the basis of the risks to their own operations. They have thus ignored the negative external
effects that banks may have on the system as a whole. This has led to a banking system with
too high a level of risk and too small buffers in terms of capital and liquidity. It has also led to
the risk of distorted market prices for risk, capital and liquidity.
Another example is that the models that the banks have used to calculate their capital
requirements for market risks systematically underestimate the risk of losses under stressed
market conditions. As a result, the calculated capital adequacy requirements have been too
low to enable the institutions concerned to manage the losses that occur in serious economic
downturns, like the one we have just experienced.
A third and closely-related example is that the banks have not held sufficient capital for the
counterparty risks that they are exposed to in their derivatives trading. As financial assets,
including derivatives, are accounted in accordance with the real value principle, changes in
counterparty risks enter the banks' balance sheets via their income statements. The fact that
the banks are not equipped to manage this type of risk became evident when Lehman
Brothers collapsed in the autumn of 2008 and the financial problems spread like wildfire
between the market agents.
A fourth and final example is that Basel II has in many cases overlooked the risks that have
developed off the banks' balance sheets, and this is something that many banks have taken
advantage of. By selling their mortgages to special companies that they have set up
themselves off their own balance sheets, the banks have been able to sell their own credit
risks and thus reduce their capital requirements. The problem with this is that the banks have
not been entirely separated from these special companies. During the crisis, the risks
therefore moved directly back onto the banks' balance sheets where there was no capital to
cover the losses that arose. This problem was particularly evident in the United States.
Inadequate standards for liquidity management
Another important lesson from the crisis is that the regulations have paid far too little
attention to the banks' liquidity management. In the present Basel regulations, there are no
binding regulations on how banks should manage their liquidity risks.4
As banks usually lend at long maturities while their funding is short term, liquidity risks are a
natural part of their operations. In the years prior to the crisis, we could see that many banks,
including the Swedish banks, exposed themselves to increasing liquidity risks, partly by
increasing their lending and partly by choosing to fund their lending on the markets to a
greater extent rather than basing it on their deposits. As market borrowing is often short-term
in nature, the banks became very sensitive to disruptions on the financial markets. This
became obvious during the crisis. The banks lost confidence in each other and they became
extremely cautious about lending money to other banks. Market rates rocketed and a large
number of banks experienced an acute liquidity crisis. Several central banks, including the
Riksbank, chose to supply liquidity to the interbank markets to ease the stressed situation. It
is of course not reasonable that government authorities should have to provide massive
loans to ensure that the markets work properly. With hindsight, it is easy to see that the
regulations have focused too little on liquidity risks.
The procyclical effects of Basel II contributed to the crisis
Finally, it has also been noted that the procyclical tendencies in Basel II contributed to the
crisis. The explanation for this is the regulatory framework's strong links to risk. During the
upturn that preceded the crisis, when risks were low, banks were able to expand their
balance sheets and present good capital adequacy figures, despite the fact that they held
relatively little capital. When the downturn then began and the risks increased, more capital
was required to reach the stipulated minimum level of capital. With the increase in risks and
the loss of confidence between the banks, the markets' capital adequacy requirements also
increased. In order to meet these requirements, banks in many countries were forced to
reduce their balance sheets. This led to a fall in lending to companies and private individuals.
This in turn triggered a downward spiral with a fall in demand and in investment capacity,
which reinforced the downturn in global economic activity.
When you list the problems in this way it becomes pretty clear that we need to revise the
existing regulations. The Basel Committee has done a lot of hard work to correct these
shortcomings and I welcome their proposals on a new international regulatory framework for
banks.
Basel III - what is new?
Basel III comprises global minimum regulations and aims to strengthen the banks' ability to
manage losses and reduce the probability of new financial crises. To achieve this, the banks
will be required to hold more and better-quality capital. An important task for the
decisionmakers involved has thus been to increase the international capital adequacy requirements
But Basel III is not just about capital. On the contrary, Basel III has many important
components, including completely new requirements concerning the banks' liquidity
management and limits for debt levels. The new regulations will be implemented over a
period of six years, starting in 2013.5 In some cases, however, the banks may be forced to
meet the requirements earlier due to the demands of the market and individual countries. I
will discuss all of the components of Basel II in more detail, but let me begin with perhaps the
most fundamental change, the revised capital regulations.
Higher capital levels and a new definition of capital
The changes in the new regulations mainly affect Tier 1 capital and Core Tier 1 capital. I will
therefore focus on these two components. An important new feature is the stipulation of a
minimum level for Core Tier 1 capital. In contrast to the present vague wording about the role
of equity in the capital base, Basel III makes it clear that all banks must have at least 4.5 per
cent of their risk-weighted assets in share capital and retained earnings. In addition, the
lowest permitted level for total Tier 1 capital is raised from four per cent to six per cent.
Basel III also introduces a capital conservation buffer of 2.5 per cent, consisting of Core
Tier 1 capital. This means that the banks should have a Core Tier 1 capital holding of at least
seven per cent. If a bank falls below the seven per cent limit, its entitlement to pay dividends
and to conduct share buy-backs will be restricted. The proportion of profits that must be
retained within the bank increases the further below the seven per cent limit the bank goes.
The idea behind this is to force the banks to accumulate their profits as capital instead of
paying them as dividends to the shareholders.
However, this will not affect Sweden, at least not directly. Swedish banks are well capitalised
and have a quota for Core Tier 1 capital that is already above seven per cent. We will,
however, see effects at the international level and, as we are highly affected by what
happens abroad, Swedish banks and Sweden in general will also benefit from the fact that
banks in other countries will become more resilient.
Apart from the changes in levels, there are also stricter requirements regarding the quality of
the capital held by the banks. As equity constitutes the difference between assets and
liabilities on the balance sheet, both the size and quality of the capital will be highly affected
by how a bank's assets and liabilities are valued. To ensure that the banks' capital really can
cover losses, they must already today make certain adjustments in their equity on the basis
of what actually exists on the asset side. The principles governing how to do this will now be
tightened up. For example, deductions will have to be made directly from the Core Tier 1
capital, unlike today when either the total Tier 1 capital or the total capital base is adjusted.
Nor will the banks be able to include assets that form the capital base in other financial
institutions. The idea behind such a limitation is to counteract the domino effects that can
arise if a bank goes bankrupt. Other important assets on the balance sheet that will require
adjustment of the capital are goodwill and deferred tax assets.
Another important change is that it will not be possible to include hybrid capital to the same
extent as before. Innovative hybrid instruments with a so-called step up will, for example, be
completely excluded from Tier 1 capital. The reason for this is that this relates to out-and-out
rule arbitrage. Under the current regulations, it is not permitted to include dated debt
instruments in the capital base. To get round this, the banks have issued securities with a
socalled step up, where the interest rate rises if the security is not repurchased before a certain
predetermined date. This has enabled the banks to signal to the markets that they will pay off
their debts on a certain date even if formally there is no specific date on which the securities
fall due.
Basel III thus entails a considerable tightening up of the minimum capital requirements. I
think this is excellent. I have long advocated clearer and stricter regulations. As equity is
expensive in relation to other sources of funding, tighter capital requirements will reduce the
banks' appetite for risk and at the same time increase their ability to manage losses. More
and better capital will thus not only soften the effects of future crises but also reduce the
likelihood of them occurring at all. A clear and uniform level for Core Tier 1 capital will also
reduce the scope for arbitrary interpretations. This in turn will reduce the scope for creating a
non-level playing field, which should benefit global competition.
Counter-cyclical capital buffer
In addition to the new minimum requirements, Basel III comprises a counter-cyclical capital
buffer of a maximum of 2.5 percentage points of Core Tier 1 capital.6 The buffer acts as a
dynamic capital requirement, which means that it varies over the economic cycle. The idea is
that the banks should build up capital in good times that they can use to deal with losses in
bad times.
According to the Basel Committee's guidelines, the buffer should come into play when the
ratio between aggregate credit provision in the economy and the development of GDP
deviates from an average trend. The greater the deviation the greater the increase, and vice
versa. However, this is not something that will happen automatically. The decision on
whether the buffer should be activated or not will lie with the national authorities. As countries
develop at different rates, the capital requirements will also vary from country to country. A
bank that is active on several markets will therefore need to calculate its capital requirement
on the basis of the geographical distribution of its exposures. Like the capital conservation
buffer, the counter-cyclical capital buffer is linked to sanctions on dividends.
The counter-cyclical capital buffer is good for several reasons. First, it can be used to
counteract the procyclical effects that a risk-weighted capital requirement automatically
entails and that result in an unwanted high expansion of credit in upturns and cutbacks in
downturns.
Second, it can be used to limit the build-up of systemic risks. The reason for this is that the
buffer is based on the risks in the economy as a whole rather than in each individual bank. In
times of high credit growth, when systemic risks usually develop, the buffer can be activated,
thereby increasing the capital requirement for all of the banks at the same time even if the
actions of the individual banks do not constitute a risk in themselves. Higher capital
requirements increase the banks' lending rates and thus dampen the overall growth of credit
in the economy. Considering that we currently lack tools that can be used to counteract risks
of a systemic nature, this type of capital requirement is thus a welcome feature.
Convertible debt instruments
A question that is under discussion but not directly related to Basel III is whether a new way
for banks to acquire new capital should be introduced. Traditionally, banks can, like other
companies, acquire capital in two ways: by issuing bonds or by issuing shares. The choice of
method often creates a conflict between the banks' owners and the responsible supervisory
authority. While the banks' owners usually prefer the first alternative because it is cheaper7
and because they do not want to see their share capital watered down, the supervisory
authorities require the banks to have a certain level of share capital that can be used to deal
with losses. As a result, the possibility to use so-called contingent convertibles, also known
as coco bonds, is therefore now being discussed. These instruments have a mix of bond and
share characteristics in that they are issued as a debt instruments but are automatically
converted to share capital when a bank experiences problems. It is still unclear what role this
type of instrument will be able to play when the banks calculate their capital requirements. A
number of questions remain to be answered - for example what type of event should trigger
a conversion?
The sum of the new capital regulations
There are many new regulations and levels and it may be difficult to estimate what the banks'
total capital requirement will ultimately amount to. It we limit ourselves to looking at Core
Tier 1 capital we can see that the new regulations mean that all banks will need to hold share
capital and retained earnings amounting to at least 4.5 per cent of their risk-weighted assets.
In addition there is the capital conservation buffer of 2.5 per cent and the counter-cyclical
capital buffer of a maximum of 2.5 per cent. This means that in a situation where the
countercyclical capital buffer is fully activated the banks will need Core Tier 1 capital amounting to at
least 9.5 per cent, and this applies to all banks.
There are also discussions about whether additional capital requirements should be placed
on those banks that are considered to be systemically important. At present, no decision has
been made on which banks this would be, nor on the levels that could apply. It is not even
certain that the measures directed at these systemically-important banks would focus on
higher Core Tier 1 capital requirements, although this is likely. Decisions on these matters
are not expected until the summer. However, if the major Swedish banks are considered to
be among the banks concerned they should make provisions for further increases. It is not
unreasonable to assume that their total capital requirement could end up somewhere
between 9.5 and 12 per cent - at least. According to our own calculations practically all of
the major Swedish banks currently have capital levels in this range.
The minimum level for Core Tier 1 capital may of course be affected by the decision on the
use of convertible debt instruments. At present, the discussion concerns whether this type of
instrument could be used for the increase for systemically-important banks. However, this is
still an open question. One method is to require, let us say, six per cent in coco bonds over
and above the 12 per cent added up here. The total potentially available share capital would
then be 18 per cent.
In connection with this I would like to mention that the Basel Committee has already decided
that this type of convertible instrument must be used for Tier 2 capital and that part of Tier 1
capital that does not consist of Core Tier 1 capital. Under the new regulations, a bank will
only be able to include debt instruments that can be converted into share capital if the
responsible supervisory authority believes that the bank has problems that threaten its
survival.8
Leverage ratio
One of the more discussed elements of Basel III is the introduction of a leverage ratio. The
aim of this measure is to restrict the banks' total indebtedness and to set a limit for how large
a part of the balance sheet the banks may fund with debts. To comply with the new
regulation, the banks must retain capital corresponding to at least three per cent of the value
of their total exposures, or assets if you like.
In contrast to the minimum capital requirement, the leverage ratio is not a risk-weighted
measure. This means that the banks should not take into account to whom or for what they
are lending when they calculate their total assets. In addition, most of the items off the
balance sheet should be included at their full nominal value. One reason why this new type
of measure has been developed is that a number of banks - not least the US investment
banks and UBS in Switzerland - experienced major problems when the financial crisis began
because of their high level of indebtedness.
However, many observers believe that a risk-neutral measure such as the leverage ratio
constitutes an incentive for the banks to invest in assets that carry a higher risk and that this
is directly counter to the traditional capital adequacy regulations. In Sweden, the criticism
from the industry has been particularly sharp. The reason for this is that a large proportion
(approximately 40 per cent) of the Swedish banks' balance sheets consists of mortgages. As
mortgages are considered to carry a low risk they are also subject to low capital
requirements. This thus means that banks can have large volumes of mortgages and
relatively little capital but still be able to report a high level of capital adequacy. When we now
introduce a measure that does not take into account the banks' risk profile, this will probably
hit the Swedish banks harder than those in some other countries.
It is probably the case that regulations that do not take risks into account can lead to a poorer
pricing of risk and to greater risk taking. As banks are companies that aim to maximise their
profits and high risk is generally related to high returns, there will always be a willingness to
invest in high-risk assets. And taking high risks can, as we all know, contribute to financial
crises that have severe effects on the economy.
Given this it may seem paradoxical for the Basel Committee to recommend a leverage ratio
that does not vary with risk. However, we should remember - and this is important - that the
traditional capital requirement has not prevented banks from borrowing too heavily, and this
was one of the central problems during the financial crisis. As long as the economy ran
smoothly the banks could use their debt-burdened balance sheets as levers and make large
profits. However, as soon as the downturn began and the banks began to make loan losses
they had hardly any capital that could be used to bear the losses. Instead, governments and
taxpayers had to provide funds to rescue the indebted banks. Of course we do not want to
experience such a sequence of events again. It is therefore positive that we are introducing a
complementary capital requirement that ensures that the banks do not overburden
themselves with debt. The idea behind the leverage ratio is to limit the growth of credit when
the economy is going well. It therefore acts as a complement to the counter-cyclical capital
buffer and helps to prevent an extreme expansion of the balance sheets.
Another reason for introducing a leverage ratio is that most large banks use internal models
to estimate the risks associated with their lending. If banks estimate these risks incorrectly,
for example by underestimating them, they may not hold enough capital. And as major
financial crises do not, I am glad to say, occur so often and the banks' data is often limited,
there is actually a risk that they will underestimate the risks in their lending. A gross solvency
requirement as a complement to the standard capital adequacy requirement thereby acts as
an extra safety measure.
In response to the criticism from the Swedish banks there is another factor that I would like to
take up. In Sweden, the banks can lend money to households with very little risk. This is
because the historical losses for mortgage lending in Sweden have been at very low levels.
This in turn can be explained by a number of factors. One explanation is that in contrast to
many other countries we do not have a speculative housing market on which households buy
several houses or flats for investment purposes and thus take a high risk. Another is that we
have a legal structure in which private individuals have to live with their debts until they are
repaid. In general, people cannot get rid of their debts by filing for personal bankruptcy. A
third reason is that we have a social insurance and benefits system that means that people
who become unemployed, for example, do not lose their entire income. The likelihood of
borrowers not wanting or not being able to make the interest and amortization payments on
their loans is therefore relatively small. This means that banks can lend money at a lower
cost than would otherwise be the case. They can thus boost the expansion of credit in the
economy without taking any significant risks themselves. This is something that we have
actually seen in recent years - lending to Swedish households has increased at a worryingly
high rate. I believe that the introduction of a ceiling for how much the banks can lend without
increasing their equity is a reasonable measure to prevent an excessive provision of credit.
New standards for the banks' liquidity management
As I mentioned at the beginning, the financial crisis has also given us reasons to consider
more direct and specific liquidity regulations. Consequently, the Basel Committee has drawn
up entirely new standards for how banks should manage their liquidity. They have drawn up
two quantitative measurements; the Liquidity Coverage Ratio and the Net Stable Funding
Ratio, and will also impose considerably stricter requirements on the banks to report their
liquidity risks.
The Liquidity Coverage Ratio focuses on the banks' liquidity buffers. The banks must hold
liquidity reserves that are sufficiently large and sufficiently liquid to cope with a 30-day
stressed cash outflow. The rules for what constitutes liquid assets are strict. At least 60 per
cent of the reserves must consist of government securities, the rest can be made up of
highquality, liquid mortgage and corporate bonds.
The second measurement, the Net Stable Funding Ratio, is a structural measurement
focusing on the banks' funding models. The aim is that the banks must reduce the
differences in maturities between their assets and liabilities and their dependence on
shortterm market funding. To achieve this, the banks must match their funding and lending to a
greater extent than they do today. Assets with short maturities can have short-term funding
while long-term illiquid assets, such as mortgages, will need more long-term and stable
funding. All funding with a remaining maturity of more than one year will be counted as stable
funding.
This is a sound and important feature of the new Basel regulations. And it will probably affect
the Swedish banks' business models. Currently, none of the four major Swedish banks meet
the structural liquidity measurement requirements (Net Stable Funding Ratio). This is mainly
because they largely fund their lending through short-term market funding. The banks will
need to think again here. In addition, a number of the Swedish banks do not meet the
shortterm measurement (Liquidity Coverage Ratio) either. These banks must, before the LCR is
introduced, either strengthen their liquidity buffers, for example by buying government bonds,
or reduce their short-term net outflow.
A weakness of the new standards is, however, that they do not contain any specific rules for
matching maturities per currency. This is something Swedish authorities should look at more
closely. Two thirds of Swedish banks' market funding is in foreign currency. A certain
proportion of this is converted via the swap markets to SEK and then lent. As a result, the
Swedish banks are sensitive to disruptions both in the primary mar