Stefan Ingves: Strengthening bank capital - Basel III and beyond
Keynote address by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of
the Basel Committee on Banking Supervision, at the Ninth High Level Meeting for the Middle
East & North Africa Region, jointly organised by the Basel Committee on Banking
Supervision, the Financial Stability Institute and the Arab Monetary Fund (AMF), Abu Dhabi,
United Arab Emirates, 18 November 2013.
* * *
As prepared for delivery
Good morning everyone, and thank you for the opportunity to speak about what - among the
myriad of recent regulatory initiatives - has probably been the most important: strengthening
bank capital.
Strengthening bank capital is not simply about asking banks to hold more capital. Rather, it is
a broader objective that involves ensuring the functioning of the entire capital regime. The
Basel Committee's approach has therefore been to work extensively on the consistent
implementation of the regulatory capital framework. The ultimate goal is to implement
Basel III so that it strengthens the quantity, quality, consistency and reliability of bank capital
ratios around the world.
Quantity and quality of capital
As you know, a set of requirements designed to raise the quantity and quality of bank capital
lies at the heart of the Basel III reforms. Not only were minimum capital requirements raised,
but the increases in capital requirements were focused on where they were needed most: in
going-concern loss-absorbing capital, or Common Equity Tier 1. The requirement for
higherquality capital was just as important as the increases in the headline minimum capital ratios,
if not more so.
Given the challenge posed by the new requirements to a banking industry still in recovery,
Basel III provides for a transitional period out to 2019 so that banks will have ample time to
build their capital bases in an orderly and sustainable fashion. The good news is that the
global banking industry is responding well to the new requirements and, for large parts of the
industry, the transitional time may not be needed. For the 101 large internationally active
banks (the so-called Group 1 banks)1 that we survey every six months, the story is one of an
industry that already on average meets the 2019 requirements. The average CET1 ratio at
end-December 2012 was 9.2%, well above the basic 7% minimum. Of course, there are
variations between banks, and some still have work to do, but even for those with a shortfall
against the 2019 requirements, that shortfall has now fallen to €115 billion, sharply down
from almost €400 billion just a year previously.2
Chart 1: CET1 Capital Ratio (%), Group 1 banks
10
8
6
Ratio
4
CET1
2
0
H1 2011 H2 2011 H1 2012 H2 2012
Basel III fully phased-in
Chart 2: CET1 Shortfall (€ bn), Group 1 banks
600
500
400
Billion
300
EUR
200
100
0
H1 2011 H2 2011 H1 2012 H2 2012
Minimum Minimum plus buffer plus G-SIB surcharge
Consistency of bank capital regulation
An important new mandate for the Committee is to be more active in monitoring the
implementation of the international minimum standards within individual member
jurisdictions. This stems from the G20 Leaders' desire that Basel III be implemented in a "full,
timely and consistent" manner. Consistent implementation is critical if there is to be a level
playing field for international banks.
Implementation is more than issuing new rules and regulations. Durable and consistent
implementation also requires monitoring, evaluation and analysis of intended prudential
outcomes. To this end, the Committee last year instituted the Regulatory Consistency
Assessment Programme (RCAP). A key feature is the jurisdiction-specific peer assessment
in which a small team of experienced supervisors and regulatory policy experts reviews a
member country's Basel III regulations across all its components and sub-elements. The
purpose is to find any divergences from the agreed standards and to weigh the current and
potential materiality of any weaknesses. To foster transparency, the resulting assessments
are made public, together with an overall review of compliance with the Basel standards.
Some comment that this effort, well intended as it is, will ultimately be fairly limited in its
impact because the Committee has no enforcement power and cannot override the
sovereign regulatory power of national authorities. It is true that the Committee does not
have this power, and nor should it. But that does not mean that the peer reviews and the
RCAP process as a whole lack impact. We have thus far published five monitoring reports,
and completed assessments on the final Basel III rules in Japan, Singapore, Switzerland and
China. In all cases, the implementation of Basel III was deemed compliant with the
international standards. But importantly, in all cases the assessment process also generated
a number of changes to the domestic regulatory framework to fill gaps and improve the
alignment with the international standards. This shows that a peer review programme,
coupled with transparency, can make an impact even without a suite of legal powers to back
it up.
Overview of assessment outcomes Table 1
Assessed member Publication date of Number of regulatory changes, Overall assessment
jurisdiction assessment amendments, and clarifications grade
made by a member jurisdiction
during the assessment
Japan October 2012 5 Compliant
Singapore March 2013 15 Compliant
Switzerland June 2013 22 Compliant
China September 2013 90 Compliant
Comparability of bank capital ratios
Over time, the consistent national implementation of Basel III standards will help ensure
greater "truth in advertising" when comparing bank capital ratios. It is important that, when a
bank publishes what purports to be a Basel III capital ratio, investors and counterparties can
be reasonably sure that the ratio has been consistently calculated and that, if there are
differences, those differences are transparent and some measure of their materiality is
available.
But there is more to bank capital calculation than just following national regulations. The
current framework makes use of internal models - these were introduced in 1996 for market
risk, and in 2006 for credit and operational risk. The rationale was clear: to provide incentives
for improved risk measurement, and reduce arbitrage via greater risk sensitivity. The Basel I
framework, established in 1988, had grown outdated and was increasingly subject to
arbitrage. Given its limited risk sensitivity, it provided banks with incentives to accumulate
risk, as the build-up of many risks would not be visible in banks' capital ratios. In the current
framework, internal models provide an important means of generating the increased risk
sensitivity that is regarded as essential.
Making capital adequacy ratios more risk-sensitive should, in theory, also make them more
comparable. Capital adequacy assessments are about measuring the adequacy of capital
relative to the risks a bank is taking. Measuring capital, ie the numerator, is relatively easy.
The denominator, ie risk, is a much more slippery concept, and a certain degree of
sophistication and complexity is needed to measure it. But by enhancing the accuracy of risk
measurement, we should be making capital adequacy ratios more comparable and reliable,
both over time and between banks.
As an aside, let me clarify that this is no criticism of the leverage ratio as a regulatory tool. It
is simply that capital adequacy and leverage are two different concepts, and measure
different things. The risk-based capital framework is not ideal for placing an absolute
constraint on leverage, just as a leverage ratio is not ideal for assessing whether capital is
adequate to cover the risks undertaken. This is why Basel III adopts a "belt and braces"
approach, using the leverage ratio as an important backstop for the risk-based capital
adequacy regime.
Returning to the rationale for using internal models to measure risk, it is important to
remember that a key premise was that banks' risk-based capital ratios should consistently
reflect banks' risk-taking. That was why Basel II provided not only for the use of internal
models in Pillar 1 of the regulatory framework, but also for the Pillar 2 and 3 requirements so
as to provide a second view on banks' solvency (Pillar 2), including one based on stress
tests and performance measurement, and to facilitate market discipline via disclosure
(Pillar 3).
Unfortunately, the financial crisis and subsequent analysis have shown that bank and
supervisory practices are not as consistent as they could be. For example, the risk weights of
some banks that introduced internal models under Basel II have been trending downwards in
recent years, when experience and intuition say they should have been moving in the
opposite direction. Many people worried that Basel II would be procyclical. It would seem that
those fears are largely unfounded, but for reasons that may be far from satisfactory!
Increasingly, this has led to questions about the credibility of internal model-based capital
ratios.
Therefore, alongside the assessment of national regulations, the RCAP has also started
studying the consistency of outcomes at individual banks. As with the introduction of a
rigorous peer review programme, the significance of this initiative should not be
international
underestimated. Never before have we had teams of supervisors looking at the
modelling practices at individual international banks. I think this is a quite telling example of
the regulatory community's commitment to improving the consistency, comparability and
reliability of bank capital ratios.
The Basel Committee's two recently published studies on RWA variability have compared
banks' estimates of risk-weighted assets on hypothetical portfolios of financial instruments
(for the trading book) and credit counterparties (for the banking book). To give you an idea of
the size of the task, in the case of the banking book, for example, the Committee collected
banks' probability of default (PD) and loss-given-default (LGD) estimates for 46 sovereigns,
77 banks, and more than 1,200 large corporates.
Both reports suggest that the underlying differences in risk remain the core driver of
differences in risk weights and capital requirements, as intended. However, there are also
supervisory and practice-based variations, and they are material. While it is difficult to be
precise on how much variation is "too much", the observed range of practice-based
variations analysed by the two studies appears too wide. To give you a flavour of that: just
taking the banking book results alone, two banks with exactly the same assets could report
capital ratios that differ by 4 percentage points - the most conservative bank would report a
regulatory capital ratio of 8% when the least conservative one would report 12%. Of course,
this simply compares the extremes in the sample - many banks were much closer to the
average. But if outsiders have no way of identifying who is "average" and who is an "outlier",
this variance is clearly too wide to underpin confidence in the measurement of bank capital.
So what are we doing about it?
Building upon these initial studies, the Committee has started extending its analysis to
establish a comprehensive picture: for the trading book, the initial analysis has been
extended to more complex portfolios, with results expected in the next few months. In
parallel, the work on the banking book will extend to the other remaining core asset classes,
especially retail portfolios, SMEs and so-called "partial use" exposures (ie exposures that
have not been migrated to the internal models). The Committee also foresees extending its
work to operational risk, the third core risk type. And once the Committee has done an initial
repeat the exercise periodically
round of assessment, we will need to to see whether the
policy measures that I will discuss shortly are having the desired impact.
Further analysis to establish a comprehensive picture will take us into 2015, but this does
not, of course, prevent us from taking action in the meantime. It is clear that a problem exists
and the Committee is considering a range of supervisory and policy responses - without, I
must add, settling on anything definitive just yet. Given the multi-faceted nature of the
problem, it is also clear that we will need a multi-faceted response. As there is no silver
bullet, we will likely end up with a series of incremental policy and supervisory changes,
drawing from the following list:

Most immediately, we will see supervisory action. Our benchmarking work has, for
the first time, given supervisors meaningful information on international benchmarks
against which they can compare their domestic banks. Many supervisors are
responsible for only a handful of IRB banks, and it can be difficult to generate
reliable benchmarks from a small sample. But our studies have provided supervisors
with a much clearer picture of how their banks stack up against their international
peers, and supervisory action is already being taken against a number of the outlier
banks that are on the low side.

Similarly, the Committee's RCAP jurisdictional assessments are having an impact
by reducing variability due to undesirable differences in national regulations. These
may often seem to be small issues of technical detail, but they can have a material
impact on capital outcomes. To the extent these differences are removed, they can
add to the consistency of outcomes. The Committee is also looking at the issue of
national discretions and Pillar 2, and it is investigating whether more can be done to
reduce variability from these sources by elinimating discretion where possible, and
strengthening supervisory guidance on model validation, review and approval.

Since transparency (or lack thereof) of bank modelling practices is at the heart of the
problem, during 2014 the Committee plans to propose enhancements to Pillar 3.
The aim is to provide banks' external stakeholders with information to better
understand banks' risk profiles and risk-weighted asset differences. But it is unlikely
that disclosure can be the sole response, and, thus, this initiative will have to be
flanked by other measures targeted specifically at practice-based deviations.

Our latest policy proposals stemming from the fundamental review of the trading
book were released at end-October, and incorporate a number of proposals that
flow directly from the findings on practice-based variation in the trading book. For
example, certain modelling choices with respect to the choice of stressed periods
and the scaling of short-horizon estimates to longer horizons have been constrained
in the latest proposals, along with more gudiance on expected supervisory practices.
 More generally, within the policy framework, we are looking at how far greater
constraints on the modelling practices of banks are needed. This could involve
enhancing the data requirements on which models are built, limiting certain
modelling assumptions or techniques, and/or strengthening validation requirements.

To make a more direct impact, we are also examining the role of floors and
benchmarks within the regulatory framework. Floors are not a new phenomenom in
the capital framework, but we need to look at whether existing floors are effective,
and whether there is a case for their greater use, particularly for products and
markets where data are limited, or other characteristics that make them hard to
model reliably.

Finally, as I mentioned earlier, we also intend to ensure that the leverage ratio fulfils
its intended role as a backstop to the risk-based regime. Despite the case for its
inclusion in the regulatory regime that I made earlier, some people have questioned
the merits of a leverage ratio. But given the very high levels of leverage that could
be generated under the risk-based regime, it is a sensible measure to include as a
backstop in the regulatory framework. And the case for a leverage ratio will only
grow further if risk-weight variability is not adequately dealt with.
In sifting through these potential actions and trying to find the preferred policy mix, it is
important that supervisors and the industry engage in a constructive dialogue on the best
way forward. Banks have a keen interest in ensuring that their risk measurement methods
are seen as robust and credible: not only does this affect confidence in the reliability of their
capital ratios, but any doubts also call into question their stress-testing results and their risk
management systems more generally, since these are invariably all built on the same
foundations. Thus the Committee is keen to hear from banks and other interested parties
what their preferred course of action is. Recent initiatives by the industry groups, such as the
International Institute of Finance (IIF) and by the Global Association of Risk Professionals
(GARP), to foster improved understanding of these issues, are therefore very welcome.
Concluding remarks
Let me sum up some of the key points I have made this morning. First, it is important that
bank capital is seen to be of sufficient quantity, quality, consistency and reliability. These four
characteristics are critical to the long-run credibility and success of the international capital
adequacy framework.
In Basel III itself, the Committee has made substantial enhancements to the quantity and
quality of capital. By agreeing to be part of the Committee's RCAP initiative, and by
responding to it, national authorities have made clear their commitment to fulfilling the G20's
call for consistency in implementing the reforms. And we are now, for the first time, delving
into the capital calculation practices of individual banks from an international perspective, to
see what needs to be done so that the results are sufficiently comparable and reliable.
The Committee is well aware that any changes to bank and supervisory practices will have
costs. The potential side effects of materially narrowing down modelling choices could
include a reduction in risk-sensitivity and a corresponding increase in the potential for
arbitrage. If not done well, it could also reduce banks' incentives to invest in risk
management models, especially their attempts to continuously broaden and deepen their
understanding of risk. As always in regulation, we need to find the right balance: we need to
reduce material practice-based differences in RWA variation, while limiting the adverse
effects from doing so.
Resolving this issue will also take time: there is no quick fix. It will be a significant
undertaking, and we need to carefully study the right mix of regulatory and supervisory
responses. But given the importance of the issue, we have to move ahead because the
consensus is building that the status quo cannot be maintained, as it helps neither banks nor
supervisors.
Hence the title of my speech today: Strengthening bank capital: Basel III and beyond. The
Basel III reforms themselves deliver two of the four characteristics that I said were essential -
higher quantity and quality of capital. They are important, but not enough on their own. It is the
Committee's current and future work programme on implementation and consistency that will
ensure that the full benefits of the regulatory reforms of bank capital can be achieved.