Klaas Knot: Want a strong financial system? Implement Basel III
Speech by Mr Klaas Knot, President of the Netherlands Bank, before the International
Institute for Banking Research (IIEB), a group of European bankers, Amsterdam, 11
October 2024.
* * *
Thank you Ralph, and thank you for the invitation to speak here before this
distinguished audience.
You are all leaders of big organisations. So you are familiar with the question of
strategic change: how do you navigate your bank through the waves of financial market
sentiment, changing consumer preferences and technological innovation? A sound
strategy starts with a lot of thinking, for sure. Strategic thinking. Board room
discussions. A couple of consultants perhaps.
Finally there is a strategy. A Strategy with a capital S. You know where you want to go
and how. But now you enter a crucial phase: implementation. How do you get all
corners of your bank from A to B? Because all the strategic thinking in the world will
come to nothing if your bank does not follow suit. Implementation is key.
So how would you feel if, after 13 years, your plans are still stuck in the implementation
phase? I ask because that's the situation we are in with Basel III. When I became
governor back in 2011, we were discussing the implementation of Basel III. And now,
towards the end of my second term, we are still discussing the implementation of Basel
III.
By now, some of you might think: 'ok, so this morning we got war for breakfast, and now
for lunch we get a central banker who wants to talk about the rules. What's next? We've
heard this scratchy old broken record dozens of times before!' But, as you know, these
are often the best records.
So let me take a step back here. Where are we coming from? In 2010, the Basel
Committee on Banking Supervision introduced the first set of Basel III standards. A set
of international rules designed to fortify the global banking system after the worst
financial crisis since the Great Depression. These reforms were not just a patch-up job.
They were a complete overhaul of banking regulation to improve bank resilience,
transparency, and risk management. Basel III focused on increasing capital adequacy,
introducing the leverage ratio, and creating more stringent liquidity requirements. With
the memory of the crisis still fresh, national implementation of this first part of Basel III
went relatively quickly.
This first set of standards was then complemented in 2017 by the final Basel III
standards. They focused on enhancing the risk-weighting framework, introducing more
robust capital floors, and limiting the variation in banks' internal risk models. These
standards, by now famously known as the Basel endgame, have not yet been
implemented by jurisdictions around the world. The EU, in its implementation, deviated
on important points, making banking regulation weaker than agreed in the new
standards. In the US and the UK, initial legislation proposals have also been weakened,
with some elements not fully aligned with the Basel III agreement. Legislators also point
at each other when making these adjustments. US banks spent tens of millions of
dollars on a lobbying campaign that included ads in the middle of American football
games. I don't think it's ethical to interrupt football games for any kind of message, let
alone on Basel III.
But on a serious note: our failure to implement fully what had already been agreed upon
back in 2017 should be worrying. Not only to me, as a regulator, but also to you, as
bankers. To explain why, let me give you my version of a pro-Basel lobbying
commercial.
Implementation of Basel III will increase the credibility of capital ratios and strengthen
the banking sector. Think of it as a safety net, your safety net. It will ensure that when
the next economic shock comes-and it will come-you will be better prepared to
withstand it. The capital buffers required by Basel III are not a burden; they are a shield,
allowing you to absorb losses while maintaining operations, protecting your customers
and preserving your reputation in times of stress.
Many in the banking sector view regulation as a constraint, something that limits
profitability and imposes undue costs. But it's just the other way around. Basel III is not
an obstacle to growth, it is an enabler of sustainable, long-term growth. Banks with
strong capital positions and sound liquidity management are better positioned to extend
and rollover credit, invest in new technologies and fund large-scale projects. They are
better able to maintain lending during an economic downturn. And stronger banks can
secure more favourable funding conditions, attract long-term customers and build
partnerships that increase shareholder value.
Basel III works best when it works everywhere. When Basel III is implemented unevenly
across jurisdictions, it creates a patchwork of regulations that opens the door to
regulatory arbitrage. Banks may be tempted to shift operations to regions with looser
standards. Consistency across borders is not just in regulators' interests-it's in yours as
well. An uneven playing field undermines confidence in the global banking system,
disrupts competition, and ultimately increases systemic risk. It puts banks at risk of
operating in jurisdictions where regulatory frameworks are not equipped to deal with
crises, leaving you exposed when things go wrong.
By contrast, global implementation of Basel III creates a level playing field, ensuring
that all banks-no matter where they operate-adhere to the same high standards. This
uniformity strengthens global financial stability and, in turn, enhances the confidence of
your shareholders, customers, and counterparties.
The opposition to Basel III reflects a kind of short-term thinking, that, frankly, I find hard
to understand. Weakening of Basel III may give you a few basis points in capital relief,
but it exposes you to long-term vulnerabilities. As the memory of the global financial
crisis fades, we risk entering a race to the bottom. A race that would be very dangerous
for financial stability. Or, as Daniel Davis said in his much-quoted Financial Times
article, 'while the road to hell is paved with good intentions, the road to the next banking
crisis is paved with good exemptions.'
So in short, it is essential to implement the Basel III standards in all jurisdictions. Not
least because, as you know, financial markets are not waiting for us to learn the lessons
of 13 years ago. New risks are always emerging, as the events in March last year
showed. The demise of Silicon Valley Bank and Credit Suisse not only brought lessons
for banks and supervisors. They also highlighted that we may need some targeted
changes in banking regulation beyond Basel III. I want to mention three areas here:
liquidity, interest risk and AT1 instruments.
First on liquidity. Partly as a result of social media and digitalisation, the outflow of
deposits at SVB was much faster than in previous cases, and much faster than LCR
calculations take into account. This raises the question of whether the LCR should be
calibrated differently for certain types of deposits. The aim would be to increase banks'
resilience and provide incentives to attract longer and more diversified funding.
Another avenue which should be explored in the light of the SVB case is whether
unrealised losses should be better reflected in the capitalisation of banks. Here I'm
referring to the difference between market and book value for bonds which are held to
maturity. And we should look at how to address the issue that, in times of stress, banks
may be hesitant to use instruments in the liquidity buffer that are not marked to market
daily for accounting purposes.
The turmoil last year also showed how important it is that banks are operationally
prepared for liquidity stress. Banks need credible and tested contingency funding plans
and they must be operationally ready to access central bank liquidity facilities in times
of stress. While this may be more of an issue in the US, we should also look at how this
can be improved in the EU.
Then interest rate risk. When banks fail to cover this risk sufficiently, changes in market
interest rates can lead to substantial losses and, in extreme cases, even to bank failure.
The recent developments at regional banks in the US offer a vivid illustration of this.
The events last year underline the importance of regulation for interest rate risk
management and the need for prudent assumptions about customer behaviour. Capital
is also necessary to absorb the uncertainty of customer behaviour. In order to promote
global harmonisation, we should explore the inclusion of interest rate risk in the Pillar 1
requirements.
And last but not least, we need to think about AT1. Rather than acting to stabilise a
bank as a going concern in stress, international experience has shown that AT1
absorbs losses only at a very late stage of a bank failure. We saw this in the case of
Credit Suisse in 2023, with the Swiss National Bank noting that 'the AT1 features
designed for early loss absorption in a going concern were not effective'. In this
instance, AT1 only absorbed losses when the point of non-viability was imminent and
failed to stabilise the entity at an earlier stage of stress. This should encourage
regulators to reflect on the role and functioning of AT1 instruments in determining the
capital position of banks.
These are all important things that we have to look into. But first and foremost we have
to implement Basel III. And while I know this is primarily a message to regulators and
lawmakers, it is also a message to you. Because what a strong signal it would be if you
as a group would say: don't water down Basel III. Don't give us weak rules, give us
strong rules. Strong rules that apply to all banks wherever they are and whatever their
size. It would not only be a strong signal to us, regulators and lawmakers, it would also
be the rational thing to do. Because strong rules are in your interest. Because a strong
financial system based on a level playing field is in your interest. Because regulation is
not a constraint on the financial industry, it is a license to operate.