sabine lautenschlager : basel iii – sense and sensitivity speech by ms sabine lautenschlager, member of the executive board of the european central bank and vice - chair of the supervisory board of the european central bank, at the institute for law and finance conference on basel iii, frankfurt am main, 29 january 2018. * * * it is done : basel iii has been finalised. i admit that it was a long journey, but in my view, it was worth the wait : basel iii will help to make banking safer. it is crucial, though, that basel iii is properly implemented – in europe and around the world. it must not be watered down. basel iii marks the end of the post - crisis reforms ; regulatory certainty has been restored. the banks know what awaits them ; they can be confident about the regulatory framework, and can plan ahead and support the real economy. but does basel iii deliver what was promised? does it, on the one hand, create rules which are sufficiently risk - sensitive to set the right incentives for banks? and does it, on the other hand, create rules which are simple enough to decrease model risk? banks are not enchanted by basel iii. many of them claim that it throws risk sensitivity overboard and penalises low risk exposures. are these claims justified? well, we have not thrown risk sensitivity overboard. and why would we? risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. it prevents arbitrage and risk shifting. and risk - sensitive rules promote sound risk management. but we all know how challenging it is to measure and model risks. much depends on the quality of the models ; much depends on the data and the assumptions that feed into those models ; and much depends on supervisors ’ capacity to act. if there are errors along the way, banks might end up undercapitalised and vulnerable. this, in turn, might lead markets to question the reliability of risk - based capital requirements in general, which would undermine trust in banks more generally. therefore we need to balance risk sensitivity with some safeguards. and this is exactly what we aim to do with basel iii. it preserves risk sensitivity. it retains internal models for most asset classes. and it enhances the risk sensitivity of the standardised approaches. but at the same time, basel iii adds a few safeguards. first, i think we can all agree that it makes no sense to allow for more complex risk -

assessments, conservative collateral valuations, continuous monitoring of the borrower ’ s risk profile, and rapid reactions to changing circumstances. addressing risks – risk management and banking supervision the market environment i just described undoubtedly calls for effective risk management in order to curb potential excess. however, with regard to leveraged finance, risk managers find it difficult to appropriately and effectively play their role in a market environment characterised by fierce competition. more specifically, there are three areas where we are currently pushing for improvement. first, with regard to procedure, historical credit norms are beginning to weaken and more market - friendly structures have been adopted – i already mentioned the covenant - lite issue. in that regard, the thorniest aspect is the credit approval process. the speed of credit approval has become a cornerstone of competitiveness in the market for leveraged finance. in order to increase their market share, banks have significantly shortened their internal validation process. anecdotal evidence suggests that many deals are presented by the borrowers as “ take it or leave it ”. in some cases, potential borrowers requested approval within 48 hours. to me, it seems rather challenging to properly understand a deal within 48 hours – both for the front office as well as for risk management. second, with regard to limits, risk managers need to be alert regarding a shift towards structures that support an expanding business. most banks have limits in place with regard to exposures held on their own books. however, these limits have sometimes been shifted upwards to accommodate business needs and the prospect of rewarding transactions ; the underwriting limit, for instance, has on average increased by 49 % between 2012 and 2014. in such circumstances, risk managers should ensure that stress tests adequately reflect the higher limits. in any case, from a supervisor ’ s perspective, large underwriters could be expected to avoid too much fluctuation in their limits. third, with regard to stress testing, all banks should conduct dedicated stress tests for their leveraged finance portfolios – i mentioned that before. such stress tests are helpful in identifying the consequences of downturns in the markets. therefore, as part of our planned supervisory actions, stress - testing frameworks will be strengthened, particularly with regard to the underwriting pipeline. to sum up : the european market for leveraged finance has grown, and european banks have increased their exposure to it. we as supervisors are closely monitoring these developments. but we go beyond mere observation ; we are also acting, combining individual and ssm - wide