Basel capital showdown pits US against Europe

• Basel regulators want a so-called capital floor to reduce the reliance on banks' own calculations of risk weighted assets
• US officials like the floor as many of their banks are already required to use higher calculations of risk weightings, Europeans argue it would compromise their balance sheets
• Deutsche Bank research says banks in Europe and Japan would be worse off than any US bank with a 65% floor

A brawl between banks and regulators on either side of the Atlantic has the potential to rattle lenders everywhere, and with it the broader economy.

What the Basel Committee on Banking Supervision wants to do is implement these proposals in an effort to reduce the variation in banks’ own calculations of risk-weighted assets (RWA). A return to a more standardised approach of calculating risk.

Disagreement over capital floor

The committee is suggesting a so-called capital floor, whereby the risk-weighting of a bank’s internal model would have to be above a certain percentage when compared to the risks calculated using standardised methods. The higher the percentage, the tighter the standard.

In a failed compromise in December, the committee suggested raising it to 75% over four years starting in 2021. The first version of proposals suggested 60-90%.
US officials like the floor as many of their banks are already required under the Dodd-Frank Act to use higher calculations of risk weightings, hence the floor would have little impact.

The Federal Deposit Insurance Corporation, one of the 45 Basel Committee members, has doubts about internal models as "management tends to underreport risks and maximise leverage in an effort to boost short-term returns." US banks have learnt their lessons from the crisis, the FDIC points out in a speech in November, and are now in better shape.

Meanwhile, the Europeans argue that these rules would unjustly hurt their balance sheets. Germany’s Bundesbank wants no floor at all, pointing out that its lenders already apply more conservative valuations of property compared to the rest of the world. Hence standardisation would remove sensitivity to the system, actually making it more risky.

"This is definitely one of the biggest concerns for me because - depending on the level at which the floor is set - it has the potential to be significant," says Davide Crippa, Singapore-based global head of risk measurement at Standard Chartered.

"Removing sensitivity from the system would be equivalent to moving back to a framework similar to Basel 1, and that resulted in several unintended consequences, such as shifting risk from regulated to unregulated entities – that was the genesis of super senior CDOs," says Crippa.

The Institute of International Finance agrees saying its primary concern "is less about models, and more about the bluntness of the approach."

Both developed and emerging markets are still highly reliant on banks for funding and reducing the alignment of capital and risk could negatively affect the availability and pricing of credit to the economy, argues the IIR, which has close to 500 members in 70 countries.

Trade finance is another area where the proposed revision may have a significant impact, say detractors of the proposed capital floor, due to the revision of credit conversion factors. This may impact the economic viability of the business, which is not at all desirable in the current economic context.

Asia waits and sees

As the argument heats up between US and European institutions, one region, which seems to be taking a more wait-and see approach is Asia.

"Broadly speaking the capital floor issue is much less topical here," says Brian Weintraub, head of financial institutions capital markets in Asia at Deutsche Bank.

"The use of internal models in Asia is less prevalent than that in Europe. And even for those that utilised the internal approach, on an aggregate basis their overall risk weighting density is often times relatively high by global standards.''

Omar Keenan and Kinner Lakhani, research analysts at Deutsche Bank, show that banks in Europe and Japan would be worse off than any US banks even with only a 65% floor. And in Europe, they estimate that a 75% floor would increase the risk-weighted assets of 26 out of 34 European banks they cover; at 60%, the number drops to ten, mainly from the Netherlands and Nordic regions.

Basel III was meant to be finalised by the end of last year and presented for approval by early 2017. But with the current impasse, the regulators including the ECB, the US Federal Reserve and Japan’s Financial Services Agency failed to reach a solution in March. The Committee, however, did state that "the differences, where they remain, have narrowed."

Since they missed that window, the next scheduled meeting is all the way in June.

“Rather than setting output floors, regulators should consider setting input floors, i.e. flooring some of the parameters that go into calculating RWA," said Standard Chartered’s Crippa. "In this way, risk sensitivity would still be largely maintained, and this should be a key principle for any change."

The Trump effect

One big factor that could have a huge impact on what the rules eventually look like is the new Trump administration. It is hard to judge exactly how as, on the one hand, Trump does not want American firms to be disadvantaged internationally, while on the other he intends to remove what he perceives to be red tape introduced by previous administrations.

One chief risk officer in Asia at a French bank, agrees that the current regulatory environment is too harsh. "From TLAC to FRTB, I feel the regulators have gone too far with their regulatory alphabet soup," he says in reference to other rules being bandied about by the Basel Committee.

"Being a risk manager, I want to have the most accurate tools available to access risk," says Crippa. "I need risk measurements that are as sensitive as possible, and the standardised approach does not fit at all."

Reaching a compromise is indeed hard work especially when everyone feels that the stakes are so high. But threats to walk out from talks and sanctimonious pleas to rise above politics, don’t really help the debate either. With so many bank regulations still up in the air, clarity on one that has the potential to be so hard-hitting, is needed fast.