Date first published: 17/10/2017

Key sectors:finance

Key risks:regulation; financial crisis; credit risk

As memories of the 2008 global financial crisis fade, the risk increases that governments, regulators and banks relax their standards. In the aftermath of the crisis, the Basel Committee on Banking Supervision agreed upon the Third Basel Accord (Basel III). With the support of national government and regulators, Basel III built upon two earlier accords, broadening both the scope of previous regulations and introducing a series of micro and macro prudential reforms to reduce systemic risk. Given the complexity of the financial sector, the accords need constant calibration. The Basel Committee is attempting to calibrate Basel III, a new set of standards that are informally referred to as Basel IV, which could increase the capital requirements of primarily European banks at a time when many are already struggling due to weak profitability, low interest rates, and a slow Eurozone recovery.

At the core of Basel III were three regulations. Firstly, the accords introduced a leverage ratio that limited the leverage of a bank compared to its high-quality capital (‘Tier 1’ capital). The leverage ratio does not change depending on the risk associated with the bank’s assets. Secondly, financial institutions are required to have sufficient high-quality liquid assets to cover outflows during a 30-day period of stress.  This requirement reduces the risk of a short-term liquidity crisis. Thirdly, banks are obliged to hold capital not less than 8 per cent of risk-weighted assets. Calculating the risk weighting can be difficult. Basel III included a ‘standardised approach’, but also introduced some flexibility given the complexity and variance in bank business as it allowed institutions to use their own models to calculate risk weighting.

Issues emerged when risk weighting assets, particularly in assessing credit risk. The use of internal models meant that banks with similar portfolios had very difficult calculations of their risk weighted assets. Basel II allowed banks to use their own models for risk weighting, but unlike Basel III, capital levels had to be at least at 80 per cent of those calculated by the standardized model. The most controversial proposed calibration of Basel III would reintroduce an ‘output floor’, which would constrain banks use of their own models.

The ‘output floor’ has split governments. American regulations tend to be tougher than those demanded by Basel III, and more American banks use the standardised approach than European banks. European banks, particularly German and French banks, fear that an ‘output floor’ will significantly increase their capital requirements and hurt the sector at a point where it is already vulnerable. American banks thus believe a tightening of Basel rules will advantage them. The increase in capital requirements has led many to call the calibration equivalent to an entirely new Basel accord.

The Basel Committee hoped to reach a compromise by the end of 2016. That deadline passed with little progress. European regulators are reluctant to accept a phased in ‘output floor’ above 70 per cent, while US institutions have pushed for a higher floor. An agreement has been slowed by the Trump Administration’s ideological aversion towards greater regulation. As the standards are formally voluntary, they need to be endorsed by all major central banks and regulators and thus without full agreement none of the Basel III reforms can go forward.

Some within the Basel Committee suggest that a compromise floor of around 72.5 per cent may be agreed, although French Finance Minister Bruno Le Maire has said he would reject any changes to Basel III that increased capital requirements for French banks, potentially including a 70 per cent floor. While it is likely that a compromise will eventually be agreed, there is a risk that it will reduce the financial sector security that the accords are meant to provide.