Basel III – journey or destination?
Keynote speech by Andrea Enria, Chair of the Supervisory Board of the ECB, at the European Commission's DG Financial Stability, Financial Services and Capital Markets Union conference on the implementation of Basel III
Brussels, 12 November 2019
The financial crisis of 2008 was a devastating event, on a global scale. Even those countries where banks were not directly affected suffered from a “second round” of effects: cross-border financial flows ebbed away, as did trade; and economic activity slowed down. In the European Union, the financial crisis morphed into the sovereign debt crisis, as the doom loop between banks and sovereigns put the integrity of the euro area at risk.
In the heat of the crisis it was not always easy to coordinate direct intervention by the official sector. Often, banking groups were split along national lines to make it easier to manage the crisis using national tools. Still, under the guidance of the G20 leaders, it was agreed that the regulatory response to the crisis needed to be shaped by a coordinated approach.
A common reform agenda was key to ruling out the kind of regulatory competition that had driven down standards in the run-up to the crisis. At the same time, it was necessary to put international banking on sounder foundations. If the policy of national ring-fencing adopted during the crisis had been followed by divergent regulatory responses, financial markets would have become even more fragmented. The banking sector would have been more fragile as a result, both at the global level and in each individual country.
Basel III was devised to pursue these two key goals: first, making banks more resilient; and second, preserving an environment that supports international banking business.
Basel III – implementation is key
It was not a quick birth, though. The debate began as long ago as 2009, and the final part of Basel III was agreed upon at the end of 2017. Including the phase-in periods, this will take us up to 2027; that is almost two decades of regulatory reforms. As some have pointed out, Basel is a journey rather than a destination. And I do understand that banks long for an end to the reforms and for regulatory certainty. I can say for sure that supervisors are also feeling a bit of fatigue. But after all the effort, we are almost there.
So was it worth the long wait? Was it the right thing to do? Yes, it was. Basel III is helping to make banks safer and sounder. Some bankers, however, claim that the pendulum has swung too far. They claim that tighter rules are weighing on their profits and making it harder for them to finance the economy. I strongly disagree. Those banks that have been faster in adjusting to the Basel standards are generally in a better position to support their customers. At the same time, to be able to get back to satisfactory profits, banks need to look at other things: how to refocus their business models faster, control costs better, and invest in new technologies.
And there is research that underscores this point of view. It seems, for instance, that banks with higher capital ratios face a better trade-off between risk and profits. In other words, they generate the same level of profits with lower risk.
I understand, of course, that the transition to the new regime can be hard. But it is not impossible. We must not forget that regulation has been tightened up all around the world. And in many places, banks have been recovering despite these tougher rules – particularly in those countries that have frontloaded adjustments to the new capital standards, such as the United States.
So yes, I do believe that Basel III was the right thing to do. However, the final part still needs to be implemented in the European Union. Negotiations have begun, and my position is clear. Basel III needs to be implemented faithfully, consistently and in good time. We must preserve effective international standards, particularly in the current environment; without them global financial markets will not work properly. The European Union is a key player in this regard, and it needs to act as a reliable partner in the global regulatory community. European legislators must stand up to national interests and the lobbying of some banks. This is the most important message I will give today.
Still, Basel III is a large and complex set of standards, which will result in a large and complex set of rules. And as always, the devil lies in the details. I will now dive into the details and highlight a few things that are important from my point of view. These concern both the implementation of the final part of Basel III and the review of the Capital Requirements Regulation and Directive in general.
The output floor – some open questions
First of all, the final part of Basel III will improve the entire prudential framework. With a view to capital requirements, it strikes the right balance between model-based and standardised elements. It preserves the risk-sensitive approach and, at the same time, introduces some safeguards. Some of the changes in the Basel package stem from analysing how the internal models-based approach functions. These analyses were conducted by the European Banking Authority and have been corroborated by ECB findings. I therefore fully support this final part of Basel III.
Some banks seem less convinced, though. They are afraid that they will have to increase their capital, in line with the general concern I have just discussed. The EBA estimates that overall Tier 1 capital requirements for European banks will increase by around 24%. So yes, some banks will indeed have to adjust.
But in contrast to the previous part of Basel III, the goal is not to increase capital requirements for all banks. The new set of standards in fact aims to repair flaws and weaknesses in the way internal models are used. This means it will have a very significant impact on some banks, and much less impact on others. A few banks will even see their overall requirements go down, as documented in the EBA’s study. And we must keep in mind that the impact assessment rests on quite conservative assumptions. It assumes, for instance, that neither banks nor supervisors will adjust their behaviour once the new rules have been introduced, and that balance sheets will remain static.
But European banks are not just worried about the absolute impact; they are also worried about the impact relative to banks in the United States. And indeed, the final part of Basel III will have a softer impact on US banks. This is mainly due to the output floor, which only affects those banks that rely on internal models to calculate their risk-weighted assets and, thus, the capital they need to hold.
In the United States, internal models play a much smaller role than in Europe. The largest US banks are allowed to use internal models, but only if the resulting capital demand is higher than under the standardised approaches. So that’s why Basel III will affect European banks more than US banks. European banks have more freedom to use internal models, and this freedom is now enshrined in Basel III. This is a good thing for European banks, but good things come at a price.
And so we have arrived at one of the most contentious elements of the final part of Basel III: the output floor.
Where does the output floor come from? We all know that it is difficult to measure and model risks. A lot depends on the quality of the models that are used and on the data that feeds into these models. There is quite some room for error, and if there are errors, banks might underestimate the risks they face and hold less capital than they should. They could become vulnerable. So the idea is to balance risk sensitivity with some safeguards.
One of these safeguards is the output floor. It ensures that risk-weighted assets calculated using internal models do not fall too far below those calculated using standardised approaches. What does “too far below” mean in this case? It means that risk weights calculated using internal models must reach at least 72.5% of those calculated using standardised approaches.
The output floor acts as a backstop; it ensures that those banks using internal models cannot end up with capital that is dramatically lower than the capital of banks that do not use these models. During the negotiations on the final part of Basel III, I repeatedly expressed my doubts about the output floor. I was convinced then, and remain convinced now, that such a sweeping limitation could somewhat distort the risk sensitivity of the regulatory framework. There is a much better way to deal with the problems identified during the crisis: repair the internal models by applying the EBA’s standards and guidelines, and address the issues raised by the ECB in its supervisory review.
Still, the output floor was a key ingredient in the international agreement for those countries that do not allow, or heavily restrict, the use of internal models. Without the output floor we wouldn’t have an internationally agreed standard. I believe that the floor is also acceptable for European banks because it has been calibrated at the lower level of the range under discussion. I also believe this compensates for the overall difference between European and US banking structures. After all, European banks do not benefit from Fannie Mae and Freddie Mac; they have to keep mortgages on their own balance sheets.
Finally, we should be mindful that the significant impact of the output floor for banks in some Member States is a legacy of a non-compliant implementation of the 80% floor that came with Basel II. So I think it is really important that we now move on and faithfully implement the output floor, as designed by the Basel Committee.
Still, there are three questions that I would like to address.
The first question concerns the level at which banking groups should apply the output floor. Should they apply it only at consolidated level or also at the individual and sub-consolidated level? From my personal point of view, they should apply it at the highest level of consolidation. This would be simpler, because each banking group would only have to calculate the output floor once. It would also be in line with our goal of supporting a truly European banking market. If the output floor were to be applied at the individual level, the European banking market would fragment further. This cannot be in our interest.
Furthermore, it would reduce banking groups’ flexibility when allocating capital internally and make market consolidation even less attractive. This is particularly unwelcome in Europe, where the universal bank model allows risks to be diversified at group level. If we were to add a risk-insensitive measure below group level, we would curb the benefits of diversification without adding anything to the sound management of risks.
But there is an even more important point. If the output floor were applied at the individual level, it would introduce a bias towards certain business models. Banking groups would have a clear incentive for regulatory arbitrage; they might start to book risky activities into subsidiaries with different business models just to mitigate the impact of the output floor. If these subsidiaries could not understand or control the risks booked to their businesses, there might be problems.
Now, the output floor falls squarely under the first pillar of the Basel framework. And this brings us to the second question, which concerns the role of the supervisor. How does the output floor interact with the second pillar; how does it interact with supervisory capital add-ons? These add-ons are in the domain of supervisors, so the Basel framework does not cover them and there is room for Europe to decide how to proceed. Let me highlight some key points.
First, for a few banks, Pillar 2 might also cover model risks. These banks could rightfully argue that, thanks to the output floor, model risks would now be covered by the first pillar, meaning that Pillar 2 capital requirements could be reduced.
Allow me to be very clear on this point. Regulation does not allow us as supervisors to double-count risks. For pure model risks covered in Pillar 1, there will be no generic risk charge in Pillar 2. This means that we will eliminate any overlapping charges from Pillar 2 if the risks are covered by the new output floor or by other limitations to the use of internal models.
There is a second point regarding Pillar 2. Pillar 2 is defined as a measure to buffer risks that are not covered by Pillar 1. Assume that today, a bank needs to hold 200 basis points of risk-weighted assets as additional capital, which amounts to EUR 1 billion of actual capital. Now, if risk-weighted assets for that bank increase by 20% due to the new output floor, the 200 basis points might suddenly go from EUR 1 billion to EUR 1.2 billion of actual capital.
This increase wouldn’t be justified, of course. It would be a purely arithmetic effect and would not reflect additional risks. I’m convinced that we should sterilise this purely arithmetic effect in our calculations.
Now, the third and final question is how the output floor fits together with our targeted review of internal models – TRIM for short. After all, both projects focus on internal models, and the goal is to “reduce and restore”: reduce unwarranted variability in risk-weighted assets and thus restore trust in risk-sensitive capital requirements. The two projects are complementary.
But they do come from different directions and have different timelines. TRIM is a supervisory project and will come to a close in 2020 – after four years of work. Its purpose is to ensure that banks implement regulation on internal models correctly, in a harmonised and consistent manner. TRIM thus ensures harmonised compliance with applicable law. The output floor, on the other hand, is part of Basel III and therefore comes from the regulatory side. It expands the scope of the law.
TRIM has raised the bar for banks that use internal models. For several of them, this has already had a non-negligible impact on capital. So one could also expect that, for some banks, the output floor might have less impact than anticipated throughout the implementation period, as banks are expected to follow up on supervisory decisions and correct the issues that were identified through TRIM. However, the magnitude of this offsetting effect can only be gauged by the banks themselves, and will depend on future market conditions.
Ladies and gentlemen,
Basel III and speeches by supervisors have two things in common: they may seem to be a journey rather than a destination. But the good news is that, in both cases, the destination is within sight. My speech is nearing its conclusion, and the same is true for Basel III. The final package of standards was already agreed upon in 2017, and will now be implemented in the European Union.
This, however, is the moment at which all could be lost – the proof of the pudding is in the eating, as they say. If legislators succumb to particular industry or national interests and fail to preserve the underlying rationale for global reforms, we might end up with regulation that is neither as global nor as sound as it should be.
When you are building something that is supposed to withstand earthquakes, you should not opt for cheaper materials in the final stages of your construction work just because your budget is getting tighter. Ultimately, you would then risk compromising the very goal you set out to achieve. So now that we are nearing the end of these regulatory reforms we should not hesitate – we should complete the regulatory framework according to the Basel III plans.
Thank you for your attention.
- Mergaerts, F. and Vennet, R.V. (2016), “Business models and bank performance: A long-term perspective” Journal of Financial Stability, Vol. 22, pp. 57-75.
- According to Table 1 of the EBA’s reply to the European Commission’s Call for Advice (“Basel III reforms: impact study and key recommendations”).