“Implementing Basel III will not be rushed”

August 2011

(Part 1 of 3) Conversation with José Maria Roldán, member of the Basel Committee for Banking Supervision, on – high quality capital – justification for Basel III – stress testing of Basel III

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Here is the transcript of the video.

1. Evolution of Basel II to Basel III

Emmanuel Daniel (ED): Basel IIIis an agenda that is very much at the top of the minds of bank CEOs around the world. We are very pleased to be able to speak today with José María Roldán, the director general of banking regulation of the Bank of Spain. But perhaps, equally important, a member of the Basel Committee for Banking Supervision and the head of the standards implementation group at the BIS. Give us a sense of what you think Basel III is really designed to deal with.

José María Roldán (JMR): Basel III very clearly is a continuation of the efforts that were started with Basel II. We want to have a regulatory system for the banking sector that is sensitive to risk. The higher the risk, the higher the capital firms should hold. This was the idea behind Basel II and this is continuing in Basel III, but with an upgraded concept in the sense that, with Basel III, we are going to maintain this differentiation among risks, but, we want to have higher capital customs, if you want to describe them like that, and higher quality of capital. By higher quality of capital, I refer to basically common shares, equity and reserves.

What we have learned during the crisis is that with high-risk capital instruments, be it preferred shares orsuperannuated debt, didn’t work as they were intended in terms of absorbing losses of firms and allowing banks to continue doing business in the case of preferred shares. So, now what we are doing is kind of back to basics in terms of what capital we want to accept in regulation. We are going to the best quality of capital that is possible.

So, it is like Basel II, with higher capital, higher quality of capital. In terms of the specific areas where we have also upgraded Basel II, I would highlight two: the trading book and that securitisation is key. We have seen as an experience of the crisis, that the capital that was devoted to those areas was not enough. What we are doing is asking for more capital to be aligned with the risks that have manifested during the crisis.

ED: In one sense can we view Basel III as an over-reaction? You just mentioned that to deal with the risk on the trading book and securitisation and really the culprits in that space were the investment banks rather than the traditional commercial banks. It would come across that you are actually trying to apply the same rules across all different types of institutions, when actually the trading book of a commercial bank may not be as significant as that of an investment bank.

JMR: I think what we are trying to do with Basel III is treat the same risks equally independently of the type of institution that we are talking about. I think that is commendable. I do not see Basel III as an over-reaction on the part ofthe regulators. It is a reaction to the crisis, let us not deny that. Is it an over-reaction? No, I do not think so, and I think that going forward it is important for all types of financial institutions to be on safer ground. This crisis has shown us how hard a crisis can hit in a global financial system.

Complex institutions doing very complex trading activity but also, not so complex institutions that are in this international financial system—if you are a bank that is active in these areas, you are going to be hit harder than a bank that is not active in these areas, for instance, a retail bank. But both need to have capital that is upgraded so that a crisis, if it happens in the future, can be resisted by the financial system.

ED: Let me just go a step back. The criticism on Basel II, during the global economic crisis was that it sort of fed into pro-cyclicalityjust when banks needed capital they were not able to secure capital in the economy as a whole. It did not really resolve the issue of liquidity. Now, to what extent does Basel III deal with these elements and take it as a continuation of Basel II.

JMR: Pro-cyclicality is going to be a challenge with Basel III as it was with Basel II. What we have designed in Basel III is a series of capital buffers that will try to limit pro-cyclicality. The first is the capital conservation buffer that you will have in a situation whereby excesses, you know, of risk weighted assets that create increases in capital requirements, will be dealt with, with limitations to dividend policies as a way to force banks to rebuild their buffer of capital and, on the upswing, for bubbles—we have the countercyclical capital buffer, which is designed specifically to deal with the emergence of potential bubbles coming from the grey markets.

So, in terms of pro-cyclicality, this is still a challenge, let us recognise that. Any measure of capital that is based on risk-weighted assets, on risk, is going to be pro-cyclicalbut in Basel III, there is a difference to Basel II. We are incorporating that pro-cyclicalityinto the system and we are building several protective walls to deal with the issue of pro-cyclicality. The same can be said on the issue of liquidity. On liquidity, we are devising two types of measures: the liquidity coverage ratio which is short-term liquidity buffer and the net stable funding ratio, which is in the end, a balance of the asset liability maturity mismatch these banks could have.

Let me also add, because this is to recognise reality, that whilst in the area of capital, we have a lot of experience—we have Basel I, Basel II, we know what went wrong with each of those, and now we have Basel III. We are kind of building over something that existed. In the case of liquidity, we never regulated liquidity. So we are faced with these special challenges when we are designing these new measures. That is why the Basel committee has been very clear that in case these liquidity regulations create unintended consequences, we are ready to go back to the drawing table and to see what can be done.

2. Learning process in Basel II

ED: Is that part of the reason why the Basel III implementation roadmap is so long? Is it to absorb some of these learning processes?

JMR: Yes, to some extent it is to absorb these novelties and be able to deal with them in a safer route can be applied to liquidity, but also to the leverage ratio and also to some extent is the message that this is a very high standard. Well, when people say that the Basel III is not really tough, I mean Basel III is enormously tough. And, it is a step in the direction of having tougher regulations. This is not about dealing with the last crisis, this is about dealing with a potential future crisis, and you should not rush to apply this new regulation. This new regulation is not to solve the crisis that we are seeing. This new regulation is to prevent the next crisis that will occur for sure in whatever timeframe.

ED: So tell me, in the deliberations in the BIS, where is the focus of the conversations? I am sure you talk a lot about stress testing and liquidity requirements and so on. But do you stress test the impact of the capital requirements this is going to have on the economy as a whole and the ability of different types of economies to sustain a banking system which has to meet a Basel III regime?

JMR: I think that these types of analysis were done during the design of Basel III. We have done our own analysis.

ED: And you are happy with them.

JMR: Yeah, we are happy with that. I think that we have had a very difficult dialogue with the industry. The industry was pointing out that they thought Basel III was going to create enormous problems. We thought that Basel III was going to create an impact on lower internal liquidity, probably lower liability of credit, but that (a) this was not going to be massive; and (b) this was needed to have a safer financial system that would prevent the boom-and-bust type of behaviour we have seen in the last crisis.

ED: But that is not what the banks are saying. The IIF for example is putting out papers and various banking associations around the world are putting out papers, pointing out, firstly it is going to increase the cost of business, secondly Basel III is far more intrusive than Basel II in businesses that did not previously have capital requirements, like trade finance and transaction banking. And thirdly, it does not really solve the issue of pro-cyclicalityand liquidity.

JMR: Our analyses are different.

ED: Are you at odds with the banking industry?

JMR: Let me be very clear. Our analysis was different, but we are not in the stage of discussing with industry anymore. Basel III is a reality. It has been approved by the Basel Committee; it has been supported by the G20. Basel III is going to be a reality. So my message is stop quarrelling about whether Basel III is a good idea or not. Basel III is going to happen as the sun is going to rise tomorrow. So you better prepare for impact as an industry rather than continue discussing the pros and cons of Basel III.

Different is the area of liquidity I was mentioning. Here, I mean we have some prevention, and we are ready to return to the issue if there are unintended consequences, but generally speaking on other aspects of Basel III, my message to industry is pass the page of the book, move forward. There is no way we are going to go back and delete Basel III. Basel III is a reality and you should incorporate that reality in your business planning.

ED: So the response of the financial institutions has been that in certain markets, especially in Europe, banks are falling over themselves to be better capitalised, but the way in which they are going about it is to actually throw in a lot of confusion as to what kind of capital comprises the capital requirement that you require today. Actually, the use of hybrid capital has increased as a result.

JMR: No, I think that the use of hybrid capital has not increased. I think what we are seeing is a tendency to prepare for these new regulations of being based on core capital, which is the better quality of capital I was mentioning. What you have is people using hybrid capital like convertible bonds into shares as a way to bridge the situation in which they are in now with the start of implementation of Basel III in 2013. You have these types of bridge instruments but generally speaking, I think that everybody is moving in the direction of better quality of capital, and that is good.

ED: How cooperative have the different regimes been around the world on Basel III? I think the European banks generally take it as fait accompliin that they have to comply and so on. The Americans, the Chinese, the Indians are still sitting on the side-lines aren’t they?

JMR: Let me be very clear. We are all members of the Basel Committee. We are all members of the Financial Stability Board. When you are a member of the Basel Committee, you have the obligation to apply what is approved by the Basel Committee as a standard. So, being in the Basel Committee is not a voluntary club. It has its advantages, you are there in the front line discussing, but you also have your responsibility. So, no country that is a member of the Basel Committee will be in a situation where they will not apply Basel III—with a timeframe that is reasonable for them and given the developments in their own country.

ED: But at the same time, they have to get it ratified domestically.

JMR: Yes, of course.

ED: And you would have different types of ratification. There will be ratification for the internationally active banks, for the banks that are essentially local.

JMR: The Basel Committee is about internationally active banks. You have jurisdictions like Europe, where we apply Basel III to the whole population of banks. There are other countries that only apply Basel III to their biggest institutions. That is a national process. What is important from the point of view of a level playing field in the global sector is that all internationally active banks are on the same capital rules. What you do with your domestic non-sophisticated institutions, each country has to decide. In Europe, we have the policy of applying it to the whole population of banks. In other countries, they may have another policy.

ED: What is your sense of how the implementation has been evolving, especially with the banks that have already decided to comply and have put their own schedules on paper? What is the practice now in terms of the way in which they raise capital? And, second really, the fact that capital is applied differently to different types of businesses and so on, there is this opportunity to sort of leverage capital requirements and some might argue that there is a possibility to be more creative even, in terms of how you apply capital?

JMR: If you have higher capital requirements you have greater incentives to capital arbitrage. Let us not fool ourselves. By definition higher capital requirements means higher capital arbitrage in principle. That is kind of a rational result. Having said that, I think that we are aware of that risk and we are ready to monitor that.

In terms of the timeframe of implementation, I think that what is very important is that we have devised a timetable that is very parsimonious. Basel III will start in 2013, but it would not be fully in place until 2019. We have to avoid from the side of supervisor to push for a faster implementation of Basel III. We have to leave this to the industry and to each of the countries to decide how to do this.

It is true that in many countries and probably the country where I am coming from is an example; you are starting to see an accelerated implementation of Basel III well in advance. We have to be careful that this is not seen as a best practice or a practice that should be applied generally. We have devised a framework that will kick in very, very slowly. We thought that it was optimal and we should let the countries and the banks implement Basel III within the timeframe that was approved how they think it is applicable.

ED: Give us a sense of the conversation taking place between the BIS and in fact even your regulator, the Bank of Spain, with the G20 and the global agenda which is really driven more by the politicians than it is by the banking community. What are the points of convergence and what are some of the points of difficulty that you had?

JMR:   My personal vision is a very positive vision of all these processes. The Basel Committee is a bit of a miracle because being a body that hasn’t got any formal powers, we have been able to deliver global standards for capital for the last 30 years that were applied around the world. But this model, which is unique, is very difficult to implement in other areas. So, the fact that you have a G20, the fact that you have a Financial Stability Board, can be a help when you are trying to devise measures that need to be implemented globally, but also are difficult to implement globally.

So, I see this relationship as really a synergy between their political sphere and the more technical sphere. I don’t see a contradiction, I don’t see competition. I see a lot of advantages in moments where you need to take tough regularity decisions to have the backing of bodies like the FSB and the G20. That is extremely important when you are dealing with such complex regulations that are going to create a real impact on many financial institutions.

3. Influence of G20

ED: If you take some of the policies of the G20—they are so caught up with the desire to ensure that the macro-economic framework is sound, liquid, and manageable, and that it is controllable at the national level that in many countries the banking system is essentially a tool to macro-economic intervention basically. And, the banking system is way too heavy-weight in terms of dealing with macro-economic issues. Given the different profiles of the countries that make up the G20, to what extent is the conversation with the BIS an even-level conversation? There are points at which they will be trying to influence the banking system in a way that perhaps you would have put a push back.

JMR: But this is not the general direction of the dialogue with the G20. On the contrary, if you see what the G20 is doing—promoting sound policies that although may have a cost in the short run in terms of credit provision—ensures in the long run that you have a sound financial system that can finance growth in the economy on a sound basis. I think that is really crucial.

If a country tries to use the financial system and lending policies as a cyclical tool, this is bound to disaster. What you want to have are banks that are managed, looking at risk, and pricing those risks in the credit concession that they have. Anything else is not going to be a good idea in the long run.

ED: I guess a simpler way to ask the same question is who leads who? The BIS leads the G20 or the G20 leads the BIS?

JMR: I think that it is very clear in the hierarchical relationship that the G20 is at the top. I mean we are talking about Finance Ministers, Prime Ministers of the greatest countries in the world of emerging and developed countries but the BIS is of a technical nature. It has a technical capacity, it is independent because it is formed by central bankers that are independent. I would not say that who leads what, it is very clear that on the legislative initiatives the G20 has the power to do whatever is needed. The BIS has the technical capacity to enforce those legislative decisions and I kind of see it as a relationship that works in both directions.

ED: What about institutions that want to buy businesses across business lines, or commercial banks or universal banks that buy into insurance companies, into securities and other businesses? How does Basel III apply for multi-faceted business lines?

JMR: It is very clear that Basel III has the rule of treating risks consistently. For instance, in double gearing,we are asking for the deduction of participation in insurance companies. That can be tough for those banks that are more in the bank insurance sector although we have, I mean kind of special treatment, some limits. But, generally speaking, this can be tough for some banks that have these types of business model. The reality is that if we want to avoid doublegearing, that is, the same capital is used to cover two risks—there is no way out of dealing with this other than being tough.

Is this going to impact business models? Yes, but our intention is not to impact business models; our intention is to treat risks in a consistent manner so that the higher the risk, the higher the capital. In the case of participation in other financial firms, avoid the problem of double gearing that the same capital being used to cover risk in two different sectors.

ED: Is there a reality that exists in emerging markets which is essentially different from developed markets, or markets that are not financial centres, which are net recipients of capital, and markets which are essentially net producers of capital?

JMR: Sometimes you hear of Basel III being designed for developed countries rather than emerging markets. I do see it like that. I think what we are doing is designing a system that is safer and probably saving some emerging markets from the mistakes that we have made. For instance, take the case of quality of capital. Quality of capital is not an issue in many emerging counties, in particular, Asia. Why? Because the road towards hybrid capital instruments was a road taken by the developed countries and by the financial institutions in those countries.

What we are doing now is telling Asia, do not go in the direction of hybrid capital instruments, because we can tell you, from experience, that is not a good idea. So, we are saving Asia the experience that we have had, of going into the road of hybrid capital instrument just to discover that they were not acting as we thought they would act in a crisis. So, I do not see this as a competing thing. On the contrary, I think what is good for a bank in a developed country should be good for bank in an emerging country, because in the end, the bank in the emerging country is going to get closer to the bank in the developed country.

I do not see this type of contradiction. In the particular area of quality of capital, it is very clear that we are saving many emerging markets the bad experience that we have had with capital instruments.


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