Basel III: Dead on Arrival?

By Richard Smith

In my last post on Basel III, I suggested that we would soon see a silly game played out over the coming months whereby banks on either side of the Atlantic would alternate in securing more and more concessions on Basel III until the whole thing became manifestly pointless and got sidelined.

In fact it is all happening rather faster than that.

Brooke Masters at the FT is keeping tabs on the whole thing. In this piece, from 10 days ago, we get a few portents:

The 19 biggest US banks will have to show they are on course to comply with the “Basel III” banking reform package as part of next year’s Federal Reserve stress tests even though the US will not have formal rules in place, global regulators pledged on Friday.

The announcement by the Financial Stability Board comes at a time when questions are being raised about the global commitment to implementing the Basel reforms, which are aimed at preventing a recurrence of the 2008 financial crisis. Only 10 of the 27 countries that belong to the Basel Committee on Banking Supervision have finished writing their Basel III regulations, and the US recently said that it would not meet the end of year deadline.

This proclamation hardly makes sense. It will naturally invite a rejoinder from the banks’ IT departments: “You are telling us to plan and build Basel III compliant computer systems, but, to do that, we need the formal rules (that you don’t have). So you are asking us to build a system, but you won’t let us know what it’s supposed to do. We’ve seen this sort of thing many times before, and we assure you that this won’t end well.”

Normally, after some monstrous latency, that message would eventually echo back up through the bank’s management hierarchy and out through the megaphone at the top; but this time, it may be overtaken by events.

Masters draws our attention to the transatlantic regulatory ratchet:

The US failure to give a firm date for its regulations has led critics of the reform package, particularly in France, to question the US’s commitment to the deal and call for a rethink in the European Union.

Not just in France, in fact. In Germany, our favourite miscreants, the Landesbanken, are equally keen to pile onto the anti-Basel-III bandwagon:

… the head of cooperative lender DZ Bank, one of Germany’s top five banks, said a “regulatory tsunami” was unnecessary, especially for smaller banks, adding further study was needed to learn more about the rules’ effects.
The chief executive of Helaba, one of the big regional public sector lenders known as landesbanks, said the wave of new rules threatened to raise the cost of lending. “The banking sector is on the brink of regulatory collapse,” Hans-Dieter Brenner told the conference.”

Ooooh, regulatory collapse.

Meanwhile, the next Bank of England Governor, Carney, stakes out the King Canute territory:

“With regard to the US, I am reassured about their intent and by the facts on the ground,”

I wonder what intent and which facts those are. Evidently they don’t include the views of Thomas Hoenig, vice chair of the Federal Deposit Insurance Corporation, who has gone public wanting to call the whole Basel III thing off.

Masters reels off more signs of strain in the following paragraphs:

The EU is struggling to reach agreement on the law that would impose the requirements across the 27-nation bloc and is almost certain to delay the start date for implementing Basel by at least six months. If a deal is not reached within the next fortnight, the start date could be delayed until December 2013. Michel Barnier, the EU’s commissioner for financial services, recently said the “bulk” of the Basel framework will be in place on time.

There is genuine annoyance among some EU member states who accused the US of backsliding and being unwilling to commit to a date. One eurozone diplomat described it as “a major rupture” that would give US banks an unfair advantage.

Ah yes, that unlevel playing field again. It just keeps tilting one way or the other.

Next the Fed weighs in with another proclamation that doesn’t make sense. I like how it just “points”, dumbly, rather than commenting:

The Fed declined to comment, but pointed to its announcement of the 2013 stress tests in November, in which it said it expected a bank to demonstrate “it can achieve, readily and without difficulty, the ratios required by the Basel III framework as it would come into effect in the United States.

That’s the Basel III framework for which, if we recall paragraph one of the article, “the US will not have formal rules in place”, right? That certainly implies the sort of stress test one might expect any bank to pass. In 2006, when Basel II was being piloted in the US, a regulator’s request from various banks for a risk weighted asset calculation, on some benchmark asset basket or other, got responses that put the risk weight at anything between 1% and 74%. From this one is supposed to calculate a capital requirement. Remember that the US banks haven’t deployed Basel II yet, never mind Basel III, and don’t appear to have put much if any effort into Basel II since the GFC. So (just as an instance, never mind all the other Basel II paraphernalia) did they ever sort out the risk weights that they got wrong in 06? Anyhow, whatever the state of their Basel II models (I would expect, flaky), none of it is in real, live use. Anyone who knows how well banks test software would say that makes Basel II implementations pretty much an unknown quantity. Now we layer a more complex Basel III on top of an untested Basel II and expect all that to work smoothly. It seems very improbable. Lisa Pollack has another recent example of what can go wrong, somewhere between the regulators and the regulatory output, when things get complicated, with this corking FSA “explanation” of a mixup:

4.7 Under CRD3, it is not clear whether or not SRT applies to securitisations originated in the trading book. More specifically, although Annex I point 16a in the Capital Adequacy Directive (CAD) (Directive 2006/49/EC, as amended by CRD3) cross-refers to Annex IX in the Banking Consolidation Directive (BCD) in relation to the use of capital charges and the supervisory formula method (SFM), it is not clear whether the extent of this cross-reference could be understood to include the remainder of the securitisation rules in Annex IX, specifically the rules on SRT. As a result, an argument could be made that CRD does not require that the SRT requirement be applied to securitisations originated in the trading book. Article 326 of the draft CRD4 Regulation, largely a copy-out of the CRD3 text, is no clearer in this regard…

Got that?

Meanwhile the latest remarks by Dan Tarullo of the Fed suggest that the Anglo-Saxons really are getting ready to go their own way on a key aspect of banking regulation:

Mr Tarullo also wants US operations of large foreign lenders to be subject to the same proposed limits on large exposures to individual counterparties that have triggered protest from leading US banks.

The aim is to protect the US taxpayer if a global bank collapses, says Mr Tarullo. “Our regulatory system must recognise that while internationally active banks live globally, they may well die locally.”

It is a shift that could be “transformative”, says Cory­­ann Stefansson, managing director at PwC and a former Fed official who helped lead the regulator’s supervision of the largest banks. “This may be signalling the end of global banking and a return to a more secular, geographically designed banking system,” she says.

In other words, a very non-Basel-III world. Hmmm.

So the IT departments must be way behind, the rules aren’t formulated yet, and at best, in the US, Basel III implementation will compete for IT resources with Dodd-Frank implementation too, when *that* starts to trickle or flood or vomit forth. Meanwhile the Eurobanks are backsliding, and global consensus among the regulators is disappearing (if it ever existed).

We can set all that against some dubious assertions about the benign aspect of “facts on the ground”.

I will end with the latest sightings. In the last few days, the Eurobanks and regulators are really beginning to break cover, fretting loudly about the two big changes in Basel III, capital:

Europe’s banks are calling for a review of tougher financial regulations on the eve of their adoption as the region sinks into a recession, dimming prospects of raising $621 billion in capital needed to meet the rules.

…and liquidity:

“If the LCR doesn’t come together next week into a consensus standard with credible prospects for EU and U.S. implementation — a very iffy proposition, — the concept of global liquidity standards will collapse,” Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics Inc., said in an e-mail…

While some regulators favor a delay, other authorities are concerned that such a step could be fatal to the LCR, as it would give reluctant countries further opportunities to kill the rule off entirely, said another person familiar with the talks…

“Basel is, in my view, on the brink,” said Petrou.

Ah Ms Petrou, you are a kindred spirit.

While all this is going on, the BIS in Basel are stuck in a timewarp, a couple of weeks behind events:

The Bank for International Settlements (BIS) is looking forward to full implementation of the new Basel III banking regulations and is not worried by the United States’ delay in applying the global rules.

BIS Economic Adviser Stephen Cecchetti said “some jurisdictions are having small technical problems on meeting the exact timetable to which they have committed so there are modest and immaterial delays.”

That’s positively quaint.

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  1. Aussie F

    Surely the creation of a Basel III compliant IT system is a straightforward matter?

    The software merely needs to facilitate the overnight transfer of worthless toilet paper, er sorry risk weighted ‘capital’ from one bank to another, and then back again. So Bank x meets its capital requirement by borrowing some worthless toilet paper from Bank y, which Bank x immediately loans again to Bank z, which loans it again to Bank y, which loans it again to Bank x….


  2. Rich R

    Whether its regulations of any kind (financial, environmental, etc), wages, or taxes…isn’t it all just a race to the bottom…?

  3. JEHR

    Here’s a front-row seat to the demise of global financial regulation by delay, non-implementation, competitive rivalry, etc., all designed to get nothing done in the end (and a Canadian shall lead them.)

  4. craazyman

    turn it all over to Goldman Sachs!

    they’ll figure it out. :0

    thanks for this well-crafted run-down Richard.

    Every time you think something can’t possibly be as stupid as it seems, a new revelation comes to light that makes you feel like a fool.

  5. Conscience of a Conservative

    We’d be far better off with simple leverage ratios and more mark to market accounting. The whole risk based weighting approach is prime for gaming in my opinion and over-encourages investment in some sectors and forces selling of assets when comon sense might indicate otherwise.

    1. Conscience of a Conservative

      Add to that holding to the banks to raising subordinated capital would subject them to market based liquidity metrics

  6. Valissa

    DOA, by the Foo Fighters

    Great post Richard, thanks! Reading it reminds me that what’s really needed for more people to appreciate the pathetic goings on at the highest levels of finance and financial regulation, is a comedy troupe that bases it’s sketches on the whole ‘silly game’ described above. Imagining a modern day Monty Python-esque crew in beautiful suits doing some wicked satire on it all.

  7. vlade

    Well, all of the above is true, we can take as given that banks will be unhappy with any regulation.

    That said, B3 is not a very good piece of regulation (as Haldane says, you can’t fight complexity with more complexity). There are good bits (such as increase in Tier1 capital – which is actually quite simple), and really bad bits (all the CVA related stuff).

    I for one won’t mourn B3 at all should it die unborn – especially if it gets regulators to think a bit before reacting.

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