Q&A: Basel Committee's Walter outlines Basel II reform agenda

Befitting the worst financial crisis in living memory, the response to the current upheaval will bring comprehensive changes to the regulatory landscape. Leading the push for reform is the Basel Committee on Banking Supervision, which, since being established in 1974, has overseen the implementation of two capital adequacy frameworks (Basel I and Basel II) and acts as the first point of reference for national regulators.

As more countries implement the Basel II Accord, it has become evident it needs to be amended to make the banking system more resilient to future crises. The Basel Committee is putting together a comprehensive reform package for Basel II, which includes a strengthening of capital requirements, identifying where the existing accord is pro-cyclical and how to address this, and the possible introduction of a leverage ratio.

Stefan Walter, secretary general of the Basel Committee, sat down with Risk to discuss the specifics of the reform agenda.

Risk: The Basel Committee has announced several initiatives in response to the crisis: what are its top priorities as we approach the second half of 2009?

Stefan Walter (SW): Our agenda is focused on putting in place the next-generation regulatory framework to promote a more resilient banking system. This requires a package of measures: stronger capital, a more robust global liquidity standard, better risk management and governance, more transparency, enhanced supervisory co-operation and global bank resolution frameworks. As we strengthen the regulatory framework, we really need to focus on the broader goal of promoting system-wide stability. We are very much guided by macro-prudential considerations and not just institution-specific goals, as well as by the types of incentives our regulations create.

The introduction of counter-cyclical buffers is extremely important to strengthen the resiliency of the banking sector over the credit cycle, while the quality of the capital base on which that is built is critical for the regime to be credible. Moreover, the principle of having multiple safeguards built into the framework, such as risk-based measures underpinned by a simple floor, are some of the other key elements I would highlight.

Risk: Does the focus on the ‘big picture’ signal a shift in emphasis?

SW: Pre-crisis assessments about the dimension of potential losses tended to be built up at the level of individual bank portfolios, and these figures generally were well below what ultimately transpired. The only way to get to more severe events that go beyond a quarter’s worth of earnings is to start thinking about system-wide dynamics – such as leverage building up across the system, risk concentrations to a whole asset class, such as mortgages, and adverse feedback dynamics, for example through interactions among valuations, losses and margining requirements. When risk managers design their limits or assess the adequacy of capital cushions, and regulators think about what buffers are needed, system-wide dynamics, links and feedback effects should be factored in to ensure firms can withstand the next potential period of stress.

Risk: During this crisis, it has emerged that certain non-banking firms, such as AIG, engaged in activities traditionally associated with banks. Yet banking regulators have no control over those firms. Does that need to be addressed?

SW: If it walks like a bank and quacks like a bank, it should be treated like a bank. If it is a systemically important institution, it should be subject to a minimum intensity of regulation – that is critical. Moreover, one needs to understand how banks and other institutions are tied in to the broader credit intermediation process. If you accept the premise that banking sector risk does not stop at the door of individual banking institutions, and there are other players in the markets in which banks compete, that comprehensive view on the financial system and markets gives you a greater chance of knowing where the real pressure points and concentrations in the system are building up. An effective systemic regulator needs that broader perspective.

Risk: Some critics of the framework have advocated ripping up Basel II and starting again with Basel III – has that ever been considered?

SW: If risk capture is inadequate, and market participants only become aware of these risk coverage gaps during stressed periods, an insidious pro-cyclical dynamic will result, with its associated hits to earnings, capital and liquidity. We therefore need a sufficiently risk-sensitive framework such as Basel II. To complete the picture, Basel II must be underpinned by strong capital, a simple floor underneath it, and a mechanism to deal with any excessive cyclicality. Those elements can be built into the existing framework. Moreover, the three pillars of the Capital Accord are critical to provide different perspectives on risk and further strengthen the framework.

Many have associated Basel III with a move towards full credit models. In light of this crisis, where financial institutions clearly didn’t have a handle on the modelling of correlations, especially in the mortgage markets, I don’t think that we should go down that route.

Risk: On March 12, the Committee said the minimum regulatory capital level will be reviewed in 2010, which will be higher than the current requirement. Does the Committee have a figure in mind at this stage?

SW: Over the course of this year, we are going to deal with some of the key building blocks of the capital framework – capturing all the key risks, defining high-quality capital, building in a mechanism for counter-cyclical buffers, and developing a simple supplementary measure. As a critical second step, we will also determine how these elements are going to interact as part of a coherent overall package. In 2010 we are going to focus on how the overall framework should be calibrated going forward.

As for the key question on what the minimum capital level will be, I can’t give you an exact number. But clearly the level of capital held in the system as we entered this crisis was inadequate for the risk within the banking system. In reaction to the emergence of unforeseen risk and concentrations, and the realisation that many firms were not sufficiently capitalised, the markets have overshot as a result of a once-in-a-century deleveraging process. The Basel Committee’s aim will be to achieve the appropriate level of capital that reasonably balances the need to cover the risks in the banking sector over the long term while not overreacting in relation to current market expectations.

We have clearly stated that we will not raise minimum capital requirements in the middle of a crisis and refrain from taking steps that could aggravate the current stress. Moreover, the Committee is also working to build in a mechanism that produces buffers above the minimum that could be used over the cycle to dampen the negative feedback channel from the banking sector to the real economy.

Risk: There has also been a lot of debate on the issue of pro-cyclicality in Basel II. I understand the capital monitoring group is looking at this issue in detail: can you say anything on what its initial findings have been?

SW: Any capital framework that is risk-sensitive will vary over the credit cycle. So there is a trade-off. What is less clear is the relationship between a cyclical minimum, total capital levels, and broader pro-cyclicality in bank lending. Bank lending is driven by many considerations, including assessments of overall economic prospects.

When it comes to the cyclicality of the regulatory minimum, the capital monitoring group has put in place a coherent framework to measure the impact of Basel II across the member countries of the Committee and to continuously examine the impact every six months. To properly assess cyclicality, at least two data points are needed and probably a few more: it is simply too early to conclude how cyclical the framework will be. We have yet to hit the full trough in terms of credit losses, so we don’t have all the data. Most of the analysis at this point is more qualitative – based on discussions with institutions about the peak-to-trough change in the capital requirements, and most of those range between 10% and 20%, assuming no further mitigating activities to dampen that variability. In the end and if necessary, we will come out with the necessary adjustments to achieve the right balance between risk sensitivity and cyclicality and we are reviewing concrete ways this can be done. More fundamentally, we are putting in place a mechanism to build counter-cyclical capital buffers over the Basel II regulatory minimum.

Risk: What stage are discussions over the introduction of a leverage ratio at? Bank holding companies in the US have been subjected to a leverage ratio for several years, but this did not prevent many firms becoming excessively leveraged. What needs to be in place to ensure a leverage ratio is effective?

SW: I don’t think it is necessarily correct to say the existence of a banking crisis in a country that had a leverage ratio invalidates the measure. Some could argue the leverage ratio might have helped to avoid an even worse scenario than that which has unfolded so far. The key question is: can this measure help put in place some floors and cushions within the system to help it better withstand crisis and stress, whatever the source?

To the extent it can also contribute to limiting the build-up of system-wide leverage in the first place, that is clearly helpful. But if the measure is only applied to some institutions and countries and not to others, there would be major pressures on the institutions applying it. It really needs to be a measure that is imposed in a globally consistent manner. Secondly, it is only one tool: the measure needs to be simple, gross-based and transparent, but it only works in conjunction with a more risk-based measure. When implementing it, there are a number of issues that need to be addressed, such as how far does one go in recognising off-balance-sheet exposures. The other issue is the accounting differences between International Financial Reporting Standards and Generally Accepted Accounting Principles, and how they treat repurchase agreements and derivatives transactions.

Risk: What is the Committee’s position on the suggestion that some banks have become ‘too big to fail’?

SW: There is a lot of thought on this issue in various forums. The first concerns how to define systemically important institutions and what their characteristics are. It is also closely tied to the perimeter of regulation and which firms should receive classic, prudential capital and liquidity regulation, and who should receive a different form of regulation. Once there is a common definition for systemic institutions, the next step is to consider what concrete measures could be taken to mitigate the risks and externalities. Possible measures that have been discussed include simple asset-size restrictions; imposing some kind of add-on within the capital framework; determining how these firms would be treated under cross-border resolution arrangements; and making further enhancements to the infrastructure of derivatives and repo markets, including possible additional incentives through capital requirements. The official sector, including the Basel Committee, is discussing these issues right now.