International Financial Regulation Since 2008: Why Implementation Delays of Basel III are Likely to Persist in the U.S. and EU

By Colby Mangels, Guest Contributor

The Basel III agreements were meant to be the international community’s answer to the lax capital requirements of many financial institutions prior to the 2008-2009 financial crises. These capital requirements stipulate the amount of liquid and non-liquid assets that financial institutions are required to keep on their books. Originating as an addition to the Basel II standards of the Basel Committee on Banking Supervision (BCBS), Basel III was first proposed in December 2010, and revised in June 2011.  The BCBS is made up of close to 30 national finance ministers from across the world. Inter alia, Basel III requires that the capital assessments of banks take into account potential market devaluations and counterparty credit risk. These measures are intended to prevent the typical asset accumulations on bank balance sheets that often lead up to financial crises. The BCBS, in conjunction with its parent institution the Bank for International Settlements, has promoted these standards among its members.

Nevertheless, Basel III implementation efforts have hardly been unified across BCBS members. Basel III implementation has especially run aground in the U.S. and the EU. Last November, a trio of American financial regulators, led by the Federal Reserve Board, indefinitely postponed its implementation, originally planned for January 2013. While the European Parliament continues to debate Basel III implementation, European regulators have already extended key assessment deadlines for the financial sector by at least a year. Additionally, Michel Barnier, European Commissioner for Internal Market and Services, remarked during an interview at the recently held World Economic Forum in Davos, Switzerland, that he would accept a two year timetable for joint implementation with U.S. regulators. So much for speedy resolve.

So, what happened to the push for more unified and precise capital standards among the post-financial crisis global community? American and European regulators each have their own set of reasons for postponement. American regulators, simultaneously dealing with the implementation of the massive Dodd-Frank Act, are afraid of the negative consequence of over-regulation. Specifically, U.S. regulatory agencies are concerned that simultaneous implementation may actually place the financial system in a worse position than it was ex ante.

Europeans, while similarly concerned about imposing heavy burdens on their own financial giants, remain in a process of intense deleveraging following recent volatilities on the European sovereign bond markets. Although recent markets have calmed, European regulators remain sensitive to intensive assessments of bank balance sheets that might reveal under capitalization. Pressured with handling this delicate balance, European regulators want to give banks more time to raise the appropriate types of assets required under Basel III.

But there remains more to this story than meets the eye. In particular, understanding the goals behind Basel III can help to understand upcoming issues in its application to the American and European financial regulatory systems.

Basel III – Why Implementation has Potential to Enhance Financial Market Stability

Basel III is the latest in the Basel Accord series originating from the BCBS. The BCBS was originally formed by the G-10 following the Herstatt banking crisis of 1974. In 1988, BCBS members agreed on the first round of unified credit risk assessments and capital standards to be issued from the Basel Accord.  Later known as Basel I, BCBS signatories to this agreement established unified risk measurements of categories of banking assets, and required banks to hold 8% collateral assets. Basel II expanded on the relatively broad asset categorization techniques under Basel I by further grading the risk categories, allowing qualified financial institutions to develop their own internal (and more sophisticated) risk models, and incorporating value-at-risk-based capital. Basel II was subsequently implemented in many jurisdictions (although implantation in the U.S. was never completed) and was in effect at the outbreak of the 2008 financial crisis. Despite the improvements in terms of asset categorization in comparison to Basel I, Basel II was discredited during the financial crisis for looking too closely at individual bank risk, and failing to look at systemic risks imposed on the financial sector as a whole.

Basel III attempts to improve these problems by (a) requiring stricter definitions of the capital that banks are required to hold, (b) requiring banks to hold greater amounts of capital and (c) creating not only asset, but also liquidity ratios (measuring the assets a bank can expect to sell at any time).

Stricter capital definitions under Basel III improve upon Basel II’s attempts to grade assets and forces financial institutions to disclose to regulators more information about the quality of assets in their balance sheets. Although this approach continues to overlook previous problems of market fluctuations in the price of the valued assets, it does have the potential to provide regulators with better information to carry out their oversight.

The debate over higher capital requirements remains a heated issue surrounding Basel III implementation. While financial institutions have stressed the inherent costs associated with requiring more capital, regulators reiterate that both quality and quantity of assets is critical. However, Basel III sets minimum capital levels between 8-9.2% (for systemically important banks). It is true that these rates are potentially lower than the rates that some banks often self-impose, or rates that domestic legislation in certain jurisdictions already imposes. Nevertheless, by establishing an international minimum requirement, across the broadest number of relevant financial systems, Basel III would minimize the impacts of future crises where capital rates typically drop much lower.

Finally, liquidity ratios would require banks to hold enough liquid capital to get through periods of contracting credit markets (i.e. 30 day periods). This is the first imposition of global liquidity standards and it has the potential to reduce future dangers in short-term market liquidity freezes of the kind that took place in September-October 2008.

U.S. Implementation of Basel III: Second to Dodd-Frank

In early January 2010, the U.S. Congress approved H. R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 171 of the Act establishes new capital requirements for financial institutions. Supervising regulatory agencies will articulate these requirements. The Dodd-Frank implementation process has taken significant time, with regulatory agencies failing to meet repeated deadlines.

Due to the broad nature of both Dodd-Frank and Basel III legislations, implementation of Basel III in the U.S. would require concerted efforts by the American authorities currently implementing Dodd-Frank to ensure that neither piece of legislation interferes with the other. The Federal Deposit Insurance Corporation, a main overseer of Dodd-Frank implementation, announced last June that it would incorporate Basel III into Dodd-Frank-related regulations during future drafting. However, last November, the Federal Reserve Board announced that it would delay Basel III implementation passed the proposed date of January 1, 2013. Recently, the Federal Reserve Bank announced that implementation could be finished “in the coming months.” Meanwhile, chief EU regulator Mr. Barnier recently agreed to coordinate European implementation with the U.S. over a two-year time frame and continues to press for U.S. cooperation. This comes at a time when implementation of Dodd-Frank is, itself, considered a challenge.

Why the slow-up on implementation in the U.S.? Simply put, regulators are concerned that enforcing simultaneous implementation of Basel III and Dodd-Frank will cause onerous compliance commitments for financial institutions. Simultaneous implementation would require the in-house compliance teams of financial institutions to juggle compliance issues between both pieces of legislation, potentially reducing the ability for effective compliance with either. Additionally, an international component is also relevant. Given the delayed implementation of Basel III in Europe, American authorities face little pressure from their European counterparts when postponing the Basel III framework.

Implementation in Europe: Stalled by the Euro-Crisis.

Basel III implementation has taken a different route in Europe. In 2009, the European Commission began work on the new European Capital Requirements Directive IV (CRD IV). The CRD IV, which preceded the Basel III proposal, has become the European Union’s template for new capital standards. Any implementation of Basel III into the CRD IV will first require approval from the Council of the European Union and the European Parliament. The European Council approved a compromise draft of the CRD IV last spring, incorporating the main aspects of Basel III, while reducing some of Basel III’s more burdensome capital requirements. The European Parliament continues to debate the Council’s proposal.

Slow European implementation reflects continuing stresses faced by the financial system. One of the most significant departures of the Council’s proposal from the original Basel III legislation concerns how each piece of legislation defines bank capital. Specifically, the Council proposes less stringent capital measures. This request by the French and German governments reflects the on-going uncertainties these governments face as they attempt to manage the financial sector’s deleveraging of sovereign bond markets.

The European sovereign debt crisis created intense volatility within a number of Eurozone bond markets, rendering financing difficult for those member-states affected. The financing market for these members has calmed since the European Central Bank’s (ECB) President, Mario Draghi, announced last year that the ECB would purchase Eurozone members’ sovereign bonds in order to relieve financing pressures. However, Eurozone national governments currently find themselves in a precarious situation, as many of their own banks that invested heavily in the sovereign debt markets in past years are currently attempting to “deleverage” or sell-off their assets without sending the market into a downward spiral.

Within this context, the governments of the two largest Eurozone economies, France and Germany, remain cautious towards any new capital requirements or capital inspections of their financial sector. Although the recently established European Banking Authority has carried out a number of “stress tests”, these have been readily discredited by financial analysts as being too vague to provide a meaningful assessment of the banks’ assets in the European financial sector. Similarly, during the European Council debate concerning Basel III implementation, Germany and France negotiated to have the strictest requirements of Basel III capital removed. The European Parliament is facing similar trade-offs between protecting national banking sectors and enforcing more stringent definitions of banking capital.

To summarize: the European Union, especially the Eurozone, faces serious short- to mid-term challenges in reducing the exposure of its financial sector to sovereign bonds. These challenges have motivated Eurozone governments to oppose more stringent capital definitions and targets, as found in Basel III. While the European Parliament continues to debate the CRD IV/Basel III implementation, these concerns will likely shape the compromise that emerges.

Where will Basel III Implementation Go from Here?

Both the U.S. and the EU have differing reasons for opposing a swift adoption of Basel III. Given the apathetic nature of European and American regulators towards its adoption, what is likely to happen to Basel III in the coming years? For one, financial institutions are likely to continue arguing that the capital requirements imposed by Basel III will be too costly.

In December 2011, the BCBS published its assessment of how much capital banks would need to raise in order to comply with the common equity Tier 1 capital ratio in Basel III. The BCBS reported that large, internationally active banks would need to raise €386 billion ($516 billion) in order to comply with a 7.0% capital level. For comparison, these same banks earned a combined profit of €356 billion ($476 billion) in 2011.

Last month, the heads of those national central banks, who are members of the BIS, entered into a compromise with the BCBS to postpone one of the key provisions of Basel III: liquidity requirements. Banks across Europe and America now have at least four years to implement the liquidity requirements of Basel III, meant to supply banks with enough capital to get through short-term financing periods. Additionally, the BCBS agreed to allow a wider range of assets to be included on the list of liquidity resources, raising questions as to how liquid these products will be in a potential crisis situation.

The long-term postponement of Basel III liquidity requirements reflects enduring concerns within both financial institutions and regulatory agencies that if the capital requirements of Basel III are actually imposed, their costs will be too great a burden for the financial system. Given the ongoing economic challenges in Europe, and the delayed Dodd-Frank implementation in the U.S., it seems likely that governments on both sides of the Atlantic will continue to push back the implementation of Basel III. If nothing else, postponement provides time for these governments to curry favor with their respective financial sectors and prioritize the implementation of national legislation.

Response from the BCBS and the BIS has been conciliatory. BIS head Stefan Ingves claims that the delays do not reflect a lost interest among regulators, but merely attempts to lay the groundwork for correct implementation. Mr. Barnier, chief EU financial regulator, has similarly stated that he expects the U.S. to respect Basel III in the coming years. However, Mr. Barnier’s comments may simply reflect the fact that Europe remembers how it implemented Basel II, while the U.S. never completed its implementation. And despite the rosy sentiment of Mr. Ingves, it seems only far too likely that despite recent calls for action, it appears that the incentives remain for regulators to continue “kicking the can” until the next crisis.