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The Basel Committee on Banking Supervision
and regulatory reform

By Nout Wellink, president, Netherlands Bank, and chair, Basel Committee on Banking Supervision

Preventing a repeat of the recent financial crisis requires the implementation of rigorous reforms and strict policies – the Basel Committee on Banking Supervision’s reform programme seeks to do just that

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The financial community is at a pivotal moment in reshaping how banks and supervisors conduct their business. The reform programme of the Basel Committee on Banking Supervision (BCBS) deals with strengthening capital standards and setting minimum global standards for liquidity risk. These reforms are designed to respond to key shortcomings that became painfully evident during the recent global financial crisis. Minimum standards for capital and liquidity must be raised substantially so that the banking sector can withstand periods of stress, thus enhancing financial stability and promoting sustainable growth. The current minimum standard for the highest quality capital is just 2 per cent of common equity to risk-weighted assets, even less when necessary deductions from capital are factored in. No global minimum standard for liquidity currently exists. Liquidity buffers before the crisis were inadequate and excessive reliance was placed on short-dated wholesale money to fund long-term illiquid assets.

All countries need to build bank sector resilience because shocks have originated from all regions of the world, from all types of asset classes, and from all kinds of business models.

The BCBS programme aims to capture all significant risks in the capital framework. During the initial phase of the financial crisis, most losses and accumulated leverage occurred in the trading book, yet the rules did not adequately capture the key risks to which banks were exposed. The higher capital requirements developed by the BCBS capture the credit risk of complex trading and derivative activities. The new rules also introduce higher risk weights to improve risk management and the measurement of securitisation and off-balance sheet exposures. They strengthen the institutional resilience and reduce the risk of transmitting shocks through derivatives and financing by improving the management of counterparty credit risk.

Another key step is the redefinition of capital. During the crisis, losses came directly out of retained earnings, but because of other forms of financial instruments, some banks maintained deceptively high capital ratios. Moreover, some capital instruments ultimately had to be converted into common equity before confidence was restored. Under the reforms, the level and the share of common equity and retained earnings will rise substantially. In addition, rigorous deductions and exclusions from common equity make for a more transparent, meaningful definition of capital.

A further key step is the introduction of a leverage ratio to backstop the risk-based system. Many firms were too aggressive in gaming the system. Many engaged in hedging strategies where the risk magically disappeared from internal risk reports and capital, only to reappear as basis risk, counterparty credit risk or illiquid positions that could not be sold. Many supervisors did not prevent this compression of risk-weighted assets. A cycle of leverage built up in the banking system, which the market forced down in the most destabilising manner, amplifying procyclicality and the economic downturn. Moreover, market participants piled into the lowest risk-weighted assets, adding to system-wide risks, which ultimately came back to haunt many institutions.

Greater buffers against severe shocks must be built into the banking sector. Banks are at the centre of the credit intermediation process. Buffers mitigate the amplification of shocks between the financial and real sides of the economy. The BCBS is promoting stronger provisioning practices, collaborating with accounting standard setters to develop a robust and operational expected loss approach and sound valuation standards. It has also recommended that banks and banking supervisors strengthen valuation processes to avoid misstatements of profit and loss.

Another buffer is capital conservation. Many banks have returned to profitability but have not sufficiently rebuilt their capital buffers to support new lending. The new framework promotes the conservation of capital and the build-up of adequate buffers above the minimum that can be drawn down in periods of stress, subject to appropriate measures that are coordinated with the national supervisor. The approach is intended to provide more clarity regarding the supervisory response. The BCBS is putting the final touches on a countercyclical buffer framework to protect the banking sector from excessive credit growth.

The problem of systemic risk arising from excess interconnectedness and the perception that some banks are too big to fail is being addressed. Reforms include capital incentives to use central counterparties for overthe-counter derivatives, higher capital for trading and derivative activities and complex securitisations, more capital for inter-financial sector exposure and appropriate capital treatment of systemic banks (in coordination with the Financial Stability Board). Recommendations for cross-border bank resolution provide a practical way to address the issue of systemic risk at cross-border banks.

With regard to liquidity, many banks got into trouble by financing long-dated, illiquid assets with short-term wholesale funding. Others had inadequate buffers of highly liquid assets to ride out a period of severe stress.

The BCBS response is to introduce a global liquidity framework that establishes minimum standards for funding liquidity risk. Banks must hold sufficient high-quality liquid assets to cover a 30-day period of acute stress. A longer-term structural ratio promotes funding activities with more stable sources of funding. By changing their funding profile, banks become less vulnerable to liquidity shocks.

These measures must be accompanied by better supervision and risk management. The BCBS is establishing rigorous mechanisms to ensure standards are implemented across its membership.

System-wide supervision must also improve. Most banking crises emerge when there are common vulnerabilities and concentrations. Bank-level supervision must be accompanied by a broader understanding of financial sector and macroeconomic vulnerabilities.

The perimeter of regulation must also keep up with financial innovation. Activities that combine substantial maturity transformation and liquidity risk should be subject to more bank-like regulation. Vigilance is required to detect major regulatory differences for similar activities that could put pressure on the soundness of the regulated sector.

The BCBS is taking steps to ensure the new regulatory package succeeds. It has thoroughly analysed comments received from the public consultations that ended mid-April. It has conducted a comprehensive quantitative impact study to assess the effects of its reform package as well as a top-down impact assessment.

It is also assessing the benefits and costs of the Basel Committee standards. The costs of a banking crisis include the direct losses borne by security holders, the massive scale and diversity of public sector interventions that strain public finances and must be scaled back over time, and plummeting national and global economic output and employment.

Raising capital and liquidity standards will reduce the probability and impact of crises. It also avoids those reductions in output and employment during a crisis, and stabilises economic output and welfare increases caused by volatility during non-crisis periods. A more stable banking system can withstand outside shocks. Other benefits of adequate standards include lower risk premia, improved allocation of resources and the avoidance of excessive credit growth.

As with the benefits, the costs of raising capital and liquidity requirements can have both temporary and permanent elements. Temporary costs can be managed through appropriate transition periods. The impact in terms of long-term costs is not clear, however. Higher capital requirements and liquidity standards could increase funding costs, but more stable, less leveraged banks would raise average ratings, improve the terms for raising funds and lower the required return on equity. Moreover, in a competitive market, the costs may not necessarily be passed on to the consumer.

One thing remains clear. Raising current minimum capital requirements involves large and permanent net benefits by raising the stability of the system and promoting more sustainable growth. These benefits accrue immediately.

It is absolutely essential to reflect on the lessons of this crisis to safeguard against something like this happening again.

Adapted from remarks made at the Institute of International Finance 2010 Spring Meeting, Vienna, 11 June 2010. See www.bis.org for information on the latest agreements, notably 26 July and 12 September.

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