THE FUTURE OF REGULATORY REFORM – MEP SURVEY 2010 - A joint report by Cicero Consulting and ComRes on MEPs’ views on future regulatory reform.

http://www.cicero-group.com/Research-Analysis/Cicero_ComRes_Research_Report_2010_FINAL.pdf

This report describes the views of Members of the European Parliament (MEPs) towards future regulatory reforms that seek to enhance the capital standards of the banking sector. The survey was conducted in July 2010 – a time when there was still a high level of stress in the financial markets; when the Basel Committee confirmed its stance on its Basel III proposal; while the European Commission was drafting its legal text on Capital Requirements IV and when the MEPs were preparing their ground to battle for the best interests of their constituents during the course of the new legislative term September 2010/2011.

• “One in three MEPs support the creation of a new EU single financial services regulator and increasing the powers for the new European Banking Authority”
• “60 per cent of EPP MEPs; 44 per cent of S&D; 38 per cent of ECR support greater cross border cooperation”
• “Only 24 per cent of MEPs were in support of handing greater power to central banks”
• “50 per cent of accession country MEPs support the derivatives legislation”
• “Only 17 per cent of MEPs support the Financial Transaction Tax as a means of preventing future crises”
• “Only 15 per cent of MEPs believe that reform of remuneration policy will have a significant impact on preventing a future crisis.”
• “The number one impact of enhanced banking capital standards is the reduction of the overall level of systemic risk.”
• “50 per cent of MEPs from the UK and Ireland believe lending to SMEs will become more costly. Only 17 per cent of core MEPs support this view”
• “Respondents from the four biggest political groups within the European Parliament – EPP, S&D, ALDE and ECR - all named the
  United States as most to blame for the current financial crisis”
• “Blaming European governments for their role in the crisis features in the top three of just three of the eight political parties surveyed - ALDE, ECR and EFD”
• “Across all political groups, at least one of the following ranked in the Top 3 “to blame” targets: US mortgage lenders; US regulators and US government; and US banks”
• “Credit rating agencies are consistently ranked among all political parties as the seventh and eighth most likely to be blamed for the financial crisis”
• “MEPs have recognised that financial services customers have a part in the blame game. All political parties point the finger of blame at retail investors and mortgage holders.”

THE TOP 3 SUGGESTIONS FOR FUTURE REFORM

• 39% of respondents believe enhanced cross-border regulatory supervision would be most effective
• 25% suggested increased regulation of complex financial products such as derivatives is required
• 23% supported enhanced capital requirements as being most effective

Why are there capital rules on banks but not on fast food restaurants? The reason is simple: Governments step in to bail out depositors of failed banks, and they sometimes bail out the full range of liability holders through common-stock holders (e.g. Royal Bank of Scotland, Citigroup, Bank of America). They don't extend such largess to fast food restaurants. As a quid pro quo for this quasi liability insurance, most governments charge a fee for deposit insurance that rarely distinguishes between high-risk banks and low-risk banks. Instead, they impose constraints on risk taking rather than measuring risk precisely and charging more for it.

There are two ways to impose constraints on risk taking. The first way, "rules- based regulation," specifies the exact financial formulas by which risk is measured. If measured risk exceeds the regulatory level of X, the bank is in violation. The second method of regulation is called "principles-based regulation." It combines a qualitative and quantitative assessment of a bank's risk level and risk management process. It asks questions like "Has the bank taken the risk of declining home prices into account in assessing its own risk?"

The capital guidelines set through the decades by the Basel Committee on Banking Supervision have been based on the premises that "rules-based" regulation is the way to go and that, because banking is an international business, these regulations should apply world-wide. Sadly, both of these premises are wrong. The road map for modified international capital guidelines known informally as "Basel III," issued by the Basel Committee as a press release on Sept. 12, shows the first signs that regulators may be recognizing the error of their ways. But it doesn't yet amount to anything close to a U-turn.

Politicians love rules-based regulation because it imposes a more concrete "punishment" on the banks that have just failed and those that will fail in the future. Unfortunately, this approach has been tried repeatedly and has failed consistently. In the United States, the process has gone like this:

• Mid 1980s. Federal Reserve imposes "primary capital ratios," a rules based regulation, in the wake of high interest rates and related bank and savings and loan association losses.

• 1992. Federal Reserve seeks to impose a more precise formula linking interest rate risk to required capital, a more complex rules-based regulation. This proposal was opposed by bankers and later by Congress as too complex and was never implemented.

• 1998. The Office of Thrift Supervision imposes principles based regulation via "Thrift Bulletin 13a" which indicates areas of risk and highlights those elements of interest rate risk management that will receive a high level of regulatory scrutiny.

The Basel Committee followed a similar path in the wake of the Russian debt crisis in 1998 and the collapse of the high tech boom in 2001-2002.

• Basel I was a highly simplified rules-based capital ratio constraint which closely resembled the Federal Reserve's primary capital rules.

• Basel II was a much more complex rules-based regulation spanning hundreds of pages and triggering billions of dollars of implementation costs. Basel II is widely regarded as a complete failure in the wake of the collapse of a large number of banks in Europe and the United States during the 2007-2010 period.

The Basel III roadmap issued this week represents a potential simplification of the Basel II rules. It is still risk management by Excel, but at least it's less-complicated Excel. In the simpler rules to be phased in beginning in 2013, Tier 1 capital will only include common equity and some equity-like debt instruments where dividend payments are discretionary, Tier 2 will just include instruments that are subordinate to depositors, have a five-year minimum maturity and no incentives to redeem, and Tier 3 will be abolished.

Still, that's not enough. We believe firmly that risk management of financial institutions and oversight of that risk by regulators is too complex for risk management by Excel to be the standard. Effective risk oversight recognizes these realities:

• The Devil is in the details. Risk should be analyzed on a transaction-level basis, one by one, spanning even the 700 million transactions held by the largest banks in China.

• Risk should recognize the potential adverse affects of a long list of factors: movements in home prices, commercial real estate prices, commodity prices, correlated corporate credit risk, stock indices — not just traditional areas of focus like interest rate risk and foreign exchange risk.

• Best-practice analysis of this risk cannot be fully specified in a 7 page press release or even the 300-plus pages of the original Basel II pronouncements. Attempts to do so are complete folly.

• Rules-based regulations are constrained by the ability of non-specialist bankers, regulators and politicians to understand them. This leads either to a collapse of the attempted regulation, like the Fed's proposed interest rate rules, or a dramatic simplification like the Basel III. This simplification creates "Risk Management by Excel" and triggers gross inaccuracies.

• Only principles-based regulation is ultimately effective in bringing highly accurate transaction-level analysis to regulators and bank management. This takes technology and smarts on the part of regulators and banks.

• When the national political will does not provide the technology and smarts to regulators, the only alternative is the kind of limited-purpose banking regulations proposed by Professor Laurence Kotlikoff in Jimmy Stewart is Dead: Ending the World's Financial Plague with Limited Purpose Banking (Wiley, 2010).

• Principles-based regulation and limited-purpose banking are by definition intimately intertwined with national culture, domestic banking practice, and regulatory organization. We note that more than 99% of banking assets in almost every major country (we exclude international banking centers like Singapore and Bermuda) are domestic. One would conclude, then, that the role of Basel in principles-based regulation is less than useful. "One world" in banking regulation is a concept whose time has not yet come.

Donald R. van Deventer is founder, chairman and CEO of Kamakura Corp., a leading provider of risk management software, information and consulting. Eitan Bar-Adam is CEO of Ayatep, a Tel Aviv-based risk management advisory firm.

Read the original blog post here: http://blogs.hbr.org/cs/2010/09/basel_iii_and_the_problem_with.html

To read the whole article including comments click on: http://www.economist.com/blogs/freeexchange/2010/09/basel_iii

But the instant enthusiasm for the agreement does seem a bit overdone. Most obviously, talking about a new regulatory scheme reducing bank profitability reflects a fundamental misunderstanding of how a competitive economy works. Profit goes to zero in situations of perfect competition. Regulation, by erecting barriers to entry, reduces competition. Those banks who are able to meet the regulatory requirements should be even more profitable than before because of lower competition. Of course, the banking sector as a whole might be less profitable under Basel III than it was before, but only if less capital in aggregate was allocated to the banking sector. Individual banks will still need to attract investors—more common-equity investors than ever, in fact—and those investors will demand a competitive rate of return. No bank regulation can change that.

More important, the new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn't address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to "manufacture" apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn't direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II. Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets. Unless I've missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status. If that happens, anyone want to guess where the next crisis will crop up?

Source: Economist

In Basel III, as in Basel II, the capital requirements are still set “in relation to risk-weighted assets (RWAs)” even though it was the risk weights which proved to be most wrong.

The Basel Committee could impose a basic 100% capital requirement but if the risk-weight is zero percent as it is in the case of lending to sovereigns rated triple-A then the effective capital requirement is zero.

It was a low risk weight of only 20% which generated a capital requirement of only 1.6 percent (.08 x .2) allowing banks to leverage 62.5 times to 1, which drove the banks to stampede after the triple-A rated securities collateralized with lousily awarded mortgages to the subprime sector.

Also if a bank lends to a small business then it needs 8 percent in capital but if it instead lends that money to the government of a sovereign rated AAA to AA then the bank needs no capital for the risk-weighted assets since the weight is 0%... lunacy!

Since the risk weights have not been modified at all in Basel III, let me assure you that the Basel Committee still has no idea about what they are doing. Frightening!

Basel III does mention that “These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described” but since that supplement seemingly will be small and what really counts are the marginal capital requirements for different assets Basel III does not provide a solution.

The Basel Committee is still so fixated with looking at the gorilla called “perceived risk” so as to completely lose track of the ball.

No financial or bank crisis has ever occurred from something ex-ante perceived as risky they have all resulted, no exceptions, from excessive lending or investment in something perceived as not risky.

Basel III still constitutes an arbitrary and regressive discrimination of small businesses and entrepreneurs whose needs we in fact most want our banks to attend. With the same risk-weight discriminations, the higher the capital requirements are, the higher the real effective discrimination.

Banks were authorized by the Basel Committee to lend to Greece leveraging 62.5 to 1!

With time I am sure that no matter how the regulatory establishment wants to hide it the financial history books will regard the Basel Accord and the so risky perceived risk-phobia it brought on, as the biggest financial regulatory blunder ever… meanwhile it would seem we are stuck with the same though larger banks, the same regulators and the same faulty paradigm. Help!

Per Kurowski
A former Executive Director at the World Bank (2002-2004)

http://subprimeregulations.blogspot.com/

Bank investors seem to love Basel III, what with shares of the recently battered U.S. financial institutions up, on average, 3% this afternoon and European bank stocks also rallying.

And what isn’t to love. The capital requirements released Sunday by international banking regulators are less stringent than many had feared. And banks have eight years to comply with most of the new requirements. (By that time, most of the central bankers who passed the new rules are likely to have moved out of office along with most of today’s bank executives.)

European banks probably have the most to gain from that generous deadline because as a group they need to raise the most capital. It will likely take Germany’s Commerzbank and Spain’s Banca MPS six years to meet the Basel III requirements, according to analysts at Societe Generale. France’s Credit Agricole could need four years.

Allied Irish Banks, which has been in crisis in recent weeks, needs two years to reach the Tier One Capital threshold, while its cousin Bank of Ireland needs two years.

The largest U.S. banks – Bank of America, J.P. Morgan Chase and Citigroup–already meet the new requirements. So, their shares are benefiting today from a combination of a relief rally to hopes that the clarity that Basel III announcement brings will result in a resumption of dividend payouts. Dividends, you might remember, were all buy killed by the global financial crisis, as banks sought to hoard capital in fear of regulation and a double dip recession.

They aren’t out of the woods, yet. This WSJ article says regulators are asking the big banks to prove that if they pay out dividends they still would have enough cash to weather the worst economic conditions.

One unsung beneficiary of Basel III: U.S. Banks that haven’t paid back their federal bailout money, but are in safe reach of meeting new Basel capital requirements.

RBC’s veteran banking analyst Gerard Cassidy says those banks (such as Zions Corp. and Regions Financial Corp.) might be able to make a case to regulators that they don’t need to raise additional common equity (thereby diluting shareholders) to pay back TARP because their capital levels are already sound.

Source: http://blogs.wsj.com/deals/2010/09/13/basel-iii-and-the-biggest-winners-are/

http://video.ft.com/v/607660171001/Basel-sets-banks-new-capital-rules

Top bankers in the UK, US and Switzerland are braced for their national regulators to impose tougher capital requirements than those required by Sunday’s landmark global agreement, even as investors bid up bank shares on relief that the standards were not more rigorous.

The 27 member countries of the Basel Committee on Banking Supervision agreed on Sunday that banks would in effect be required to triple core tier one capital ratios from 2 per cent to 7 per cent by 2019. This ratio measures the buffer of highest-quality assets that banks hold against future losses.

http://di.se/Default.aspx?pid=214705__ArticlePageProvider

Felix Salmon blog at Reuters: There’s a lot to unpack and explain here. But the first thing to note is that we’ve moved from a simple “Tier 1 has to be 4%, Tier 2 has to be 8%” to a 3×3 matrix with all manner of different minima. It’s a bit more complicated, but it’s also more intelligent, and should be much more effective as well.

Possibly the most important thing here is the existence of the first column, setting minimum standards for common equity — which is also known as core Tier 1 capital. Such standards did exist in the past, but they were set extremely low, at just 2%, and so were generally ignored. As of now, common equity is the main thing that matters. No more throwing any old garbage into the Tier 1 bucket and calling it capital: the new standards for common equity are significantly tougher than the old standards for Tier 1 capital in total.

The absolute bare minimum for core Tier 1 capital is 4.5%, and the new minimum for Tier 1 capital in general has now been raised to 6%. The minimum for Tier 2 remains at 8%.

But that’s just the beginning. On top of that there’s a “conservation buffer” of another 2.5 percentage points; to a first approximation, any bank you’ve heard of is going to want to be well outside that buffer, because they won’t be able to pay dividends if they don’t have the full buffer in place. If there’s some kind of crisis and they’re forced to write down a lot of bad loans, they can eat into the buffer — but that will bring extra regulatory oversight, and they won’t be able to pay dividends. That’s sensible.

With the conservation buffer, then, banks need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital.

And it doesn’t stop there, either. When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

But wait, there’s more! “Systemically important banks should have loss absorbing capacity beyond the standards announced today,” says the BIS — we don’t know what they’re going to announce on that front, but the chances are that when an announcement comes, the biggest banks are going to need significantly more capital than what we’re seeing here.

This is all very welcome stuff. But it neither can nor should be implemented overnight. Instead, there’s a timetable built in to the new capital standards.

This is even more complicated, obviously, than the capital standards themselves. But in a nutshell, the standards start being phased in on January 1, 2013, with a core Tier 1 requirement of 3.5%. That rises to the final 4.5% in 2015. Other parts of the structure take longer, but they’re all phased in by January 1, 2019 — which is more than enough time for the world’s banks to raise any extra capital they might need.

Meanwhile, various dubious things which currently count as Tier 1 or Tier 2 capital but shouldn’t will be phased out even more slowly, over a period of 10 years beginning in 2013.

Other key parts of the Basel III regime, which weren’t announced today, will also come during these years: the liquidity coverage ratio gets introduced in 2015, while the net stable funding ratio arrives in 2018.

The banks aren’t going to take all this lying down, but I’m hoping their reaction is going to be relatively muted. This is a done deal, now, and they just have to live with it. And the banks which embrace the new standards and are proud of exceeding them will ultimately be more successful than those which try to get around them. Indeed, it would be great to see non-bank lenders adopt these standards too, on a voluntary basis. Most shadow banks easily exceed these ratios already, and I’d love to see the ones which don’t slowly wither away.