09 February 2022

Implementing Basel III Remarks by Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision and Governor of the Bank of S

Financial stability is a global public good. The cross-border spillovers of financial distress can result in under-investment in financial stability by individual jurisdictions and regions... distress in one jurisdiction or region can easily spill over to other parts of the globe.

Good afternoon and thank you for inviting me to take part in this public hearing on the EU banking reform package.

I will be focusing my remarks today on the implementation of the outstanding Basel III reforms. I will first offer some reflections in my capacity as Chair of the Basel Committee and then offer some specific comments on the state-of-play in Europe in my capacity as Governor of the Bank of Spain.  

By way of a brief overview, the Basel Committee is the primary global standard setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing global financial stability. In pursuing its work, the Committee is anchored by rigorous empirical analysis, including a comprehensive evaluation work programme. Such an approach helps ensure that the Committee's approach is grounded as far as possible by impartial evidence.

Financial stability is a global public good. The cross-border spillovers of financial distress can result in under-investment in financial stability by individual jurisdictions and regions.[1] Given the global nature of the financial system, distress in one jurisdiction or region can easily spill over to other parts of the globe. We have seen numerous examples of such cross-border spillovers in previous financial crises. An open global financial system therefore requires a set of global minimum and consistent prudential standards. In our interconnected world, a failure to achieve this could result in regulatory fragmentation, regulatory arbitrage, an uneven playing field for internationally active banks, and increased risks to global financial stability.

Since its inception in 1974, Basel Committee members have demonstrated their strong commitment to cooperating on global financial stability issues, including by means of developing a global regulatory framework for internationally active banks. The latest version of this framework, known as Basel III, seeks to address the shortcomings in the banking system that were exposed by the Great Financial Crisis (GFC). The Basel III framework was finalised in 2017 and was endorsed by the G20 Leaders. 

Starting with my perspective as Chair of the Committee, I would like to make three broad points.

First, I think it is helpful to recall the rationale of these reforms and why they remain as important today as they were when they were finalised in 2017.^[2]

While much has changed since 2017, the Covid-19 pandemic and other structural trends have only further underlined the importance of a resilient banking system. The Basel III reforms have played a central role in ensuring the banking system has remained operationally and financially resilient during the pandemic.^[3] Unlike the experience of the GFC, banks have been able to continue supporting the real economy. Bank customers, whether they be depositors, borrowers or users of other banking services, have benefitted greatly from the resilience of the banking system and will continue to do so. We should also recognise that public support measures have largely buttressed banks from losses to date. We should therefore not become complacent about the need to implement the outstanding Basel III reforms.

While the initial set of Basel III reforms fixed a number of fault lines in the pre-GFC regulatory framework, the way in which banks calculated risk-weighted assets (RWA) – the denominator of banks' risk-weighted capital ratios – remained largely unchanged. Yet the GFC painfully demonstrated the excessive degree of variability in banks' modelled capital requirement. For example, when banks were asked to model their credit risk capital requirements for the same hypothetical portfolio, the reported capital ratios varied by as much as 400 basis points.[4] Similarly worrying levels of variability could also be seen in other modelled risk categories, including market and counterparty credit risk.[5] And the GFC highlighted shortcomings with the operational risk framework, where banks' modelled capital requirements were insufficiently robust to cover losses stemming from misconduct and inadequate systems and controls.

This excessive degree of RWA variability threatened the credibility of banks' reported capital ratios. At the peak of the GFC, investors lost faith in banks' published ratios and placed more weight on other indicators of bank solvency.

The outstanding Basel III reforms seek to help restore credibility in the calculation of banks' RWA in four ways:

• First, they will enhance the robustness and risk sensitivity of the standardised approaches for credit risk, market risk and operational risk, which will facilitate the comparability of banks' capital ratios.
• Second, they will constrain the use of internally modelled approaches by ensuring that modelled parameters are subject to greater safeguards and that advanced modelling approaches are not used for portfolios with limited historical data.
• Third, the Basel III reforms will introduce a robust risk-sensitive output floor. The output floor provides a risk-based backstop that limits the extent to which banks can lower their capital requirements relative to the standardised approaches. This helps to maintain a level playing field between banks using internal models and those on the standardised approaches. It also supports the credibility and comparability of banks' risk-weighted calculations thanks to the accompanying public disclosure requirements, as banks will be required to publish their total RWA that constitute the denominator of their risk-weighted capital requirements, including with the output floor adjustment.
• And fourth, the reforms will complement the risk-weighted framework with a finalised leverage ratio. The leverage ratio provides a safeguard against unsustainable levels of leverage and mitigates gaming and model risk across both internal models and standardised risk measurement approaches.

The gravity of the regulatory fault lines that Basel III seeks to address remains as important today as it was pre-pandemic. For example, a recent report by the European Banking Authority on banks' modelled capital requirements points to a "significant" level of capital dispersion "that needs to be monitored".^[6] So it is critical that all Basel Committee jurisdictions implement the Basel III reforms in a full and consistent manner.

The second point I would like to address is the assertion that the Basel III reforms have not been adequately designed to reflect jurisdiction- or region-specific characteristics, and that their implementation will impede economic growth and banks' ability to tackle structural trends and challenges, such as the digitalisation of finance or climate-related financial risks. Such statements do not accurately reflect the rigorous process that the Committee followed, and do not serve the interests of a sustainable and inclusive economic recovery....

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