26 November 2016

The Economist: A showdown looms over bank-capital rules

The committee of central bankers and supervisors is due to thrash out revisions to Basel 3, the version agreed on after the financial crisis of 2008. European (and some Asian) bankers and officials fear additional capital requirements are coming; Americans are all for the changes.

Spurred by Basel 3, banks have stuffed billions into capital cushions that the crisis showed to be woefully thin. Between mid-2011 and the end of last year, 91 leading lenders bolstered their common equity by €1.4trn, or 65%, according to the Bank for International Settlements (BIS), which provides the Basel committee’s secretariat. The ratio of equity to risk-weighted assets, an important regulatory gauge, climbed from 7.1% to 11.8%. Although Basel 3 need not be fully honoured until 2019, most banks are far above the minimum of 4.5% (additional buffers, some at national level, raise the actual floor much higher).

But the committee has been taking a closer look at banks’ calculations of risk-weighted assets. It has concluded that banks’ internal models vary too much: in an exercise in 2013, in which it asked 32 lenders to assess the required capital ratio for the same hypothetical credit portfolio, the highest answer was four percentage points above the lowest. Some banks, it believes, are too sanguine about credit risk.

So the committee has suggested restricting the use of banks’ in-house models in assessing loans to large companies and other banks, and in specialised lending such as project finance. (Because defaults are rare, the reasoning goes, there are not enough data to model risks well.) Where banks’ own models are used, it wants minimum values for important parameters, such as the probability that loans go bad. And it is considering an “output floor”—a lower bound for the risk-weighted sum of their assets—of 60-90% of the figure calculated under a “standardised” method.

Supervisors and ministers have said that the changes should not “significantly” raise “overall capital requirements”. But some lenders can expect an increase.

Analysts at Morgan Stanley estimate that global, non-American banks could see risk-weighted assets rise by an average of 18-30%, depending on the level of the output floor. Extra capital of €250bn-410bn could be needed, a tall order when earnings are thin and investors wary. The committee’s reviews of operational and market risks would add even more.

European banks complain of being forced into an American-designed straitjacket. Higher capital requirements, they complain, will crimp lending and growth—although research by the BIS suggests that better-capitalised banks have lower funding costs and lend more, not less. American banks will be little affected by the credit-risk proposals. They sell most mortgages to Fannie Mae and Freddie Mac, two government-owned entities, whereas European lenders keep them on the books; American companies borrow from markets rather than banks. Americans retort that their post-crisis supervision has been stricter than in Europe and that they were quicker to knock themselves into shape.

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