Basel III to Stay on Course

G20 confirms its commitment. We are not surprised.

By Jeb Beckwith and Sanjay Sharma, Ph.D.

“We confirm our support for the Basel Committee on Banking Supervision’s (BCBS) work to finalize the Basel III framework without further significantly increasing overall capital requirements across the banking sector, while promoting a level playing field.” – G20 Communique, March 18th, 2017.¹

Nestled within the body of the G-20 communique² from BadenBaden over the weekend was an important statement of support for the Basel III framework. With recent elections in the U.S., Brexit in the U.K., and the rise of nationalistic forces in France, there were growing concerns that the enormous thought and resources expended by the BCBS, global regulators and the banking industry to construct the Basel III framework would be undone.

The G20 statement, ostensibly agreed to by President Trump’s Treasury Secretary, Steve Mnuchin, is an indication that the new U.S. administration stands behind the implementation of Basel III, complete with its timelines and new risk management frameworks. The only change between this week’s G20 statement and the prior statement issued prior to the U.S. election was the removal of the phrase “we will resist all forms of protectionism.” In context, this statement speaks more toward trade than financial regulation. This week’s G20 statement lays to rest speculation that the forces driving nationalist movements around the world will somehow creep into global Standards for banking regulation. The reaffirmation should jolt into action banks that may have expected Basel III to be diluted or defrayed.

How does this indication align with talk from the new Trump Administration³ and the U.S. Congress about reducing financial regulation? On the face of it, we should assume that Basel III is not on the table, and the focus will likely be on domestic U.S. regulations As we have written in recent articles⁴, the focus of both Executive and Legislative branches in the U.S. is on enacting deregulation by attacking domestic rules and legislation. These include reshaping the Dodd-Frank Amendment (DFA), including the Volker Rule, reducing living will and CCAR requirements, revoking the Department of Labor (DOL) rules regarding financial advisory governance and changing the role of the Financial Stability Oversight Council (FSOC). To date, the Trump Administration has not publicly criticized the global regulatory framework promulgated by BCBS and implemented under the supervision of the Federal Reserve Board of Governors. Tables 1 and 2 summarize the distinction between Basel III components and domestic U.S. regulation.

Table 1

Table 2

The breadth of areas in U.S. domestic regulation reflects the opportunity for the Trump Administration to simplify the regulatory landscape by executive or legislative action.This could be a monumental task, given that most of these regulations and bodies are already in force and functioning. Changing global policies overseen by the Federal Reserve would have been even more challenging. Away from purely domestic policies, this week’s statement from G20 should be viewed as a strong affirmation that Basel III provides the framework for leveling the banking risk field across geographies and regulatory jurisdictions, and thus, protects the global economy from future financial crises led by the banking sector. Steve Mnuchin and Gary Cohn, former President of Goldman Sachs & Co. and now Chair of President Trump’s National Economic Council (NEC), are presumably the principal drivers of the Trump Administration’s thrust for regulatory reform. Both are Goldman Sachs alums and should be well aware of the need for regulatory controls of the global financial markets. To date, both have expressed support for the Basel III framework so long as those regulations are adhered to globally.

The specific reference in the G-20 statement of support for Basle III framework “without further significantly increasing capital requirements” may turn out to be challenging for some of the BCBS initiatives – particularly FRTB. Initial quantitative studies performed by BCBS and others on the industry, as well as our own analysis, suggest that significant capital increases may be required, particularly if the new internal models approach under FRTB becomes over-burdensome or if the capital floor is set at too high a bar. We interpret this statement as an indication that there is movement towards keeping the floor towards a lower bound and thus maintaining the internal models approach to FRTB as a viable option even for smaller banks.

For banks that will face higher capital requirements for market risk under FRTB, the need for optimizing capital usage and deployment will be paramount. These banks will need to mitigate significant declines in ROE. For some, this may even be lower than their cost of capital. Managements should gear up to evaluate risk portfolios, invest in improving risk and capital models, and focus on data quality improvements, optimization of capital deployment and improvements to operational efficiency.

There are significant concerns in the industry regarding global synchronization of FRTB implementation timeframe. Clearly, banks in regions and countries that adopt and implement FRTB within the BCBS prescribed time frame will be at a competitive disadvantage compared to those that may delay regulatory rule setting, and follow-up deadlines. This could be mitigated by phasein periods of FRTB capital requirements, i.e. banks may be required to hold 65% of the total market risk capital charge mandated by “fully loaded” FRTB as proposed in Europe. A phase-in capital requirement could kill two birds with one stone for BCBS – it could muffle the industry protests about onerous capital requirements at a time when global economies are slowly recovering, and it could set the
stage for taking a hard line on implementation timelines. This would also open the intriguing possibility that banks in “early-FRTB-adopter” regulatory regimes may actually have lower market risk capital charges during the phase-in period compared to those that are capitalized under Basel II.5

Finally, in response to the questions we have received about the Trump Administration’s intention to undo the very idea of financial regulation, we conclude with these cautionary notes from President Trump’s Chief Economic Advisor:

“We don’t want to [reform] in an unregulated way.We want to do it in a smart, regulated way.”⁷

“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business.”⁸

– Gary Cohn

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