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Supervisors declare global bank-capital standards completed

Supervisors declare global bank-capital standards completed

EIGHT years ago, bank supervisors began overhauling the global capital standards that proved too flimsy to withstand the financial storm of 2007-08. Their work is at last done. On December 7th Mario Draghi (pictured), the president of the European Central Bank, who heads the committee of supervisors that approves the standards, declared that agreement had been reached on a thorny set of revisions to Basel 3, as the post-crisis rules are known. Banks, already obliged by Basel 3 and national supervisors to add lots of equity to their balance-sheets, have moaned about further fiddling. They, analysts and many commentators often call these revisions “Basel 4”.

Basel 3 uses several gauges of banks’ ability to survive catastrophes that sweep away equity and drain liquidity. Perhaps most closely watched is the “CET1 ratio”, of common equity to risk-weighted assets (RWAs). Most banks calculate RWAs using a standardised method, itself revised as part of Basel 4. But big ones often use their own internal models. The snag is that internal models vary: if one bank uses lower risk-weights than another with an identical balance-sheet, its RWAs will be lower, allowing it to hold less shock-absorbing equity to achieve a given CET1 ratio. So Basel’s standard-setters have been trying to narrow the variation by limiting the use of internal models and setting a floor for the minimum ratio of RWAs calculated from internal models to that from the standardised approach.

Because European banks tend to hold a lot of safe-ish assets with low risk-weights, such as mortgages and corporate loans, they argued for a low floor, or even none. Low weights, they said, reflected their sober business models; their supervisors and politicians backed them up. American banks have fewer such loans. They often sell on housing loans to Fannie Mae and Freddie Mac, two government-owned giants, and their corporate clients often sell bonds rather than borrow from banks. American banks and officials wanted a higher floor—arguing that without it the use of internal models gave the Europeans an unfair, even unsafe, advantage.

A first draft of the revised standards proposed a floor for RWAs of between 60% and 90% of the answer from the standardised model. For the past year officials have been haggling over numbers in the middle of that range. The French have been the hardest to persuade. Mr Draghi said that 72.5% is the magic number. The new rules also forbid the use of fancier internal models for loans to large companies and other banks. Risk weights for residential mortgages will depend on loan-to-value ratios.

At first blush, this could mean a hefty additional increase in capital requirements for European banks. In a note on December 1st analysts at Citigroup estimated that a 72.5% floor could deplete their average CET1 ratio from a bonny 13.5% to a peakier 11.5%. (That includes the effect not only of the floor, but also of other bits of the package, including tweaks to market-risk and operational-risk standards, as well as a new accounting rule that takes effect on January 1st.) Banks could face a combined capital shortfall of €162bn ($191bn).

In fact, the Citi team also noted, it won’t be anything like that bad. The Basel standard-setters said long ago that the revisions would not “significantly increase overall capital requirements”. On December 7th the European Banking Authority said it reckoned the average CET1 ratio would drop by just 0.6%. Minimum requirements would rise by about an eighth, but most banks should clear that hurdle comfortably.

Those requirements are partly set by national supervisors, who are likely to use their discretion to offset Basel 4; some, notably in Britain and the Nordic countries, have already indicated as much. So it may be that only a few banks have a shortfall. And as with Basel 3’s previous strictures, the revisions will not take effect at once. They do not kick in until 2022, when the floor will be only 50%; it will be raised over five years.

That said, markets are less patient than supervisors: they have tended to view banks as if all Basel 3’s requirements were already in place, regardless of the regulatory timetable. But even if some banks have to consider raising more capital, they may breathe a sigh of relief. After almost a decade of uncertainty, they at last know what the Basel rule-book will look like for years to come. The question is whether it will make the financial system robust enough to withstand another disaster. Banks and supervisors say so. A few former watchdogs and some outspoken academics aren’t so sure. Everyone else? In the next crisis, they’ll find out.

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Source: The Economist Latest News

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