GFMA report warns of Basel III and IV risks

Author: Edward Price | Published: 2 Sep 2016
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A Global Financial Markets Association (GFMA) report has highlighted risks stemming from post-crisis Basel reforms. Market participants agree with the report’s key suggestion: a cost-benefit analysis of existing and proposed bank regulation.

According to the report, commissioned from Oliver Wyman, the initial Basel III package has resulted in a more resilient banking system. That’s positive, but the report also argues that the implementation of the new rules has raised the costs of financial intermediation. 

Those costs are likely to be passed down to the real economy, in the form of reduced lending. It also finds regulation is fundamentally changing the shape of banks’ balance sheets and business models, noting banks’ trading balance sheets have contracted by 25-30% since 2010. The industry’s wider contention is that this, along with capital and liquidity regulations, has led to an associated erosion of market liquidity.

M Sholem
Michael Sholem, Davis Polk

Regulators address the effects of post-crisis reforms from a slightly different angle. On August 31, The Financial Stability Board (FSB) published a letter from its chair and Bank of England governor Mark Carney to the Group of Twenty (G20) leaders ahead of September’s G20 Summit in Hangzhou

Carney’s letter argues the G20 financial reforms are working, with the financial system changing to rely more on markets and less on banks. The FSB concurrently published the second annual report on the Implementation and Effects of the G20 Financial Regulatory Reforms.

Those arguments are broadly the same as the GFMA’s; less bank activity is the common finding. But the FSB interpretation is more positive. “In the face of recent shocks the financial system has continued to function effectively, dampening aftershocks rather than amplifying them,” said a FSB press release.

Chair Carney’s letter does acknowledge that the shift from bank-based financial activity to a market-based activity carries risks. Future regulation in that space is likely. But many lawyers agree with industry, and the GFMA report, that a more immediate risk is present: regulatory incoherence on the bank side.

“The miscalibration of rules can have the most obvious effect and traceable negative impacts,” said Michael Sholem, European counsel at Davis Polk.

Measuring impact

The GFMA report highlights how there’s been no comprehensive quantitative analysis, to date, of the impact of the full range of the Basel reforms when taken as a whole. 

According to Sholem, such comprehensive quantitative analysis might be possible on a regional basis, across for example the EU or US. But the results of the so-called Basel IV reforms, for example, will vary so much across banks that it will be an extremely complicated task.

Nonetheless, some sort of cost analysis is required, especially outside the US. Capital ratios and regulatory initiatives that can impact the material amount of bank lending will arguably hit the EU harder than the US, as approximately 80% of funding to the real economy is bank-originated in the EU, a figure that’s not nearly so high in the US.


"The miscalibration of rules can have the most obvious effect"


“Different markets have different levels of tolerance for the amount of bank stability regulation required,” Sholem said. “Some of the objections to this basis are coming from the EU banks, which one might interpret as self-serving, but I think it’s a real issue,” he said.

Counsel also find the two lead contentions of the GFMA report – the higher costs of financial intermediation and changes in bank structures and business models – compelling. And on the issue of regulatory overlap, it’s not just capital requirements that are important. Instead, the combination of requiring greater capital alongside liquidity requirements is key. With the latter, the requirements focus on holding high quality liquid assists (HQLA), which are primarily shaded towards public, and away from private, debt.

KEY TAKEAWAYS

  • A GFMA report has highlighted risks stemming from post-crisis Basel reforms
  • The report argues the Basel III package has resulted in a more resilient banking system, but also reduced lending
  • Counsel agree with the report’s key suggestion: a cost-benefit analysis of existing and proposed bank regulation
  • Industry worries that capital and liquidity regulations, and bank structural reforms, have led to an erosion of market liquidity
  • The FSB argues the G20 financial reforms are working, with the financial system relying more on markets and less on banks

“HQLA certainly don’t include bank loans – so that’s a constraint on the maturity transformation function of banks,” said Luigi De Ghenghi, partner at Davis Polk.

According to De Ghenghi, there may also be a contradictory tension in the way banks structure themselves, again caused by regulation – that between complying with local regulatory requirements to set up a local presence and the prudential mandate to rationalize legal entity structures.

Luigi De Ghengi
Luigi De Ghengi, Davis Polk

Frustrated solutions 

Ironically, policymakers in G20 countries seem to agree with the GFMA report’s findings on reduced bank lending – at least when judged on their policy actions. 

There have been attempts in EU, for example, to re-start the securitisation market with proposed amendments to CRD IV, although counsel view them as less ambitious than might have been hoped.  

And to combat the lack of market-based funding in the EU, and restrictions on banks, policymakers launched the capital markets union (CMU) project in 2014. The June 23 referendum in the UK to leave the EU, however, means CMU’s intention of increasing cross-border activity levels in European capital markets is under threat.

“Sadly, Brexit may lead to the CMU project being scaled down or delayed,” said Sholem.

The result is, over the short term, that it’s unlikely there will be much of a move away from reliance on bank funding in the EU economy. That reliance, in turn, could mean Basel reforms, if improperly calibrated, could have even more of a negative economic effect. This, at just the time politicians in the EU may find it hard time pin pointing Basel initiatives as the cause of those effects.

“Will unintended consequences get noticed? Will the calibration issues get noticed? I think the level of detail is too high for most politicians to engage with it in detail,” said Sholem.

As a result, whatever the GFMA’s findings, political reality may intervene. “It’s also politically difficult to do anything that suggests a watering down of the standards imposed on banking groups,” Sholem said.

See also

NSFR questioned by US banks
POLL: Challenges of Basel IV
Internal risk model squeeze faces back lash

 

 


 

 

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