New Basel rules must address shortfalls of the past
By Hugo Bänziger
Published: April 26 2010 15:57 | Last updated: April 26 2010 15:57
When the French vineyards became infected in the 1800s it led to the collapse of the country’s wine industry. When potato crops in Ireland became plagued in the 1840s it created famine. When the corn fields in Southern US were struck by disease in the 1970s it cost farmers hundreds of millions of dollars.
On the face of it these agricultural disasters appear entirely unrelated to the current regulatory debate in the banking industry, but at their heart is a common theme: mono-culture.
Within the agricultural industry, farmers and growers used mono-culture – the focusing on one strain – in order to enhance production. This lack of diversity made crops less resilient to parasites and disease, resulting in the destruction described above. Within banking regulation we are rapidly moving towards a mono-cultural approach, ignoring the warning signs of history.
There is no doubt that Basel II improved risk management practices by setting higher minimum standards. However, because of this standardisation, the reforms also ensured that all banks were increasingly doing the same things at the same time. During economic good times banks’ requirements for capital declined, whilst in the bad times demand surged. The latest banking reform proposals from Basel, also known as Basel III, are about to take this to a new level.
They include a narrower definition of capital focusing on paid-in capital and retained earnings, and a new leverage ratio. New standardised liquidity and funding requirements will also be introduced. While these all sound sensible, there will be major unintended consequences:
1. The exclusion of deferred tax assets from banks’ capital will significantly increase swings in the capital needs of institutions as the buffer provided by tax credits is greatest during economic downturns. Not only will an institution have no more loss carry-forwards, but also any payments owed across different tax jurisdictions are to be treated like losses.
2. The introduction of a non-netted leverage ratio will cause problems for any bank with a derivatives portfolio. Using the conditions of the current crisis (dollar rallying, asset volatility spikes) and higher replacement values for non-netted derivatives portfolios, banks would have to liquidate billions of non-derivative assets in order to stay within leverage ratios. Price volatility of these assets would heighten, causing simultaneous, industry-wide markdowns.
3. The new liquidity rule requires banks to hold a large high-quality liquidity portfolio at all times. This reserve cannot be sold immediately when needed, but only after a time-consuming and backward-looking stress test. As a result, banks cannot use the buffer proactively but will have to sell other assets, again contributing to a downward price spiral.
4. The new funding rules will require banks to term-fund a certain percentage of their asset inventory – a sensible provision in principle. But linking this term funding ratio to credit ratings is not due to the built-in cliff effects of the proposal. For example, the term funding ratio for sovereign debt would jump from 5 per cent at AA to 100 per cent for a single downgrade. This would cause all banks holding this debt to look for term funding simultaneously, which – as has been demonstrated by the crisis – is least available for those institutions wanting it most.
5. Additionally, the requirements for subordinated bank debt will be made so strict – by ruling out fixed coupons – that the entire hybrid market and within it, the nascent contingent capital instruments may disappear. Not only was contingent capital employed successfully by several institutions to mitigate the downturn, it is also one of the few instruments counteracting pro-cyclicality.
In aggregate, the proposed measures will increase market volatility during a crisis with a significant impact on the fair value of assets. Shocks that had previously affected banks to different degrees will in future prompt every bank to raise equity and term debt at the same time, or massively cut their balance sheets. With such perfect synchronicity and no room for banks to exercise judgment, it is well imaginable that the next financial crisis is even more severe than that of the past few years.
New robust regulation is essential for financial stability, but we must ensure that we have addressed issues of the past. Credit ratings could be made less volatile by using stress values or a five-year time horizon; term-financing requirements should be decoupled from credit ratings; liquidity buffers should be accessible when needed; and the creation of alternative capital instruments should be encouraged by sensible standards.
While the shortfalls in the risk management of some institutions need to be addressed, we must also rectify the deficiencies in regulation and avoid introducing further pro-cyclical standards. Only by addressing the full extent of these weaknesses can we hope to provide a solution that puts the banking industry on a firm footing for the long-term.
Dr Hugo Bänziger is chief risk officer at Deutsche Bank and a member of its management board and executive committee
FT.com / Markets / Insight - New Basel rules must address shortfalls of the past
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Da notare che l'articolo è scritto da un funzionario di Deutsche Bank.
