Basel Regulations
We are going to be discussing financial regulation to understand what is going on today we need to have a look at what went on in the past So, if you can envision setting the clock back to the early 1980s what was regulation like at the time? While we had industry specialization in financial services, banks were banks Insurance companies only did insurance and the markets were very much national markets. There were national boundaries national regulators, and national market It was the very early days of the computer and we're talking here mainframe computers and of course the internet was only just being discovered In fact, it would not be used in financial services until a couple of decades later As a result, regulation was fairly simple and use one size fits all kind of rules. The best example for that is the first global banking guidelines that were adopted in the 80s which is the Basel guideline - Basel I as it came to be known later If we fast-forward to today where do we have while we still have national regulators and we still have actually global finance so how do we deal with global institutions when you are national regulator? Philosophy about regulations also differ between jurisdictions some jurisdiction like an approach which is very principle space in other words they look at the spirit of the law Other regulations look at rules-based. The letter of the law that has very significant implications of course for the financial institutions, While the regulators some jurisdictions say for example Singapore has one single regulator the MAS overseeing the entire financial industry Other regulation like the United States have multiple regulators In some cases, regulated the same segment of the financial services industry We have also evolved in how we look at companies and how we looked at cooperate governance and we've moved beyond the focus on shareholders to looking at stakeholders. Finally, we have to be aware of what it takes for regulators to keep up with innovation in the financial industry So regulators have tended to play a game of catch me if you can and what does it mean in reality so we'll have a look at that First to explain what it actually means for financial institution were the regulation that they are subject to Well if you take a big financial institution like HSBC, Morgan Stanley, Citibank They have multiple sectors that they are involved in. There not just the commercial bank they also an investment bank they have asset management sometimes they have an insurance subsidiary Well, as a bank you have to abide by the banking rules and banking regulations of every single country in which you operate You have to comply by the laws of every country in which you operate You have to follow the rules of every exchange on which your shares are listed and you have to abide by the code of conduct of the self-regulatory body that you belong to for example in Hong Kong the Hong Kong association of banks. Take that and apply it to all sectors of the financial industry where you are involved and you can imagine the complex web of regulations that you have to comply with not only that but of course that web is not stationary It evolves and it changes so you have to keep up to date on the regulation and the laws of every country every jurisdiction, in which you operate Which for a bank like HSBC or Citibank more or less operating in about a 100 different jurisdiction is an actual nightmare Who wants to be the head of compliance with these bank? I don't know Another very important in impact that we need to talk about is what I call the regulatory pendulum It goes like this When a crisis happens the first thing that the public and the government wants to find out is who's responsible for the terraces Step back to 1929 and the stock market collapse in the United States that caused absolute economic devastation. The public wanted to know who was responsible. The answer at that point seemed very clear, it's the banks The banks finance excessive speculation and lost the deposits of millions of helpless people So what was the reaction? We're going to stop this from ever happening again and we had a series of legislation in Particular, the famous Glass Steagall Act But all time, things get better and there is a tendency to deregulate So we have new crisis is coming up and every time you have a regulatory reaction and over time we deregulate until the next crisis So on this chart for example I have highlighted a couple of things related to the mid eighty's banking crisis that happen to live through The regulations response was for all banking regulators to look at what had happened and come up with common guidelines that we're addressing the risk that popped during that crisis in particular the credit risk, So in came Basel I Of course the moment you put a regulation in place the banks are going to look at how they are going to deal with that and how to find a way around it is still completely legal and in compliance with the rules So came by off balance sheet financing because the principle behind basel guidelines is that you ought to maintain a certain amount of capital related to the amount of risks that you put on your balance sheet, So moving things off balance sheet allows you to carry on with the financing activities while avoiding having to keep capital against it Part of that off balance sheet financing drive was the securitization which is basically selling off assets and borrowing against the sale of these assets and of course derivatives transactions which were recorded on the balance sheet Well, it's needless to say they were crisis related to some of these In particular in the world of derivatives. we had a number of big scandals in the U.S. which brought the attention of regulators to the fact that when you're engaged in derivatives transaction you are taking on risk So there was the Market to Market of derivatives there was in 1996 market risk amendment to the bustle rules which take in count for the first time marketers Then over time, banks started to say well the basel rules number one was not detailed enough and don't really take into account some of the aspects of credit So the Basel two version was adopted back in the 90s and unfortunately for us we will see that there has been now a new regulation post global financial crisis which is Basel II So let's look at what the regulatory landscape looks like now after the global financial crisis Well, the global financial crisis brought the attention of regulators to a number of risks that they had seemingly overload all these years and in one of the most important aspects of that in terms of global regulation is systemic risk That was broad vividly to the front because of the collapse of Lehman Lehman being a U.S. institution but with ties to other financial institution the collapse of Lehman exposed as a systemic risk that existed in the financial system In order to identify early on the systemic risk that can arise in financial system a number of institutions were set up that assimilate all the information coming out from the different regulators and put it into a global organization called the Financial Stability Board. The function of that board which is a global multilateral organization is to try and identify systemic risk before it becomes too important to control anymore Then Financial Stability Board in turn receives information coming out from its equivalent at the national level For example; in the United States a new organization was set up which is the Financial Stability Oversight Council It's counterpart in Europe in the EU is the European Systemic Risk Board and now there is an equivalent of course in China and various other countries This is very important to try and identify the risks before they become too big to control The regulatory landscape also includes a very important Basel Committee on banking supervision which we're going to talk about in more detail later which is the body that concerned with the famous Basel guidelines and we will look at the evolution of those guidelines over time If you look in the middle of the picture you will see the regulatory landscape in the United States. The United States regulatory system is extremely complicated and very siloed As you look at the bottom you can see that if you look at commercial lending for example it has several regulators which has the office of the control of the currency it has the Federal Reserve it has the FDIC not to mention the state regulators So the regulatory landscape is quite complicated and it makes it very complicated for bank compliance offices to provide all the information that these different regulators want in different formats.
Dodd-Frank Act regulation
One of the very important pieces of legislation that was passed in the aftermath of the global financial crisis is the US Dodd-Frank Act regulation that was passed in 2010. The intent of that legislation was actually to simplify the regulatory system in the United States Unfortunately, as you can see on the picture right before it did not end up simplifying it but it did introduce some new regulators in particular the Consumer Financial Protection Bureau that was supposed to look after the interests of the consumers directly and it also extended regulation to parts of the financial system that until then had not been regulated In alignment with all other global regulators wanting to identify systemic risk it expanded the authority of the banking regulators to identify systemically important financial institutions. The regulation over derivatives was also expanded and the acts also addressed stronger consumer and investor protection and finally, building on what happened with Lehman forced but large financial institutions to deal with what would happen when and if they fail This can be done through living whales and of course the authority of the regulators to deal with the financial institution in the case of failure in order to limit the losses to the taxpayers. Now that we have looked at the panorama of what financial regulation has looked like over time Let's focus more precisely on one of the biggest banking regulatory aspects which has to do with capital requirement Banks around the globe are currently subject to minimal capital requirement. The idea behind this is that capital should be sufficient to absorb losses that the banks may incur in their activities without triggering the need for a rescue by the taxpayers In the United States there are three capital requirements: one is the leverage ratio the other two ones are basically related to the basil guidelines it includes the capital adequacy ratio as well as a capital requirement on trading activities Alright. So let's focus now on one of the most famous and most important aspects of banking regulation which is the capital adequacy ratio Back in the 80s banking regulators in reaction to the financial crisis agreed that in order to have a level playing field between banks across jurisdiction all banks should have a minimum capital adequacy ratio expressed as the total capital to the sum of risk-weighted assets and other related risk exposed item of no less than eight percent So eight percent is a very important number it's what I call the magic number Now of course the devil is in the detail What is the capital base and what is a risk-weighted asset? Before going to the detail it's really important to understand the logic behind this the logic was we should have capital enough so that we can cover losses arising out of the business How much capital is necessary is a function of the riskiness of the assets in the books of the bank. This is really important to understand because the capital adequacy ratio differs substantially from the leverage ratio where the riskiness of the assets is not a factor In the leverage ratio as we will see later we look at capital base to total assets So what are the risk weighted assets and what is the capital base? Well, in the risk-weighted assets under Basel one were actually fairly simple there were only four risk weight categories and they were determined by the government based on their expectation of what could be risky and not risky As you can see here cash and government securities are considered risk-free for the purposes of the ratio But you can also see some unusual definition and in particular OECD government securities. So only government securities issued by OECD countries were counted as risk-free If they were from non-OECD countries than 20 percent risk weight would apply, Now those categories were actually quite simple making it fairly easy to calculate the basel one capital ratio. Then basel two came about after a prolonged period of a few decades because those risk categories that we saw before were so simple So if you look at what basel one was it was a simple formula simple ratio, one size fits all model In fact, when you look at when the Bank of England directive that implemented Basel one whereas it was about 10 pages But when we look at Basel II, what happened? A couple of things. First of all Basel II intend to cover risks that were not covered under Basel I. Basel I remember focused on credit risk Basel II incorporates other aspects of risk that arises out of banking business namely market risk and operational risk So Basel II is what we call a three pillars structure where pillar 1 is effectively basel I with the market risk amendment that was passed in 1996 and additional requirement for capital to cover risks arising out of operations Other risks are included under Basel II and it gives the regulators the authority to review the bank's capital planning Pillar 3 is a matter of disclosure The idea behind it is that if the banks disclose more of what they're doing then the regulators will be able to spot problems before they become too important Now basel III, Basel II was a long time in coming and very long come in being implemented and it was way more complicated than Basel I So remember I said Basel I was about 10 pages when you talk about Basel II implementation we're looking at a couple of tomes of memorandum Because it had different approaches it was extremely complex and in fact one of the things that happened is that implementation started in Europe spread to Asia but the US did not implement or did not start implementing Basel Two until right before the next crisis So in fact, Basel Two was never implemented in the United States Why? Because now we have Basel Three Basel Three is a regulatory reaction to the global financial crisis So, what happened during the global financial crisis? Well, we had a liquidity crisis and our banks suffered from the disappearance of the money market in the fourth quarter of 2008 A lot of the banks that had heavily relied on money markets from themselves in a very tight liquidity situation and as a result liquidity risk was at the forefront of the worries of regulators Of course as a result Basel Three now includes new provisions new ratios that cover liquidity risk and the two aspects of liquidity risk that banks have to worry about is what happens if there is a stress scenario like a run on the bank do we have enough liquid assets to cover the activities during that period? This is what we call the liquidity coverage ratio Also, do we have a good asset and liability team policies so that we match the duration of our assets with the duration of our liabilities This is what is called the net stable funding ratio Now on this chart, which admittedly is a little bit dated but I believe is a very very potent illustration of the history of the Basel regime You can see that at the beginning with Basel one the main focus was credit risk Market risk was actually added in 1996 but it is considered as part of Basel One How is capital base defined? We had Tier One which was called core capital Tier Two which was supplementary capital and for market risk we had Tier Three Under Basel Two, you can see that we have added a new risk which is operational risk and we have disclosure requirements under the pillar three A few tinkering happened between Basel Two Basel Three related to securitization the trading book, and incremental risk but look at Basel Three and look at all the changes that happened First, how you define capital was tied in which means that the Tier One and Tier Two definition were tied in significantly because during the crisis it became very clear that some of what was called Tier Two was not actually loss absorbing capital The buffers, that is how much capital you have to hold were significantly increased and a couple of things were added for example the systemic add-on, that means that institution that are considered to be systemically important be they're at the local or the global level have to maintain even higher levels of capital than the others and finally a new leverage ratio was added So, I have mentioned that in the US we had a leverage ratio already but because the crisis focused on how differently the implementation of Basel Two had taken place and why it was a failure of the regulatory system it was felt very strongly that a simple one size fits all ratio was needed as well on top of the Basel ratio Notice that the leverage ratio is a simple ratio and does not take into account the riskiness of the asset Another risk that was integrated because of the collapse of Lehman was counter-party risk and counter-party risk now requires capital ratio against it Finally, the two liquidity ratios that are featured at the bottom that are completely new in the Basel landscape for the reasons that I mentioned above So, now we have Basel Three and what is the issue with Basel Three? Remember, Basel is guidelines that are agreed by global regulators between themselves in the Basel Committee for banking regulation However, remember implementation and regulation is still national so it is up to each national regulator how and when they implement the Basel guidelines Each regulated publishes its implementation rules and they may have different opinions about it So for example, with Basel Three some regulators went harder and faster than others For example, the Swiss regulator established minimum capital ratio that was significantly higher than what was recommended under the Basel III guidelines Some jurisdictions like Singapore and China had implementation tables that were faster than what was recommended for Basel Three Nevertheless, the implementation temp table was also very long and that is because some of these ratios were completely new and required of course a lot of work for the banks to become in compliance with it So some of the parts of Basel Three are yet not completely implemented which of course with the passage of time raises a question of will there be another crisis before Basel Three is fully implemented The consequences of Basel III was also the need for many banks to increase the amount of capital that they held on the book and that unfortunately coincided with the sovereign crisis in Europe in 2010 So, it made it difficult for the European banks to raise capital to comply with Basel Three because there was a big crisis in the European market So, if you cannot raise capital and you still have to comply with the capital ratio, what can you do? Well, you have to shrink your assets which is why a lot of European banks pulled out of a number of markets in order to be able to meet the capital requirements because they were not able to raise capital Some of the rules have been actually really hard to implement in some markets For example, the liquidity rules require banks to have a high percentage of liquid assets on the balance sheet and remember, liquidity is relative So how do we find liquid assets? You will immediately think of cash and government security but in Asian markets the government securities markets are very small and very shallow Where are we going to find liquid assets to meet this liquidity coverage ratio requirement? The impact of Basel has also spread the capital requirements to areas which were not really well covered before such as securitization project and trade finance which means the cost for the customers has increased of those products because the banks have to hold up capital against it when they didn't before All of this and the passing of time and volatility in the market brings of course a question of when will be Basel Four? What was the impact of the implementation of Basel Three? Well, the banks are indisputably in a stronger position than they were before the global financial crisis Leverage has decreased considerably capital ratios have improved across the board Is this a good thing? Well, in terms of profitability, not so much But Basel III is not the only thing that the banks have to deal with The European Union has come up with a Markets in Financial Instruments Directive, MIFID Two this is the second version of this directive which has significant implications for the research sector in the financial industry because one of the aspects of MIFID Two is that asset managers are no longer able to bundle research costs with other services that they pay for from the big broker dealers We all know about the new president in the United States and his focus on deregulation which has resulted in a number of very important moves in particular the revision of the Volcker Rule and appointment in regulatory institution's top jobs of people who are very much in favor of deregulation One of the institution that has been most impacted by the Trump administration is the Consumer Financial Protection Bureau At the same time as you have banking regulators at work you also have accounting regulators and in particular IFRS Standard Nine in the banking industry and IFRS Standard 17 in the insurance industry have come into force this year IFRS Nine has enormous implications for the banks because it introduced mark to market for the loan portfolio At the beginning, in reaction to the global financial crisis the regulators all agreed on the basic principle but as time went by and interest diverged well, we'll have a balkanization of regulation That means basically, that each regulator national regulator is pretty much looking after their own interests Understandably, if you think for example in the United Kingdom where the banking industry is larger than the economy So, would the taxpayer in the UK should they be responsible for bailing out an HSBC? That has led to some very important changes in regulation in the UK that has brought about localization of financial institutions and the same thing in other jurisdictions Finally, it's not just about financial risk it's also about non-financial risk As I've mentioned, Basel Two and Basel Three look at operational risk This is a huge category which includes many things such as legal risk, reputational risk cybersecurity but also emerging particularly in Europe is ESG categories Environmental, Social and Governance risks that are now part of the regulatory picture With that.
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