Let's Embrace Basel's Higher Capital Buffers for Big Banks

Seventh in a nine-part series

The Basel Committee on Banking Supervision's recent recommendation to add new and more in-depth criteria to determine a global systemically important bank, or GSIB, is a sign that it is very serious about reeling in large, globally interconnected banks.  

The new guidelines are badly needed and are a significant improvement of a version issued in 2011. The language in the new paper demonstrates that the Basel Committee is very concerned about the potential moral hazard costs associated with implicit guarantees for GSIBs, which, rightly or wrongly, often come from the perceived expectation of government support. This type of support can end up reducing necessary market discipline and increase bank's risk-taking with depositors' money. Moral hazard could even increase the probability of distress in the future and again, very adversely affect taxpayers. 

In order to address these concerns, the Basel Committee sets out new measures on the assessment methodology for global systemic importance, higher loss absorbency requirements for GSIBs, the arrangements by which these requirements will be phased in and the data that banks above a certain size must publicly disclose.

The assessment methodology is comprised of a five indicator-based measurement approach: banks' size, their interconnectedness, the lack of readily available substitutes or financial institution infrastructure for the services they provide, their global cross-jurisdictional activity and their complexity. This multiple-indicator measurement approach could prove advantageous as it encompasses many dimensions of systemic importance, is definitely more robust than currently available measurement approaches that rely on only a small set of indicators or market variables and is relatively simple.

Fortunately, like with most other guidelines this summer, the Basel Committee wants to improve banks' public disclosure. Starting at the end of this year, it is recommending that all banks with a leverage exposure measure exceeding $266 billion should be required to make the indicators used in their assessment methodology publicly available. The fact that the Basel Committee chose this threshold is very good as it means that 75 of the world's largest and most interconnected banks will have higher public disclosure requirements.

Given a system of buckets that the Basel Committee has designed, the higher loss absorbency requirements for GSIBs are likely to range from 1% to 3.5% of risk-weighted assets.  Fortunately, banks will be required to meet this new buffer with common equity Tier 1 capital, because it is the best to absorb unexpected losses. In the U.S., JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley and Wells Fargo are likely be required to meet the top level of an additional 3.5%.

GSIBs will surely protest that this buffer would be in addition to Basel's existing capital ratio, conservation buffer, procyclicality buffer and non-risked-based leverage ratio. While all of these different buffers, including the GSIB buffer, will be phased in over the next five years, U.S. GSIBs could end up being required to allocate almost 23% in capital, 16.5% in risk-weighted assets and 5-6% through the non-risk-based leverage. 

All of these buffers are sorely needed to improve the soundness and safety of the global banking sector. While Basel III's major intent is to increase the quality and quantity of capital that banks allocate to sustain unanticipated losses, prior to this new consultative paper, it did not go far enough to contain the significant global negative externalities that GSIBs can pose. GSIBs' numerous, widespread and often opaque legal entities, their enormous and often primarily speculative derivatives portfolios, and their thousands of transactions with foreign counterparties make it imperative to impose higher capital requirements than those recommended for less internationally interconnected banks. 

While the Dodd-Frank Act and the European Market Infrastructure Regulation are focused on increasing capital requirements for GSIBs and improving cross-border resolution frameworks, more focus should be on increasing their loss absorbency so that we do not end up trying to figure out how to carve out a GSIB in what would be a challenging cross-border resolution. While the Federal Deposit Insurance Corp. has achieved much with living wills and resolution strategies, efforts in the European Union are very nascent. This should worry the U.S., since many of our GSIBs have branches there and numerous European banks have branches here.

For the moment, U.K. and euro-zone banks do not have leverage ratios as high as the ones recently voted on in the U.S. There is enough pressure, however, on both sides of the Atlantic for this to change. U.S. financial lobbies have already been raising the trite “competitive disadvantage” flag. Yet, it is high time that we take the lead in having the safest and soundest banks, rather than to strive toward the lowest common and detrimental denominator.

Next: Basel's recommended best practices for Anti-Money Laundering and Terrorism Financing.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.