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Will there ever be a Basel V?

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Below is a lightly edited transcript of the podcast:

MARIO DRAGHI: Well I’m actually pleased and proud that we’ve come to this agreement here in Frankfurt today.

HANNAH LANG: This is Mario Draghi speaking in Frankfurt, Germany, in 2017. Today, Draghi is the Prime Minister of Italy, but back then he was president of the European Central Bank and chair of what is known as the Group of Governors and Heads of Supervision — a group of international financial ministers that oversees the Basel Committee on Banking Supervision.

DRAGHI: The governors and heads of supervision, otherwise called GHOS met and endorsed the outstanding Basel III post-crisis regulatory reforms, also called Basel III endgame. The focus of the reforms today, agreed in a very general way, is to reduce regulatory uncertainty.

LANG: The Basel III endgame he’s referring to is the last and most difficult aspects of the Basel III accords — which were agreed to in fits and starts between 2007 and 2010, and endorsed by the G-20 in 2010 — and dragged on for so long that they came to be known colloquially as Basel IV.

Basel IV involved a lot of things, but the deliberations hinged on how much risk-based capital banks should have to hold against certain assets and how to weight those risks. The Basel III accords were all about assigning universal capital and liquidity standards to prevent excessive risk from concentrating in any one country or market and spreading across the globe, just as the U.S. housing bubble had done in 2008.

Since its inception, the Basel Committee on Banking Supervision, along with another international body, the Financial Stability Board, has sought to establish a regulatory floor for member banks, ensuring that the failure of one bank doesn’t bring down the rest of the financial system, and diffuse excessive risk before it starts. That kind of mission requires foresight and coordination, as this promotional video from the Financial Stability Board explains.

FINANCIAL STABILITY BOARD: But just as a footballer needs to focus on where the ball is going, not where it is now, we are scanning the horizon for new and emerging risks and addressing them before they get out of hand. That way, the financial system can concentrate on serving households and businesses, so you can concentrate on what really matters to you.

LANG: But as the global economy emerges from the COVID pandemic, the issues that the financial system is reckoning with today are fuzzier and consensus more elusive than the capital and liquidity rules that Basel and the FSB have had to grapple with in the past. Establishing global standards for offsetting climate risks, curbing cyber crime and regulating cryptocurrency could be among the most difficult negotiations those bodies have ever faced, and it’s not totally clear how or whether they can reach an agreement before a crisis actually materializes.

For American Banker, I’m Hannah Lang, and this is Bankshot, a podcast about banks, finance and the world we live in.

LANG: International agreements are inherently complicated, and the structure of these bodies and the source of their authority is no exception. The Basel Committee on Banking Supervision is housed within the Bank for International Settlements, which is kind of like a central bank for central banks. It was established in 1930 in Basel, Switzerland, to help facilitate payments between central banks, like the Federal Reserve in the United States and the ECB in Europe. But the Basel Committee didn’t come about until 1974, when the German-based Herstatt Bank went bankrupt.

LANG: Why don't we start, if you could just introduce yourself with your name and title that would be great.

MAYRA RODRIGUEZ VALLADARES: Mayra Rodriguez Valladares, managing partner of MRV Associates, a financial risk consultancy based in New York. The reason Herstatt was just such an earth shattering situation was that there were German marks — I mean, this is how old this case is, right? — German Marks and U.S. dollars being exchanged, and when Herstatt was closed down, there was no announcement or coordination from the German regulators to tell U.K. or American regulators that this bank was being closed down, and it caused a lot of chaos.

LANG: The Herstatt collapse made it clear to global regulators that there wasn’t a venue for them to talk to and coordinate with each other, and the lack of such a venue could have material and preventable consequences for the global economy. So they established the Basel committee to develop uniform supervisory standards, regulatory guidelines and formal agreements known as the Basel accords.

VALLADARES: When Herstatt failed, you know, after a number of years, eventually the Basel Committee on Banking Supervision was created. It was very much a group of 10. So that would have been the United States, U.K., Germany, Canada, Japan, and that now has expanded to membership of 28 members, or 27 countries, plus Hong Kong.

GREG LYONS: The Basel Committee is a group of central bankers, central organizations, and what they do is they try to set a legal framework on the various rules.

LANG: This is Greg Lyons, who is a partner at Debevoise & Plimpton.

LYONS: They can't establish rules under themselves, but they establish frameworks which are then intended to be adopted by various countries and jurisdictions, and the goal is to prevent regulatory arbitrage between jurisdictions by having a uniform set of rules.

LANG: The Financial Stability Board, which is also housed within the Bank for International Settlements, was created in 2009 as a successor to the similar Financial Stability Forum. It counts among its members not only member countries of the G-20, but also bank regulators and exchange commissions, like the Securities and Exchange Commission here in the U.S. As of right now, the FSB is chaired by Randy Quarles of the Federal Reserve.

TODD PHILLIPS: The Financial Stability Board focuses on, really, financial stability. I'm Todd Phillips. I'm director of financial regulation and corporate governance at the Center for American Progress. They take the whole financial ecosystem and look at it from a 30,000 foot view and then also in more detail. So, FSB looks at the banking stuff, but also securities and derivatives and other issues that might cause financial stability issues.

VALLADARES: The Financial Stability Board kind of sees itself as the top of all of these regulators — or I should call them standard setters — and it is now an incredibly important organization, because its job is to indeed try to detect systemic risks. So is it going to come from climate change? Is it going to come from cybersecurity, or is it going to come from very lightly regulated nonbanks?

LANG: Neither Basel nor the FSB have any enforcement powers, so they can’t themselves enact laws or regulations. But they do set guidelines that their members generally agree to take back to their home country and codify. They are also only two of many international financial standard-setting organizations — in fact, there are at least sixteen out there, including the World Bank and the International Monetary Fund.

PHILLIPS: What it does is, having an international floor really ensures that we don't have a race to the bottom in terms of regulation, so that one country can't reduce its standards so capital flies there and away from other countries. The problem with that, of course, is that if you have a race to the bottom, you end up with real financial instability and issues with banks potentially collapsing. That's something that they really want to avoid.

LANG: The first set of Basel accords was issued in 1988, and essentially said that banks that operate on an international level should hold capital equal to at least 8% of their risk-weighted assets. The second set of accords, or Basel II, as it is known, served as an update to Basel I and centered on three pillars: minimum capital requirements, supervisory review and market discipline.

VALLADARES: Even before Basel II was fully implemented, there started to be discussions about, “Wait a minute, there are no guidance or requirements for leverage, there's no uniform guidance for liquidity.” So already in 2006, 2007, the Basel Committee had been discussing and making those changes to the accord. Then came the financial crisis of 2007, exacerbated in 2008, and by that point it was clear that Basel would do this big overhaul, and so it strengthened all the three pillars, and that's what then put us to Basel III.

PHILLIPS: We all saw that Basel II was not working as expected. There was a global financial crisis, and so in 2008, they started putting together what would become Basel III. Basel III contains a couple of different facets of regulation that the different governments tried to put into effect. There's capital requirements, there are risk coverage requirements, leverage ratio requirements, liquidity, exposure requirements, all sorts of things like that.

LANG: That takes us back to 2017, when Mario Draghi announced that Basel had finalized the Basel III endgame, or Basel IV.

DRAGHI: So this endorsement by the GHOS of the Basel III reforms is a major milestone, and this will, as I said, reduce excessive variability of risk-weighted assets without significantly increasing capital requirements in the aggregate, of course.

LANG: Originally, Basel had set January 1, 2022 as the deadline for countries to finish implementing the Basel IV standards. But in light of the coronavirus pandemic, the committee pushed back that deadline to 2023. That means many of the signatories to Basel IV — including the United States — are still finalizing their own rules to align with this framework. That gives you a sense of how slow these agreements can move, even when the signatory countries are aligned in principle.

LYONS: Basel III or Basel IV, as some banks refer to it, really was to a large extent a tightening of the rules, but it was all within kind of a known set of issues: liquidity, capital risk, you know, those types of things. You're adjusting, but you're adjusting within kind of a traditional framework.

LANG: These rules are really quite complex, and they are the product of incredible amounts of negotiation. The results, at least for some observers, are far from perfect, and can lead to unforeseen consequences.

STEPH MILLER: I'm Steph Miller. I'm a senior research fellow at the Mercatus Center. I work on financial regulation, primarily bank regulation, and I also do research on crises and why they happen and what you can do to stop them. You can see that for some of the largest banks, when these new capital requirements came out, it favored holding really low risk-weight assets, such as U.S. Treasuries, and excess reserves, and it disfavored holding loans. But what I found is that some of these risk-based capital requirements actually could have made it less advantageous for the largest banks to lend.

LANG: So for many, the onset of the COVID-19 pandemic was the first real test of how the newest set of Basel accords would actually hold up in a crisis.

CNBC: We are here tonight because of the violent market reaction to the very real threat that the coronavirus is about to impact this country in ways that we have never seen before.

BLOOMBERG MARKETS AND FINANCE: Financial institutions set aside billions to cover losses on bad loans. Among Us banks, JP Morgan's provisions increased more than fivefold from a year ago. at Goldman Sachs they almost quadrupled.

RODRIGUEZ VALLADARES: The banks came in better capitalized, more liquid, less leveraged, and that helped them withstand the severity of the unexpected nature of COVID. Had banks been significantly undercapitalized and illiquid the way that they were at the beginning of 2007 and into 2007 and COVID had struck then, you know, banks would have been wiped out.

LANG: But it’s also hard to tell if COVID was a success story for Basel alone, or whether it was a combination of things that left banks in good shape.

PHILLIPS: I think that it's really ... it's really hard to disentangle what benefits came from capital, increased capital requirements, and what benefits came from a ton of stimulus and a ton of liquidity.

LANG: Here’s Steven Kelly, a research associate at the Yale Program on Financial Stability.

STEVEN KELLY: It's hard to judge. I would say that, you know, by and large, the system did well, and if you want to credit Basel with that, you can. I don't think they deserve the credit necessarily, but they don't not. I mean they're a coordination body and, you know, I think the system did pretty good. Again, the crisis response was just absolutely huge.

LANG: Whether Basel III helped the financial system withstand COVID or not, it certainly didn’t hurt, and the Basel Committee and the FSB would probably count that as a win. But it also left them in this pretty unusual place that they haven’t really been in before, which is: what’s next?

KELLY: It's like, if a corporation decides it's going to start a mergers and acquisitions team in-house, that team is never going to just sit on their hands and say, “Hey, I don't think we should do a merger for a couple years,” even if that's the best course of action. And similarly, the FSB is not just going to sit on its hands and say, “Well, you know, capital did fine in the COVID crisis. You know, we'll wait until you guys need us again.” They're just going to start working on other stuff.

VALLADARES: At any rate, the Basel Committee is done with all of the rules under Basel III, and so now, the Basel Committee has really pivoted to monitoring how the different countries are implementing Basel III, and what are any of the shortcomings, etc. So, at the same time, what the Basel Committee is also looking at is to try to figure out okay, does it need to create and publish guidance on climate change? Does it need, to a lesser extent, to figure out what kind of guidance it may have to put out on cryptocurrency? Does it have to figure out what to do about cybersecurity?

LANG: These issues, like climate change, cryptocurrency and cybersecurity, are not only issues that the Basel Committee and the FSB have never had to deal with before, but they’re also issues with a lot less clarity around them compared to things like bank capital requirements.

LYONS: With the Basel Committee, Basel III, the banking industry was pushing back on certain things, but folks kind of knew where things were heading as a general matter. On this, there's just so many divergent opinions and so many different objectives in play. I think it makes it much more difficult.

KELLY: It's really kind of a different story than it's been historically. The FSB, really, was formed in the aftermath of the financial crisis, working on things like capital standards, and sort of well-known banking problems. And it really had sort of this mandate — this obvious mandate — to strengthen capital requirements and liquidity requirements, and you know, this stuff is already being done in the U.S. and elsewhere, and there was a lot more synergy involved. And some of the issues that it's focused on now are more emerging and less obviously within their purview, which kind of leaves them in an interesting spot.

LANG: Both the FSB and Basel Committee are currently doing work on cryptocurrency and stablecoins, and trying to figure out exactly how they might impact the financial system on a global scale. Last year, the FSB put out a report with some very high-level recommendations about how global stablecoins should be overseen, and earlier this year, the Basel Committee issued a proposal laying out what amount of capital banks should ideally hold to protect against digital asset losses.

LYONS: Obviously, currency can affect the system. Currency flows in and out of the system, and so forth, and obviously, it could affect the stability of banks in certain regions and that type of thing. It behooves everybody to have, again, a common set of rules. But again, you know, that there's always the question of, you want stability, you want guidance, but you want good guidance.

LANG: And without knowing what the digital asset landscape might look like in the future — or even where it stands right now — it’s really challenging to come up with good guidance that all member countries can agree on.

VALLADARES: That's so undefined because in some countries, is crypto really a currency? Is it an asset? And so should it then be regulated by an Exchange Commission, like the SEC? There's a lot there to be ironed out.

LANG: Climate change is another enormous challenge that is top-of-mind for financial regulators, many of whom are just beginning to probe what kind of risk global warming could pose to the global economy. Here’s Steph Miller again.

MILLER: I think today that climate change is what's on everyone's mind with, and, at least with the Basel Committee. I haven't seen concrete proposals yet, but I think there's a lot of research and other activities to kind of work out what would be the best way forward.

VALLADARES: For climate change, I would say that the Basel Committee still has to come up with standardized definitions and standardized requirements as to, “Okay, how should a bank be doing sensitivity analysis? How should it be doing stress testing? How should it incorporate climate change into the stress testing, because there's a lot of data gaps?” There's a lot of issues for banks to measure the impact of climate change on their portfolios from a credit risk perspective and a market risk perspective.

LYONS: Climate change, you have a whole risk that, frankly, wasn't contemplated at all when the Basel Committee came out, and of course, there are huge political [discrepancies] as well, as you know, and other issues associated with these as well.

LANG: Global regulators are also increasingly focused on cybersecurity, and how to ensure that attacks wouldn’t bring down the international financial system. Here’s FSB Chair Randy Quarles speaking in March.

QUARLES: The COVID event has underscored the financial sector's susceptibility to operational risks especially those related to cybersecurity. The speed of technological change and a growing reliance on third-party, technology-based services is increasingly introducing new risks and vulnerabilities to the sector. To begin to address this, the FSB is focused on achieving greater convergence in areas such as regulatory reporting of cyber incidents, and we will deliver those recommendations to the G20 in October.

VALLADARES: This is the top issue that I would say keeps [Federal Reserve] Chair Jerome Powell awake at night, and no doubt many of his counterparties around the world, on what would happen if you had a massive cybersecurity attack that, you know, made our banks inoperable.

LANG: But what makes tackling some of these issues, like cybersecurity, particularly challenging is navigating the political minefield among member countries, many of whom have divergent or even oppositional stances on many of these vexing problems.

VALLADARES: This is even more challenging, because there's a lot of political sensitivities here. I mean, you do have, you know, the Russian state, as opposed to Russian individuals, you have the Chinese state, you have Chinese individuals, but these two in particular, you know, have tried repeatedly, to infiltrate and to do cybersecurity attacks on U.S. companies, U.S. financial institutions. So there's a lot of sensitivities in trying to have these conversations in these meetings about cybersecurity.

KELLY: China has taken a very “anti” position on crypto that might not go over as well in somewhere like the U.K., you know, and things like that. And climate is the same way, you know, especially when you're talking about the G-20. You still have, you know, big emerging markets, and there's the question of, “Why are we making everybody think about the climate now when the U.S. got its chance to develop without thinking about the climate, and now that it's rich, it gets to worry about the climate and make everyone else follow these new rules?”

LANG: Some of these issues are also more important for certain countries than others. Even with the previous Basel accords, countries with more advanced economies likely had an easier time getting into compliance with these standards than some of their less-advanced counterparts.

MILLER: One problem is this complexity, and especially maybe for smaller countries, who have to suddenly adopt these very complex standards, it's sometimes hard to find expertise in small countries to comply with that, but people go along with it, I think, because obviously, you want to at least signal that you are following these global standards.

VALLADARES: It really is even more challenging to have to work with such very different political figures who have different opinions and different goals.

LANG: So what can we expect out of Basel and the FSB now? American Banker reached out to both groups for an interview on these questions, but neither made themselves available for this episode. But observers say in the near term, the most likely path is to find what the member countries can agree on, whatever that may be, and wait for consensus to emerge over time.

KELLY: It's likely going to be a research-sharing exercise for the time being at the Basel level and at the FSB level. Because this, like I said, the impetus just isn't as unanimous like it was in 2009 for some of these more simpler, more narrow banking related issues.

LYONS: If you start to see some movement in the U.S. that starts to get ahead of where the Basel Committee is and in turn, because the U.S. is a prominent voice on the Basel Committee, that may start to guide where the Basel Committee goes. It's like a ghost of Christmas future to a certain extent to see where that's going. Again, I don't mean to say they closely follow the U.S., but certainly it's an indicator as to where it's going to go.

KELLY: It's sort of like an analogy to democratizing the world. You know, once the US and the UK and maybe Germany all agree on something, then they can go spread the good news via the FSB. There's room on the technical side of things to kind of illuminate, you know, here's a mechanism by which crypto can spread contagion, or here's a mechanism by which climate can, but the policy recommendations, I think will be weak until the advanced economies come through with their own.

LANG: And on the opposite side, movement and research from Basel and the FSB could pull the United States and other countries along with their own regulations and policy decisions. Here’s Todd Phillips again.

PHILLIPS: By other countries, or these international organizations, doing things on an issue, it can show the United States that this really is an issue and that other countries are working on it and have adopted solutions for addressing these worldwide problems that, for example, that the U.S. can adopt.

LYONS: I don't think anybody's waiting for the Basel Committee to get it done before. I mean obviously, countries are doing things in their jurisdictions. But nonetheless, I think it is the kind of thing that benefits from, frankly, the perspectives of a bunch of different countries and you get the benefits of everybody's thoughts under the theory of maybe at a minimum, you create a base level of framework with climate change, kind of like with Basel rules.

LANG: At least for the time being, Basel and the FSB will likely remain more of a coordination body than a policy-making one, until some of these big issues facing the financial system become less nebulous.

VALLADARES: It is now dealing with some really, really large issues that affect all kinds of financial institutions, and, frankly, governments, and so all of these standard setters really do need to work together more often. And you also need the FSB to really take charge of being a very, very good coordinator for all of the work that all these entities are doing.

LYONS: They are doing many consultations and doing many, you know, they're going back, and because it's going to take a long time, I think, to try to get this done. And then, once they do, you know, then again, it remains to be seen again, as with other things, whether the countries adopt it as they're suggested.