International Banking Standards Stall as Regulators Mull Options

Nobody expected that crafting international capital reserve and risk standards for banks would be easy. But few probably predicted it would be this hard.

After years of debate since the global financial crisis of 2008, there remains great confusion and divisiveness over international standards, especially when it comes to new capital rules promoted by the Basel Committee on Banking Supervision, known as Basel III.

The latest developments on Basel III do more than hint at hand-wringing by global regulators as they contemplate how to implement the standards. Last month, the Federal Reserve, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency jointly decided to postpone new rules slated to take effect at the start of the year that would align U.S. banking regulations more closely with the Basel III requirements. The banking regulators have not yet proposed a new timeline for imposing the regulations.

“Given the questionable performance of past Basel capital standards and the complexities introduced in Basel III, the supervisory authorities need to rethink how capital standards are set,” Thomas Hoenig, vice chairman of the FDIC, said during a recent speech.

The eleventh-hour decision by U.S. banking regulators to back away from the rule, at least for now, is triggering a domino effect of delays abroad. European Union officials are now signaling, despite initial tough talk of a Jan. 1 implementation date and pushing the U.S. to clarify its plans, that it may take a step back as well.

The European Banking Industry Committee, a consortium of banking industry federations, has already called for postponing the introduction of the Basel III for its members, citing a “serious competitive disadvantage” they would face by following rules the U.S. chooses not to adopt. Last week, Heinrich Haasis, president of the World Savings Banks Institute, an international banking association representing financial institutions in 90 countries, also urged a delay, saying that a Jan. 1 deadline is nearly impossible “if the final terms of these requirements are not even fixed at the end of November.”

Lingering debates were illustrated by battling experts who testified at a hearing on the impact of Basel III standards convened last Thursday by the House Committee on Financial Services. At that hearing, even representatives from the federal banking agencies conceded that more work remains to be done before final U.S. rules move forward.

While Basel III standards have no shortage of critics, not everyone sees it as a bridge too far. George French, deputy director, Division of Risk Management Supervision, for the FDIC, testified at the House hearing that FDIC-insured institutions have strengthened their capital ratios since 2008 and that the “large majority” of insured banks would not find it difficult to meet new capital requirements. Nevertheless, with 2,000 public comments and counting, he conceded that regulators have plenty of work ahead of them to address concerns about costs and unintended consequences.

The majority of the public comments came from community banks, he said, many urging that Basel III standards not be applied to them.

James Garnett Jr., head of risk architecture at Citi, spoke up for his smaller industry peers and against the greater operational and compliance challenges they face compared to large banks. “Large banks, like Citi, already have incurred many of these costs in preparation for Basel II and enjoy economies of scale in technology and systems,” he said. “Community banks are justifiably concerned about the compliance costs.”

Garnett said that because community banks do not have complex balance sheets, regulators should permit them to continue to comply with Basel I, “or some other simplified risk-based capital regime.”

John Lyons, chief national bank examiner for the Office of the Comptroller of the Currency, said he appreciates “the burden for community banks” but pushed back against a call to exempt them. “It is important to remember that over 460 smaller banks have failed in the aftermath of the financial crisis, ultimately because they did not have enough capital in relation to the risks that they took,” he said.

It's not just small, community banks that are lining up against Basel III standards. Several large insurance companies say the compliance aspects are overly burdensome. Paul Smith, treasurer and chief financial officer for State Farm Insurance Co., raised cost concerns within his industry. He said imposing “bank-centric regulations” could weaken the capital strength of insurance-based savings and loan holding companies, which have “starkly different” business models, risk exposures, and capital needs.

The most costly example of “a regulatory mismatch,” Smith said, is a requirement that all insurance-based savings and loan holding companies utilize Generally Accepted Accounting Principles (GAAP) in preparing financial statements. As a mutual insurance company, State Farm Mutual is not required to, and does not, prepare GAAP financial statements. Instead, it uses Statutory Accounting Principles (SAP), a state-mandated accounting system used by all insurance companies in the U.S. Mandating GAAP would take several years to implement and cost hundreds of millions of dollars, he said.

A Credit Drought?

Others at the hearing argued against the increased complexity and costs for asset risk weighting, particularly as they relate to residential mortgages. The proposed standards would lower capital requirements for the safest mortgages, while raising capital requirements for riskier mortgages, which could raise their cost.

Daniel Poston, chief financial officer of Fifth Third Bancorp, testified on behalf of the American Bankers Association and urged regulators to withdraw and rework their current proposals. The issue is not about higher levels of capital, he said, but “arbitrary and excessive risk weights” that will hurt banks, customers, and the economy.

The assumption that many traditional hybrid adjustable-rate mortgages and mortgages with balloons or interest deferral periods have double the risk of other loans, is wrong, Poston said. Requiring “very granular data on a mortgage-by-mortgage basis” would lead banks to either scale back, or eliminate, mortgage lending, he predicted. Small businesses would suffer as the proposed rules penalize second mortgages— including home equity loans often used for start-up capital and supporting credit needs—with a higher risk weighting.

Derivatives market participants are also lining up with critics of the Basel III requirements. Terrence Duffy, executive chairman of CME Group, whose clearing house division of the Chicago Mercantile Exchange is among the largest in the world, said the Basel framework treats all cleared derivatives as if they require margin to cover a five-day period of risk. Highly liquid derivatives contracts are put into the same category as OTC contracts that are not liquid or transparently traded.

The result of this “blanket categorization” is “unrealistic and market distorting,” Duffy said, adding that it could “drive customers back into an opaque OTC market,” contrary to the regulatory goals of the Dodd-Frank Act.

Far Enough?

With the pullback by U.S. regulators and signals from Europe that regulators there may also put the requirements on hold, concerns are mounting from Basel III proponents that the standards could wither on the vine. Anat Admati, professor of finance and economics at Stanford University's Graduate School of Business, urges regulators to stay the course when it comes to implementing international standards or even to do more than what has been proposed already. She says Basel III should become a minimum requirement and that, by itself, it is insufficient to protect the public from risks in the financial system.

Banks “fight to continue to live on the edge” and seem to “prefer debt over equity as a form of funding,” Admati said. The tax code encourages borrowing because of the tax deductibility of interest payments. There is also a “flawed fixation” on return-on-equity or similar measures for compensation, which encourages excessive risk taking. Worst of all, she said, is the “government safety net of implicit and explicit guarantees that make it possible and attractive to borrow at subsidized rates.”

The “too big to fail megabanks” are dangerous for the economy and should be immediately banned from making any payouts, such as dividends, to their shareholders until a way is found to contain the risk they impose, Admati cautioned. “If banks used the same funds to make loans or repay some of their inessential debts, the economy will only benefit,” she said. “If Basel III is viewed as the target, why allow banks to move away from it?”

Marc Jarsulic, Chief Economist, Better Markets, an organization that advocates for transparency and oversight, of the financial system, said claims of excessive or burdensome compliance costs are predictable and overstated.

“Since the emergence of financial market regulation, the financial services industry has claimed that new regulatory requirements will have a devastating impact by imposing excessive compliance costs or prohibiting profitable activities,” he said. “Yet the industry has always absorbed the cost of those new regulations and has consistently remained one of the most profitable sectors in our economy.”