The Banking Regulation Review: International Initiatives
This chapter summarises the most important international developments in the field of banking regulation adopted by the principal global standard setting bodies.
Until the recent covid-19 crisis, much attention had been devoted to the reform of banking regulation as a result of the 2007–2009 banking crisis. It is far too early to ascertain how the global pandemic will work out and what its implications will be for the international banking system. Undoubtedly, banks in affected countries will face both immediate and longer-term challenges as a result of the effects on global and domestic economies. Lockdowns implemented by many countries will adversely affect economic activity, while recessions, travel bans and restrictions on international trade will impact supply chains and business models with unpredictable effects on the solvency of banks' customers. Thus, although the current crisis is not a banking crisis, in that it did not originate in the banking sector but outside it, and the banking system is stronger and more resilient than it was in 2007 as a result of the measures taken since, the current situation is likely to have profound long-term implications for the way banks do business. Entire corporate sectors may require state bail-outs or simply disappear with consequences for banks' assessment of credit risk and balance sheets. This will inevitably feed into prudential requirements, even if the standards themselves remain unchanged.
Moreover, the taking of emergency powers by states to address the pandemic is likely to have implications for banks whether or not such measures constitute regulations in a strict sense. For example, the UK government has effectively closed the UK housing and mortgage market, and pressured banks to suspend dividends, as has the European Central Bank in the eurozone. The breadth of such powers, and the consequent unpredictability in how they will be exercised by governments, will add to the uncertainty of the environment in which banks will have to operate. Doubtless direct regulatory measures will follow in due course, although whether this happens in a globally coordinated manner, as in recent years, or with each country taking ad hoc measures to protect their own banking system, as seen in the immediate aftermath of the 2007 financial crisis, remains to be seen. Past precedent is not encouraging that international coordination will prevail, particularly where essential state interests are seen as being at stake, and the safety and security of the banking system is certainly regarded as one of those interests.
On 27 March 2020, the Basel Committee on Banking Supervision's oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), endorsed a set of measures to provide additional operational capacity for banks and supervisors to respond to the immediate financial stability priorities resulting from the impact of the coronavirus disease on the global banking system:
- the implementation date of the Basel III standards finalised in December 2017 has been deferred by one year to 1 January 2023. The accompanying transitional arrangements for the output floor has also been extended by one year to 1 January 2028;
- the implementation date of the revised market risk framework finalised in January 2019 has been deferred by one year to 1 January 2023; and
- the implementation date of the revised Pillar 3 disclosure requirements finalised in December 2018 has been deferred by one year to 1 January 2023.
The revisions have been published by the Basel Committee as follows.
|Standard||Original implementation date||Revised implementation date|
|Revised leverage ratio framework and global systemically important bank buffer||1 January 2022||1 January 2023|
|Revised standardised approach for credit risk||1 January 2022||1 January 2023|
|Revised internal ratings-based approach for credit risk||1 January 2022||1 January 2023|
|Revised operational risk framework||1 January 2022||1 January 2023|
|Revised credit valuation adjustment framework||1 January 2022||1 January 2023|
|Revised market risk framework||1 January 2022||1 January 2023|
|Output floor||1 January 2022; transitional arrangements to 1 January 2027||1 January 2023; transitional arrangements to 1 January 2028|
|Revised Pillar 3 disclosure framework||1 January 2022||1 January 2023|
On 20 March 2020, the Basel Committee announced:
The spread of covid-19 has reached a critical phase and is having an increasingly significant impact on economic activity. The Basel III standards have strengthened the resilience of the banking system over the past decade. The global banking system has significantly higher levels of capital and liquidity, and is therefore in a stronger position to absorb shocks and mitigate interruptions to banking services. Banks and supervisors must remain vigilant in light of the evolving nature of covid-19 to ensure that the global banking system remains financially and operationally resilient.
Member jurisdictions are pursuing a range of regulatory and supervisory measures to alleviate the financial stability impact of covid-19. These measures target the provision of lending by banks to the real economy and facilitate banks' ability to absorb losses in an orderly manner. The Committee supports the objectives of these measures and notes that members have flexibility to undertake further measures if needed.
The Basel Committee also announced that 'the Committee is suspending consultation on all policy initiatives and postponing all outstanding jurisdictional assessments planned in 2020 under its Regulatory Consistency Assessment Programme'.
Aside from recent developments, much of the current structure of banking regulation emerged from the aftermath of the 2007 to 2009 financial crisis. If anyone assumed that an internationally agreed set of common principles as to how banks should be regulated would emerge quickly from the financial crisis of 2007 to 2009, they have been disappointed. However, almost all of the replacement regulatory framework is now in place or due to be implemented in the coming years, with the time frame for implementation of the new framework scheduled. Doubtless further measures will be proposed as a result of the financial implications for banks of the covid-19 crisis although what they may be is uncertain at present.
Since the global crisis first manifested itself in 2007, it has at times been difficult to keep track of the numerous international initiatives that have been launched. These initiatives may broadly be classified as those developed to try to understand what went wrong before and during the financial crisis, and those developed to propose and monitor the implementation of reforms to prevent the recurrence of problems that were identified. The proliferation of international initiatives has reflected the number of stakeholders involved and the potentially conflicting approaches to identifying and addressing the causes of the crisis as well as differing political agendas, with the crisis being seen by some as an opportunity for advancing proposals that previously had attracted limited support. It has also reflected a period of intense reflection among financial regulators and governments on the causes and consequences of the financial crisis. However, cynics may argue that the world could have done with fewer initiatives and greater clarity about the direction of reform in the past few years.
As far as banking regulation is concerned, we focus on the two main bodies that have emerged from the crisis to lead the debate: the Basel Committee and the Financial Stability Board (FSB), which emerged in 2009 as a new global leader in the debate on measures to improve international financial stability.
II BASEL COMMITTEE
The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for international cooperation on banking supervisory matters. It is principally concerned with the prudential regulation of banks rather than the regulation of their business activities as such. It must, however, be recognised that there are many overlaps between these two areas of regulation, with capital requirements creating incentives for banks to engage in certain activities but not in others.
The Basel Committee comprises senior officials with bank regulatory and financial supervisory responsibilities from central banks and banking regulators in 28 jurisdictions.2 The current Chair is Pablo Hernádez de Cos, who is also Chair of the Bank of Spain. The Committee now reports to an oversight body, the GHOS, which comprises central bank governors and (non-central bank) heads of supervision from member countries. The current Chair of the GHOS is François Villeroy de Galhau, Governor of the Banque de France. The Basel Committee reports to the GHOS and seeks its endorsement for major decisions. In addition, the Committee looks to the GHOS to approve the Basel Committee Charter and any amendments to it, to provide general direction for the Basel Committee work programme, and to appoint the Committee Chair from among its members.
The stated mandate of the Basel Committee is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.3 Its main focus has traditionally been on internationally active banks, although the Committee's standards have been applied more widely, particularly in the European Union.
The Basel Committee formulates standards and guidelines and recommends statements of best practice. The rules and guidance adopted by the Basel Committee have no legal force4 and their authority derives from the commitment of banking supervisors in member countries (and, increasingly, non-member countries) to implement the requirements agreed by the Committee. The Basel Committee has adopted standards on a wide range of issues relevant to banking supervision, including banks' foreign branches, core principles for banking supervision (revised in September 2012), core principles for effective deposit insurance, internal controls, supervision of cross-border electronic banking and risk management guidelines for derivatives.
However, in recent years, the Basel Committee has devoted most of its attention to regulatory capital, principles for effective banking supervision and cross-border banking supervision. It has also been active in the important areas of liquidity risk and developing frameworks for the recovery or orderly wind-down of internationally active banks that get into financial difficulties.
The Basel Committee's work is largely organised around groups, working groups and taskforces. Groups report directly to the Committee and form part of its permanent internal structure. Working groups consist of experts who support the technical work of Committee groups. Taskforces comprise technical experts from Committee members and are created to undertake specific tasks for a limited time; high-level taskforces serve a similar purpose.
The Basel Committee's work is organised under five main groups:
- the Supervision and Implementation Group, which concentrates on the implementation of the Committee's guidance and standards and the advancement of improvements in banking supervision. The Supervision and Implementation Group is also responsible for the implementation of Basel III;
- the Policy Development Group, which is charged with identifying issues of importance to banking supervision as they emerge, and with developing policies for the Basel Committee that promote a sound banking system and high supervisory standards;
- the Macroprudential Supervision Group, which monitors and reports to the Committee on systemic risk and global developments that relate to macroprudential and systemically important banks' supervision policy;
- the Accounting Experts Group, which is concerned with international accounting and auditing standards and, in particular, with ensuring that those standards promote sound risk management at financial institutions, support market discipline through transparency, and reinforce the safety and soundness of the banking system; and
- the Basel Consultative Group, which provides an interface between the Basel Committee and non-member banking regulators.
ii The Basel framework
The Basel Committee on Banking Supervision has its origins in the financial market turmoil that followed the breakdown of the Bretton Woods system of managed exchange rates in 1973, which led to a number of banks across the globe incurring large foreign currency losses, with some forced to close as a result. In response to these and other disruptions in the international financial markets, the central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices, later renamed the Basel Committee. At the outset, one important aim of the Committee's work was to close gaps in international supervisory coverage so that no foreign banking establishment would escape supervision, and supervision would be adequate and consistent across member jurisdictions. A number of principles and standards on sharing supervisory responsibility and exchanging information between the regulatory authorities followed, laying down the foundation for supervision of internationally active banks.
Once this initial framework was in place, capital adequacy became the main focus of the Committee's activities. In 1988, a capital measurement system (commonly referred to as the Basel Capital Accord (Basel I)) was approved by the G10 governors and released to banks. Basel I comprised a set of international banking regulations setting out the minimum capital requirements aimed at minimising credit risk and creating a bank asset classification system. Over the next few years the framework evolved with several amendments and additions introduced to it, including the Market Risk Amendment, which took effect at the end of 1997. One important aspect of the Market Risk Amendment was that banks were, for the first time, allowed to use internal models (value-at-risk models) as a basis for measuring their market risk capital requirements, subject to quantitative and qualitative standards.
In June 1999, the Basel Committee issued a proposal for a new capital adequacy framework to replace Basel I. This led to the release of the Revised Capital Framework in June 2004 (generally known as Basel II), which remained the prudential regulatory framework promulgated by the Basel Committee until the financial crisis of 2007 to 2009.
Basel II was based on three pillars that were intended to be interdependent and mutually reinforcing and remain applicable today:
- Pillar 1 (minimum capital standards) set out the minimum capital requirements for banks;
- Pillar 2 (the supervisory review process) set out standards for banking supervisors in applying Basel II. In particular, it required that supervisors should have the power to compel banks to hold capital in excess of the 8 per cent minimum ratio set under Basel II, where this was justified. Standards were also established for the control of interest rate risk in a bank's loan portfolio, and to capture other risks not specifically covered under Pillar 1 (e.g., certain risks arising out of securitisations); and
- Pillar 3 (market discipline) provided for extensive disclosure of information to the market. The intention was that pressure from a bank's counterparties, analysts and rating agencies would serve to reinforce the minimum capital standards and ensure that banks carried on their business prudently. As was seen in the 2007–2009 financial crisis, it is highly debatable whether this aim was achieved. A revised Pillar 3 standard was published in December 2018 and is due for adoption by January 2023. In November 2019, the Committee published a consultative document on Pillar 3 disclosures related to the market risk framework finalised in January 2019. This is now on hold.
iii The structure of Basel II
Basel II provided a choice of approaches for determining capital requirements. For example, it set out three ways of calculating credit risk and up to four ways of determining the capital charge for operational risk. Generally, banks were free to choose between more complex methodologies with the potential for capital savings, and simpler approaches that generally led to a higher capital charge, but with lower operational and systems costs.
The focus of Basel II was on internationally active banks. However, the Basel Committee considered that the principles developed in Basel II, when taken with the reforms described later in this chapter, were suitable as an international benchmark.
Overall, Basel II was considerably more risk-sensitive (and hence procyclical) than its predecessor, Basel I. It also marked a shift away from the approach in Basel I of allocating specific capital charges for particular exposures in favour of greater reliance on banks' internal models and methodologies and external credit ratings. It was the intention of the Basel Committee that most sophisticated banks would adopt internal models to determine their capital requirements once they had the operational capacity to do so. Given the perceived failures by credit rating agencies in the run-up to the financial crisis, more recently the focus on external ratings under the standardised approach has been challenged.
Basel II underwent a number of developments prior to the financial crisis. In July 2005, the Basel Committee published a document addressing the treatment of banks' trading books under Basel II, which it had prepared in conjunction with the International Organization of Securities Commissions (IOSCO). The Basel Committee integrated this document into Basel II, and published a revised consolidated text of Basel II in June 2006.
III FROM BASEL II TO BASEL III
i The limitations of Basel II
It is fair to say that critics of Basel II, who blamed aspects of the financial crisis on features of that regime, did not properly take into account the fact that when the crisis arose, Basel II had not been implemented at all in a number of key jurisdictions, and had not long been implemented in others. The main requirements of Basel II came into force on 1 January 2007, with the most advanced methodologies only being implemented in January 2008. On the other hand, it is reasonable to conclude that, had Basel II been implemented in more countries for a longer period of time before the financial crisis, it is unlikely that the regime would have prevented many aspects of the crisis as they emerged. Hindsight is easy to employ, however, and there are many who argue that the crisis might not have been so severe had Basel II been implemented earlier.
In response to the crisis, the Basel Committee chose to build on Basel II incrementally rather than fundamentally change it. A consensus emerged that there were a number of deficiencies in the Basel II framework that needed to be addressed, including:
- insufficient capital in the banking system, often of inadequate quality;
- an excessive focus on capital at the expense of liquidity and leverage;
- a failure by firms and supervisors to see the overall picture;
- inadequate capital requirements in respect of banks' trading books (as well as capital arbitrage between the trading and banking books); and
- deficiencies in respect of the treatment of securitisations.
ii The Basel Committee's July 2009 reform package (Basel 2.5)
The first package of changes to Basel II following the financial crisis was adopted by the Basel Committee in July 2009, and included the following:
- increasing the capital charges for securitisation exposures, including introducing a new higher capital charge for resecuritisations (e.g., collateralised debt obligations and certain conduits) as well as increasing the capital charge for certain liquidity facilities. Banks that invest in securitisations are required to carry out due diligence on the underlying asset pool, and if they fail, or are unable to do so, they are required to deduct such positions from their capital;
- eliminating the regulatory arbitrage under which banks that chose to hold securitisation exposures in their trading book could avoid higher capital charges: instead, capital requirements for such exposures have been broadly aligned across the banking and trading books, based on the former's requirements;
- improvements to banks' models used to calculate capital charges for non-securitisation positions held in the trading book through a stressed value-at-risk calculation, which took into account a defined observation period relating to significant losses. The intention is to capture the risks of low-frequency, high-impact tail events (colloquially, black swan events), as well as significant market movements over a sustained period; and
- the introduction of an incremental risk capital charge to address the effect of credit risk migration (i.e., ratings downgrades) on a bank's holdings of debt instruments in the trading book. This reflects the fact that trading book losses during the financial crisis did not principally result from defaults, but from credit migrations combined with the widening of credit spreads as a result of a loss of liquidity. Subsequently, the Basel Committee published substantial changes to this treatment, which will apply from 1 January 2023.
The Basel Committee's July 2009 reform package initially addressed the treatment of securitisation and trading book exposures. However, the Committee recognised the need for a comprehensive set of measures to strengthen the regulation, supervision and risk management of the banking sector. The result was a consultation paper entitled Strengthening the Resilience of the Banking Sector, published on 17 December 2009. This led to the adoption of a new, comprehensive reform package on design of the capital and liquidity requirements (Basel III) in 2010 (see below). Since then, the main focus of the Committee has been on finalising Basel III.
iii Other work
The Basel Committee has also engaged in work in the following areas.
Systemically important financial institutions
The Basel Committee has undertaken work with the FSB to implement an integrated approach to systemically important banks. On 28 September 2011, the Basel Committee finalised details of the additional capital buffer that will apply to global systemically important banks (G-SIBs). G-SIBs will be required to hold an additional buffer (above the Basel III requirements) of between 1 and 2.5 per cent of common equity, depending on the bank's systemic importance (the percentages being of risk-weighted assets (RWAs)). An initially empty 3.5 per cent bucket will be imposed on G-SIBs that become even more systemically important as a disincentive to such behaviour. Final rules for G-SIBs were published on 2 November 2011. In October 2012, the Basel Committee adopted a framework for domestic systemically important banks (D-SIBs), which builds on the rules adopted for G-SIBs. The framework is composed of 12 principles and gives states considerable national discretion to reflect the characteristics of their domestic financial system. D-SIBs will be required to meet higher capital requirements to reflect their degree of systemic importance. An updated assessment methodology for G-SIBs was published by the Basel Committee in July 2013. The latest FSB list of banks identified as G-SIBs using the Basel Committee's methodology was issued in November 2019 (the list will next be updated in November 2020). This was accompanied by further information related to the 2019 assessment of G-SIBs published by the Basel Committee. In March 2017, the Basel Committee consulted on a revised framework for G-SIBs. The proposed changes include removal of the cap on the substitutability category, expansion of consolidation to include insurance subsidiaries, introduction of a trading volume indicator, revisions to the disclosure requirements and transitional provisions, and are now scheduled to be implemented in January 2023.
Work continues internationally and in the EU on the feasibility of developing debt write-down and conversion of debt to equity to enable a failing bank to continue (whether temporarily or permanently) as a going concern. The Basel Committee published its requirements for enhanced loss absorbency for additional Tier 1 and Tier 2 capital instruments on 13 January 2011. These requirements are summarised in Section IV. The EU has implemented its own approach to bail-in through the Bank Recovery and Resolution Directive and the Single Resolution Mechanism Regulation.
In December 2019, the Basel Committee published a discussion paper on designing a prudential treatment for crypto-assets. According to the Committee:
the growth of crypto-assets and related services has the potential to raise financial stability concerns and increase risks faced by banks. Crypto-assets are an immature asset class given the lack of standardisation and constant evolution. Certain crypto-assets have exhibited a high degree of volatility, and present risks for banks, including liquidity risk; credit risk; market risk; operational risk (including fraud and cyber risks); money laundering and terrorist financing risk; and legal and reputation risks.
According to the discussion paper:
[S]hould the Committee decide to specify a prudential treatment of crypto-assets, it will issue a consultation paper detailing its proposals and seek further input from stakeholders. Any specified treatment would constitute a minimum standard for internationally-active banks. Jurisdictions would be free to apply additional and/or more conservative measures if warranted.
According to a statement published on 13 March 2020, if a bank is authorised and decides to acquire crypto-asset exposures or provide related services, the following should be adopted at a minimum.
- Due diligence: before acquiring exposures to crypto-assets or providing related services, a bank should conduct comprehensive analyses of the risks noted above.
- Governance and risk management: the bank should have a clear and robust risk management framework that is appropriate for the risks of its crypto-asset exposures and related services. Given the anonymity and limited regulatory oversight of many crypto-assets, a bank's risk management framework for crypto-assets should be fully integrated into the overall risk management processes, including those related to anti-money laundering and combating the financing of terrorism and the evasion of sanctions, and heightened fraud monitoring.
- Disclosure: a bank should publicly disclose any material crypto-asset exposures or related services as part of its regular financial disclosures and specify the accounting treatment for such exposures, consistent with domestic laws and regulations.
- Supervisory dialogue: the bank should inform its supervisory authority of actual and planned crypto-asset exposure or activity in a timely manner.
- In considering how to specify a prudential treatment for crypto-assets, the Committee was guided by the following general principles:
- same risk, same activity, same treatment: a crypto-asset and a 'traditional' asset that are otherwise equivalent in their economic functions and the risks they pose should not be treated differently for prudential purposes;
- simplicity: crypto-assets are currently a relatively small asset class globally and are not widely used, but there is the potential for certain types of crypto-assets to become systemically important. The design of the prudential treatment of crypto-assets should, therefore, be simple and flexible in nature; and
- minimum standards: any specified prudential treatment of crypto-assets by the Committee would constitute a minimum standard. Jurisdictions would be free to apply additional or more conservative measures if warranted.
As such, jurisdictions that currently prohibit their banks from having any exposures to crypto-assets would be deemed compliant with any potential global prudential standard.
iv Consolidated text of Basel III
On 16 December 2019, the Basel Committee published in modular form its consolidated Basel III Framework. The framework brings together all of the Basel Committee's global standards for the regulation and supervision of banks. The Basel Framework is a consolidated version of the full set of standards of the Basel Committee.
IV BASEL III: CAPITAL REQUIREMENTS
On 12 September 2010, the Basel Committee announced its agreement on the new Basel III minimum capital requirements for banks, which significantly increased the amount of common equity that banks must hold. The detailed requirements were published on 16 December 2010 and revised on 1 June 2011. Further guidance on the new capital definitions and the requirements for counterparty credit risk was published in the form of frequently asked questions in September 2017.
The Basel III reforms aim to strengthen the regulation, supervision and risk management of the banking sector, and are designed to target both microprudential regulation and macroprudential risks. More specifically, Basel III extends the framework in a number of ways, including introducing the following additional measures:
- a capital conservation buffer, an additional layer of common equity that, when breached, restricts distribution of capital to help protect the minimum common equity requirement (see subsection iv for further details);
- a countercyclical capital buffer, which places restrictions on participation by banks in country-wide credit booms with the aim of reducing their losses in credit busts (see subsection v for further details);
- a leverage ratio (a minimum amount of loss-absorbing capital relative to all of a bank's assets and off-balance sheet exposures regardless of risk weighting) (see subsection vi for further details);
- two liquidity requirements: a liquidity coverage ratio (LCR), a minimum liquidity ratio intended to provide enough cash to cover funding needs over a 30-day period of stress; and a net stable funding ratio (NSFR), a longer-term ratio intended to address maturity mismatches over the entire balance sheet (see Section V for further details); and
- additional proposals for systemically important banks, including requirements for supplementary capital, augmented contingent capital and strengthened arrangements for cross-border supervision and resolution.
i New definitions of capital
Much greater common equity
Under Basel II, banks were required to hold common equity equal to 2 per cent of RWAs (although, in practice, most banks held more). Regulatory deductions were applied to total Tier 1, or total capital, so certain hybrid instruments and preference shares, as well as some subordinated debt, could be used to cover such deductions.
Under Basel III, the common equity component of capital (including reserves) increased to 4.5 per cent and the total Tier 1 ratio to 6 per cent. For banks structured as joint-stock companies, the equity requirement must be met solely with ordinary shares. New rules on deductions from capital have been promulgated.
Non-core Tier 1 capital
Detailed requirements were adopted in respect of additional (i.e., non-core) Tier 1 capital, which has been effectively limited to 1.5 per cent of RWAs. These instruments must be perpetual, and may only be called after five years and with prior supervisory consent. Interest payments must be made out of distributable profits and, if the instrument is classified as a liability for accounting purposes, it must have principal loss absorption through either conversion to common equity or write-down of principal. The trigger level for write-down or conversion must be at least 5.125 per cent, although banks can choose (or be required by their regulator) to apply a higher trigger. The European Union also applies this requirement to equity-accounted instruments (e.g., most preference shares).
Other tiers of capital
Basel III abolished innovative Tier 1 and Tier 3 capital, and harmonised Tier 2 capital, based on lower Tier 2 capital under Basel II. Recognition of Tier 2 capital is effectively limited to 2 per cent of RWAs. Under Basel II, the limit was 4 per cent.
Under Basel III, all Tier 1 and Tier 2 capital instruments (other than common equity) must include a clause in their terms and conditions requiring the instrument to be written off on the occurrence of a trigger event (i.e., the bank ceases to be a going concern or receives an injection of public sector capital) if there is no statutory scheme under which such instruments can be required to absorb losses. The only compensation for such write-off that may be provided to investors is the issue of new ordinary shares (or the equivalent for mutuals).
The new requirements for common equity, as well as the other minimum ratios, were phased in until 2019.
Detailed rules set out the contribution that third-party minority interests in group companies can make towards consolidated capital.
ii Grandfathering of existing capital instruments
The Basel III agreement included a detailed approach to the grandfathering of existing instruments. It should be noted that the approach to grandfathering in the European Union under the Capital Requirements Regulation5 is different. Under Basel III:
- non-compliant capital instruments issued on or after 12 September 2010 are not grandfathered. It follows that any such instruments needed to satisfy the Basel III requirements for Tier 1 and Tier 2 capital in full if they were to be eligible from 1 January 2013. An exception to this rule is available for non-core Tier 1 and Tier 2 capital instruments that did not meet the requirement for write-down or conversion to common equity at the point of non-viability if issued before 1 January 2013. Such non-compliant capital instruments are eligible for grandfathering;
- capital instruments that no longer qualify as non-common equity Tier 1 or Tier 2 capital under Basel III are being phased out over a 10-year period that started on 1 January 2013. The base is fixed at the nominal amount outstanding on 1 January 2013. The level of recognition was capped at 90 per cent on 1 January 2013, and is being reduced by 10 percentage points in each subsequent year. Recognition of such capital instruments will be fully phased out by 1 January 2022; and
- recognition of instruments with an incentive to redeem (e.g., a step-up in their coupon if redemption does not take place on a certain date) will be phased out at their effective maturity date. This will catch most existing innovative Tier 1 issues as well as Tier 2 issues with a step-up.
iii Deductions from capital
Basel III provides for a harmonised set of deductions from capital, most of which are made from common equity. The list of deductions includes:
- goodwill and other intangibles;
- deferred tax assets that rely on future profitability to be realised;
- cash-flow hedge reserve relating to hedging of items not fair valued on the balance sheet;
- shortfall of provisions to expected losses;
- cumulative gains and losses owing to changes in a bank's own credit risk on fair-valued liabilities (including derivatives);
- defined benefit pension fund assets and liabilities;
- investments in own shares;
- reciprocal cross-holdings; and
- significant investments in the capital of banking, financial and insurance entities outside of the consolidated group.
These deductions are made under a corresponding deduction approach, so the deduction is from the element of capital that it would have constituted had it been issued by the bank.
The new approach to deductions started on 1 January 2014 (i.e., one year after the implementation of the new requirements for common equity) and was phased in progressively, coming fully into effect on 1 January 2018.
iv Capital conservation buffer
A key element of Basel III is the requirement that banks hold a capital buffer on top of the minimum capital requirements. This buffer is not intended to form part of the minimum capital requirement. It follows that a bank that fails to hold sufficient common equity to satisfy the buffer (but meets the other minimum capital requirements) will not be subject to restrictions on its operations, and will not be at risk of resolution or the withdrawal of its banking licence. However, banks that operate within the buffer are subject to restrictions on the distribution of capital, including the payment of dividends and staff bonus payments, with the result that the buffer is likely to be treated by banks as an effective floor. According to the Basel Committee:
- the purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distribution; and
- banks will, of course, be able to rebuild capital buffers through raising new capital. However, in the Committee's view, it is not acceptable for banks that have depleted their capital buffers to use future predictions of recovery as justification for maintaining generous distributions to shareholders, other capital providers and employees.
The restrictions on distributions, share buy-backs and staff bonus payments are as follows.
|Common Equity Tier 1 (%)||Minimum capital conservation ratio (expressed as a percentage of earnings)|
|Between 4.5 and 5.125||100|
|Between 5.125 and 5.75||80|
|Between 5.75 and 6.375||60|
|Between 6.375 and 7||40|
|More than 7||Zero|
On 20 March 2020, the Basel Committee announced:
The Basel III framework includes capital and liquidity buffers that are designed to be used in periods of stress. These include the capital conservation buffer and, by extension, the countercyclical capital buffer and buffers for systemically important banks. . . . Using capital resources to support the real economy and absorb losses should take priority at present over discretionary distributions.
This is a clear encouragement to national banking regulators to restrict dividends and staff bonus payments.
The requirements apply on a consolidated basis, although supervisors are able to apply the regime at a solo level to conserve capital in specific parts of the group. The new capital buffer requirements came into force on 1 January 2016 (i.e., after the new common equity and Tier 1 capital requirements were required to have been fully implemented), but once again a transitional period applied, which has now expired.
v Countercyclical capital buffer
The countercyclical capital buffer is intended to ensure that capital requirements take account of the macroprudential environment in which banks operate. It is applied when excess credit growth is associated with a build-up of system-wide risk. It is based on the following elements:
- each regulator will decide, based on credit conditions in its country, when to activate the buffer. Once activated, the buffer will take the form of an add-on to minimum capital requirements. At all other times the buffer will be zero;
- a decision to impose a buffer will be announced up to 12 months before it takes effect to give banks time to adjust (if necessary, by increasing capital or reducing lending). Reductions to the buffer will take effect immediately when announced;
- banks with purely domestic exposure will be subject to the full amount of the buffer; and
- banks that are internationally active will apply an add-on depending on the geographical location of their credit exposures.
The Basel Committee has stated that setting this buffer is likely to be appropriate where the ratio of credit to gross domestic product (GDP) exceeds its long-term trend. However, as this measure is not always a clear indicator of excessive credit growth, judgement will need to be applied.
The range of the buffer will generally be between zero and 2.5 per cent, and will be added to the capital conservation buffer. Unlike the capital conservation buffer, this additional buffer may be satisfied by common equity or other fully loss-absorbing capital, although until the Basel Committee has issued further guidance on the requirements for such loss-absorbing capital, the buffer will need to be met with common equity. According to the Committee, countries that experience excessive credit growth should consider accelerating the build-up of the capital conservation buffer and the countercyclical capital buffer.
In December 2010, the Basel Committee published guidance for national authorities operating the countercyclical capital buffer, and in October 2015, the Committee published further guidance on the countercyclical capital buffer in the form of frequently asked questions.
In November 2019, the Committee issued guiding principles for the operationalisation of a sectoral countercyclical capital buffer. The guiding principles are defined by tailoring the broad-based countercyclical capital buffer principles on a sectoral basis. The guiding principles are not included in the Basel standards and are only applicable for those jurisdictions that choose to implement them on a voluntarily basis.
The announcement by the Basel Committee in March 2020 on the ability of banks to resort to the countercyclical capital buffer to support the real economy and absorb losses is noted in subsection iv.
vi Leverage ratio
The years leading up to the 2007–2009 financial crisis were characterised by a significant increase in the leverage of financial institutions, enhancing the (apparent) profitability of the financial sector, but also resulting in a greater probability of individual firms failing as well as increased systemic risk generally. Basel III's leverage ratio is defined as the capital measure (the numerator) divided by the exposure measure (the denominator), and is expressed as a percentage. The capital measure is currently defined as Tier 1 capital, and the minimum leverage ratio is 3 per cent. Accounting values will generally be applied. More detailed requirements for the leverage ratio, including its disclosure from 1 January 2015, were published by the Committee in January 2014. In July 2015, the Committee published guidance on the leverage ratio in the form of frequently asked questions.
Supervisors measured the leverage ratio between 1 January 2013 and 1 January 2017. Banks were required to disclose their leverage ratio from 1 January 2015. In December 2017, the Committee published various refinements to the definition of the leverage ratio exposure method. These include modifying the way in which derivatives are reflected in the exposure measure and updating the treatment of off-balance sheet exposures. The new definitions come into force on 1 January 2023.
In December 2017, the Basel Committee also published a revised leverage ratio framework for G-SIBs, which will come into force in January 2023.
In March 2019, the Committee and IOSCO published a statement on the final implementation phases of the margin requirements for non-centrally cleared derivatives.
vii Counterparty credit risk
Basel III brought about a number of improvements to the treatment of counterparty credit risk with effect from 1 January 2013. The changes included the following:
- banks that use an internal model to calculate their counterparty credit risk on over-the-counter (OTC) derivatives, repurchase agreements and securities financing transactions are required to use stressed inputs to address the risk of the model underestimating low-frequency, high-impact events;
- a new capital charge was introduced to cover mark-to-market losses associated with a deterioration in the creditworthiness of counterparties;
- requirements have been imposed to address wrong-way risk (i.e., where an exposure to a counterparty is adversely correlated to the credit quality of that counterparty);
- risk weights on exposures to large financial institutions are subject to a multiplier to reflect the fact that during the financial crisis, the credit quality of financial institutions deteriorated in a more highly correlated manner than that of non-financial counterparties;
- standards for collateral management and margining have been strengthened. Banks with large and illiquid derivatives exposures have to apply a longer margining period when determining their capital requirements;
- greater haircuts apply to securitisation collateral, with a prohibition on recognition of resecuritisation exposures as collateral to reduce counterparty exposures; and
- harmonised capital charges for exposures to central counterparties (CCPs) have been introduced distinguishing between qualifying and non-qualifying central counterparties.
viii Revised standardised approach (January 2023)
In December 2014, the Basel Committee published a consultation document on revisions to the standardised approach to credit risk. In December 2015, the Committee published a second consultation document, with the aim of addressing the issues raised by respondents with respect to the initial proposal. The new standardised approach was published in December 2017 and is due to be implemented by 1 January 2023. Securitisation exposures are addressed in the Basel securitisation standard. The key aspects of the proposals are.
- Exposures to sovereigns and public sector entities are unchanged from Basel II (which, given the 2010–2011 eurozone crisis, and the probable increase in government indebtedness due to national responses to covid-19, may not be justifiable).
- Exposures to banks will be risk-weighted based on the following hierarchy: external credit risk assessments, and the standardised credit risk assessment approach for unrated banks as well as jurisdictions that do not allow the use of external credit ratings. Under the latter approach, banks are allocated to three risk-weight buckets or grades ranging from 40 to 150 per cent for the base risk weight. Compared with Basel II, some of the risk weights have been recalibrated. A stand-alone treatment for covered bonds has also been introduced.
- Exposures to corporates (including insurers) differentiate between general corporate exposures and specialised lending exposures. The former will be risk-weighted between 20 per cent and 150 per cent; unrated corporates will be risk-weighted at 100 per cent. Jurisdictions that do not allow the use of external ratings may allow a 65 per cent risk weight for exposures to investment grade borrowers (as defined in the standard). Unrated small and medium-sized enterprise exposures will generally receive a risk weight of 85 per cent. Specialised lending is now divided into three categories: project finance, object finance and commodities finance. Issue-specific (not issuer-specific) ratings may be used where available and permitted. Otherwise, object and commodities finance will be risk-weighted at 100 per cent and project finance at 130 per cent during the pre-operational phase, and at 80 per cent or 100 per cent during the operational phase.
- A new risk class is introduced for subordinated debt, equity and other capital instruments not deducted from regulatory capital or risk weighted at 250 per cent under Basel III (i.e., threshold deductions). Speculative unlisted equity exposures will be risk weighted at 400 per cent and all other equity holdings at 250 per cent.
- A more granular treatment will apply to residential real estate, distinguishing between different types of portfolio.
- A new treatment for commercial real estate will be introduced based on the loan-to-value ratio, and whether repayment is materially dependent on cash flows generated by the property.
ix Internal ratings-based approach (January 2023)
Basel II introduced two model-based approaches for the calculation of credit risk in the banking book: the foundation internal ratings-based (IRB) approach and the advanced IRB approach. New requirements for the IRB approach were published in December 2017 and will come into effect on 1 January 2023 (at the same time as the revisions to the standardised approach). According to the Basel Committee, the 2007–2009 financial crisis highlighted a number of shortcomings in the use of internal models, including the excessive complexity of IRB approaches, the lack of comparability in banks' internally modelled capital requirements and the lack of robustness in modelling certain asset classes. The intention is to remove own-estimates of loss given default and exposure at default for those portfolios that the Committee considered were important sources of RWA variability.
As a result, the availability of the IRB approach will be significantly curtailed. In summary, the position under Basel III, when finally implemented, will be as follows:
- large and mid-sized corporates (consolidated revenues of greater than €500 million): only the foundation IRB approach will be available;
- banks and other financial institutions: only the foundation IRB approach will be available;
- equities: no IRB approach will be available; and
- specialised lending: the same approaches will be available as under Basel II.
The advanced IRB approach remains available for sovereign, small corporate, specialised lending and retail lending. Where available, Basel III will introduce revised floors, depending on the type of transaction (except for sovereigns). However, the Committee published a discussion paper in December 2017 on the regulatory treatment of sovereign exposures. This included a proposal (among others) that the IRB approach for sovereign exposures be withdrawn. In November 2019, the Committee reviewed the feedback received to the discussion paper, and further evaluated the merits and demerits of pursuing such measures. The Committee is further seeking the views of interested stakeholders on three potential disclosure templates, which would require banks to disclose their sovereign exposures and risk-weighted assets by jurisdictional breakdown, by currency breakdown, and according to the accounting classification of the exposures. According to the paper, '[t]he Committee has not reached a consensus to make any changes to the regulatory treatment of sovereign exposures at this stage. For this reason, these potential disclosure templates would be voluntary in nature, with jurisdictions free to decide whether or not to require their banks to implement them.'
x Credit valuation adjustment risk framework (January 2023)
In December 2017, the Basel Committee published revisions to the framework addressing mark-to-market losses as a result of the deterioration of the creditworthiness of counterparties (credit valuation adjustment (CVA) risk). The main changes are as follows: enhancement of the risk sensitivity of the framework and removal of the internal models approach to CVA risk (instead there will be a standardised approach and a basic approach); and improvement of consistency with new market risk charges (see subsection xi). A consultation paper on changes was published on 28 November 2019 but no response has been published in accordance with the Committee's current policy of postponing responses to consultation.
xi Revised market risk framework (January 2023)
In 2009, the Basel Committee introduced amendments to the Basel II market risk framework to address the weaknesses in the capital framework for trading activities that became apparent during the crisis: this was updated in December 2010. In addition, the Committee initiated a review of the trading book with the aim of tackling a number of structural flaws in the market risk framework that were not addressed by the amendments introduced in 2009. This work has led to the revised market risk framework. Following a number of consultation papers and several quantitative studies, the Basel Committee issued standards on minimum capital requirements for market risk on 14 January 2016. The new framework takes effect in 2023. In January 2017, the Basel Committee published its first set of frequently asked questions on market risk capital requirements. In January 2019, the Basel Committee revised its proposals for market risk in certain respects.
In summary, the revisions focus on three key areas.
- A revised boundary between the banking book and the trading book to reduce incentives for a bank to arbitrage its regulatory capital requirements between the two regulatory books, while continuing to respect banks' risk management practices. In particular, stricter limits and capital disincentives are applied to the transfer of instruments between the banking book and trading book, which will now be applied at a trading desk level and not across the bank.
- A revised internal models approach for market risk with more coherent and comprehensive risk capture. In addition, the new approach introduces a more rigorous model approval process.
- A revised standardised approach for market risk that facilitates more consistent and comparable reporting on market risks across banks and jurisdictions, and is suitable for banks with limited trading activity while also sufficiently risk sensitive to serve as a credible fall-back for, as well as a floor to, the internal models approach.
The reasons for the changes are essentially fourfold:
- existing incentives for banks to take on tail risk: this is inherent in value-at-risk (VaR) models;
- inability to capture the risk of market illiquidity: in times of market stress, the market is likely to become illiquid when the banking system holds similar positions;
- inability to capture adequately the credit risk inherent in trading positions; and
- excessive recognition of the risk-reducing effect of hedging and diversification.
The basis of the Market Risk Amendment is the new internal models approach, which replaces VaR models. The new models-based metric is founded on three components: expected shortfall, which determines capital requirements for those factors for which a sufficient amount of data is available; a non-modellable risk factor for factors for which there is insufficient data, and a default risk requirement to determine the capital requirement associated with default risk for credit and equity positions.
The new standardised approach for market risk is based on a sensitivities-based method, similar to a stress test. The framework specifies a set of risk factors considered to be the main market variables that affect the value of banks' trading portfolios; risk weights applicable to those risk factors calibrated to stressed market conditions; and a methodology for aggregating the losses calculated for each risk factor to determine the loss for the scenario at the portfolio level.
The sensitivities-based method comprised delta risk (the potential loss due to a small change in the price of an equity or a commodity), vega risk (the potential loss due to a change in the implied volatility of an option) and curvature risk (the potential incremental loss beyond delta risk when large movements occur). To this is added a standardised default capital requirement and a residual risk add-on for other risks not adequately addressed (e.g., exotic derivatives).
In January 2019, the Basel Committee adopted a number of changes to the market risk framework based on feedback from banks. The main changes are as follows:
- clarifications to the allocation of positions between the trading book and banking book;
- revisions to the internal models approach: these include, in particular, a traffic light system for distinguishing between well and poorly performing models, and a more risk-sensitive approach to non-modellable risk factors;
- reductions to the operational burdens of the new standardised approach; and
- retention of the current standardised approach as a simplified alternative to the revised standardised approach subject to the application of specific scalars.
xii Operational risk (January 2023)
According to the Basel Committee, the 2007–2009 financial crisis demonstrated flaws with the Basel II operational risk framework: basically, capital requirements for operational risk proved insufficient to cover losses suffered by some banks while the nature of those losses, such as those caused by misconduct, highlighted the difficulties associated with using internal models to estimate capital requirements. All existing operational risk approaches in Basel II will be withdrawn. Instead, a new standardised approach based on two components will be introduced: a measure of a bank's income and a measure of a bank's historical losses. Operational loss will be calculated from 2023 as the multiplier of the business indicator component and an internal loss multiplier. The business indicator component is the sum of three components: (1) the interest, leases and dividends component, (2) the services component and (3) the financial component. The internal loss multiplier (ILM) is a function of the business indicator component and the loss component, where the latter is equal to 15 times a bank's average historical losses over the preceding 10 years. It increases as the latter increases, although at a decreasing rate. At national discretion, the ILM may be set at 1, with the result that solely the business indicator component would drive the operational risk capital calculation.
xiii Interest rate risk in the banking book
Interest rate risk in the banking book is part of the Pillar 2 framework of Basel II and subject to 2004 guidance. In April 2016, the Committee decided to update the principles to reflect changes in market and supervisory practices that will remain within Pillar 2. The key updates to the principles are:
- greater guidance on expectations for a bank's management process, in particular the development of shock and stress scenarios, the key behavioural and modelling assumptions, and the internal validation process;
- updating disclosure requirements to promote greater consistency, transparency and comparability;
- updating the supervisory process; and
- Section IV of the standard sets out a standardised framework that supervisors could require banks to follow, or a bank could choose to adopt.
Banks were expected to implement the standard by 2018.
The Basel Committee has undertaken a fundamental review of the securitisation framework, including an alternative treatment for simple, transparent and comparable (STC) securitisations. The new framework came into force in 2018. The changes reflect the following perceived deficiencies in the Basel II securitisation framework:
- mechanistic reliance on external ratings;
- excessively low risk weights for high-rated securitisations;
- excessively high risk weights for low-rated senior securitisation exposures;
- cliff effects; and
- generally insufficient risk sensitivity.
The new framework is based on a hierarchy that places the internal ratings-based approach at the top followed by the external ratings-based approach (where permitted in the jurisdiction) and then the securitisation standardised approach. A slightly modified (and more conservative) version of the standardised approach is the only approach available for resecuritisation exposures. The STC framework increases the risk sensitivity of the securitisation framework but, owing to its potential to introduce significant operational burdens, jurisdictions retain the option not to implement it. The Basel STC criteria build on the July 2015 Basel and IOSCO criteria with certain enhancements. The EU has implemented its own standards.
In July 2017, the Committee published a consultation document on the capital treatment for STC securitisations. This sets out additional guidance and requirements for the purpose of applying a preferential regulatory capital treatment for banks acting as investors in, or as sponsors of, STC short-term securitisations, typically in asset-backed commercial paper (ABCP) structures. The additional guidance and requirements include that investors have access to key monthly information on the performance and key characteristics of the ABCP structure; the redemption risk of the underlying assets is addressed from the sponsor's perspective; and the transactions funded by the conduit have an enforceable legal structure and that the relevant information is disclosed by the sponsor to investors.
xv Basel I floor (output floor)
Basel II introduced a capital floor based on Basel I capital requirements of 80 per cent. Basel III will replace the Basel II floor with a new floor based on the use of standardised approaches to limit the benefit obtained by banks from the use of internal models. This will be introduced in stages from 1 January 2023 to 1 January 2028, rising from 50 per cent to 72.5 per cent.
V BASEL III: LIQUIDITY
The 2007–2009 financial crisis demonstrated the critical importance of liquidity. Before then, funding was easily available at relatively low cost. However, the rapid reversal of market sentiment demonstrated how quickly liquidity can evaporate, necessitating unprecedented central bank intervention to support the money markets and individual financial institutions. A similar situation may be occurring now because of covid-19. As a result, the Basel Committee has adopted two liquidity standards: the LCR and the NSFR. These liquidity requirements apply on a consolidated basis. Revisions to the LCR, incorporating amendments to the definition of high-quality liquid assets (HQLA) and net cash outflows, were adopted in January 2013. Details of the NSFR were published in 2014. In March 2020, the Basel Committee stated, 'HQLA stocks should be used to meet liquidity demands. Many supervisors are already encouraging banks to make use of these tools, which allow for flexibility in responding to the current circumstances.'
The LCR is an essential component of the Basel III reforms. It seeks to ensure that banks have an adequate stock of unencumbered high-quality liquid assets that can be converted into cash to meet their liquidity needs over a 30-day period under a significant liquidity stress scenario. The 30-day period is based on the assumption that this will be sufficient for corrective action to be taken by the bank, or for the bank to be resolved in an orderly manner without exposing the taxpayer to losses.
The LCR standard is as follows:
Stock of high-quality liquid assets
≥ 100 per cent
Total net cash outflows over a 30-day period
The LCR is based on two elements: a definition of high-quality liquid assets and a metric for calculating net cash outflows in a liquidity stress scenario.
ii High-quality liquid assets
The Basel Committee has identified two types of eligible assets: Level 1 and Level 2. Level 1 assets can be used to satisfy the LCR without limit, whereas Level 2 assets are capped at 40 per cent of the overall stock of assets held to satisfy the LCR. The calculation of the limit is adjusted to reflect the impact of secured funding transactions or collateral swaps.
Level 1 assets include cash, central bank reserves, claims on sovereigns and public sector entities assigned a zero per cent risk weight under the Basel II standardised approach, and claims on non-zero per cent risk-weighted sovereigns and public sector entities that are issued in the domestic currency of the relevant sovereign.
Following the January 2013 revision to the LCR, Level 2 assets are divided into Level 2A and Level 2B assets. Level 2A assets include claims on sovereigns and public sector entities risk-weighted at 20 per cent or below under Basel II, with corporate bonds and covered bonds that are rated AA- or better and have a proven record as a reliable source of liquidity during stressed market conditions. Level 2 assets are subject to a minimum 15 per cent haircut on their current market value. Level 2B assets comprise lower-quality assets and are capped at 15 per cent of overall liquid assets. This subclass includes corporate bonds rated A+ to BBB-, certain equities and residential mortgage-backed securities rated AA or higher. Haircuts of 15 per cent or 50 per cent apply to Level 2B assets. In addition, supervisors may choose to include within Level 2B assets the value of any committed liquidity facility provided by a central bank where this has not already been included in high-quality liquid assets.
iii Net cash outflows and inflows
Basel III sets out a metric with assumed outflows and inflows depending on the type of deposit or transaction, which was revised in January 2013. Some examples of outflows are set out in the following table.
|Transaction type||Assumed cash outflow (%)|
|Trade finance||Zero or 5|
|Fully insured retail deposits||3 or 5|
|Less stable retail deposits||10|
|Unsecured wholesale funding (small business)||5 or 10|
|Unsecured wholesale funding within operational relationships||25|
|Unsecured wholesale funding from non-financial corporates, sovereigns and public sector entities||20 or 40|
|Unsecured wholesale funding from others||100|
|Secured funding||Zero to 100 depending on collateral|
|Derivatives||Zero to 100 depending on collateral|
|Covered bonds and structured financing instruments||100|
|Asset-backed commercial paper, conduits, structured investment vehicles and other financing facilities||100|
|Committed credit and liquidity facilities||5 to 100 depending on borrower. The assumed outflow on committed liquidity facilities extended to corporates has been reduced from 100% to 30%|
The Basel Committee has also specified parameters for expected cash inflows. Some examples are given in the following table.
|Transaction type||Assumed cash inflow (%)|
|Maturing reverse repos and similar transactions||Zero to 100 depending on collateral|
|Lines of credit, liquidity facilities and similar arrangements||Zero|
|Retail and small business receivables||50|
|Receivables from non-financial wholesale counterparties||50|
|Receivables from financial institutions||100|
Of particular relevance to banks is the assumption that credit lines and other contingent funding arrangements provided by other financial institutions are assumed to be incapable of being drawn. The intention is to reduce the contagion risk of liquidity shortages at one bank causing shortages at other banks.
Inflows are capped at 75 per cent, requiring banks to hold liquid assets of at least 25 per cent of outflows.
The LCR was introduced in stages from 1 January 2015, reaching 100 per cent in 2019.
In January 2014, the Basel Committee published the final version of the disclosure requirements for the LCR. The Committee expects national authorities to give effect to the liquidity disclosure requirements relating to the LCR by no later than 1 January 2015. Banks were expected to comply with these requirements from the date of the first reporting period after 1 January 2015. In June 2017, the Committee published a second set of frequently asked questions on the LCR.
The Basel Committee was unable to finalise the detailed requirements for the NSFR in the initial text of Basel III though this has since been done. The objective of the NSFR is to establish a minimum amount of stable funding based on the liquidity characteristics of a bank's assets and activities over a one-year horizon. The aim is to ensure that longer-term assets are funded with at least a minimum amount of stable liabilities.
The requirement is as follows:
Available amount of stable funding
≥ 100 per cent
Required amount of stable funding
Stable funding is defined as the portion of those types and amounts of eligible equity and liability financing expected to be reliable sources of funds over a one-year period in conditions of extended stress. The required amount of this funding depends on a bank's assets, off-balance sheet liabilities and activities. The detailed definitions of stable funding were published in October 2014.
The amount of available stable funding is summarised in the following table.
|Category of stable funding||Percentage recognised (%)|
|Regulatory capital before the application of deductions||100|
|Any capital instrument that has an effective residual maturity of one year or more||100|
|Secured and unsecured borrowings and liabilities with effective residual maturities of one year or more||100|
|Stable deposits provided by retail and small business customers||95|
|Less stable deposits provided by retail and small business customers||90|
|Funding with a residual maturity of less than one year provided by non-financial corporate customers||50|
|Funding with a maturity of less than one year from sovereigns, public sector entities and multilateral and national development banks||50|
|Other funding (secured and unsecured) not included in the above with residual maturity of not less than six months and less than one year||50|
|All other categories including liabilities without a stated maturity||Zero|
The amount of stable funding required depends on the broad characteristics of the risk profile of a bank's assets and off-balance sheet liabilities. Some examples are as follows.
|Asset||Required stable funding (%)|
|Coins and banknotes||Zero|
|Central bank reserves||Zero|
|Unencumbered Level 1 assets||5|
|Unencumbered loans to financial institutions with residual maturities of less than six months where the loan is secured against Level 1 assets||10|
|Unencumbered Level 2A assets||15|
|All other unencumbered loans to financial institutions with a maturity of less than six months||15|
|Unencumbered Level 2B assets||50|
|High-quality liquid assets encumbered for a period of between six months and one year||50|
|Loans to financial institutions and central banks with a residual maturity of between six months and less than one year||50|
|Other assets not included in the above with a residual maturity of less than one year including loans to non-financial corporate clients, loans to retail customers, loans to sovereigns, central banks and public sector entities||50|
|Unencumbered residential mortgages with a residual maturity of one year or more attracting a risk weight of 35% or less under Basel II||65|
|Other unencumbered loans – excluding loans to financial institutions – with a residual maturity of one year or more and a risk weight of 35% or less||65|
|Unencumbered performing loans – excluding loans to financial institutions – with risk weights greater than 35% and a residual maturity of one year or more||85|
|Unencumbered securities that are not in default and do not qualify as Level 1 or Level 2 assets and exchange-traded equities||85|
|Physical commodities and gold||85|
|All other assets including assets encumbered for one year or more, net derivatives assets, non-performing loans and loans to financial institutions with a residual maturity of over one year||100|
Off-balance sheet liabilities are subject to the NSFR, based broadly on whether the commitment is a credit or a liquidity facility, or some other contingent funding obligation, without assigning actual percentages other than for irrevocable and conditionally revocable credit and liquidity facilities. National supervisors will be able to specify the required stable funding based on national circumstances.
In June 2015, the Basel Committee published the final version of the disclosure requirements for the NSFR. The Committee expected national authorities to give effect to the liquidity disclosure requirements relating to the NSFR no later than 1 January 2018. Banks were required to comply with these requirements from the date of the first reporting period after 1 January 2018. In February 2017, the Basel Committee published Basel III – The Net Stable Funding Ratio: frequently asked questions.
VI FINANCIAL STABILITY BOARD
The FSB is an international body that monitors and makes recommendations about the global financial system. It has its origins in the Financial Stability Forum (FSF), which was founded in 1999 by the finance ministers of the G7 countries.6 The foundation of the FSF arose from work carried out by the then Deutsche Bundesbank president, Hans Tietmeyer, on structures to enhance regulatory cooperation and cooperation between regulators and international financial institutions to promote international financial stability.
The FSF was re-established as the FSB at the G20 Summit held in London in April 2009, following calls in November 2008 by leaders of the G20 countries to enlarge the FSF's membership, and subsequent calls for the FSF to assume a more central role in developing structures and mechanisms to address international financial stability issues.7 The FSB emerged from the 2009 G20 Summit with a broader mandate to promote financial stability. On 28 January 2013, the FSB established itself as a not-for-profit association under Swiss law, with its seat in Basel, Switzerland.
The Charter and organisation of the FSB
The Charter of the FSB came into effect on 25 September 2009, but is not intended to create legal rights and obligations. It does, however, set out the FSB's objective, which is:
to coordinate at the international level the work of national financial authorities and international standard-setting bodies (SSBs) in order to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. In collaboration with the international financial institutions, the FSB will address vulnerabilities affecting financial systems in the interest of global financial stability.8
The mandate and tasks of the FSB are stated in the Charter to be to:
- assess vulnerabilities affecting the global financial system, and identify and review on a timely and continuing basis, within a macroprudential perspective, the regulatory, supervisory and related actions needed to address them, and their outcomes;
- promote coordination and information exchange among authorities responsible for financial stability;
- monitor and advise on market developments and their implications for regulatory policy;
- advise on and monitor best practice in meeting regulatory standards;
- undertake joint strategic reviews of, and coordinate the policy development work of, the standard-setting bodies (SSBs) to ensure their work is timely, coordinated, focused on priorities and addressing gaps;
- set guidelines for and support the establishment of supervisory colleges;
- support contingency planning for cross-border crisis management, particularly with respect to systemically important firms;
- collaborate with the International Monetary Fund to conduct early warning exercises;
- promote member jurisdictions' implementation of agreed commitments, standards and policy recommendations through monitoring of implementation, peer review and disclosure; and
- undertake any other tasks agreed by its members in the course of its activities and within the framework of its Charter.9
The FSB has also taken on the task of coordinating the alignment of the activities of SSBs.10
The FSB comprises a Plenary Group, Steering Committee, standing committees, working groups, regional consultative groups, a chairperson and a Secretariat.11 The Plenary is the sole decision-making body of the FSB for all matters governed by its Charter, and comprises representatives of the members of the FSB,12 chairs of the main SSBs and committees of central bank experts, and senior representatives of the International Monetary Fund (IMF), the World Bank, the Bank for International Settlements and the Organisation for Economic Co-operation and Development. Decisions are taken by consensus.13 The Plenary may establish standing committees and working groups as necessary.14
The Steering Committee of the FSB is mandated with providing operational guidance for the FSB between meetings of the Plenary. The duties of the Steering Committee include monitoring the progress of the FSB's work, distributing information to members of the FSB, and reviewing the policy development work of the SSBs for the Plenary to consider.15
The Chair of the FSB is Randal Quarles, currently Governor and Vice-Chairman for Supervision at the US Federal Reserve. On 19 February 2020, Quarles published a letter setting out priorities for the Saudi Arabian Presidency of the G20:
- transition from the London inter-bank offered rate (LIBOR);
- cross-border payments. Recognising the importance of efficient and inclusive payment services for global growth, the Saudi G20 Presidency has requested the FSB to coordinate the development of a roadmap for improving cross-border payments;
- non-bank financial intermediation (NBFI). NBFI now accounts for roughly half of global financial assets. As this sector grows and evolves, there may be new vulnerabilities that need assessment;
- evaluating the post-crisis regulatory framework. The FSB is continuing to evaluate whether the post-crisis financial regulatory reforms are working as intended; and
- implementation monitoring.
The FSB stated in March 2020 that 'representing a broad and diverse membership of national authorities, international standard setters and international bodies, [it] is actively cooperating to maintain financial stability during market stress related to covid-19'.
The global financial system today is in a better position to withstand shocks, maintain market functioning and sustain the supply of financing to support the real economy as a result of post-crisis reforms, including the formation of international coordination mechanisms such as the FSB. The FSB encourages authorities and financial institutions to make use of the flexibility within existing international standards to provide continued access to funding for market participants and for businesses and households facing temporary difficulties from covid-19, and to ensure that capital and liquidity resources in the financial system are available where they are needed. Many members of the FSB have already taken action to release available capital and liquidity buffers, in addition to actions to support market functioning and accommodate business continuity plans.
Peer reviews take place under a new FSB Framework for Strengthening Adherence to International Standards. Under this Framework, member countries of the FSB disclose their level of adherence to international financial standards; they undergo periodic, thematic and single-country peer reviews to evaluate their adherence to these standards; and the FSB identifies non-cooperative jurisdictions (especially those of systemic importance with weak adherence) and assists them with adherence.
OTC derivatives and rating agencies
In October 2010, the FSB published a report on implementing OTC derivatives market reforms. The report includes 21 recommendations addressing practical issues in implementing the G20 leaders' commitments concerning standardisation, CCP clearing, exchange or electronic platform trading, and reporting of OTC derivatives transactions. In particular:
- the report concluded that the proportion of the OTC derivatives market that is standardised should be substantially increased to promote CCP clearing and trading on organised platforms, to reduce systemic risk and improve market transparency;
- the report specifies factors that should be taken into account when determining whether a derivative product is standardised and suitable for CCP clearing;
- authorities may consider measures to limit or restrict trading in OTC derivatives that are suitable for clearing but not centrally cleared. Authorities should also ensure that access to CCPs is based on objective criteria, and that a safe and sound environment exists for indirect access. Supervisors should apply prudential requirements that appropriately reflect the risks of non-centrally cleared OTC derivatives;
- work should be undertaken to identify those actions needed to ensure that all standardised OTC derivative products are traded on exchanges or electronic trading platforms, where appropriate; and
- national authorities need to have a global view of the OTC derivatives markets through full and timely access to relevant data.
In Europe, these recommendations have been addressed through the regulatory regime for OTC derivatives and CCPs contained in Regulation (EU) No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR) (Chapter 20, Section VIII). EMIR was amended by Regulation (EU) 2019/834 applicable at various dates from December 2019 to June 2021.
On 27 October 2010, the FSB published principles for reducing reliance on credit rating agency ratings. Excessive reliance on ratings as a substitute for independent credit analysis was a feature of the run-up to the financial crisis.
The recommendations included the following:
- standard setters and authorities should assess references to credit rating agency ratings in standards, laws and regulations and, wherever possible, remove them or replace them with suitable alternative standards of creditworthiness;
- banks, market participants and institutional investors should make their own credit assessments, and not rely solely or mechanistically on ratings;
- central banks should reach their own credit judgements on the financial instruments that they will accept in open market operations, both as collateral and as outright purchases; and
- banks must not rely mechanistically on ratings for assessing the creditworthiness of assets. Larger, more sophisticated banks should be expected to assess the credit risk of all assets that they hold (either outright or as collateral).
These principles are echoed in the Basel Committee's consultation papers on the revisions to the standardised approach (see above). In October 2019, the FSB concluded that there had been limited additional implementation of the reforms between 2018 and 2019.
Dealing with systemically important financial institutions
On 2 November 2010, the FSB published a report containing recommendations for enhanced supervision of systemically important financial institutions (SIFIs). The FSB considered that the level of supervision applied by national authorities to SIFIs must be commensurate with the potential destabilisation risk that such firms pose to their domestic financial system, as well as the broader international financial system. The report made a series of recommendations covering the mandates of supervisors, independence, adequate resources, supervisory powers, techniques of supervision, group-wide and consolidated supervision, macroprudential surveillance and the use of third parties.
On 12 November 2010, the FSB followed up with a report on reducing the moral hazard posed by SIFIs. Its recommendations included the following.
- All FSB member jurisdictions should put in place a policy framework to reduce the risks and externalities associated with domestic and global SIFIs (G-SIFIs) in their jurisdiction.
- G-SIFIs should have a loss-absorption capacity beyond the Basel III standards. They should have a higher share of their balance sheets funded by capital or by other instruments that increase the resilience of the institution as a going concern. Depending on national circumstances, this could be drawn from a menu of alternatives, and achieved by a combination of a capital surcharge, a quantitative requirement for contingent capital instruments, and a share of debt instruments or other liabilities represented by bail-inable claims. In some circumstances, further measures, including liquidity surcharges, tighter large exposure restrictions, levies and structural measures could reduce the risks that a G-SIFI presents. The Basel Committee's proposals for additional capital to be held by G-SIBs have already been mentioned. In November 2011, the FSB published an initial list of G-SIFIs that are subject to requirements for additional loss absorbency. The list is reviewed and updated annually; the most recent update was issued in November 2019.
- All jurisdictions should undertake legal reforms necessary to ensure that they have in place a resolution regime that makes feasible the resolution of any financial institution without taxpayer exposure to losses. National authorities should consider restructuring mechanisms to allow recapitalisation as a going concern by way of contractual or statutory debt-equity conversion and write-down tools.
- Recovery and resolution plans that assess G-SIFIs' resolvability should be mandatory. Authorities must have powers to require a financial institution to make changes to its legal and operational structure to facilitate resolution. If a SIFI has multiple significant legal entities, it should:
- maintain information on a legal-entity basis;
- minimise any undue intragroup guarantees;
- ensure that service agreements are appropriately documented and cannot be abrogated in resolution; and
- ensure that significant global payment and settlement services are legally separable.
On 4 November 2011, the FSB published its Key Attributes of Effective Resolution Regimes for Financial Institutions, setting out the core elements necessary for an effective resolution regime. The Key Attributes include essential features that should be part of the resolution regimes of all jurisdictions, including scope, the resolution authority, set-off, segregation of client assets, safeguards, crisis management and institution-specific cross-border cooperation arrangements. The Key Attributes continue to provide the fundamental practical and intellectual basis for resolution regimes in all major banking jurisdictions, including the EU and, to a significant extent, the United States. The FSB concluded that an effective resolution regime (interacting with applicable arrangements for the protection of depositors, insurance policyholders and retail investors) should:
- ensure continuity of systemically important financial services, and payment, clearing and settlement functions;
- protect, where applicable, depositors, insurance policyholders and investors that are covered by insurance arrangements, and ensure the rapid return of segregated client assets;
- allocate losses to firms' owners (shareholders) and unsecured and uninsured creditors in a manner that respects the hierarchy of claims;
- not rely on public support and not create an expectation that such support will be available;
- avoid unnecessary destruction of value, and therefore seek to minimise the overall costs of resolution and, where consistent with the other objectives, losses for creditors;
- provide for speed and transparency and as much predictability as possible through legal and procedural clarity and advanced planning for orderly resolution;
- provide a legal mandate for cooperation, information exchange and coordination domestically and with foreign resolution authorities;
- ensure that non-viable firms can exit the market in an orderly manner; and
- be credible, and thereby enhance market discipline.
It was also determined that resolution powers should include stabilisation options (through the sale or transfer of shares to a purchaser or to a bridge bank, recapitalisation, or both) as well as liquidation options.
In July 2013, the FSB published three reports on aspects of recovery and resolution planning for SIFIs to assist authorities and firms in meeting the requirements of the FSB's Key Attributes of Effective Resolution Regimes.
The first of these set out guidance on developing effective resolution strategies; that resolution plans should help achieve an orderly resolution and facilitate the effective use of resolution powers. Common considerations included:
- the sufficiency of loss-absorbing capital;
- the position of that capital in the creditor hierarchy and the operational structure, legal structure, enforceability and implementation of bail-in;
- the treatment of financial contracts in resolution;
- funding arrangements; and
- cross-border cooperation and coordination in the proximity of failure.
The report considered as alternatives a single point of entry and multiple points of entry in a banking group in a resolution scenario. In the former case, resolution powers would be applied at the top parent or holding company level, and would involve the write-down or mandatory conversion of unsecured debt into equity. Multiple point of entry resolution involves the application of resolution powers by two or more resolution authorities to different parts of the group, and is likely to result in the break-up of the group into two or more separate units. The choice of resolution strategy should take into account the structure and business model of the group concerned and the group's particular characteristics. According to the report, a single point of entry may represent the most effective option for a banking group that operates in a highly integrated manner, whereas a multiple point of entry strategy may well be suitable for a group with a decentralised structure, with subgroups of relatively independently capitalised and separately funded subsidiaries. Neither strategy is, in reality, without significant legal and practical challenges, and it may be that, over time, the norm for global banking groups (if there could be such a thing) will be a resolution strategy that is a hybrid of the single point of entry and multiple point of entry strategies.
The second FSB report set out guidance on recovery triggers and stress scenarios. The report referred to both quantitative and qualitative triggers. Quantitative triggers include ratings downgrades, credit risk limits, withdrawal of deposits or other funding, and the three-month interbank rate. This will presumably be replaced by risk-free rates as a result of the regulatory push to adopt risk-free rates. Qualitative triggers could include requests from counterparties for early redemption of liabilities, difficulties in issuing debt at current rates, an unexpected loss of senior management or adverse court rulings. The report noted that G-SIFIs typically use two to four stress scenarios for recovery planning purposes. These may include both systemic and idiosyncratic stress scenarios. Examples of stress scenarios include losses through a rogue trader, a euro or dollar crisis, decreasing GDP rates, loss of goodwill, a significant withdrawal of deposits, an exodus of talent, a collapse of global financial markets, and fraud. The report notes that some G-SIFIs also perform reverse stress testing (which involves identifying scenarios in which the group would fail).
The third FSB report provided guidance on the identification of critical functions and critical shared services that resolution regimes and strategies should seek to preserve. A critical function is one provided by a G-SIFI to third parties where the sudden failure to provide the function would be likely to have a material impact on third parties because of the systemic relevance of the function or of the G-SIFI in providing the function.
In October 2016, the FSB published the Key Attributes Assessment Methodology for the Banking Sector. The Methodology is intended primarily for use in assessments performed by authorities of existing resolution regimes and of any reforms, and peer reviews of resolution regimes, and IMF and World Bank assessments of resolution regimes. The document sets out five preconditions for effective resolution regimes and 12 key attributes. The preconditions include:
- a well-established framework for financial stability, surveillance and policy formulation;
- an effective system of supervision, regulation and oversight of banks;
- effective protection schemes for depositors and clear rules on the treatment of client assets;
- a robust accounting, auditing and disclosure regime; and
- a well-developed legal framework and judicial system.
The key attributes set out essential criteria as well as explanatory notes.
In November 2017, the FSB consulted on proposed guidance to support resolution planning and promote resolvability. The first consultative document proposes a set of principles to assist authorities as they make G-SIB bail-in resolution strategies operational. The second sets out proposed guidance on the development of a plan for funding in resolution that builds on the FSB's August 2016 Guiding Principles on the temporary funding needed to support the orderly resolution of a G-SIB and existing supervisory and resolution guidance on liquidity risk management and resolution planning. In November 2019, the FSB published a report providing an update on progress in implementing policy measures to enhance the resolvability of SIFIs and setting out plans for further work.
The FSB published a report entitled Shadow Banking: Strengthening Oversight and Regulation on 27 October 2011, addressing the risks posed to financial stability in the pre-crisis period by non-banks that engaged in maturity transformation. The FSB defined shadow banking as credit intermediation involving entities and activities outside the regular banking system. National authorities should have appropriate system-wide oversight of the shadow banking system, backed up by adequate data-gathering powers and exchange of data within and between jurisdictions. The FSB proposed a three-step approach involving an assessment of the overall shadow banking system, the identification of systemic risk or cases of regulatory arbitrage followed by a detailed assessment of concerns identified. Particular attention should be paid to maturity transformation, liquidity transformation, credit risk transfer and leverage. The report also set out specific regulatory responses:
- consolidation rules should ensure that shadow banking entities that a bank sponsors are included within its regulatory balance sheet for the purposes of capital, liquidity and leverage;
- limits on the size and nature of a bank's exposures to shadow banking entities should be enhanced;
- risk-based requirements for banks' exposures to shadow banking entities should be reviewed to ensure all such risks are captured;
- banks' ability to stand behind non-consolidated entities should be restricted through stricter regulation of implicit support;
- the regulation of money market funds needed to be enhanced;
- further regulation should be considered in respect of other shadow banking entities where they pose systemic risk or provide opportunities for regulatory arbitrage (e.g., conduits, structured investment vehicles), finance companies, mortgage insurance companies and credit hedge funds); and
- regulation of repo agreements and securities lending should be considered.
In August 2013, the FSB set out an Overview of policy recommendations for strengthening oversight and regulation of shadow banking.16 The FSB identified five areas in which oversight and regulation needed to be strengthened:
- mitigating risks in banks' interactions with shadow banking entities;
- reducing the susceptibility of money market funds to runs;
- improving transparency and aligning incentives in securitisation;
- dampening procyclicality and other financial stability risks in securities financing transactions such as repos and securities lending; and
- assessing and mitigating financial stability risks posed by other shadow banking entities and activities.
The Overview was accompanied by two reports. IOSCO had previously published policy recommendations for money market funds and global developments in securitisation markets. The first report provided a policy framework for addressing shadow banking risks in securities lending and borrowing. The report made a number of recommendations, including the following:
- authorities should collect more granular data on securities lending and repo exposures among large international financial institutions;
- trade data and regular snapshots of outstanding balances for repo markets should be collected;
- the total national and regional data for both repos and securities monthly lending should be aggregated;
- authorities should review reporting requirements for fund managers to end investors;
- authorities for non-bank entities that engage in securities lending should implement regulatory regimes meeting the minimum standards for cash collateral reinvestment in their jurisdiction;
- authorities should ensure that regulations governing rehypothecation of assets meet minimum standards;
- authorities should adopt minimum regulatory standards for collateral valuation and management for all securities lending and repo market participants; and
- authorities should evaluate the costs and benefits of introducing CCPs in the inter-dealer repo market.
The EU has adopted standards for securities financing transactions. The report also set out a proposed regulatory framework for haircuts on non-centrally cleared securities financing transactions. This regulatory framework was revised in November 2015 and again in July 2019.
The second report set out a policy framework for strengthening oversight and regulation of shadow banking entities. The report included a set of toolkits available to address risks presented by specific shadow banking entities.
These are based on four overarching principles:
- authorities should define and keep up to date the regulatory perimeter (i.e., the activities that are regulated);
- authorities should collect information needed to address the extent of risks caused by shadow banking;
- authorities should enhance disclosure by other shadow banking entities; and
- authorities should assess non-bank financial entities based on their economic functions.
ii Total loss-absorbing capacity principles for G-SIBs
In November 2014, the FSB published a consultation paper on the adequacy of loss-absorbing capacity of G-SIBs, expounding the concept of total loss-absorbency capacity (TLAC). The consultation paper consisted of two parts. The first proposed principles on loss absorption and recapitalisation capacity of G-SIBs in resolution. The second part contained a proposal for a term sheet for instruments that contribute to TLAC as an implementing measure of these principles in the form of an internationally agreed standard for G-SIBs.
On 9 November 2015, the FSB published the final TLAC principles and term sheet, which reflects changes made following the public consultation and the comprehensive impact assessment studies.
G-SIBs will be required to meet the TLAC requirement alongside the minimum regulatory requirements set out in the Basel III framework. Specifically, they are required to meet a minimum TLAC requirement of at least 16 per cent of the resolution group's RWAs (RWA minimum TLAC) from 1 January 2019 and at least 18 per cent from 1 January 2022. Minimum TLAC must also be at least 6 per cent of the Basel III leverage ratio denominator (leverage ratio exposure (LRE) minimum TLAC) from 1 January 2019, and at least 6.75 per cent from 1 January 2022.
G-SIBs headquartered in emerging market economies will be required to meet the 16 per cent RWA and 6 per cent LRE minimum TLAC requirement not later than 1 January 2025, and the 18 per cent RWA and 6.75 per cent LRE minimum TLAC requirement not later than 1 January 2028. This period will be accelerated if, within five years of 2015, corporate debt markets in these economies reach 55 per cent of the emerging market economy's GDP. At the time of the last measurement, this only applied to China where the 55 per cent threshold had not been met. According to the FSB, preparations are under way for Chinese G-SIBs to comply with the TLAC Standard ahead of 2025.
The FSB monitored implementation of the TLAC Standard and undertook a review of the technical implementation at the end of 2019. The report concluded that progress has been steady and significant in both the setting of external TLAC requirements by authorities and the issuance of TLAC by G-SIBs. All relevant G-SIBs meet or exceed the TLAC target ratios of at least 16 per cent of risk-weighted assets and 6 per cent of the Basel III leverage ratio.
In December 2016, the FSB consulted on the Guiding Principles on the Internal TLAC Capacity of G-SIBs (internal TLAC). Internal TLAC is the loss-absorbing capacity that resolution entities have committed to material subgroups. It provides a mechanism by which losses and recapitalisation needs of material subgroups may be passed with legal certainty to the resolution entity of a G-SIB resolution group without the entry into resolution of the subsidiaries within the material subgroup. A material subgroup is either an individual subsidiary or group of subsidiaries that are not resolution entities, and that meet certain quantitative criteria, or are identified by a firm's crisis management group as material to the exercise of the firm's critical functions. Each material subgroup must maintain internal TLAC of between 75 and 90 per cent of the external minimum TLAC requirement that would apply if the subgroup were a resolution group. The guiding principles cover:
- the process of identifying material subgroups and their composition;
- the role of home and host authorities, and the factors to be considered when determining the size of the internal TLAC requirement;
- practical considerations relating to the issuance and composition of internal TLAC;
- features of the trigger mechanism for internal TLAC; and
- cooperation and coordination between home and host authorities in triggering internal TLAC.
The Basel Committee published a standard for the prudential treatment of banks' investments in TLAC in October 2016. Basically, G-SIBs and non-G-SIBs will be required to deduct non-regulatory capital TLAC holdings from Tier 2 capital. However, a materiality threshold will apply of 10 per cent of the common shares and TLAC holdings of the issuer. Amounts above 10 per cent will be deducted and lower amounts risk-weighted. For G-SIBs, there is a 5 per cent threshold for the investing bank's common equity for TLAC holdings held in the trading book and sold within 30 business days. A review was published of the technical implementation of the TLAC Standard in July 2019:
The review concludes that progress has been steady and significant in both the setting of external TLAC requirements by authorities and the issuance of external TLAC by G-SIBs. This has been instrumental in enhancing the resolvability of G-SIBs, strengthening cooperation between home and host authorities and boosting market confidence in authorities' capabilities to address too-big-to-fail risks.
The FSB sees no need to modify the TLAC Standard at this time. However as implementation is ongoing, further efforts are needed to implement the TLAC Standard fully and effectively and to determine the appropriate group-internal distribution of TLAC resources across home and host jurisdictions.
In December 2016, the FSB published a consultation document on guidance on continuity of access to financial market infrastructure for a firm in resolution.
iii Market fragmentation
In June 2019, the FSB published a report on market fragmentation. The report noted that:
[M]arket fragmentation can arise for a number of reasons, including differences in national regulations and supervisory practices governing financial activities that are international in nature. This, along with differences in both the substance and timing of implementation of international standards, may disincentivise or prevent market participants from undertaking certain cross-border activities.
The report identified areas for further work, noting that there may be positive and negative reasons for such fragmentation.
In October 2019, the FSB published a report on the regulatory issues of stablecoins (which are cryptocurrency tied in value to real or other assets). It seems likely that the report was triggered by Facebook's announcement of the Libra cryptocurrency that would be 'stable' based on a basket of real assets managed by the Libra Foundation. According to the report, the FSB will:
- take stock of existing supervisory and regulatory approaches and emerging practices in this field, with a focus on cross-border issues and taking into account the perspective of emerging markets and developing economies; and
- based on the stocktake, consider whether existing supervisory and regulatory approaches are adequate and effective in addressing financial stability and systemic risk concerns that could arise from the individual components of a stablecoin arrangement or their interaction as an ecosystem as a whole.
The intention is to publish a consultative report in April 2020 and a final report by July 2020. However, in October 2019, the G7 (which is not an international standard-setting body covered by this chapter) published a report on the impact of global stablecoins. According to the G7 report, stablecoins, regardless of size, pose legal, regulatory and oversight challenges and risks related to:
- legal certainty;
- sound governance, including the investment rules of the stability mechanism;
- money laundering, terrorist financing and other forms of illicit finance;
- safety, efficiency and integrity of payment systems;
- cyber security and operational resilience;
- market integrity;
- data privacy, protection and portability;
- consumer and investor protection; and
- tax compliance.
Moreover, stablecoins that reach global scale could pose challenges and risks to:
- monetary policy;
- financial stability;
- the international monetary system; and
- fair competition.
Whether these criticisms are valid or a reflection of a government desire to control the provision of means of payment will be left to the reader to decide. In April 2020, EU banks for the first time lent their public support to a pan-European payment system initiative to rival Visa, Mastercard and, potentially, Libra.
In June 2019, the FSB published a report on decentralised financial technologies. The report notes that the application of decentralised financial technologies – and the more decentralised financial system to which they may give rise – could benefit financial stability in some ways. It may also lead to greater competition and diversity in the financial system and reduce the systemic importance of some existing entities. At the same time, the use of decentralised technologies may entail risks to financial stability. These include the emergence of concentrations in the ownership and operation of key infrastructure and technology, as well as a possible greater degree of procyclicality in decentralised risk-taking.
v Leveraged loans and collateralised loan obligations
In December 2019, the FSB published a report assessing the financial stability implications of developments in the leveraged loan and collateralised loan obligation (CLO) markets. The report concludes that:
- vulnerabilities in the leveraged loan and CLO markets have grown since the global financial crisis. Borrowers' leverage has increased; changes in loan documentation have weakened creditor protection; and shifts in the composition of creditors of non-banks may have increased the complexity of these markets;
- banks have the largest direct exposures to leveraged loans and CLOs. These exposures are concentrated among a limited number of large global banks and have a significant cross-border dimension;
- a number of non-bank investors, including investment funds and insurance companies, are also exposed to the leveraged loan and CLO markets; and
- given data gaps, a comprehensive assessment of the system-wide implications of the exposures of financial institutions to leveraged loans and CLOs is challenging.
1 Jan Putnis is a partner and Tolek Petch is a senior associate at Slaughter and May.
2 Argentina, Australia, Belgium, Brazil, Canada, China, the European Union, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. (In addition to member organisations, a number of institutions currently hold observer status. These include country observers: the Central Bank of Chile/Banking and Financial Institutions Supervisory Agency, the Central Bank of Malaysia and the Central Bank of the United Arab Emirates; and the following supervisory groups and international agencies or bodies: Bank of International Settlements, Basel Consultative Group, European Banking Authority, European Commission and International Monetary Fund.)
3 Basel Committee on Banking Supervision Charter, Paragraph 1.
4 ibid., Paragraph 3.
5 Regulation (EU) No. 575/2013.
6 Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
7 The member jurisdictions of the FSB now comprise Argentina, Australia, Brazil, Canada, China, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, Korea, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Switzerland, Turkey, the United Kingdom, the United States and the European Union. Other members include international financial institutions (comprising the Bank for International Settlements, the International Monetary Fund, the Organisation for Economic Co-operation and Development and the World Bank) and international standard-setting, regulatory, supervisory and central bank bodies (comprising the Basel Committee, the Committee on Payments and Market Infrastructures, the Committee on the Global Financial System, the International Accounting Standards Board, the International Association of Insurance Supervisors and IOSCO).
8 FSB Charter, Article 1. The Charter was amended and restated in June 2012. It is supplemented by articles of association and procedural guidelines.
9 FSB Charter, Article 2(1).
10 FSB Charter, Article 2(2).
11 FSB Charter, Article 7.
12 The representatives are to be at the level of central bank governor or immediate deputy, head or immediate deputy head of the main supervisory or regulatory agency, and the deputy finance minister: FSB Charter, Article 10(1).
13 FSB Charter, Article 9(2).
14 FSB Charter, Article 9(3)(g).
15 FSB Charter, Article 12(3).