Basel's not-so-brave new world

Despite the initial grand designs, compromise – and lobbying – has prevailed as the global banking industry shifts ever so slowly towards more conservative, post-crisis settings.

Were global banking regulators being "realistic" when they watered down the proposed new liquidity rules for international banks at the weekend or have they bowed to the intense pressure from the global banking lobby?

On Sunday the Basel Committee on Banking Supervision made significant changes to the liquidity regime it had proposed in 2010, broadening the range of assets that qualify as liquidity in a crisis, lowering the assumed rates of outflows of funds in a crisis and delaying full introduction of the regime from the original 2015 deadline to 2019. The banks will only have to be 60 per cent compliant in 2015.

The objective of the rules is to ensure banks hold sufficient high-quality liquidity to be able to withstand a month-long and acute liquidity crisis, similar to that period of severe stress in bank funding markets that occurred after the collapse of Lehman Brothers in 2008.

The net effect of the changes the Basel committee has now made to the proposed rules is to reduce the amount of liquidity banks will need to raise to comply, making it easier and cheaper to find those liquid assets and giving them far more time to build the liquidity.

The global bank lobby has been fiercely resisting both the liquidity regime and new tougher capital requirements, arguing that they were too costly and would adversely affect real economies during a period of global economic weakness by reducing the banks’ ability to lend and raising the costs for banks and therefore ultimately borrowers.

Certainly the Basel committee’s overall response to the financial crisis has encouraged banks to hoard liquidity and capital in anticipation of the introduction of the proposed new regimes, although it could be argued that it has had little real world impact because demand for credit has fallen away so significantly post-crisis as companies and households attempt to deleverage.

Bank of England Governor Mervyn King said the committee hadn’t set out to make the liquidity rules either stronger or weaker but to make them "more realistic". He did say the committee had listened to criticisms that people had made.

Just over a year ago the committee had estimated that less than 100 of the top 200 international banks were holding sufficient liquidity in the right form to comply with the original proposals and estimated that the major banks would have to raise more than $2 trillion of what was then a very narrow range of deemed highly liquid assets to meet the original timetable for the regime’s introduction in 2015.

The changes could, therefore, be seen to be pragmatic. In the current economic and financial climate in Europe in particular forcing big banks to hold more and more expensive liquidity could be counter-productive and have unintended real world consequences.

It is also the case that a core aspect of the original proposals has been found to be misguided. Originally the banks were only going to be allowed to count a very narrow range of assets, mainly government bonds and cash held with central banks, as high-quality liquid assets.

The eurozone’s sovereign debt crisis destroyed the notion that sovereign debt is always risk-free and liquid. While in a handful of cases – including Australia – the scarcity of sovereign paper created a particular challenge that the Australian Prudential Regulation Authority and the Reserve Bank responded to by creating arrangements under which, as a last resort and at significant costs, the Australian banks can get access to emergency liquidity from the RBA.

The Basel committee now proposes to allow some highly-rated mortgage-backed securities, corporate debt and even some equities to be included within its definition of high-quality liquidity, although there will be a limit to the proportion of those assets that can be included and their value will be discounted.

The inclusion of the mortgage-backed securities will be particularly welcomed by US and Australian banks, although APRA has been marching to the beat of its own drum, much to the chagrin of the major Australian banks.

Whereas the European and US banks were badly damaged by the financial crisis and many of them are still in recovery mode the Australian majors sailed through the crisis and, as a system, have more high-quality capital and liquidity than just about any other in the world other than Canada’s.

They were on track to meet or better the original Basel committee timelines for a range of prudential reforms.

While they have complained about the costs of APRA’s determination to keep the Australian system at the front of the global pack as the industry shifts towards more conservative settings, there is an obvious benefit for the major banks in terms of their access to wholesale funding and its cost, and perhaps their cost of equity if sharemarkets factor in lower risk profiles, from the Australian system being more conservative than the rest.

The next phase of Basel reforms relates to the introduction of a "net stable funding ratio" and a simple leverage ratio, the former designed to reduce the banks’ reliance on short term funding and the latter to reduce the overall level of gearing within the system.

The reform process moves slowly – the rules for a stable funding ratio won’t be finalised for two years and won’t be introduced, if they are introduced, until 2019. Assuming the global regulators can keep to that timetable, it would mean it will have taken more than a decade for the full response to the lessons learned from the crisis to be implemented.