Bank Regulators Face Santiago Showdown on Capital Overhaul

  • Europe, U.S. seek compromise on range of key Basel III issues
  • Basel Committee convenes Nov. 28-29 in the Chilean capital

A contentious reform of international bank capital standards is going down to the wire, as regulators including the U.S. Federal Reserve and the European Central Bank try to bridge a wide gap on key issues before the end of the year.

At issue is the way banks measure the risk of mortgages, corporate loans and even the threat of cyber crime. The Basel Committee on Banking Supervision wants to curb banks’ ability to game the rules by using their own complex models to reduce capital requirements. The U.S. has long been skeptical of banks’ models, while Europe and Japan insist they provide accurate assessments of some assets.

The U.S. election of Donald Trump could complicate the negotiations. Trump has vowed to roll back financial regulations, fueling concern that his administration might shift the U.S. stance in international organizations such as the Basel Committee as he asserts his hold on power.

“Europe is having a constructive approach and is willing to reach a balanced agreement,” Valdis Dombrovskis, the EU’s financial-services chief, said in a Nov. 17 interview in Brussels. “Hopefully, we can do it within the agreed time frame.”

Public Ultimatum

Germany added to the drama this week, warning that it’s prepared to walk away from the table unless it wins major concessions. The rare public ultimatum delivered by Andreas Dombret, a member of the Bundesbank Executive Board, capped months of increasingly strident opposition in Europe to the Basel Committee’s proposals. The next round of talks is scheduled for Nov. 28-29 in Santiago, Chile.

Regulators need to “narrow down the gap which we’re still having, because there is a gap,” Dombret said on Nov. 16. “I’m not interested in postponing” an agreement, he said. “I’m interested in closing a transaction, but this has to be a sensible transaction. We’re not there yet.”

Banks have warned that the proposed restrictions, the final piece of regulators’ response to the 2008 financial crisis, could send costs spiraling by billions of dollars and hamper economic growth. The regulators are constrained by a promise first made in January not to increase overall capital requirements significantly in the process.

If the Basel Committee members can’t resolve their disagreements in Santiago, outstanding issues would probably be kicked up to the regulator’s oversight body, led by ECB President Mario Draghi, according to two people familiar with the deliberations. The goal would still be to complete the overhaul on schedule at the January meeting of the oversight group, the people said, declining to be identified because the talks are private.

To do that, the negotiators will have to overcome some deep-seated differences on a range of issues. Here are three of the most hotly debated:

  • Capital Floors

One of Europe’s main demands, made by Dombret among others, is to scrap a proposed “output floor,” which limits the extent to which banks can lower their capital requirements by using internal models compared with formulas set by regulators. The U.S. has supported floors to guard against banks gaming regulations. Stefan Ingves, chairman of the Basel Committee, said on Nov. 10 that the floors remain under discussion. 

Dombrovskis said it’s important to make sure the rules continue to “reward banks with less risky business models,” and “this issue of output floors is exactly one of the issues which is reducing risk sensitivity of the models.”

A potential route to a compromise has begun to emerge, with EU policy makers suggesting that residential mortgages be exempted. That would lessen the blow to European banks, which tend to keep mortgage risk on their balance sheets more than U.S. banks, which offload it to Fannie Mae and Freddie Mac.

“The obvious thing is to reconsider whether the floor should apply to retail mortgages,” Jesper Berg, director general of Denmark’s Financial Supervisory Authority, has said. “That could be the thing which would make it easier to clinch a deal.”

  • Operational Risk

The Basel Committee proposed abandoning the model-based approach to calculating operational risk, which encompasses the impact of litigation, misconduct and cyber crime. Deutsche Bank AG analysts have estimated that banks’ risk-weighted assets would increase by about 50 percent under the proposal. Bank of England Governor Mark Carney said the plan would drive up capital requirements “substantially.”

As a result, Carney said he expects “that element of the original package will be taken off the table effectively, or will be substantially reduced.” What’s more, Carney said there’s no need for international rules on operational risk: “We don’t need a model coming out of Basel to tell us how to do it.”

Watering down this proposal could give the Basel Committee more room to tighten rules on banks’ models for loan and other credit risks while sticking to its promise to keep overall capital increases to a minimum, Carney said.

  • Corporate Loans

The Basel Committee proposed to bar banks from modeling the risk posed by loans to corporations with at least 50 billion euros ($53 billion) in assets, arguing that there isn’t enough data on corporate defaults to properly estimate risks. The industry argues that the proposals are too blunt, and has found support among European regulators for making them more risk-sensitive.

Andrea Enria, head of the European Banking Authority, said the proposals have “an impact which we consider excessively high.” While regulators should strive to reduce differences in how banks assess similar risks, “there is not great reason to increase the capital charges for these portfolios,” he said.

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