TIGHTER RULES ON CAPITAL : BANKERS VERSUS BASEL / THE FINANCIAL TIMES ANALYSIS ( A MUST READ )

October 2, 2011 10:20 pm

Tighter rules on capital: Bankers versus Basel

By Brooke Masters and Tom Braithwaite

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The industry is preparing a full-on assault on a deal regulators see as the best way to prevent future financial meltdown – and the question is whether the accord will be left with enough teeth
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Vehement complaint: Jamie Dimon of JPMorgan Chase argues that the Basel III plan to impose extra requirements on the biggest financial groups is economically and philosophically wrong

Two weeks ago , the simmering battle over how to make the financial system safer turned nasty.


On one side: Jamie Dimon, chief executive of JPMorgan Chase, one of the world’s largest banks and one of the few institutions to emerge from the financial crisis relatively unscathed. On the other: the silver-tongued Mark Carney, formerly of Goldman Sachs, now governor of the Bank of Canada. He too was speaking from a position of strength because the banks he supervised survived the turmoil of 2008 in good shape.

The setting for the showdown was the National Archives building in Washington, the grand neoclassical home of the American constitution, the Bill of Rights and a copy of the Magna Carta. But the document that sparked the fight was a much more modern affair – one that curtails freedom rather than guarantees it.

Basel III, named after the Swiss-based international committee of regulators that issued the rules, is a complex package of reforms designed to make banks more resilient and less likely to need taxpayer rescue in future. It forces all lenders – particularly the largest – to build up buffers of equity, cash and liquid assets to protect themselves against unexpected losses or another market crisis.


According to some of the 30 or so people gathered in a meeting room at the archives, Mr Dimon lambasted Mr Carney – complaining vehemently that the Basel committee’s plan to subject his own and other large institutions to even higher capital requirements than those faced by smaller peers was ill-thought-out and economically and philosophically wrong. He also insisted that some provisions discriminated against US banks.


European bankers were left wide-eyed by the outburst but many of them have been launching their own, usually quieter, attacks on Basel III from the other side of the Atlantic. They argue that parts of the liquidity and capital rules unfairly penalise their universal banking model, which combines both insurance and banking in a single group and is found mainly in France and the Benelux countries.


The ill-tempered exchange in Washington was more than a lone instance. Behind complaints about level playing fields, the entire industry is warming up for a full-on assault on the Basel deal, which was hailed last year as the single most important step towards preventing the next financial Armageddon. The next year or so could determine whether that accord will be left with enough teeth to reshape banking fundamentally – or cease to be worth the paper it is written on.


“The large banks are seeking to undo the relatively moderate progress that has been made on improving regulation thus far, using the very economic crisis they helped trigger as an excuse,” says Sony Kapoor, managing director of Re-Define, a financial think-tank.


As the bankers see it, they are preserving the already shaky world economy and the global financial system. Forcing them to hold more capital and low-yielding liquidity will, they say, make many of their business lines unprofitable and drive up costs for customers. The Institute of International Finance, an industry group, estimates that the reform package could push up borrowing costs by 3.5 per cent, cut global output by 3.2 per cent by 2015 and cost 7.5m jobs.


Regulators see it differently. To them, the real threat comes from an unreconstructed industry still addicted to short-term funding that can dry up at the drop of a hat. They also argue that profits remain too dependent on risky derivatives and proprietary trading. Their “impact studies” suggest that enforcing a build-up of capital would trim growth only mildly in the short term. Any pain would be far outweighed over the long run by the benefits of stability.


“The crisis is akin to a heart attack for banks. Some people would like to go on smoking and drinking, but what we are asking banks to do is have the same market discipline as non-banks,” says Tom Huertas, who represented the UK in many of the Basel talks.


Supervisors are also adamant that forcing banks to shore up their capital over time, rather than paying out earnings in staff bonuses and shareholder dividends, is the correct thing to do.


The Basel committee, a group of regulators from 27 large economies, late last month reaffirmed its plans to slap a surcharge on big international banks, forcing them to hold extra capital on top of the global minimums set last year. That means JPMorgan, for example, must hold top-quality capital equal to 9.5 per cent of its assets weighted for risk – whereby the riskiest loans need to carry more capital against them than safer assets.


“If some institutions feel pressure today, it is because they have done too little for too long, rather than because they are being asked to do too much, too soon,” Mr Carney said in a speech two days after Mr Dimon’s verbal onslaught.


Too bad, says the industry, but no surprise. Mr Carney was just target practice. The only hope, according to several senior executives, is that politicians will ride to the rescue.


Bankers now want to reopen, or at least delay the implementation of, last year’s overall Basel III deal, arguing that to adopt it would be to kill off the nascent economic recovery. With world leaders scheduled to endorse the big bank surcharge at a meeting of the Group of 20 leading nations in Cannes in November, they sense that time is running out.


At the same time, lobbyists are making the case to legislators and national regulators in charge of implementing Basel III in each country that changes are needed to make sure their local banks are not disadvantaged.


On this level, the banks are starting to score some successes. In Europe, the draft version of the regulation that would enshrine Basel III in law includes a clause that would make it easier for French banks to count the capital in their insurance subsidiaries towards their overall total. With the market already suspicious about French banks’ resilience, the change would help them keep their capital ratios – an important measure of bank strength – high.


The EU draft also appears to gut the “leverage ratio” – a measure backed by the US and UK that seeks to keep banks from bulking up their total assets in relation to their equity. High leverage has been cited as an important reason for the 2008 collapse of Lehman Brothers.


The cap on insurance subsidiaries, meanwhile, formed part of a grand trade to tighten up the definition of what could be counted as capital – again a response to problems uncovered in the financial crisis, when many items previously classified as capital turned out to be useless. If the French win their special category, then what, observers ask, is to stop the Germans, Japanese and Americans from doing the same?


The various moves have alarmed some global banks that would prefer a single set of consistent standards to a raft of local rules, even if some are more favourable. “It opens the door to everyone else cheating too,” says one weary industry lobbyist.


American banks are also starting to gain local traction with some of their complaints – particularly Mr Dimon’s allegation that European lenders are manipulating the way they measure risk in order to reduce their capital requirements.


Under Basel rules, the amount of capital a bank needs depends on the size and riskiness of its assets – and banks are allowed to use their own internal models to measure risk. Yet the difference between a group’s risk-weighted assets and its unweighted total assets varies considerably by institution and by country, suggesting that some may be cutting their capital needs by understating their risk.


Mr Dimon and other US bankers are convinced their European counterparts are cheating, a charge that has drawn some sympathy from Barney Frank, the senior Democrat on the House of Representatives financial services committee. “It’s plausible to me that there could be some manipulation on the risk-weighting,” he says. He fears some European countries might weaken the regulation in practice by undervaluing risk.


On this gripe, US banks have not only the likes of Mr Frank behind them but also a number of regulators. Andrea Enria, head of the European Banking Authority, expressed concern at the variation in risk-weights that EU banks used during stress tests that produced results the market branded laughably positive. A UK pilot project to test bank models also found enormous differences.


Last week the Basel committee announced plans to conduct a formal study of the issue, to decide once and for all whether some banks and their regulators are fiddling the figures. It is also to put out report cards highlighting when countries put the rules in place and when they depart from them.


Bank complaints about the liquidity rules are also starting to bear fruit. The eurozone sovereign debt crisis has certainly boosted the argument that the definition of safe assets – which included the bonds of countries such as Greece – needs a fundamental rethink. The Basel group has agreed to speed up planned adjustments to the way this requirement is calculated to “provide greater market certainty”. The changes could please banks by broadening the kind of assets they can count and reducing the overall amount they have to hold.


Time is the bankers’ best hope. If the global economy is still reeling next year and in 2013, governments may be more willing to take the fetters off the big banks. If Barack Obama fails to win a second presidential term in 2012, a Republican White House may be more sympathetic.


For now, however, most regulators and politicians are still in favour of standing up to the banks, particularly on the fundamental question of capital requirements. Mr Frank, for instance, has no interest in ditching the capital surcharge that so angers Mr Dimon – and insists he does not want the rules to be watered down, just made fair.


The global redrawing of financial regulation should, he says, be “a race to the top and not the bottom”.

REFORM AGENDA

There are four key elements to the Basel III deal aimed at making banks more able to survive unexpected losses or funding problems and less likely to need taxpayer rescue.

The rules will be fully phased in by 2019.

● Capital Banks must have top quality (“core tier one”) capital equal to 7 per cent of assets, adjusted for risk, or face restrictions on paying bonuses and dividends.

● Surcharge The biggest “systemically important financial institutions” have to carry an extra 1-2.5 per cent in capital, for a total of up to 9.5 per cent of risk-weighted assets.

● Liquidity Banks have to keep enough cash and easy-to-sell assets to survive a 30-day market crisis.

● Leverage The ratio of core tier one capital to a bank’s total assets, with no risk adjustment, may not exceed 3 per cent.

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Copyright The Financial Times Limited 2011.