Europe, despite the vast amount of post-crisis regulations it finalised in 2015, is still exhaustingly distant from finishing the job.
Even before the Basel Committee on Banking Supervision has finished the rules it considers to be major pieces of the Basel III puzzle, the committee has already flagged the European Union as significantly non-compliant in some key areas.
And though, in theory, the European Union’s regulators could just refuse to hold themselves to the Basel III standard, they will most likely be under pressure to continue to converge toward it.
And that will be while playing catch-up with other regulatory initiatives. 2015 brought the final versions of some of the most important regulations of the post-crisis years. Market participants got a final version of the Financial Stability Board’s Total Loss Absorbing Capacity proposal and some of the final Markets in Financial Instruments Directive regulatory technical standards, accounting for a bunker’s worth of letter size paper alone.
Bankers breathed a collective sigh of relief as it became clear late in the year that the European Parliament would grant a stay of implementation for the Markets in Financial Instruments Directive II by one year — not least because they were already going to have their hands full.
The weight of Basel compliance
Having assessed the European Union’s level of compliance with Basel III standards in late 2014, the BCBS found that the region was “materially non-compliant” in its regulations implementing the internal ratings-based approach for calculating credit risk, and “non-compliant” in its counterparty credit risk framework.
“At some point, Europe will begin to become fully Basel III compliant,” says Adrian Docherty, head of FIG advisory at BNP Paribas in London.
But some of the deviations from Basel’s standard have seemingly been brushed off by the European Central Bank, Europe’s bank supervisor. In November, after a long review of more than 150 options and national discretions available to national regulators which allow their banks to relax their capital requirements, the ECB decided the vast majority resulted in insignificant deviations.
The two most significant deviations, a 10 year phase-in for deferred tax assets and the ability to deduct insurance subsidiary holdings — part of what is known as the “Danish Compromise” — were nonetheless regarded by the ECB in a way that surprised some bankers.
“The paper that the ECB released on national discretions [in November] was alarmingly glib,” says Docherty. “They said [deferred tax assets] were basically a non-issue, and that they wouldn’t remove the Danish Compromise, period.”
That gives banks some margin of respite, but probably only temporarily.
“They will be under pressure from the Basel Committee to address this,” Docherty says.
€6tr sovereign debt weight
Becoming fully Basel compliant will mean, among other things, applying non-zero risk weights to sovereign debt exposures, an idea that has been gaining traction with national regulators including Sweden and Belgium, and has more recently garnered the support of the EBA.
“That’s going to be impactful,” says Docherty. “It will translate into a significant increase in risk-weighted assets for holders of sovereign debt.”
Banks, which rely heavily on sovereign debt for their liquidity coverage ratios, could have to raise €6tr in additional capital if a large exposure limit on sovereign debt holdings is imposed, according to ECB data.
Though the BCBS’s Basel III framework isn’t legally binding, global governments are all but certain to converge towards it over time. The remainder of its framework, expected to be published at various points between December 2015 and the second half of 2016, is projected to be even more painful than much of the existing Basel III regime.
Standardised pain
New year hangovers are likely to be compounded by the completion of Basel’s Revisions to the Standardised Approach for Credit Risk and the Fundamental Review of the Trading Book, expected to be published by the end of 2015, at the time of writing.
Both are much feared by industry professionals, who refer to the package as ‘Basel IV’, to regulators’ chagrin, who counter that the rules merely complete the Basel III framework.
The Basel Committee estimated in November that FRTB would increase capital requirements by 128% compared to the current standardised approach.
But the industry expects the impact to be much more significant: the International Swaps and Derivatives Association projects that portfolios under the standardised approach will have their market risk charges increased by 320%. Meanwhile, Deutsche Bank analysts last year projected that Basel’s Revisions to the Standardised Approach to Credit Risk could result in a 10%-30% increase in risk weighted assets for European Banks.
2016 will also see the introduction of a capital floor for internal model-based approaches to credit risk.
“In 2016 we’ll get the decision on the capital floor methodology — that’s key,” says Docherty. “We might get it in the first half of next year. At that point, people will know the floor as a percentage of the standardised approach.”
Add to that the Standardisation of Operational Risk, also expected to be open to consultation by the end of 2015, which will disallow banks from using internal models to gauge the capital needed against the risk of fraud, misconduct fines and control failures, among other things.
That could also significantly add to capital requirements for many banks, said Fitch Ratings analysts in a November report.
“We expect operational risk to rise as banks increasingly rely on technology, heightening exposure to systems failure and cyber attacks. Banks also face growing compliance and regulatory risks and the overhang of unresolved litigation is still considerable in some markets,” the rating agency wrote.
It’s impossible to know at this point just how much additional capital all this adds up to, but given profitability at banks has remained muted compared to the boom years, it is imaginable that many will struggle to keep pace.
Capital Rorschach test
All of these measures are intended to increase the transparency of the banking system, and make banks more comparable not just for the regulators overseeing them, but for investors.
But much of the regulations coming into force seem to do almost as much to obscure the true nature of bank balance sheets.
One of 2016’s main events will be the European Banking Authority’s next round of stress testing. The regulator will test the health of 53 of Europe’s banks, but with a major change from its 2014 test — this time, the EBA won’t set pass/fail thresholds.
Instead, the regulator will adopt a methodology similar to the ECB’s Supervisory Review and Evaluation Process (SREP), part of a review of bank’s Pillar II compliance.
When the EBA announced its test, set to be launched in February with results published in the third quarter, many thought that the regulator could lose the credibility it gained with its 2014 test by not being transparent about how banks pass and fail the test, given Pillar II is confidential between the regulator and the bank.
But some bankers think that, although the test may not give a transparent picture of how the EBA assesses the health of its banking system, it may actually be more difficult for banks to pass this time around. In 2014, the EBA failed only 24 banks of the 123 tested — an outcome seen by market participants as both a sign of good health in the sector as well as a sign of the competency of the regulator.
“I would not say that because the EBA is not setting a common threshold that that means they want to make it easy to pass,” says Emil Petrov, head of capital solutions at Nomura in London. “They are just making it a more integral part of the SREP process.”
Some have speculated that it may leave the door open for the regulator to be particularly harsh on banks for which it has concerns.
But the opacity of SREP and Pillar II, so important to this round of tests, is a bugbear for many in the market.
That extends to the Minimum Requirement for Own Funds and Eligible Liabilities (MREL), which goes into effect at the start of 2016. The requirement all but amounts to a Total Loss Absorbing Capacity rule for non-global systemically important banks.
“MREL is the person at the party that everyone wants to leave,” says BNPP’s Docherty. “It’s the same, but different than TLAC. It should be irrelevant. It’s confidential, so it’s hard to have a conversation on it. I’m not sure it’s a concept that makes sense.
“MREL is supposed to be non-conflicting with TLAC. To a market observer it’s completely opaque. I have no idea what Deutsche Bank’s MREL requirements are, for example.”
Perhaps the apparently imminent postponement of MiFID II will give banks some much needed time to draw out a map for themselves of what full compliance with post-crisis regulation will truly look like for their respective businesses.
But even as bankers spend 2016 coming to terms with the drip feed of new rules, it seems likely the market itself is at risk of becoming ever more inscrutable in the post-crisis world.