Almost 15 years on from the peak of the financial crisis, banks are approaching the final phase of reform, known as Basel 3.1. However, despite this being a globally-negotiated package, I’m seeing increasing signs that major jurisdictions are taking a divergent approach to implementation. So what does this fragmentation mean for global banks and the future of the Basel Committee?
Basel 3.1 is intended to reduce excessive variability of risk-weighted assets and provide for the transparent and comparable assessment of banks’ capital ratios. Despite the Basel Committee being asked to focus on not significantly increasing overall capital requirements, the impact is likely to be significant for many banks (the European Banking Authority (EBA) estimated in 2021 that full implementation of the Basel 3 reforms would result in an average increase of 13.7% on the current Tier 1 minimum required capital of EU banks). I feel certain elements have also proved controversial, such as the output floor, which limits the extent to which capital requirements calculated through internal models can fall below those calculated through the standardised approach.
The potential impact of these risks in terms of specific prudential outcomes and implications for the wider economy should not be underestimated.
Earlier this year the Basel Committee called for a timely and consistent implementation of Basel 3.1 by January 2023, but I think meeting this deadline now appears unrealistic for many jurisdictions. For example, while Hong Kong is expected to implement most of the Basel 3.1 reforms from 1 July 2023, the US is yet to confirm its approach. Japan has delayed its deadline for implementation to March 2024, while the UK and EU have set a target date of 1 January 2025. The EU’s proposed approach appears to significantly diverge from the actual Basel 3 package in important areas. The European Central Bank (ECB) expressed concern about the faithfulness of the EU’s proposals in an opinion earlier this year, particularly around the treatment of real estate exposures and credit risk from unrated corporates.
The Prudential Regulation Authority (PRA) is due to consult on the UK’s implementation of Basel 3.1 in Q4 2022, and will need to balance alignment with Basel with the implications of a potentially divergent approach in the EU, and the consequences for competitiveness and wider economic priorities such as supporting SME, infrastructure and the net zero transition. This will be important as the Government is proposing to give the PRA and Financial Conduct Authority (FCA) secondary objectives to support economic growth and international competitiveness, through the Future Regulatory Framework review. The PRA will also have to consider how the Basel 3.1 package will interact with its proposed ‘strong and simple’ prudential regime for smaller banks (having recently published a consultation paper on the proposed definition of firms that will be eligible for the simpler regime).
This situation raises the prospect of regulatory fragmentation and divergence across the major banking jurisdictions, which could create further regulatory and financial risks. Banks with international operations could face disproportionate regulatory complexity and costs, and possibly an uneven playing field in terms of competition and market access. This in turn could hamper the flow of capital and investment across borders, negatively impacting economic growth.
The potential impact of these risks in terms of specific prudential outcomes and implications for the wider economy should not be underestimated. If regulators fall at the final hurdle, this would not only create the prospect of increased complexity and costs for firms in planning how they will meet these requirements, but could potentially bake in the type of regulatory discrepancies that prompted the development of the Basel 3 framework in the first place.
