“Light touch regulation does not work. Strong rules are needed”

Stefan Ingves

In July last year, Stefan Ingves, governor of the central bank of Sweden, took over chairmanship of the Basel Committee on Banking Supervision. The Committee, which increasing­ly acts as a standard-setting body for the banking sector, issued a new accord (Basel III) in December 2010 – a direct response to the 2007/8 crisis and the deficiencies in international financial regulation that it revealed. In this exclusive interview with Global, Ingves explains how Basel III has strengthened banking regulation, supervision and risk management. But, he cautions, the new rules and principles will only be effective if they are rigorously enforced.

Global: The 2007/8 banking crisis saw the collapse of some large global banks and government bailouts for others, in order to ensure the survival of the banking system. What do you think are the principal lessons to be drawn for national banking supervisors?

Stefan Ingves: There are many important lessons to be learned. The first is that banking crises almost always have the same root causes: too much leverage (i.e. too little capital); or the opposite, an abundance of credit, or a perceived liquidity with the mispricing of credit; and not enough proper risk management. During the [2007/8] crisis, market discipline also did not exert the kind of influence one would have expected or hoped.

Second, regulation and supervision have, in the past, almost exclusively focused on the health of individual banks and paid too little attention to the risks posed to the financial system as a whole – the systemic risk. This time around, what was news to many was the fairly high element of contagion [as a result of] the interdependence between banks – both within coun­tries and across borders. It is precisely these contagion effects that may have the most serious repercussions for the financial system and the real economy, and this needs to be dealt with bet­ter in the future.

A third lesson is that ‘light touch regulation’ does not work. Strong rules are needed but they are only effective if you implement them in a robust way.

How will the new standards and approaches as framed by the Basel III Accord help ensure that future banking crises are prevented?

Basel III is trying to ensure that banks of all sizes and complexity manage risk better. If we are to be prepared the next time a crisis hits the financial system, enhanced risk management is crucial.

The accord aims to strengthen the capital framework by requir­ing better quality and more capital, focusing on the highest-quality, most loss-absorbing form: common equity. It also introduces a glo­bal standard for liquidity, which did not exist in the past. So we’re going from having produced fairly general statements about liquid­ity to hard constraints on how much money a bank has to hold. Third, a global leverage ratio will be introduced. That’s a safety precaution, a backstop to the risk-weighted asset framework and will place a cap on the amount of overall leverage a bank can take on. Also, a capital buffer must be built up in good times so that banks can draw down on this buffer in bad times – this too is a new innovation. In addition to this, Basel III has a macro-prudential perspective that stresses the impor­tance of looking at the system as a whole, not only thinking about the measures on capital and liquidity for individual institutions.

Having said this, there is no guarantee that there won’t be another crisis. Basel III is part of a broader policy agenda. All aspects need to be introduced and implemented to ensure the probability of a crisis is considerably reduced.

What extra resilience measures have been devised for systemically important financial institutions (SIFIs) – i.e. institutions that are too big to fail?

They need to hold even more capital. Of course, you have to classify them first, to figure out which institutions they are. There is an evaluation process going on to find a method­ology for defining SIFIs. Eventu­ally, SIFIs will be divided into four groups, with a higher capital charge going from 1 to 2.5 percent addi­tional capital.

National banking supervisors will apply new minimum equity, maximum leverage and liquidity requirements on their ‘home’ banks. Could you explain why the Basel Committee feels it needs to have a new framework of direct oversight on the standards implemented by national jurisdictions? You suggested in a recent speech that this would otherwise be equivalent to “building a lighthouse without ever switching the light on.” What will this mean in practice?

One of the current key priorities for the Basel Committee is to en­sure that the Basel rules and principles are fully implemented into its members’ national regulations, as agreed. To explain why this is important, let me, in addition to the lighthouse analogy, use another one related to motorway speed limits. Speed limits are important for the driver’s own safety as well as for other drivers. Without the limits, some drivers may drive recklessly and become a danger to others who share the road. But the importance of the limits are greatly diminished if they are not enforced. If drivers believe that the rules will not be enforced, they will not respect them. This is the role of the highway patrol – to enforce the limits on all drivers, for the safety of everyone.

In the context of the Basel framework for capital and liquidity, the rules – the speed limits – have now been agreed and are in the process of being signposted. The next critical step is to implement the rules in a timely and consistent manner. This was the mistake that was made in the past – good rules were agreed but the next critical step of rigorous enforcement was not taken. The Commit­tee’s implementation framework has been designed to ensure this mistake will not be made again.

To ensure regulatory consistency, the Committee has developed a completely new review process, comprising three levels of as­sessment. At the most basic level, the Committee is assessing countries’ progress in adopting the Basel regulatory framework into national law and legislation. A first progress report detailing the degree to which national authorities have implemented the Ba­sel rules was published in October 2011 and will be updated on a regular basis. The second level of review is to evaluate if the Basel rules, adopted at a domestic level, are consistent with the agreed framework. The first three assessments covering the US, the EU and Japan are already under way, with final reports planned for September this year. Finally, the third level will be to determine whether, in practice, the rules are delivering the anticipated out­comes across different countries and whether the rules result in comparable outcomes at the bank level.

The Committee’s work in this area will increase transparency. This will help identify new issues that pose prudential or level playing-field concerns, foster information sharing both within and outside member countries on how our rules are implemented, and facilitate more timely and consistent implementation for all coun­tries by learning from one another’s implementation experience.

Will there be any specific sanctions against countries that don’t follow the rules of the Basel framework?

No, because the Basel Committee has no legal tools to order a coun­try to comply. But on the other hand, in a transparent world, if a coun­try is completely non-compliant with the core principles for banking supervision and the Basel III Accord, that will be commonly known, and will affect its banks’ ability to operate in the global market.

Are you confident that the Committee will be able to adequately influence the application of the framework across all jurisdictions, especially in the fast-growing economies of Asia and South America?

Yes, I am confident that the Committee is in a strong position to exert influence on its 27 member countries – the G20 leaders fully support Basel III implementation. In addition, I am confident that market discipline will play an important role.

In many cases, the Basel Committee’s rules have become glo­bal standards. From an emerging market perspective, many of the reforms that comprise Basel III – such as higher capital ratios, simpler capital structures that are primarily comprised of common equity – are already in place. Basel III implementation is progress­ing very well among the Basel Committee membership and I am confident that our rules will be applied globally. It is important to note that, since the Committee was expanded in 2009, many of the leading economies in these regions are now represented – for example, China, India, Korea, Singapore, Hong Kong, Australia, Argentina, Brazil and Mexico. The role that these countries play in setting the examples in their respective regions will undoubtedly help spread the Basel standards to other countries too.

Many of the global investment banks are concerned that the costs of implementation are too high in relation to the benefits, that this will hit their profitability and raise the cost of the finance they provide for business. Does your own analysis give you confidence that the future benefits will outweigh these overall costs?

I would say that the costs of not implementing the rules far ex­ceed the implementation costs. We have conducted a number of quantitative impact studies analysing the costs and benefits of the new rules. In the short run, yes, there is a cost but it’s not remark­able, especially as the new standards are [to be] phased in gradually between 2013 and 2018. The transition period ensures the higher standards can be achieved through earnings retention, de-risking of certain capital market exposures and appropriate capital raising. And in the long run, there is clearly a good return on this invest­ment – higher levels of capital, combined with a global liquidity framework, will significantly reduce the probability and severity of banking crises in the future.

In relation to the issue of trade credit for low-income countries, are you satisfied that enough has been done to ensure that the new measures do not inadvertently penalise banking finance for these countries?

The Basel Committee believes that the changes made in October last year will improve the access to and lower the cost of trade finance instruments for low-income countries. The changes, which are of a technical nature and which have the effect of reducing capital charges for these instruments, is based on a comprehen­sive study which we conducted in collaboration with the World Bank, the World Trade Organization and the International Cham­ber of Commerce. However, it should be noted the Basel Com­mittee is keen on making sure that we will avoid any unintended consequence of the new capital and liquidity framework, and will continue to carefully study the impact of the implementation of the new framework.

How do you see the role and work of the Basel Committee changing in the future?

The role of the Basel Committee will not radically change, but it will evolve as all organisations do. There are two areas where the Committee’s focus might change compared with recent years. The first is the increased focus on ensuring agreed standards are actu­ally implemented. Second, we will try to achieve a better balance between our efforts to promote strong regulation and on empower­ing strong prudential supervision. As I noted earlier, one without the other is inadequate.

Interview by Elissa Jobson and Saxon Brettell, Director, Piametrics Ltd

About the author:

Stefan Ingves is the Governor of Sveriges Riksbank and Chairman of the Basel Committee on Banking Supervision


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