Basel III: if ever there were three syllables that could bring a grown banker to tears, these are they. In the 15-plus years since the financial crisis, the western world has been through a protracted process of rewriting regulations to protect against another 2008. The last pieces of that puzzle — conceived by the Basel Committee on Banking Supervision and known as Basel 3.1 — are now close to being slotted into place across the western world.
Until recently, US banks thought they were set to come off worst. Federal Reserve vice-chair for supervision Michael Barr had gold-plated the Basel rules, provoking a fierce backlash from Wall Street’s finest. But that lobbying, and the placatory intervention of Fed chair Jay Powell, appears likely to leave US banks with a watered-down impact that will be very similar to their European rivals — an uplift of perhaps 10 per cent in their capital requirements compared with the 20 per cent or so previously predicted, according to bankers.
The oddest feature of the US reforms is that most small and mid-sized banks will escape tougher treatment, despite the fact that it was precisely mid-sized regional banks that were the focus of depositor jitters last year, when the likes of Silicon Valley Bank and First Republic collapsed. (Only this month New York Community Bank needed an emergency capital infusion.) Yes, the definition of what constitutes a large bank has been expanded to anything greater than $100bn, rather than $250bn, but that still leaves thousands of lenders — all but the top 99 — to pose a potential systemic risk.
In Europe, less obvious dangers may accumulate. Last year, EU and UK banks and regulators felt quietly smug when the region’s institutions emerged unscathed from the market turmoil and client nervousness that brought down Switzerland’s Credit Suisse and the US regionals. But the way in which the EU is implementing Basel 3.1 — particularly the way it embeds a previously temporary provision giving capital relief to banks with insurance subsidiaries — is a cause for concern.
Policymakers argued that this so-called Danish Compromise was justified because insurers are also closely supervised financial institutions, so they should be treated as less risky investments in bank capital terms than other subsidiary holdings. But in essence the Danish Compromise — conceived during Denmark’s 2012 EU presidency — was a sop to help banks that owned insurance operations and found themselves stretched for capital amid the eurozone crisis.
Much of that stress came about because of the “doom loop” stemming from banks’ ownership of so much of the sovereign debt of their stressed home countries. The falling value of this debt led to bank losses, which then led to lending cutbacks, further hitting economies. Ironically, the Danish Compromise and the encouragement it gives to buy more bonds amplifies that risk. Some regulators and independent insurers complain the measure is a political fudge, and fought — but failed — to have it removed from the new rule book. “The impact on increasing systemic risk is massive,” says one insurer.
One particular area for concern is exactly the issue that tripped up US regional banks: in the higher-interest-rate environment, large volumes of hidden losses accumulated on long-dated bonds. The value of eurozone banks’ domestic government bond exposure, currently €1.5tn, slumped nearly 20 per cent in the two years to early 2023.
And while European bank rules mean losses for most banks are transparently accounted for, and insurers apply similar fair-value accounting, there is a mismatch when insurance subsidiaries are consolidated into bank parent companies. Losses in the insurance subsidiary are not reflected in the bank’s consolidated accounts. (Data on insurers’ sovereign exposure is less granular, but across the European Economic Area is about €1.6tn.)
The issue is troubling on other grounds, too. The politically convenient fiction that all eurozone sovereign bonds are risk-free means that banks need set no capital against them. At the same time there is less effective regulatory supervision of a so-called bancassurer because the structure of banking and insurance supervision is split between the ECB and the less muscular European Insurance and Occupational Pensions Authority.
The final phase of post-2008 Basel III regulation will boost the solidity of much of the global banking system. But thanks to a Mexican stand-off in the US, and a Danish Compromise in the eurozone, there are still weak points. And a crisis does love a weak point.