Main Content

Rethinking the Basel Committee on Banking Supervision

The structure of the Basel Committee is well overdue for a rethinking, as the impact of its work has gradually decreased in relevance.

By Greg Baer

The Basel Committee is an organization overdue for a rethinking. Its goal of consistent regulation of internationally active banks remains a worthy one, but its self-defined scope has increased dramatically post-crisis, even as the impact of its work has decreased in relevance. Meanwhile, its organizational structure appears odder by the day and is likely to prove untenable over the long term.

The Basel Committee will soon experience one of its periodic turnovers in leadership, marking a good time for revisiting its structure and operations. And a Basel IV package placing greater emphasis on standardized approaches and establishing an output floor either will have been completed or failed to be completed. (Its fate is uncertain as of our deadline.) This seems an opportune moment to try to imagine a reorganization that would allow the Basel Committee to retain – or, really, regain – relevance and effectiveness.

A core goal of the Basel Committee has been to ensure that a common set of regulatory and supervisory policy standards applies to all internationally active banks, regardless of nationality. Yet one of the great ironies of post-crisis regulation is that at the same time that the Basel Committee has rapidly expanded its work to produce myriad new global standards, national regulators increasingly have charted their own path, putting in place policy frameworks that diminish the relevance of the standards agreed upon at Basel.

This trend is most pronounced in the United States, where core elements of the prudential framework now bear little resemblance to Basel standards. For example, the binding capital requirement for the largest U.S. banks (G-SIBs) is the Federal Reserve’s CCAR stress testing requirements or the enhanced supplementary leverage ratio (eSLR), not the Basel III capital requirements. The former is not even an example of “gold-plating,” or taking a Basel standard and making it more stringent only for U.S. banks, but rather an altogether different concept. The latter is based on Basel III standards, but if the Basel leverage ratio is fish, ours is more fowl. (Pause for those who don’t get it immediately.) The eSLR standard is 200 basis points higher than the Basel standard and is imposed on an average rather than a spot basis. (While it sounds arcane, the latter difference has significantly affected repo activity.) The story is the same for liquidity, where the binding constraint for most if not all of the largest U.S. banks is not the Basel Committee’s liquidity coverage ratio (LCR) measure, but rather a series of supervisory liquidity requirements imposed through the living will process outside of any public notice and comment process. The LCR has also been supplemented in the United States by a Comprehensive Liquidity Assessment and Review (CLAR) process with no Basel roots whatsoever, as well as liquidity stress testing requirements that go well beyond standards prescribed by Basel. (Note: Multiple U.S. G-SIBs have publicly disclosed that their binding liquidity constraint is determined by their resolution plan liquidity requirements rather than the liquidity coverage ratio.)

In Europe, the Bank of England and European Banking Authority also have made stress testing a significant focus of their approach to capital regulation, though the European test is not (at least yet) a binding constraint for European banks. The EU has varied from Basel capital standards when it deemed appropriate (e.g., through divergences in the institutional review board approach to credit risk and CVA adjustments in counterparty credit) and liquidity standards (e.g., by including covered bonds as high-quality liquid assets under the LCR and making a range of adjustments to the net stable funding ratio). Additionally, the Bank of England has permitted U.K. banks to begin deducting central bank reserves from the leverage ratio denominator, which is not permitted in the international version of Basel III.

On the Asian front, Chinese regulators participate in the Basel Committee but do not fully implement its standards. This is significant, given that Chinese banks are among the largest in the world, and growing. Japan has generally adhered to Basel standards but consistently rejected a central tenet of post-crisis regulation, which is that no bank should be too big to fail. (For that matter, European law also specifically permits state aid, albeit only after a very substantial bail in of creditors has occurred. U.S. law specifically outlaws it.)

Many of these divergences are highlighted by the debate over a Basel IV output floor – effectively, a cap on the extent to which internal ratings-based capital measures can produce a lower capital charge than would otherwise apply under standardized measures. For U.S. banks, the debate is somewhat academic, as CCAR or the eSLR is the binding capital constraint, and in any event U.S. regulators already have imposed a 100% output floor (though the latter could be revisited in the wake of a Basel agreement). To some European banks, an output floor appears inappropriate, given that they hold a far larger percentage of mortgages on balance sheet than banks in the U.S. (where regulators have chosen to push mortgage risk away from banks and to the U.S. government-sponsored enterprises, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks) and standardized charges for mortgages appear unduly high.

None of this is to say that local inventions or deviations from Basel standards are necessarily bad policy – again, in many cases, they make a great deal of sense. But if the goal is international harmony on bank capital and liquidity standards, the present challenge is less to keep the Basel Committee together and more how to put it back together.

And that process would seem to require rethinking the voting membership of the Basel Committee itself, which has been expanded twice in the last eight years. The Russian Banking Federation is a member. So too is the Bank of Indonesia and the Indonesia Financial Services Authority. There are 45 members from 28 jurisdictions, plus another nine observers. A further problem with this expanded membership has emerged as capital and liquidity rules increasingly govern capital markets activity: most of those members supervise no capital markets activity, and thus bring to the exercise little to no expertise, no real stake in the success of capital markets, and therefore a general aversion to risk. (Included among those members is the FDIC in the United States.)

The European membership is at this point especially difficult to understand. A theme of post-crisis European reforms, and in particular the EU’s work to establish a true banking union, has been enhancing the authority of the European Central Bank as an EU-wide prudential regulator. Supervisory policy for large banks in the EU is now set predominantly and increasingly by the European Union, the European Central Bank (via its Single Supervisory Mechanism), and, for resolution matters, the , and not by the member states. Yet all the member states of the European Union still send one representative (or, in some cases, two) to Basel. (Note: National authorities in individual member states retain authority over small and medium size banks in the EU. They also currently maintain authority over local branches of non-EU banks and non-bank financial subsidiaries, though the authority of the ECB vis-à-vis such branches and large investment firms to the ECB is under active reconsideration.)

U.S. participation in the Basel Committee is similarly problematic. It includes the Federal Reserve Board, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the FDIC. The odd result is that while only two of those agencies (the Federal Reserve Board and OCC) set regulatory policy for large, internationally active banks under U.S. law, all four are permitted to do so in Basel. This also means that any U.S. position must begin with a pre-negotiation among four U.S. agencies, including one that is a regional member of another and one that is a deposit insurer with a heavy bias against risk-taking.

Hence, while the pun is perhaps too easy, the term Tower of Basel is not as unfair a term as it may seem. The process of agreement takes years and involves a large amount of international horse-trading among constituents who have varying stakes – and in some cases may have no real stake at all – in the outcome. It is not difficult to analogize to the General Assembly of the United Nations, where voices are too numerous to receive real consensus on much of anything, particularly as small countries have the same vote as large ones.

But the U.N. has a Security Council in addition to a General Assembly, and perhaps the future of Basel lies there. It is worth noting that in order to achieve consistency in regulation among the 30 largest internationally active banks – the G-SIBs, as identified by the Financial Stability Board in consultation with the Basel Committee – only a small handful of regulators would need to be on a Basel security council: the Federal Reserve Board, the European Central Bank, the (post-Brexit) Bank of England, the Swiss National Bank or Financial Market Supervisory Authority, the Bank of Japan, and the China Banking Regulatory Commission. Central banks or supervisors from other countries could be encouraged to attend and participate in working groups but would not have a vote on final standards.

A smaller executive body could also make it easier for the Basel Committee to adopt procedural protections of the type required by U.S. law – and by fairness and common sense. Among those requirements are explaining the basis of any proposed rule, considering all comments received, explaining how those comments were addressed in the final rule, and documenting rational basis for the final rule. In the United States, the Federal Reserve could publish any Basel proposal contemporaneously for comment in the United States.

Such a process would have significant impact on the substance of what is produced in Basel. With regard to the two of the more prominent Basel Committee standards not yet implemented globally – the Net Stable Funding Ratio (NSFR) and the Fundamental Review of the Trading Book (FRTB) – it is difficult to imagine how the Committee could meet these procedural standards. As The Clearing House has demonstrated in our research, the NSFR is not calibrated to anything, and would have significant adverse economic effects. The FRTB – a standardized measure of market risk now estimated by the Basel Committee to produce a capital charge 100% higher than the current internal ratings based approach – has never been well explained. In both cases, the primary motivation for finalization is by all accounts exhaustion and a desperate need to move on rather than a studied look at the comments received.

More broadly, a next-generation Basel Committee will have much work to do in reevaluating the collective impact of Basel 2.5, III, and now IV, as well as considering how stress testing can be made consistent across jurisdictions. This work is important, but it is hard to see how it can be achieved by the current construct.