Wednesday, October 9, 2013

Are Dangerous Gaps Forming in Basel III Implementation?

Are dangerous gaps forming in the Basel III implementation in the US and EU? Bradley Sabel, a partner and co-head of the Financial Institutions Advisory & Financial Regulatory practice group at Shearman & Sterling LLP, believes so. Sabel believes that differences between the way in which Basel III standards are being put in place in the US and EU may "have a profound impact on the relative competitiveness of US and EU institutions as well as the product mix that banking institutions will offer to customers and the types of debt and equity instruments sold to investors." In his October 9, 2013 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation, and in a recent client memorandum, Mr. Sabel lays out just which differences in Basel III implementation are cause for concern.

Chief amongst Mr. Sabel's worries is the the gradual “phase in” of certain rules, particularly on liquidity and leverage.  These, he says, are differences that will have the most effect on the relative competitiveness of US and EU financial institutions.
 

Implementing rules are now in place in the US and EU, although many requirements are to be “phased in” ahead of the timetable for full implementation of Basel III by January 1, 2019. The timing of the US and EU phase-in of certain rules, such as leverage and liquidity requirements, is not consistent.


Other areas where gaps are forming in the timing and method for implementing Basel III in the US and in Europe are:

 

 

  • Treatment of capital instruments;
  • Risk weight calculation;
  • The leverage ratio;
  • Adjustments for derivative counterparty risk (the “credit valuation adjustment”);
  • References to external credit ratings; and
  • Large exposures.

 

 

One example of where differences in approaches in the US and EU may create competitive imbalances is the so-called Collins Amendment of the Dodd-Frank Act (Section 171). The Collins Amendments prevents Advanced Approaches Banks from having minimum capital requirements below the general risk-based capital requirements.  A non-US bank employing the Advanced Approaches of Basel III and pursuing a strategy of lower risk loans and investment grade assets may enjoy a competitive advantage over US institutions, because the capital floor imposed under the Collins Amendment would eliminate any ultimate capital relief large US banks may otherwise obtain under the internal models approach of Basel III.
 
Despite a degree of commonality in the US and EU implementation of Basel III, there is significant divergence in some respects which may give rise to certain arbitrage opportunities.
 
These gaps, says Sabel, may not only cause competitive imbalances between US and EU financial institutions, but may open up regulatory arbitrage opportunities.  For example, new risk weight calculations included as part of the US Basel III Rules would significantly modify risk weighted asset calculations under the “Standardized Approach.' effective January 2015; however, the EU has not effected a wholesale change to asset risk weightings. These differences in the relative capital charges applied to assets held by US institutions, as compared to those applied in the EU, would change the competitive dynamic between institutions located in those jurisdictions and could present opportunities for arbitrage.

In other areas, the Dodd-Frank Act has introduced several capital-related provisions unique to US
financial institutions that are inconsistent with, and stricter than, the Basel III framework.  These include:

 
  • Leverage ratio implementation,
  • Regulatory capital base, and
  • Removal of references to external credit ratings


Mr. Sabel does the yeoman's work of putting together a detailed issue-by-issue comparison of US versus EU implementation of Basel III, with some commentary on potential fallout from differences in approaches or timing.  According to Sabel, the effects of these gaps between US and EU implementation will differ by asset classes, becoming clearer as time passes.
 
The breadth and impact of the relative cost advantages stemming from divergence in the rules will differ by asset class. Despite implementation of Basel III in the US and EU, many rules are to be “phased-in” over the coming years and in the US regulators are expected to propose future rulemakings in the areas of capital and liquidity. As a result, the resulting scope of the competitive differences may not become entirely clear for some time.
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