Outreach Blog

Tuesday, May 30, 2017

Is Final Basel III Just Around the Corner?

"The output floor is the final piece of the jigsaw”


Author: David Schwartz J.D. CPA

In speeches on April 5 and May 25, 2017, William Coen, Secretary General of the Basel Committee, hinted that final Basel III standards are “just around the corner.” Despite a setback in January 2017 in which the Committee members could not reach accord on the calibration of the aggregate output floor, Coen signaled optimism for the upcoming meeting the Committee in June. In a May 25 speech, Coen announced that ‘based on feedback from the consultative process and the results of our impact studies, the Committee has largely completed the technical work needed to revise the framework.” Despite this optimism, calibration of the output floor still remains somewhat of a sticking point, one that Coen says “is the final piece of the jigsaw.”

 

The output floor is a result of a long process of consultation and revision. The design likely to be put forward for approval of the Basel Committee in June reflects a great deal of trial and error learning from this process to arrive at the output floor concept, Coen says. 

 

“[T]he Committee has reviewed and consulted on various ways of designing the output floor. This includes a very granular "exposure class/type" floor, based on individual exposures such as mortgages. We also considered a floor based on 'risk types' such as credit risk and market risk. In the end, the Committee has chosen the simplest form - an ‘aggregate' output floor. This is simple and straightforward - a bank's measure of risk-weighted assets (using internal models) can in aggregate be no lower than, say, 70-75% of the risk-weighted assets that would result if the bank had applied the standardised approaches to determine its risk-weighted assets."

 

The reason the output floor remains such a point of contention is its prospective effect is fairly widespread, with banks in some jurisdictions not yet fully prepared for these effects. To mitigate some of these effects, Coen says that he expects the Committee will address a phase-in process offering much deference to the timetables national supervisors.

 

"The calibration of the output floor is a difficult question because of concerns related to its impact. Even though the use of models for regulatory capital purposes related to credit risk has only been in place since around 2008 and despite the 80% floor that is part of the Basel II capital framework, the floor will likely have an impact on some banks. To acknowledge such differences in the readiness of banks across jurisdictions to meet new rules, the Committee has in the past allowed time for banks and supervisors to meet the implementation timelines, along with transitional arrangements to meet the new standards. Recall that in 2010, the Committee adopted 2019 as the date by which the Basel III requirements needed to be fully phased in. I suspect a similar approach will be taken for this set of revisions. Given the wide range of revisions, some time is needed to allow jurisdictions to conduct their legislative and rule-writing processes, and for banks to implement the changes in their systems and processes.

 

The Committee is also considering a reasonable phase-in for some elements of the revised standards. When it comes to the start date for the new rules and the adoption of any transitional and phase-in arrangements, it is important to note that these are solely at the discretion of the national supervisor. Early adoption of the rules is always an option.”

 

Implementation and Review

 

The Basel III framework has two goals: (1) ensuring minimum global standards of resilience so that banks are less likely to fail and (2) reducing the effect on the financial system and the economy when banks do fail. According to Coen, “full and consistent implementation of these standards within the internationally agreed time frame” is critical to achieving these goals. Through its Regulatory Consistency Assessment Programme (RCAP), the Committee has monitored the timely adoption of Basel standards by its member jurisdictions. RCAP has also conducted peer reviews on the "completeness and consistency of the standards adopted by member jurisdictions, including the significance of any deviations from the Basel framework.” Most importantly, however, RCAP also monitors the outcomes from adopting Basel III standards. In the course of the RCAP process, the Committee has used this process to calibrate regulatory capital ratios and arrive at the latest version of the output floor.

 

"The Committee has published five reports on the consistency of risk-weighted assets for similar assets in banks’ loan portfolios and trading books. These analyses confirmed that there are material variances in banks’ regulatory capital ratios that arise from factors other than differences in the riskiness of banks’ portfolios. This motivated the range of ongoing Basel III reforms aimed at reducing excessive variability of risk-weighted assets. These reforms include revisions aimed at enhancing the standardised approaches, constraining the discretion of internally modelled approaches and  complementing the risk-weighted framework with a robust leverage ratio and output floor.”

 

Mr. Coen said that the RCAP process, particularly monitoring outcomes and assessing calibration, will continue and remain a priority when the Committee does, at last, finalize Basel III.

 

"Implementation is a continuum and not a one-off event. To realise the full benefits, implementation requires a rigorous system of monitoring and analysis as well as a feedback loop to policy work.”

 

The full text of Mr. Coen’s recent speeches are available via:

 

http://www.bis.org/speeches/sp170405.pdf

 

http://www.bis.org/speeches/sp170525.htm

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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