Canada and Australia may move ahead of Basel III

A long-awaited global agreement on capital standards within the Basel III reform package may be finalized “in the near future," according to the Basel Committee on Banking Supervision. Banks, however, are likely to be granted a lengthy implementation period possibly extending until 2025.¹

The Basel Committee has missed a number of deadlines as members are at odds over the setting of an "output floor", effectively a minimum level of capital to ensure banks can withstand volatile markets.²

The output floor would limit the extent to which banks can use their own models to calculate their lending risk, and would prevent them from using risk estimates that are too far below the outputs of Basel's standardized approach to credit risk.

European banks, in particular, have resisted the output floor and are concerned that it could significantly increase their capital requirements at a time when profitability is under pressure due to historically low interest rates.

Canada eager to pursue own reform agenda

The Office of the Superintendent of Financial Institutions (OSFI), Canada's banking regulator, has backed the global effort to set capital standards but has also shown its willingness to pursue domestic reforms if there are further delays to the Basel III revisions.

Jeremy Rudin, OSFI's superintendent, said domestic reforms could go above and beyond the Basel committee's recommendations. “Moreover, that plan will recognize that an effective capital regime includes much more than the minimum requirements that have been the primary focus of attention at Basel in recent years," Rudin said in April.³

Canada's banking regulator has also shown its willingness to pursue domestic reforms if there are further delays to the Basel III revisions

OSFI's sense of urgency is underpinned by historically low interest rates that resulted in a housing boom in multiple cities and households taking on record levels of debt.

Although Canada's financial institutions maintain robust levels of capital and liquidity, ratings agency Moody's downgraded the country's six major banks several months ago, stating that continued growth in consumer debt and elevated housing prices had left banks "more vulnerable to downside risks facing the Canadian economy than in the past."⁴

At the heart of the Canadian regulator's push for reform are the risk weights that underpin capital standards. Rudin said neither Basel's standardized approach to risk weights, nor the internal ratings-based approach used by the bigger banks, were adequate in “calibrating risk weights in proportion to risk."⁵

At the heart of the Canadian regulator's push for reform are the risk weights that underpin capital standards

OSFI suggested it would look at rebalancing risk weights where Basel III's standardized approach did not adequately account for variability of risks between different asset categories, such as mortgages for investment properties versus owner-occupiers. OSFI has also proposed additional capital requirements — or “buffers" — that would be above Basel's standards.

In times of economic distress, such buffers aim to establish confidence and would also be employed, under a regulatory framework, to allow banks to re-capitalize and continue lending.⁶

Strong ratios 

The high dependency of Australian banks on foreign capital and savings has also strengthened the demands from authorities for standards that ensure “capital ratios are unquestionably strong." ⁷

The Australian Prudential Regulatory Authority (APRA) has already imposed strict capital requirements on local banks, most notably with the 2015 announcement of 25 percent floor under risk-weightings for residential mortgages.⁸

APRA chairman Wayne Byres has suggested more stringent standards could be unveiled in the coming months. Industry experts see the floor under risk weightings being raised to 30 per cent, meaning the country's four major banks would need to raise as much as AUD 15 billion of capital among them.⁹

APRA chairman Wayne Byres has suggested more stringent standards could be unveiled in the coming months

Such moves would likely make Australia's capital standards stricter than what is ultimately agreed by the Basel Committee, according to Brad Carr, director of banking prudential policy at the Institute of International Finance. “Basel 4 will essentially move the global standard closer to where Australia is already at," he said.¹⁰

After much delay, the Basel Committee may be close to striking agreement on global credit standards, but with banks leveraged to record household debt, Canada and Australia's regulators may feel they can ill-afford to wait for the breakthrough.

Sources

1. Financial Times (May 25, 2017) Basel III reforms package closer to being finalised
2. Reuters (May 25, 2017) Global regulators expect deal soon on finalising capital rules
3. Office of the Superintendent of Financial Institutions (April 6, 2017) Waiting for Basel?
4. Moody's (May 10, 2017) Moody's downgrades Canadian Banks
5. Office of the Superintendent of Financial Institutions (April 6, 2017) Waiting for Basel? Next steps for Canada's bank capital regime
6. Ibid.
7. Financial System Enquiry (December, 2014) Capital levels
8. The Australian (April 5, 2017) APRA can deal with lending risks and Basel delays in one stroke
9. Ibid.
10. Australian Financial Review (June 8, 2017) Basel 4 'will be quite benign for Australian banks'