Current Regulatory Developments in Washington and Basel

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On Thursday 8 June, ACFS in conjunction with Finsia, hosted a boardroom briefing featuring Brad Carr, Director in Regulatory Affairs at the Institute of International Finance (IIF) in Washington DC. Mr. Carr presented on the topic ‘Current Regulatory Developments in Washington and Basel’, drawing on insights from investigations conducted by the IIF.

Mr. Carr commenced with the US regulatory environment. In February, President Trump’s issued an Executive Order for the Treasury Secretary to prepare a report on potential areas of financial deregulation by June 3, 2017. This is one of a four-staged delivery of reports concerning regulation of varying aspects of the US financial system, and a reaction to an under-resourced US Treasury.

This first report addresses the topic of banking regulation, and with its public release imminent, Mr. Carr discussed the report’s likely contents. Potential topics include significant relief for Community Banking, due to its widespread political interest and bipartisan support. Such relief may be also be offered to the US Federal Reserve’s Comprehensive Capital Assessment Review (CCAR) process, but in terms of the impost of time and complexity, rather than widespread capital relief.

The Volcker Rule, which outlaws proprietary trading in entities subject to deposit insurance, is also expected to be addressed in this first report, because of the ambiguity associated with banks being able to participate in market-making, but not proprietary trading. This ambiguity has become increasingly prevalent, due to a recent noticeable decline in banks’ inventories of corporate bonds and a resultant deterioration of market activity in these instruments. The decreased liquidity, and consequently increased timeframes in which banks hold the bonds they have bought from their clients, has made it more difficult for them to demonstrate that many of their transactions fall under market-making, rather than proprietary trading. Whilst a fractured US Senate makes it unlikely the Volcker Rule will be abolished completely, there is a consensus that an adjustment to its formal definitions and guidelines should be made by the Fed.

Although it may only receive a cursory mention, due to it being the focus of a separate Treasury report, Title II of the Dodd-Frank Act, which is concerned with resolution, bankruptcy and the Orderly Liquidation Authority (OLA) is also likely to be acknowledged in this first Treasury report. In contrast to the Volcker Rule, a consensus is much more likely to exist in the Senate that Title II be repealed. Mr. Carr explained that eradicating the OLA is troubling, as the resolution or recovery of a failing financial report could then only be solved by a judge in US Bankruptcy Court, biased towards payouts to creditors, lacking knowledge of the financial system, and incapable of providing liquidity support.

In addition to the amendment of existing US regulations, Mr. Carr also suggested that the report would seek to draw the Fed’s attention to Pending Basel Standards, including the Fundamental Review of the Trading Book (FRTB) and the Net Stable Funding Ratio (NSFR). Whilst the former is less likely to be a cause of international fragmentation, due to equivalent concurrent discussion in international forums, the latter is expected to be of greater concern. Pushback to this in the US can be attributed to complaints by certain US banks, about inappropriate required stable funding factors regarding the funding of derivatives, as well as the available stable funding factors for different sources of funding. Most concerning is that unlike the FRTB, parallel discussion regarding the NSFR, is not occurring in the Basel Committee (BCBS) or any other international forum outside of the US.

With regards to the most recent Basel package (commonly referred to as “Basel IV” in industry), it seemed in early 2017 as if an agreement would occur only after key US appointments were made in the US Agencies with representation in Basel (i.e. the FRB, FDIC and OCC). Despite this, the IIF’s recent feedback suggests that these US Agencies, the Fed’s Chair Janet Yellen and Secretary Mnuchin are willing to proceed and enter a deal without these appointments being made. Mr. Carr suggested that an agreement could potentially be reached as early as next week’s BCBS meeting. He felt that this willingness from a US perspective stems from the fact that the key components of this Basel package revolving around Credit Risk, Operational Risk and the Capital Floor, have already been largely accepted and implemented by US banks. Moreover, it is the European banks that are more likely to be negatively impacted by this package than US banks.

In terms of the components of this package, as he predicted in his previous address to ACFS in November 2016, Mr. Carr confirmed that an emerging consensus amongst banks and corporates favouring the Foundation IRB approach, rather than the Standardized approach for credit risk, had recently taken place. Nevertheless, some moderation has occurred within the Standardized approach, including BBB corporates receiving a risk-weight of 75% instead of 100% and grade-A banks receiving 30% instead of 50%. Whilst these factors have all been agreed upon, it is the standardised-based capital floor that remains the most contentious issue, with 75% seeming the most likely final value. Whilst this figure is preferred by the US, Europe tends to be in favour of a lower value. As an example, the Netherlands consists of a high prevalence of large LVRs, meaning that in the case of relatively low IRB risk-weights, a much lower capital floor is required so that an onerous charge is not sustained.

Resultantly, most banks in the US and Canada will likely benefit from the change, or at the very least, experience a benign outcome that preserves risk sensitivity at the centre of the capital framework, and will not result in a significant increase in capital. Having said this, it is Europe, and specifically, the French, German and Dutch banks, that stand to be very adversely affected by this outcome.