The evolution of banking regulation (2024)

Panel remarks by Sabine Lautenschläger, Member of the Executive Board of the ECB, at the Financial Stability Institute 20th anniversary conference, Basel, 12 March 2019

The crucial challenge with Basel III was to get the balance right between risk sensitivity and simplicity. Overall, I believe we did a good job. I know there are many complaints coming from the industry for a few of the asset classes, but I doubt that it is possible to establish a perfect balance for such a heterogeneous group. A perfect balance cannot be our objective as it would be impossible to deliver.

But let’s start from the beginning.

I remember the often passionate discussion in the Basel Committee on Banking Supervision (BCBS) about balancing risk sensitivity and simplicity. Not all of us believed in risk sensitivity as a basis for capital requirements.

So first of all, I am glad that we still have a risk-sensitive capital framework, although restricted by important backstops.

I am convinced that risk sensitivity is the only way to give banks effective incentives. Bigger risks need to be accompanied by higher capital buffers. Lower risks need smaller capital buffers. If we were to de-link capital requirements from risks and, therefore, potential losses, we would have to deal with unhealthy consequences.

In a crisis there would not be sufficient capital to cover increasing risks and losses, as we would incentivise weak banks to take on high risks in pursuit of high returns.

Although I am convinced by the idea of making capital requirements more risk-sensitive, I acknowledge that estimating actual risk weights is very hard. Thus, it was very important to combine greater sensitivity with backstops. So, with Basel III we introduced the input and output floors, which will limit the influence of modelling choices. And we prohibited the most complex model choices for some specific asset classes.

And then there is the leverage ratio, of course, which serves as an additional backstop to the risk-sensitive capital requirements.

Overall, I think we managed to strike a balance by combining a risk-sensitive approach with solid backstops.

But did we manage to keep the framework simple? Well, it is not actually simple; that much I admit. But we must remember that BaselIII is targeted at a financial sector that is very complex. It is a grave mistake to believe that there are simple solutions to complex problems.

Think about the leverage ratio, for example, which has been promoted as a simple measure to restrict risks. Designing a leverage ratio compatible with the different banking systems has been anything but simple; at the BCBS it took us several years and I would not call the outcome a simple design either. Often there was no easy answer available to those negotiating BaselIII as we had to cater for the heterogeneity of our markets, market participants and banking systems.

As for the future, I believe the basic architecture of Basel III is solid and that it will serve us well for years to come. But it’s no secret that the business of banking changes fast. So, it was clear from the start that some parts of any framework might have to be fine-tuned. The same is true with BaselIII’s complexity. We have to see how the rules work in practice and what impact they have. But still, we can reinforce the framework without introducing new rules or reworking its architecture.

The next step is now to faithfully implement BaselIII around the world.

Overall, I agree with the idea that we should not try to come up with a new framework every three years. We should rather focus on implementation.

But I would not want to give the impression that I am in favour of less regulation. Over the decades, we have seen a regulatory and supervisory cycle. The post-crisis phase of this cycle has been characterised by an understandable tendency to strengthen regulation and supervision. This is natural when the memory of the consequences of light-touch regulation is still fresh.

However, as the memory of the crisis fades, the cycle usually enters a phase where regulation and strong supervision are perceived as a hindrance to growth and markets. In this phase, regulation leaves less room for supervisory discretion. The requirements for the supervisor to be allowed to act begin getting more stringent. In this phase of the cycle, it is usually harder for regulators and supervisors to react to new risks.

My impression is that we are now between these two phases of the cycle. Between a phase where strong regulation and supervision are encouraged, and one where there are strong calls for fewer restrictions. This could be risky, and I would strongly advise against weakening rules we have already agreed on.

Besides this general point, there are several issues which should and could be dealt with, or discussed at the BCBS. Work can be done to improve joint understanding of emerging risks in the banking sector, to exchange information on standards and best practices on new or increasingly relevant topics, and to work on a minimum convergence of supervisory practices. And if I am informed correctly, many of the topics I will mention can be found in the 2019 work programme of the BCBS.

  • First and foremost, the BCBS should monitor how the new Basel rules are implemented in national laws and ensure it has a thorough overview of how these are then translated into supervisory practices.
  • It should also foster an intensive exchange of information about the risks and vulnerabilities we see in today’s and, in particular, tomorrow’s macroeconomic environment. These discussions should also cover the approaches supervisors could use to analyse, assess and react to these upcoming risks via Pillar 2, or other instruments. After all, a US supervisor’s challenge today may be a European supervisor’s concern tomorrow. I believe that supervisors from around the world would benefit from sharing views and experiences. The one thing we have to keep in mind is this: good supervision is a positive-sum game – everyone wins.
  • The BCBS could and should be a hub for exchanging supervisory knowledge, tools and approaches regarding cyber risk.
  • And finally, the BCBS could be of great help for supervisors regarding operational, legal and reputational risks in banks which are linked to conduct risks or anti-money laundering. The same is true for green finance or climate-related risk. Here, too, a structured exchange of information about different tools and methods would help to strengthen supervision globally.

As someone deeply immersed in the field of financial regulations and banking supervision, I can attest to the complexity and significance of the Basel III framework, as discussed by Sabine Lautenschläger in her panel remarks at the Financial Stability Institute 20th-anniversary conference in Basel on March 12, 2019.

Sabine Lautenschläger, a Member of the Executive Board of the ECB, highlights the fundamental challenge faced during the development of Basel III – finding the right balance between risk sensitivity and simplicity. Having actively participated in the discussions within the Basel Committee on Banking Supervision (BCBS), she emphasizes the difficulty of achieving a perfect balance for a heterogeneous group within the financial sector.

Lautenschläger acknowledges the industry's complaints regarding certain asset classes but defends the decision, asserting that a perfect balance is unattainable. She emphasizes the importance of maintaining risk sensitivity in capital requirements to provide effective incentives for banks. The recognition of bigger risks requiring higher capital buffers and vice versa forms the foundation of a risk-sensitive capital framework.

To address the inherent difficulty in estimating actual risk weights, Basel III introduces input and output floors, along with prohibiting the most complex model choices for specific asset classes. The leverage ratio serves as an additional backstop to the risk-sensitive capital requirements, contributing to a balanced approach.

Lautenschläger acknowledges the complexity of Basel III, highlighting that simplicity is challenging in a financial sector with inherent complexity. She cautions against seeking overly simplistic solutions for complex problems, using the example of the leverage ratio's intricate design process.

Looking towards the future, she expresses confidence in the solid basic architecture of Basel III but acknowledges the need for potential fine-tuning as the business of banking evolves. Emphasizing the importance of implementation over constant framework changes, she cautions against a cycle of excessive regulation followed by calls for fewer restrictions.

The expert underscores the need for continuous monitoring and evaluation of the implementation of Basel III in national laws. Additionally, she calls for a proactive approach in understanding and addressing emerging risks in the banking sector, emphasizing the role of the BCBS as a hub for exchanging supervisory knowledge. Areas such as cyber risk, operational, legal, and reputational risks, as well as green finance and climate-related risks, are highlighted as crucial topics for discussion and collaboration among global supervisors.

In conclusion, the expert echoes Lautenschläger's stance on the positive-sum game of good supervision, emphasizing the potential role of the BCBS in fostering international cooperation and knowledge exchange for the benefit of all stakeholders in the financial ecosystem.

The evolution of banking regulation (2024)
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