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insight

Basel 3 – The Timing Dilemma

Last month the United States (US) regulatory authorities announced that they did not expect their rules implementing Basel 31  would become effective on 1 January 2013, although they are working as "expeditiously as possible” to complete their rulemaking process.

Similarly in the European Union (EU), the trilogue between the European Commission, the European Parliament and the Council of Ministers to agree the text of Capital Requirements Directive IV (CRD IV, the EU version of Basel 3) is still ongoing and, even if a political agreement can be reached by year-end (which still appears to be the intention), it is recognised in the EU that there will not be sufficient time for CRD IV to be codified as legislation and put into effect on 1 January 2013.

So, does it necessarily follow that we should delay Basel 3 implementation in Hong Kong because the US and the EU cannot meet the internationally agreed timeline?  Or should we follow the timeline set by the Basel Committee on Banking Supervision and begin the first phase of Basel 3 implementation from 1 January 2013?  Our Basel 3 rules (the Banking (Capital) (Amendment) Rules 2012) are currently tabled at LegCo and notwithstanding the expected delays in the US and the EU, the Basel Committee’s timeline remains unchanged.  Its gradual phase-in of the new capital standards over six years begins from January 2013 and extends until 2019.

In resolving the timing dilemma, it might first be instructive to remind ourselves that Basel 3 is being introduced to rectify weaknesses made all too starkly apparent in the recent global financial crisis.  Or, put another way, Basel 3 is considered good for financial stability.  The Basel 3 capital standards are designed to strengthen banks’ resilience by requiring more and better quality capital and by addressing and capturing risks not adequately recognised previously.  The aim is to ensure that banks can weather future financial storms without disruption to their lending.  This should in turn make them less likely to create or amplify problems in other areas of the economy and facilitate their contribution to long-term sustainable economic growth.  The roller-coaster of excessive leverage pre-crisis and excessive deleveraging post-crisis is not conducive to sustainable growth. 

Regulation is all about balance.  If regulation is too lax, excessive risk-taking may result with devastating effects.  If regulation is too tight, it may suppress beneficial financial activity and reduce growth.  In our view, Basel 3 represents an appropriate balance in bolstering resilience whilst at the same time (with its extended phase-in) not unduly hampering lending to business and households today and ensuring banks can continue to lend in any downturn tomorrow.  For this reason we propose to begin implementing Basel 3 from 1 January 2013.

We are not alone in this.  Our regional peers, Mainland China, Japan, Singapore and Australia have all published their final rules for Basel 3 implementation next year.  As has Switzerland, another important financial centre.

But notwithstanding the intrinsic benefits of Basel 3, should we nevertheless be swayed by the argument put to us that Asia is taking the “medicine” designed for the countries worst affected by the crisis, whilst the intended “patients” defer and thereby give their banks significant “competitive advantages” over our own? 

This competitive advantage argument would seem to be based on two assumptions.  First that US and EU global banks (i.e. those banks that could realistically compete with our own) are currently holding much lower levels of capital than required by Basel 3 (and hence will have a genuine cost advantage); and second that our banks will, come 1 January 2013, have to hold more capital than they currently hold (and hence will incur additional cost). 

Are these assumptions correct?  Well even though adoption of Basel 3 is delayed in the US and the EU, this certainly does not mean that banks in these regions remain at their pre-crisis capital levels.  There has been significant re-capitalisation.  The Dodd Frank Wall Street Reform and Consumer Protection Act in the US already requires the regulatory agencies to conduct stress-testing programmes to ensure banks and other systemically important financial institutions have enough capital to weather severe financial conditions and, even before the passage of the Dodd Frank Act, the US Federal Reserve Board put some of the largest US bank holding companies through stress-tests, the results of which have led to significant increases in capital.  By 2012, the 19 bank holding companies subject to the Fed’s Comprehensive Capital Analysis and Review had increased their aggregate tier 1 common capital to US$803 billion in the second quarter of the year from US$420 billion in the first quarter of 2009, with their tier 1 common capital ratio (which compares high quality capital to assets weighted according to their riskiness) doubling to a weighted average of 10.9% from 5.4%. 

In the EU, under a recapitalisation exercise in 2011 that covered 71 of the EU’s major banks, the European Banking Authority (EBA) required most to attain a “core tier 1 ratio” of not less than 9% by the end of June 2012.  In October 2012, the EBA indicated that it will focus on capital conservation to “support a smooth convergence to the CRD IV….. regulatory requirements” and require the banks to maintain an absolute amount of core tier 1 capital corresponding to the level of the 9% core tier 1 ratio. 

So even absent formal adoption of Basel 3, the capital levels of the largest banks in the US and the EU have increased significantly post-crisis to levels comparable with, or even in excess of, those required under Basel 3 and so the prospect of such banks “competing” by being allowed to maintain much lower capital levels than Basel 3 banks would seem more apparent than real.

Turning to the second “competitive” assumption, will the first phase of Basel 3, which starts next year, require local banks to hold significantly more capital than they do at present, to the extent that they may become constrained in their ability to lend and compelled to pass on the costs of the extra capital to borrowers?  Well, the results of the HKMA’s quantitative impact studies tell us that our local banks are already very well-placed to meet the new Basel 3 capital ratios.  Their capital levels are already in excess of the standard taking effect on 1 January 2013 and the issuance of ordinary shares (common equity) already accounts for a very significant proportion of their capital base, positioning them well for Basel 3’s new focus on common equity as the highest quality capital for the purpose of loss absorption.

In summary then, irrespective of any delay in formal implementation of Basel 3, major banks in the US and EU are inexorably moving to higher levels of capital.  This, together with the benefits offered by Basel 3 and the relative ease with which local banks can comply, serves to underpin our view that we should proceed to implement the first phase of Basel 3 in line with the Basel Committee’s timeline.  Generally speaking, jurisdictions in Asia have in the past tended to adopt regulations that are in some respects higher than the Basel Committee’s minimum standards.  This may have helped Asia weather the global financial crisis relatively unscathed when compared with the jurisdictions worst affected.  There would, therefore, seem little to be gained from seeking to engage in, or indeed prompt, a “race-to-the-bottom” in regulatory terms by deliberately delaying the introduction of Basel 3 at this point in time.  In implementing on 1 January 2013, we will be fulfilling our commitment both as an international financial centre which customarily adopts best international standards and as a member of the Basel Committee on Banking Supervision.

 

Karen Kemp
Executive Director (Banking Policy)
6 December 2012


1Basel 3 is a package of new capital and liquidity standards devised by the Basel Committee on Banking Supervision to address the lessons learned in the recent global financial crisis. It is to be phased-in, beginning with certain of the capital standards from 1 January 2013. Phase-in of both capital and liquidity standards should be complete by 2019.

Last revision date: 6 December 2012
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