Basel 4 – Emerging from the Mist? | 1

Basel 4 – Emerging from the mist? | 1 FINANCIAL SERVICES Basel 4 – Emerging from the mist? September 2013 kpmg.com 2 | Basel 4 – Emerging from the mist? Executive Summary Basel 4 – Emerging from the mist Even before Basel 3 is supporting higher minimum leverage of banks’ internal models (perhaps ratios and reduced reliance with greater complexity allowed only fully implemented, ‘Basel on models; in the assessment of Pillar 2 capital 4’ may be emerging from requirements). • A corresponding flurry of papers the mist. Developments from the Basel Committee that Second, requiring banks to meet a in recent months lay the look beyond Basel 3, including on higher minimum leverage ratio. A groundwork: the regulatory approach to banks’ minimum leverage ratio of substantially treatment of trading books, on above 3 percent would act more as a • Some countries are already the variability across banks of risk ‘front stop’ for Pillar 1 minimum capital beginning to impose requirements weights generated by banks’ internal requirements than the ‘back stop’ role it that go beyond Basel 3. The US and models, and on the balance between plays in Basel 3. Europe are requiring banks to meet risk sensitivity, simplicity and minimum capital ratios even after the Third, greater disclosure by banks. To comparability; and impact of severe stress; Switzerland, the extent that banks are allowed to the US and UK have set a minimum • For euro area banks, the prospective use complex models, this would require leverage ratio at above 3 percent; actions of the European Central banks to explain and justify why their others (Australia and UK) are insisting Bank (ECB) as supervisor, regulator risk weightings based on internal models that ‘Pillar 2’ capital add-ons are met and macro-prudential authority – the differed from the standardised approach through highest quality capital; and emergence of ‘Frankfurt 1’. risk weightings. And to the extent that finally, countries such as the US greater reliance was placed on a simple and UK are pushing for tougher These developments are leverage ratio, banks would be able to liquidity standards; likely to result in three explain how this differed from a more risk-sensitive approach. • Widespread concerns among changes that might form the regulators and market analysts basis of a future Basel 4. What implications might about banks’ internal modelling and First, restricting the advantages to this have for banks’ capital the accuracy of the resulting risk banks of using internal models to weighted assets; requirements? calculate their capital requirements. • Resulting calls for greater simplicity This could take the form of limits on We understand the pressures for change in regulatory requirements from the extent to which risk weights based here, but an over-zealous pursuit of some leading regulators (including on internal models could diverge from simplicity and over-reliance on from Andrew Haldane in the UK risk weights under the standardised standardised risk weightings – or on a and Thomas Hoenig in the US), approach; or of reducing the complexity non-risk sensitive leverage ratio – could © 2013 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved. Basel 4 – Emerging from the mist? | 3 have unintended consequences. It initiatives running in parallel to Basel 3. systemic risk buffer) under the EU could encourage banks to hold riskier These include stress testing, capital implementation of Basel 3, which will assets and could increase significantly surcharges for systemically important require these banks to increase their the cost of funding a portfolio of low banks, Pillar 2 add-ons, macro-prudential common equity capital by nearly £40 risk-weighted assets, including mortgage policy tools, and the loss absorbency billion collectively, from £220 billion to lending and high quality liquid assets. provided in a resolution by the bailing-in £260 billion. Moreover, the conditions that banks are of liabilities. To meet the core elements of a required to meet before they can use Indeed, there is a strong sense here prospective Basel 4 these banks would internal models were always intended of regulators building up layers and have to increase their common equity to encourage banks to improve their layers of uncoordinated conservatism capital by a further £50 billion or risk management capabilities: this link to address multiple perceived causes of reduce their balance sheets by around could usefully be reinforced, rather the financial crisis, rather than starting 20 percent – taking the core elements than weakened. from scratch and building a more to be (i) a minimum common equity Meanwhile, as we have commented coherent approach. leverage ratio of 5 percent, and (ii) a 20 elsewhere(1), the relentless introduction percent increase in risk weighted assets We support greater disclosure by banks, of more and more regulation may arising from restrictions on banks’ internal who should have a strong self-interest in already have taken many economies, models. A tougher approach to either demonstrating why their internal models especially in Europe, beyond the ‘tipping element would increase further the generate an accurate picture of their point’ to a position where the costs additional capital required. underlying risks. of regulation exceed the benefits. The In addition to these quantitative impacts, permanent downward drag on economic What would it mean for capital? banks need to ensure that they fully growth from greater regulation may now Taking the major UK banks in aggregate as understand their capital and liquidity exceed the benefit of avoiding future an example, at end 2012, their collective needs. This needs to be based on clear periods of financial instability. common equity risk-weighted capital ratio statements of strategy and risk appetite was 8.5 percent on a fully implemented Regulators also need to pay more that drive both their internal assessment of Basel 3 basis and their leverage ratio based attention to developing more coherent capital and liquidity and how they manage on common equity capital was and proportionate linkages between their businesses. 3.6 percent.(2) the Basel 3 minimum capital and liquidity requirements and the additional These banks are expected to be required demands on capital and liquidity arising to meet a 10 percent minimum common from the multiple regulatory reform equity capital ratio (including a 3 percent (1) Moving on: the scope for better regulation, KPMG International, May 2013. (2) Source: Prudential Regulation Authority completes capital shortfall exercise with major UK banks and building societies, Prudential Regulation Authority, June 2013. © 2013 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved. 4 | Basel 4 – Emerging from the mist? The path to Basel 4 Basel 4 Implications for banks Already emerging? Simplicity Capital requirements • Front stop leverage ratio • Less reliance on internal Liquidity requirements models Disclosure requirements National standards • Quality of Pillar 2 capital National divergences • Minimum requirements post stress testing Risk sensitivity • Liquidity Regulatory requirements Regulatory Disclosure Use of internal models • Enhanced requirements to in decision making aid comparability Basel 3 Parallel tracks ‘Strengthened global capital Large exposures Structure and liquidity regulations’ Balkanisation OTC derivatives Capital reform SIFI surcharge Banking union • Quality of capital base • Quantity of capital Bail-in liabilities Risk governance • Leverage Macro-prudential • Counterparty credit risk Liquidity standards • Short term • Long term Time Source: KPMG International, September 2013 © 2013 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. All rights reserved. Basel 4 – Emerging from the mist? | 5 Beyond Basel 3 to Basel 4 Differences are already emerging across countries in the design, interpretation and timing of the implementation of Basel 3. This is generating important inconsistencies across countries, and some unravelling of Basel 3 is already under way. However, we focus here on the significant steps being taken by some countries – and by the Basel Committee – to move beyond Basel 3. We view these steps as a move towards a Basel 4 characterised by: • A higher minimum leverage ratio playing a more prominent role in Pillar 1 minimum capital requirements; • Tighter limits on the advantages to banks of using internal models to calculate their capital requirements; • A tougher approach to stress testing, Pillar 2 capital add-ons and liquidity requirements; and • More disclosure by banks. Leverage ratio consultative document on the leverage • Simple rules (using leverage ratios Some countries are moving ahead of ratio(6) it stated that the ‘parallel run’ and market capitalisations) would the 3 percent minimum leverage ratio period (from 2013 to 2017) will ‘test’ the have predicted better which banks currently in the Basel 3 standards, in 3 percent minimum leverage ratio, and ran into difficulty during the financial terms of the

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