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Thursday, March 24, 2011

Basel III - Cracks Appear Part 2

In part 1 of the "Basel III cracks are appearing" post which can be accessed by clicking here, we discussed the general misunderstanding on how capital works in Basel III. In this article we are going to look at some of the disparate issues around the new Liquidity Coverage Ratio.

The Liquidity Coverage Ratio or LCR and the Net Stable Funding Ratio or NSFR, work hand-in-hand with capital as a three pronged mechanism and the entire system, can be viewed as an "all encompassing" solution designed to reduce liquidity funding feedback loops. All that aside, there are some broad concerns with the way in which specific elements are being interpreted by national regulators across the globe.

These new aspects of Basel III need careful tweaking to avoid unintended market consequences.
At the end of February 2011, the Australian Prudential Regulatory Authority (APRA) issued a memorandum on the type of instruments it accepts as high quality liquid assets. To the surprise of the market, Kangaroo Bonds were not included in the itinerary, even though many of these bonds are AAA rated. What is even more amazing is that these bonds do actually qualify as haircuts or collateral for repo style transactions which are accepted by the Reserve Bank of Australia.

Kangaroo bonds are debt securities with relatively long tenors and are issued by offshore firms into the Australian domestic market. They are denominated in Aussie Dollars, have to meet the Australian investment legal requirements, are settled through Austraclear and they are listed on the Australian Stock Exchange. Financial institutions such as the Asian Development Bank and the European Investment Bank issue Kangaroo bonds to raise cash for funding world class infrastructure projects, the instruments have surged over 80% in the market over the last twelve months before the APRA announcement.

There are several concerns with this ruling.

Firstly, if a AAA rate bond with no currency exposure is not up to standard for a quality liquid asset, then banks will be forced onto a slim range of instruments which could eventually be a driver for concentration risk down the track.

Secondly, if debt issued by a world class development bank is below the bar, countries further afield, especially in the emerging markets are going to struggle to find anything that comes close to being a "quality asset". The result of all of this will be an uneven global playing field on what one regulator classifies as liquid capital in one jurisdiction, another regulator will disallow it elsewhere. Finally for the Kangaroo market, there will be a noticeable drop in demand for this paper as the institutional buyers move away from the asset class.
I would not agree that our bonds are not liquid enough, this ruling was surprising  
Eila Kreivi | EIB 
On the other side of the planet, Denmarks regulator, the Finanstilsynet has stated that it wants to move the definition of the Liquidity Coverage Ratio away from any puritanical set of assets altogether. While it is strongly supporting the liquidity cover ratio concept, it has issues with the classing some top rated instruments as liquidity and others as not. 
Finanstilsynet strongly supports the aim of the Basel Committee's capital and liquidity reform package.  We are however deeply  concerned with the treatment of Danish covered bonds in the definition of liquid assets in the Liquidity Coverage Ratio. 
Finanstilsynet | Finanstilsynet link
When it comes to capital rules and preparedness specifically, APRA defends the case that Australian banks are already well capitalised and APRA has clearly stated this opinion with the Bank for International Settlements.
Australian banks and authorised deposit taking institutions already or nearly meet the central Basel III capital rules ... It is a long transition period to the new rules and there is a virtue in being able to declare Australian banks compliant with Basel III ahead of schedule  
Wayne Byres | APRA
Given that Australian banks have skirted the Global Financial Crisis or perhaps the consequence of it and that Australia's regulatory standards have been stringent for several years, that assessment is probably quite accurate. Basel III capital charges for Australian Banks are unlikely to be a massive burden either way and the main view from APRA is that capital charges should not be increased. This is quite a different outlook to that of the UK-FSA on capital.

For US banks, Basel III is likely to find mixed acceptance. Many of the smaller state based institutions are still struggling with large portfolios of distressed assets and some banks are only just discovering the quirks of Basel II. The large internationally based US investment banks are in a different trajectory and have to deal with new mandates including the Volcker rule and the Dodd Frank Wall Street Reform Act. Neither of these mandates particularly feature capital or liquidity in their briefs and if US regulators don't start releasing some opinion or guidance, one does fair that the US may end up behind in the Basel III game as it did in Basel II.
If we swing over to Europe, only a month ago, a European assessment of Basel III highlighted a number of potential problems. These were mostly targeting the core tier 1 capital end of the game.
The arugment is that European banks are at a competitive disadvantage with specific rulings compared to the US banks, this is due to the nature in which they fund their businesses and an impact studye needs to be carried out.
New Quotes | GFS News Quotes
There have also been disagreements over the period and asset classes needed for the effective implementation of a Liquidity Coverage Ratio. At present the European central Bank is in the throws of running stress tests across its member banks and the ECB won't be featuring asset liquidity at all in their stress test scenarios. On this point, I personally struggle to see how useful these tests will be for identifying bank resilience especially without a measure of liquidity built into the experiment.

The importance of harmonization
If you add it up, this is a pretty disparate playing field.

The FSA perceives Basel III as being light on capital requirements, APRA has capital requirements as being more than adequate and is focusing on the liquidity of instruments and in its own manner and the ECB is running stress tests on sovereign debt but with no focus on liquidity at all.

These regulatory bodies aren't right or wrong with their current opinions on Basel III but on the surface there appears to be a level of discontinuity between what the individual regulatory bodies are attempting to achieve. 

The Bank For International settlements has a team known as the Standards Implementation Group (SIG) for plugging these communication cracks and their charter is to ensure a consistent global implementation of the Basel rulings. Given what is going on and so early, I would say SIG has a huge task in front of it.

So what's next then?

Well if the global regulators don't start to agree on approaches for a liquidity coverage ratios, including the asset classes for acceptance, Basel III might end up suffering the same disparate implementation curse that its predecessor, Basel II did.

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