A changing economic environment and populist pressures are potentially threatening the faithful implementation of Basel IV across the world. This is an outcome that jurisdictions should try to resist. By Justin Pugsley.

What is happening?

The Basel framework sets out a clear and useful framework for regulating the world’s largest globally active banks, but it could be under threat from a changing political and economic environment. Members of the Basel Committee on Banking Supervision are now implementing the finalised Basel framework, known as 'Basel IV' by bankers. The problem is that this voluntary framework was completed some 10 years after the global financial crisis and policy-makers’ priorities are visibly shifting away from making the financial system safer towards economic growth. 

Reg rage anxiety

The EU is currently going through its paces of translating Basel III into its Capital Requirements Regulation III and Capital Requirements Directive VI. The European Banking Authority (EBA) is advising a faithful implementation of the Basel regime in Europe and estimates that this will add €135.1bn in extra capital requirements for EU banks. This is unwelcome in a number of EU states. 

The measure, which EU banks and, to an extent, their regulators really dislike is the output floor. When it fully comes into force on January 1, 2027, it will restrict the output from bank internal models to 72.5% of those produced by the Basel Committee’s standardised approach. The output floor accounts for 38% of the EBA’s projected capital shortfall. The Europeans feel they only agreed to it due to strong US insistence, but are now beginning to see it as a real future drag on the European banking system.

The EU approach to Basel already contains a number of exemptions, such as a special supporting factor (that is, more favourable capital treatment) for loans to small businesses. 

The EU’s new parliament may also want to add a supporting factor for green loans, and to penalise lending towards high-carbon-emitting projects, potentially creating more distortions in the framework, which are not related to containing risk. 

Also, the Europeans are likely to drag their feet on implementing the output floor, which will annoy the US. The US, meanwhile, is pursuing a deregulation agenda, though admittedly not so much for its eight global systemically important banks, which are on Basel rules. 

Also, should the UK ever leave the EU, many industry sources think the EU will be less inclined to follow the Basel framework as faithfully, as the UK tends to be a strong advocate of international agreements. And if the Europeans go soft on Basel, the US may feel entitled to do the same in areas such as on Basel liquidity ratios, which are not popular with US banks. If those two go their own way then it is likely that everyone else will do the same. 

Why is it happening? 

This is a reaction to regulatory exhaustion and the fact that the global economic cycle is probably turning downwards, with early signs of that in parts of Europe. 

Should the world find itself in recession within the next couple of years, then regulators under duress from their political masters are unlikely to insist on banks hoarding ever more capital, leaving their economies starved of funding. 

This could lead to a rush towards national regulatory solutions to stimulate economic activity. Unfortunately, in the light of a US-China trade war, EU-US tensions and Brexit, jurisdictions seem less ready to work together in the way they did during the 2007 to 2009 global financial crisis.  

What do the bankers say? 

Bankers have mixed views. They would clearly welcome a relaxation of some aspects of the Basel rules. 

However, global banks are very worried about jurisdictions pursuing highly individualistic interpretations of Basel IV, or simply ignoring bits of it, as that results in the fragmentation of markets, which is already happening. This leads to trapped liquidity and higher costs and frictions for moving capital across borders.   

Will it provide the incentives?  

There is a growing incentive for individual jurisdictions to pursue their own agendas as they try to head off populist pressures. This risks leaving frameworks such as Basel IV increasingly marginalised and, in the long run, potentially ignored. This would not be desirable, because countries with capital will get even lower returns and those needing it will have to pay more for it, which does not augur well for developing countries, for example. It would also mean there would no longer be a level playing field, so many users would pay more for financial services than they do now. 

On that basis, jurisdictions should do their best to maintain the Basel framework – for instance, globally agreeing that delays might be necessary under some circumstances. Such actions would be far better than a gradual abandonment of Basel, as it sets out a clear framework for regulating the world’s largest globally active banks. 

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