WASHINGTON — Though the Basel II process to write new international capital standards lingered for nearly a decade, its successor has come a remarkably long way in just the past year.
Global leaders under the auspices of the Basel Committee on Banking Supervision agreed on a new set of regulatory standards that would improve the quantity and quality of bank capital and discourage excessive leverage.
Still, 2011 will be critical as regulators across the globe start the difficult task of implementing the new rules even while they tackle issues left unfinished by the agreement, such as a potential capital surcharge on the largest institutions.
"A lot of hard work lies ahead in terms of implementing all these new capital guidelines and liquidity" requirements, said Mary Frances Monroe, vice president in the office of regulatory policy at the American Bankers Association. "The domestic agencies have to issue notices of proposed rulemaking that will have to take into account Basel III, plus the overlay of Dodd-Frank."
The new agreement was designed to prevent a repeat of the financial crisis.
"The lessons of the crisis are very well understood," said Karen Shaw Petrou, the managing partner at Federal Financial Analytics Inc. "All of these rules are significant improvements, and far tougher than the U.S. and the global financial system has ever had before."
But even with a consultative paper released in December 2009 to jump-start the process, reaching a new agreement this year was not without fits and starts along the way.
Fearing potential unintended consequences, the Basel Committee agreed to make revisions to its original framework, which was released in July. The panel expanded its definition of Tier 1 capital to include limits on mortgage servicing rights and deferred tax assets at a cap of 10%, as well as minority interest. It set a combined cap of 15% for all three.
Though some in the U.S. wanted more allowances, that such holdings could at least partially be considered as Tier 1 common was seen as a step in the right direction.
"If the crisis has shown anything," it's that "banks are still critical to the world economy," said Greg Lyons, a partner at Debevoise & Plimpton LLP. "The concern was they might put too much pressure on the banks that they either stopped lending or would be unable to support the economy just as it was starting to mend."
By September, after further negotiations, financial institutions learned with greater detail — and some relief — what the new capital requirements would be under Basel III rules. Those principles were later agreed upon by the Group of 20 nations at their annual meeting in November in Seoul.
To most, the framework was close to what they had expected, although regulators agreed to a longer-than-anticipated transition period to accommodate concerns from countries outside the U.S. Doing so, observers agreed, had been a necessary compromise that would ensure a much more robust agreement than would have been accepted under a faster timetable.
"While the ratios were higher than they are now, they were not at the high end of what people expected," Lyons said. "They were within a range of what people expected, and what's more, fundamentally people were generally pleased by the fairly lengthy transition periods to allow banks to raise the capital or meet the standards in a less disruptive fashion."
The new standards written by the members of the board of governors and heads of supervision, who oversee the Basel Committee, effectively raised common equity standards to 7% by 2019. Regulators said banks would have to hold at least 4.5% of common equity by 2015, and added a 2.5% conservation buffer that would go into effect gradually by 2019.
The panel also agreed to raise the core Tier 1 level to 6% from 4% by 2015, and left room for a capital charge that would come in addition to all the other requirements. The Basel Committee said regulators could implement a countercyclical buffer of up to 2.5% for banks to build up capital during good economic times. But the panel left it unclear when or how that buffer would be phased in, leaving implementation up to "national circumstances."
That wasn't the only part of the new standards that the panel left unfinished. It agreed to an observation period for both the liquidity coverage ratio, which was timed to be introduced by 2015, and the net stable funding ratio, which would commence by 2018.
U.S. and global regulators for decades have used capital ratios, but using a global liquidity ratio would be the first time Basel had undertaken setting such a standard, prompting an even more cautious approach by negotiators.
"Liquidity is a whole new ball game for the Basel Committee," said Frances Monroe, who endorsed the committee's approach. "They are taking the time to look at it over the observation period to make sure they get it as right as they can get it."
"The need for a transition period on the capital rules makes clear in the liquidity arena, which is far less well understood, that [that] kind of caution is even more appropriate," Shaw Petrou said. "There are a lot of moving pieces in creation of a revised and improved global regulatory framework, and while no one wants to relive the crisis, it's really careful not to create one by virtue of unanticipated and what is called perverse consequences in a complex regulatory framework."
Also left unanswered was how much additional capital should be charged for systemically important financial institutions. That surcharge, which could be a combination of a capital surcharge, contingent capital and bail-in debt, would come on top of all the other requirements.
The ABA and others have argued against placing surcharges on such institutions.
"The regulatory authorities already have the authority to require additional buffers for institutions that are taking risks that may not be fully covered by their regulatory capital," Frances Monroe said.
Susan Krause Bell, a partner at Promontory Financial Group, said uncertainty about what regulators are planning is a worry for the biggest banks.
"U.S. banks are very concerned about piling on layers over and above Basel minimums, but they have no real target to point to now," she said. "They can't really argue yet against it because the decisions have yet to be made."
But the panel has delayed progress on that issue until further work was completed by the Financial Stability Board, including identifying which firms should be considered systemically important. The Basel committee is expected to issue some guidelines on the issue to the stability board by mid-2011.
"There is a lot of appetite among the G-20 to really strengthen capital structures of significant financial institutions," Krause Bell said.
The biggest hurdle facing regulators will be how the new rules will be implemented in the respective countries.
"There are significant international issues," Shaw Petrou said. "The U.S. is very fearful of becoming an island of draconian regulatory practice in isolation from the rest of the world. How the law is implemented in key markets and how they are enforced is a very critical set of unanswered questions."
Federal Reserve Gov. Daniel Tarullo has already expressed concern about the implementation process.
"The benefits of Basel III for financial stability will be realized only if they are implemented rigorously," Tarullo said in November.
Tarullo called on the Basel Committee to monitor the effective implementation and compliance with the new capital standards.
But observers caution changes will need to be made to accommodate for the different size and structures of banks throughout the world, perhaps jeopardizing consistent implementation.
"The banking system in the U.S. is not the same banking system in Europe, or in Britain or in Japan, so there may be a need for some differences to reflect the diversity of size and business model," Frances Monroe said. "I'm not sure the agencies have fully fleshed it out, but I think there are a lot of issues still under discussion domestically."
Others agreed that the challenge for regulators is not only achieving internationally broad coordinated standards, but also implementing them harmoniously.
"History has shown that even with broadly global standards, if they're not in roughly consistent fashion, then you can have differentials," said Richard Spillenkothen, a former head of supervision at the Federal Reserve Board and now the director of governance, regulatory and risk strategies at Deloitte & Touche LLP. "To be sure, whenever you have a menu of options, then you open the latitude of the country to approach a concept … [which means] not all countries may come to the same conclusion on how to reach it, which opens up questions of implementation consistency."
U.S. institutions and regulators face the additional pressure of meeting capital requirements under Basel III, as well those under the Dodd-Frank financial reform law.
"The real question in the next year or two is how do the Basel Committee rules integrate with other requirements of Dodd-Frank?" Lyons said. "It will be difficult enough for banks to meet the tests and comply with the rules."
There is also pressure on the U.S. to show good faith in moving ahead with implementation after failing to execute on the previous Basel II accord.
Still, observers said, the U.S. has demonstrated its commitment to implementing the new standards and has shown very little reservations that process will not move ahead.
"Going into Basel III, there was considerable skepticism among other countries about U.S. intentions," Krause Bell said. "[But] the Obama administration has been very vocal and very hawkish on capital in the international community, partly to make the point they are going to move forward and implement Basel III."
Others foresaw a similar scenario.
"The devil is always in the details of implementation," Frances Monroe said. "But, I expect the rules to be implemented quite rigorously."