The Banking Regulation Review: International Initiatives

I Introduction

This chapter summarises the most important international developments in the field of banking regulation adopted by the two principal global standard setting bodies. As far as banking regulation is concerned, we focus on the two bodies that lead the post-financial crisis debate: the Basel Committee and the Financial Stability Board (FSB), which emerged in 2009 as a new global leader in the debate on measures to improve international financial stability. FSB reports that address issues not relevant to banking regulation are not discussed in this chapter.

II The Basel Committee

i Introduction

The Basel Committee is the primary global standard-setter for the prudential regulation of banks and provides a forum for international cooperation on banking supervisory matters. It is principally concerned with the prudential regulation of banks rather than the regulation of their business activities as such. It must, however, be recognised that there are many overlaps between these two areas of regulation, with capital requirements creating incentives for banks to engage in certain activities but not in others.

The Basel Committee comprises senior officials with bank regulatory and financial supervisory responsibilities from central banks and banking regulators in 28 jurisdictions.² The current chair is Pablo Hernádez de Cos, who is also chair of the Bank of Spain. The Committee now reports to an oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), which comprises central bank governors and (non-central bank) heads of supervision from member countries. The current chair of the GHOS is Tiff Macklem, governor of the Bank of Canada. The Basel Committee reports to the GHOS and seeks its endorsement for major decisions. In addition, the Committee looks to the GHOS to approve the Basel Committee Charter and any amendments to it, to provide general direction for the Basel Committee work programme, and to appoint the Committee chair from among its members.

The stated mandate of the Basel Committee is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.³ Its main focus has traditionally been on internationally active banks, although the Committee's standards have been applied more widely, particularly in the European Union.

The Basel Committee formulates standards and guidelines and recommends statements of best practice. The rules and guidance adopted by the Basel Committee have no legal force⁴ and their authority derives from the commitment of banking supervisors in member countries (and, increasingly, non-member countries) to implement the standards agreed by the Committee. The Committee has adopted standards on a wide range of issues relevant to banking supervision, including banks' foreign branches, core principles for banking supervision, core principles for effective deposit insurance, internal controls, supervision of cross-border electronic banking and risk management guidelines for derivatives.

In recent decades, the Basel Committee has devoted most of its attention to regulatory capital, principles for effective banking supervision and cross-border banking supervision. It has also been active in the important areas of liquidity risk and developing frameworks for the recovery or orderly wind-down of internationally active banks that get into financial difficulties. The Committee has also become involved in the debate on the small but growing market for cryptoassets. In November 2020 the GHOS stated that future work of the Basel Committee would 'focus on new and emerging topics including structural trends in the banking sector, the ongoing digitalisation of finance and climate-related financial risk'. Whether the near failure of Credit Suisse in March 2023 will prompt further work is too early to say.

ii The Basel framework

The Basel Committee has its origins in the financial market turmoil that followed the breakdown of the Bretton Woods system of managed exchange rates in 1973, which led to a number of banks across the globe incurring large foreign currency losses, with some forced to close as a result. In response to these and other disruptions in the international financial markets, the central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices, later renamed the Basel Committee on Banking Supervision. At the outset, one important aim of the Committee's work was to close gaps in international supervisory coverage so that no foreign banking establishment would escape supervision, and supervision would be adequate and consistent across member jurisdictions. A number of principles and standards on sharing supervisory responsibility and exchanging information between the regulatory authorities followed, laying down the foundation for supervision of internationally active banks.

Once this initial framework was in place, capital adequacy became the main focus of the Committee's activities. In 1988, a capital measurement system (commonly referred to as the Basel Capital Accord (Basel I)) was approved by the G10 governors and released to banks and national supervisors. Basel I comprised a set of international banking regulations setting out the minimum capital requirements aimed at controlling credit risk and creating a bank asset classification system. Over the next few years, the framework evolved with several amendments and additions, most notably requiring capital to be held against market risks in 1996.

In June 1999, the Basel Committee issued a proposal for a new capital adequacy framework for credit risk to replace Basel I. This led to the release of the Revised Capital Framework in June 2004 (generally known as Basel II), which remained the prudential regulatory framework until after the financial crisis of 2007 to 2009.

Basel II was based on three pillars that were intended to be interdependent and mutually reinforcing, and remain applicable today:

1. Pillar 1 (minimum capital standards) sets out the minimum capital requirements for banks;
2. Pillar 2 (the supervisory review process) sets out standards for banking supervisors in applying Basel III. In particular, it requires that supervisors should have the power to compel banks to hold capital in excess of the 8 per cent minimum ratio, where this is justified. Standards were also established for the control of interest rate risk in a bank's loan portfolio, and to capture other risks not specifically covered under Pillar 1; and
3. Pillar 3 (market discipline) provides for extensive disclosure of information to the market. The intention was that pressure from a bank's counterparties, analysts and rating agencies would serve to reinforce the minimum capital standards and ensure that banks carry on their business prudently. As was seen in the 2007 to 2009 financial crisis, it is highly debatable whether this aim was achieved. A revised Pillar 3 standard was published in November 2020 and is due for adoption in January 2023.

III From Basel II to Basel III

i The limitations of Basel II

It is fair to say that critics of Basel II, who blamed aspects of the financial crisis on features of that regime, did not properly take into account the fact that when the crisis arose, Basel II had not been implemented at all in a number of key jurisdictions, and had not long been implemented in others. On the other hand, it is reasonable to conclude that, had Basel II been implemented in more countries for a longer period of time before the financial crisis, it is likely that the regime would have prevented aspects of the crisis.

In response to the crisis, the Basel Committee chose to build on Basel II incrementally rather than fundamentally change it, though the cumulative effect of the changes published between 2009 and 2019 will result in a radically updated approach to all aspects of Basel III when they finally come into effect. This was intended to be January 2023, although the EU and United Kingdom have deferred implementation of the final changes until January 2025.

ii Other work

The Basel Committee has also engaged in work in the following areas.

Systemically important financial institutions

The Basel Committee has undertaken work with the FSB to implement an integrated approach to systemically important banks. In September 2011, the Basel Committee finalised details of the additional capital buffer that applies to global systemically important banks (G-SIBs). G-SIBs are required to hold an additional buffer (above the Basel III requirements) of between 1 per cent and 2.5 per cent of common equity, depending on the bank's systemic importance (the percentages being of risk-weighted assets (RWAs)). An initially empty 3.5 per cent bucket exists for G-SIBs that become even more systemically important as a disincentive to such behaviour. In October 2012, the Basel Committee adopted a framework for domestic systemically important banks (D-SIBs), which builds on the rules adopted for G-SIBs. The framework is composed of 12 principles and gives states considerable national discretion to reflect the characteristics of their domestic financial system. D-SIBs must meet higher capital requirements to reflect their degree of systemic importance. An updated assessment methodology for G-SIBs was published by the Basel Committee in November 2021 and will come into force in 2023. The latest FSB list of banks identified as G-SIBs using the Basel Committee's methodology was issued in November 2022 (the list will next be updated in November 2023).

Cryptoassets

In December 2022, the Committee finalised its standard on the prudential regulation of cryptoassets. These assets are sub-divided into two groups. Group 1 cryptoassets comprises tokenised traditional assets and regulated asset-backed stablecoins. To qualify for Group 1 treatment: (1) tokenised traditional assets must be digital representations of such assets; (2) the token must have the same level of credit and market risk as the underlying assets; and (3) must have the same level of legal rights as cash held in custody. To qualify as a stablecoin: (1) the token must, inter alia, be redeemable for the underlying asset, currency or commodity; (2) the stabilisation mechanism must be effective (and cannot be a computer algorithm); (3) it passes the 'redemption test' defined in the standard; and (4) the issuer is authorised and regulated by a competent authority. The redemption test seeks to ensure that the reserve assets are sufficient to enable the cryptoassets to be redeemable at all times at the peg value. Group 1 cryptoassets are assigned to the banking or trading book based on standard criteria and then subject to the normal capital charges for credit or market risk, supplemented by additional charges for any further risks.

Group 2 consists of all other cryptoassets, including all non-asset-backed tokens (like bitcoin). There are, again, two categories, based on whether the 'hedging recognition criteria' are met. This, essentially, is a market capitalisation, liquidity and trading requirement test. Where these criteria are satisfied, a modified version of the market risk capital charge applies (without the possibility of banks using internal models). In other cases, the cryptoasset positions are subject to a 1250 per cent capital charge (equivalent to a deduction from capital). Banks' exposure to Group 2 cryptoassets should generally be below 1 per cent of their Tier 1 capital, and must not exceed 2 per cent. Countries may adopt stricter requirements, such as banning banks from any holdings of cryptoassets.

Climate-related financial risks

In April 2021, the Basel Committee published a report on conceptual issues connected to climate-related financial risk measurement and methodologies, as well as practical implementation by banks and supervisors. The report includes the following findings:

1. climate-related financial risks have unique features, necessitating granular and forward-looking measurement;
2. measurement of climate-related risks by banks and supervisors has centred to date on mapping near-term transition risk factor drivers; and
3. banks and supervisors have predominantly focused on credit risk.

Key areas for future analytical exploration relate to measurement gaps in data and risk classification methods, as well as methodologies suitable for assessing long-term climate phenomena.

At this stage the Committee is not proposing any prudential standards in respect of such risks. In June 2022 the Committee published Principles for the Effective Management and Supervision of Climate-related Financial Risks containing 12 principles for banks on effective management of such risks and six for supervisors.

IV Basel III: capital requirements

In September 2010, the Basel Committee announced its agreement on the first part of the Basel III minimum capital requirements for banks, which significantly increased the amount of common equity that banks were required to hold. The detailed requirements were published in December 2010, and revised in June 2011. Further guidance on the new capital definitions and the requirements for counterparty credit risk was published in the form of frequently asked questions in June 2020.

Basel III aims to strengthen the regulation, supervision and risk management of the banking sector, and is designed to target both microprudential regulation and macroprudential risks. More specifically, Basel III extends the former framework in a number of ways, including adopting the following additional measures:

1. a capital conservation buffer, an additional layer of common equity that, when breached, restricts distribution of capital to help protect the minimum common equity requirement (see Section IV.iii for further details);
2. a countercyclical capital buffer, which aims to restrict participation by banks in country-wide credit booms with the object of reducing their losses in credit busts (see Section IV.iv for further details);
3. a leverage ratio (a minimum amount of loss-absorbing capital relative to all of a bank's assets and off-balance sheet exposures regardless of risk weighting) (see Section IV.v for further details);
4. two liquidity requirements: a liquidity coverage ratio (LCR), a minimum liquidity ratio intended to provide enough cash to cover funding needs over a 30-day period of stress; and a net stable funding ratio (NSFR), a longer-term ratio intended to address maturity mismatches over the entire balance sheet (see Section V for further details); and
5. additional requirements on systemically important banks, including requirements for supplementary capital, augmented contingent capital and strengthened arrangements for cross-border supervision and resolution.

i New definitions of capital

Common equity

Under Basel III, the common equity component of capital (including reserves) is 4.5 per cent of RWAs. For banks structured as joint-stock companies, this must be met solely with ordinary shares.

Non-core Tier 1 capital

Detailed requirements have been adopted in respect of additional (i.e., non-core) Tier 1 capital, which is effectively limited to 1.5 per cent of RWAs. The instruments must be perpetual and may only be called after five years with prior supervisory consent. Interest payments must be made out of distributable profits and, if the instrument is classified as a liability for accounting purposes, it must have principal loss absorption through either conversion to common equity or write-down of principal. The trigger level for write-down or conversion must be at least 5.125 per cent, although banks can choose (or be required by their regulator) to apply a higher trigger. The EU has also applied this requirement to equity-accounted instruments (e.g., most preference shares).

Other tiers of capital

Basel III abolished innovative Tier 1 and Tier 3 capital, and harmonised Tier 2 capital, based on lower Tier 2 capital under Basel II. Recognition of Tier 2 capital is effectively limited to 2 per cent of RWAs. Tier 2 instruments are long-term subordinated debt with a mandatory coupon.

Under Basel III, all Tier 1 and Tier 2 capital instruments (other than common equity) must include a clause in their terms and conditions requiring the instrument to be written off on the occurrence of a trigger event (i.e., the bank ceases to be a going concern or receives an injection of public sector capital) if there is no statutory scheme under which such instruments can be required to absorb losses. The only compensation for such write-off that may be provided to investors is the issue of new ordinary shares (or the equivalent for mutuals). In the case of Credit Suisse, the Additional Tier 1 instruments were written off despite shareholders retaining some value after the merger with UBS. It is understood that this resulted from the terms of the instruments combined with emergency Swiss legislation. The EU and UK regulators have distanced themselves from this approach.

Minority interests

Detailed rules set out the contribution that third-party minority interests in group companies can make towards consolidated capital.

ii Deductions from capital

Basel III provides for a harmonised set of deductions from capital, most of which are made from common equity. The list of deductions includes:

1. goodwill and other intangibles (from 2025, cryptoassets are not regarded as intangibles regardless of the accounting classification);
2. deferred tax assets that rely on future profitability to be realised;
3. cash-flow hedge reserves relating to hedging of items not fair valued on the balance sheet;
4. shortfall of provisions to expected losses;
5. cumulative gains and losses owing to changes in a bank's own credit risk on fair-valued liabilities (including derivatives);
6. defined benefit pension fund assets and liabilities held on the balance sheet;
7. investments in own shares;
8. reciprocal cross-holdings; and
9. significant investments in the capital of banking, financial and insurance entities outside of the consolidated group.

These deductions are made under a corresponding deduction approach, so the deduction is from the element of capital that it would have constituted had it been issued by the bank.

iii Capital conservation buffer

A key element of Basel III is the requirement that banks hold a capital buffer on top of their minimum capital requirements. This buffer is not intended to form part of the minimum capital requirement. It follows that a bank that fails to hold sufficient common equity to satisfy the buffer (but meets the other minimum capital requirements) will not be subject to restrictions on its operations and will not be at risk of resolution or the withdrawal of its banking licence. However, banks that operate within the buffer are subject to restrictions on the distribution of capital, including the payment of dividends and staff bonus payments, with the result that the buffer is generally treated by banks as an effective floor. (Some evidence suggests that banks were unwilling to dip into their capital buffer during the covid-19 pandemic out of fear it might signal financial weakness.) According to the Basel Committee:

1. the purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distribution; and
2. banks are, of course, able to rebuild capital buffers through raising new capital. However, in the Committee's view, it is not acceptable for banks that have depleted their capital buffers to use future predictions of recovery as justification for maintaining generous distributions to shareholders, other capital providers and employees.

The restrictions on distributions, share buy-backs and staff bonus payments are as follows.

iv Countercyclical capital buffer

The countercyclical capital buffer is intended to ensure that capital requirements take account of the macroprudential environment in which banks operate. It is applied when excess credit growth is associated with a build-up of system-wide risk. It is based on the following elements:

1. each regulator decides, based on credit conditions in its country, when to activate the buffer. Once activated, the buffer takes the form of an add-on to minimum capital requirements. At all other times the buffer is zero;
2. a decision to impose a buffer will be announced up to 12 months before it takes effect to give banks time to adjust (if necessary, by increasing capital or reducing lending). Reductions to the buffer take effect immediately when announced;
3. banks with purely domestic exposure are subject to the full amount of the buffer; and
4. banks that are internationally active apply an add-on depending on the geographical location of their credit exposures.

The Basel Committee has stated that setting this buffer is likely to be appropriate where the ratio of credit to gross domestic product (GDP) exceeds its long-term trend. However, as this measure is not always a clear indicator of excessive credit growth, judgement needs to be applied.

The range of the buffer is generally between zero and 2.5 per cent and is added to the capital conservation buffer. Unlike the capital conservation buffer, this additional buffer may be satisfied by common equity or other fully loss-absorbing capital, although until the Basel Committee issues further guidance on the requirements for such loss-absorbing capital, the buffer needs to be satisfied by common equity. During the covid-19 pandemic, most jurisdictions with a countercyclical capital buffer released it.

v Leverage ratio

The years leading up to the 2007–2009 financial crisis were characterised by a significant increase in the leverage of financial institutions, enhancing the (apparent) profitability of the financial sector, but also resulting in a greater probability of individual firms failing as well as increased systemic risk. Basel III's leverage ratio is defined as the capital measure (the numerator) divided by the exposure measure (the denominator) and is expressed as a percentage. The capital measure is Tier 1 capital, and the minimum leverage ratio is 3 per cent. Accounting values generally apply. More detailed requirements for the leverage ratio were published by the Committee in January 2014. In 2016, the Committee published revised guidance on the leverage ratio in the form of frequently asked questions.

In December 2017, the Committee adopted various refinements to the leverage ratio. These include modifying the way in which derivatives are reflected in the exposure measure and updating the treatment of off-balance sheet exposures. The changes came into force on 1 January 2023.

vi Counterparty credit risk

Basel III brought about a number of changes to the treatment of counterparty credit risk (which have been revised with effect from January 2023). These include the following:

1. banks that use an internal model to calculate their counterparty credit risk on over-the-counter (OTC) derivatives, repurchase agreements and securities financing transactions are required to use stressed inputs to address the risk of the model underestimating low-frequency, high-impact events;
2. a new capital charge was introduced to cover mark-to-market losses associated with a deterioration in the creditworthiness of counterparties;
3. requirements have been imposed to address wrong-way risk (i.e., where an exposure to a counterparty is adversely correlated to the credit quality of that counterparty);
4. risk weights on exposures to large financial institutions are subject to a multiplier to reflect the fact that during the financial crisis, the credit quality of financial institutions deteriorated in a more highly correlated manner than that of non-financial counterparties;
5. standards for collateral management and margining were strengthened. Banks with large and illiquid derivatives exposures have to apply a longer margining period when determining their capital requirements;
6. greater haircuts apply to securitisation collateral, with a prohibition on recognition of re-securitisation exposures as collateral to reduce counterparty exposures; and
7. harmonised capital charges for exposures to central counterparties (CCPs) have been introduced distinguishing between qualifying and non-qualifying central counterparties.

vii Standardised approach to credit risk

In December 2014, the Basel Committee published a consultation document on revisions to the standardised approach to credit risk. The new standardised approach was due to be implemented by 1 January 2023. Securitisation exposures are addressed in the Basel securitisation standard (which is not discussed here). The key aspects of these changes are as follows:

1. exposures to sovereigns and public sector entities are the same as under Basel II (which, given the 2010–2011 eurozone crisis, and the increases in government indebtedness because of national responses to covid-19, may not be justified);
2. exposures to banks are risk-weighted based on the following hierarchy: external credit risk assessments (where allowed) and then the standardised credit risk assessment approach for unrated banks. Under the latter approach, bank exposures are allocated to three risk-weight buckets or grades ranging from 40 per cent to 150 per cent. A stand-alone treatment for covered bonds has been introduced;
3. exposures to corporates (including insurers) differentiate between general corporate exposures and specialised lending exposures. The former are risk-weighted between 20 per cent and 150 per cent with unrated corporates being risk-weighted at 100 per cent. Jurisdictions that do not allow the use of external ratings may allow a 65 per cent risk weight for exposures to investment grade borrowers (as defined in the standard). Unrated small and medium-sized enterprise exposures generally receive a risk weight of 85 per cent. Specialised lending is divided into three categories: project finance, object finance and commodities finance. Issue-specific (not issuer-specific) ratings may be used where available and permitted by national regulators. Otherwise, object and commodities finance is risk-weighted at 100 per cent and project finance at 130 per cent during the pre-operational phase, and at 80 per cent or 100 per cent during the operational phase;
4. a new risk class is introduced for subordinated debt, equity and other capital instruments not deducted from regulatory capital or risk weighted at 250 per cent under Basel III (i.e., threshold deductions). Speculative unlisted equity exposures are risk weighted at 400 per cent and all other equity holdings at 250 per cent;
5. a more granular treatment applies to residential real estate, distinguishing between different types of portfolio, which is considerably more complex than the Basel II standard; and
6. a new treatment for commercial real estate has been introduced based on the loan-to-value ratio, and whether repayment is materially dependent on cash flows generated by the property.

viii Internal ratings-based approach to credit risk

Basel II had two model-based approaches for the calculation of credit risk in the banking book: the foundation internal ratings-based (IRB) approach and the advanced IRB approach. New requirements for the IRB approach came into effect on 1 January 2023. According to the Basel Committee, the financial crisis highlighted a number of shortcomings in the use of internal models, including the excessive complexity of IRB approaches, the lack of comparability in banks' internally modelled capital requirements and a lack of robustness in modelling certain asset classes.

As a result, the availability of the IRB approach has been curtailed. In summary, the position under Basel III, is as follows:

1. large and mid-sized corporates (consolidated revenues of greater than €500 million): only the foundation IRB approach is available;
2. banks and other financial institutions: only the foundation IRB approach is available;
3. equities: no IRB approach is available; and
4. specialised lending: both foundation and advanced IRB approaches are available.

The advanced IRB approach remains available for sovereign exposures, small corporate exposures, specialised lending and retail lending. The Committee published a discussion paper in December 2017 on the regulatory treatment of sovereign exposures which included a proposal that the IRB approach for sovereign exposures should be withdrawn. In November 2019, the Committee reviewed the feedback received and concluded that '[t]he Committee has not reached a consensus to make any changes to the regulatory treatment of sovereign exposures at this stage'. In November 2021, the Committee published a standard on voluntary disclosure of sovereign exposures 'with jurisdictions free to decide whether to require their banks to implement them'.

ix Credit valuation adjustment risk framework

In 2017, the Basel Committee published revisions to the framework addressing mark-to-market losses as a result of a deterioration in the creditworthiness of counterparties (credit valuation adjustment (CVA) risk) which came into effect in January 2023. The main changes are as follows: an enhancement of the risk sensitivity of the framework and the removal of the internal models approach to CVA risk. Now there is a standardised approach and a basic approach.

x Market risk framework

In 2009, the Basel Committee proposed amendments to the Basel II market risk framework to address certain weaknesses in the capital framework for trading activities that became apparent during the crisis. In addition, the Committee initiated a fundamental review of the trading book with the aim of tackling structural flaws in the market risk framework that were not then addressed. This led to a revised market risk framework that came into force in January 2023. In summary, the changes focus on the following key areas:

1. a revised boundary between the banking book and the trading book has been introduced which is based on rebuttable or irrebuttable presumptions as to the allocation of instruments to the trading and banking books to reduce the ability of a bank to arbitrage its regulatory capital requirements;
2. a new internal models approach for market risk (see below);
3. a revised standardised approach for market risk that aims to achieve more consistent and comparable reporting on market risk across banks and jurisdictions, and is intended to be suitable for banks with limited trading activity; and
4. a simplified standardised approach has been introduced, which is available to banks with small trading books, at supervisory discretion, which is a revised version of the 1996 standardised approach for market risk.

The basis of the new market risk standard is its new internal models approach. The new metric is founded on three components: expected shortfall (ES), which determines capital requirements for those risk factors for which a sufficient amount of data is available; a non-modellable risk factor capital charge for those risk factors for which there are insufficient market data; and a default risk requirement to determine the capital requirement associated with default risk for credit and equity positions (i.e., loss caused by a jump-to-default, as opposed to daily losses based on movements in market prices).

The new standardised approach for market risk is based on a sensitivities-based method, similar to a stress test. The framework specifies a set of risk factors considered to be the main market variables that affect the value of banks' trading portfolios; risk weights applicable to those risk factors calibrated to stressed market conditions; and a methodology for aggregating the losses calculated for each risk factor to determine the loss for the scenario at a portfolio level. The standardised approach must be used by all trading desks that are not allowed to use an internal model and is calculated both across the bank and by each trading desk with model approval.

The sensitivities-based method comprises delta risk (the potential loss because of a small change in the price of an equity or a commodity), vega risk (the potential loss because of a change in the implied volatility of an option) and curvature risk (the potential incremental loss beyond delta risk when large price movements occur). Vega risk and curvature risk only apply to positions with 'optionality', which includes, but is broader than, options (e.g., debt securities with pre-payment rights). To this is added a standardised default capital requirement and a residual risk add-on for other risks not adequately addressed elsewhere (e.g., exotic derivatives).

xi Operational risk

According to the Basel Committee, the financial crisis demonstrated flaws with the Basel II operational risk framework. Basically, capital requirements for operational risk proved insufficient to cover losses suffered by some banks while the nature of those losses, such as those caused by misconduct, highlighted the difficulties associated with using internal models to estimate capital requirements. All operational risk approaches under Basel II have been withdrawn and a new standardised approach, based on two components, has been introduced. The capital charge for operational loss is the multiplier of the business indicator component and an internal loss multiplier. The business indicator component is the sum of three elements: (1) the interest, leases and dividends component; (2) the services component; and (3) the financial component. The internal loss multiplier (ILM) is a function of the business indicator component and the loss component, where the latter is equal to 15 times a bank's average historical losses over the preceding 10 years. It increases as the latter increases, although at a decreasing rate. At national discretion, the ILM may be set at 1, with the result that solely the business indicator component will drive the operational risk capital calculation.

xii Basel I floor

Basel III replaced the Basel II floor with a new floor based on the use of standardised approaches to limit the benefit derived by banks from using internal models. This is being introduced in stages from 1 January 2023 to 1 January 2028 and will rise over that period from 50 per cent to 72.5 per cent.

xiii Basel III framework

A report on the impact of the Basel III framework was published on 28 February 2023.

V Basel III: liquidity

The financial crisis demonstrated the critical importance of liquidity. Before then, funding was easily available at relatively low cost. However, the rapid reversal of market sentiment demonstrated how quickly liquidity can evaporate, necessitating unprecedented central bank intervention to support the money markets and individual financial institutions. As a result, the Basel Committee has adopted two liquidity standards: the LCR and the NSFR. These requirements apply on a consolidated basis.

i LCR

The LCR seeks to ensure that banks have an adequate stock of unencumbered HQLA that can be converted into cash to meet their liquidity needs over a 30-day period under a significant liquidity stress scenario. The 30-day period is based on the view that this will be sufficient for corrective action to be taken by the bank, or for the bank to be resolved in an orderly manner without exposing the taxpayer to losses.

The LCR standard is as follows:

The LCR is based on two elements: a definition of HQLA and a metric for calculating net cash outflows in a liquidity stress scenario.

ii HQLA

The Basel Committee identified two types of eligible assets: Level 1 and Level 2. Level 1 assets can be used to satisfy the LCR without limit, whereas Level 2 assets are capped at 40 per cent of the overall stock of assets held to satisfy the LCR. The calculation of the limit is adjusted to reflect the impact of secured funding transactions or collateral swaps.

Level 1 assets include cash, central bank reserves, claims on sovereigns and public sector entities assigned a zero per cent risk weight under the Basel III standardised approach, and claims on non-zero per cent risk-weighted sovereigns and public sector entities that are issued in the domestic currency of the relevant sovereign.

Level 2 assets are divided into Level 2A and Level 2B assets. Level 2A assets include claims on sovereigns and public sector entities risk-weighted at 20 per cent or below under Basel III, together with corporate bonds and covered bonds that are rated AA- or better and have a proven record as a reliable source of liquidity during stressed market conditions. Level 2 assets are subject to a minimum 15 per cent haircut on their current market value. Level 2B assets comprise lower-quality assets and are capped at 15 per cent of overall liquid assets. This subclass includes corporate bonds rated A+ to BBB, certain equities and residential mortgage-backed securities rated AA or higher. Haircuts of 15 per cent or 50 per cent apply to Level 2B assets. In addition, supervisors may choose to include within Level 2B assets the value of any committed liquidity facility provided by a central bank where this has not already been included in HQLA.

iii Net cash outflows and inflows

Basel III sets out a metric with assumed outflows and inflows depending on the type of deposit or transaction. Some examples of outflows are set out in the following table. The metric is driven by supervisors. Banks cannot rely on actual inflow and outflow data to set their own parameters.

The Basel Committee has also specified parameters for expected cash inflows. Some examples are given in the following table.

Of particular relevance to banks is the assumption that credit lines and other contingent funding arrangements provided by other financial institutions may not be drawn. The intention is to reduce the contagion risk of liquidity shortages at one bank causing shortages at other banks.

Inflows are capped at 75 per cent, requiring banks to hold liquid assets of at least 25 per cent of outflows.

During the covid-19 pandemic, some jurisdictions temporarily reduced or amended their LCR standard. Others publicly communicated their view that the metric was flexible and that banks could operate below the 100 per cent requirement in the circumstances.

iv NSFR

The objective of the NSFR is to establish a minimum amount of stable funding based on the liquidity characteristics of a bank's assets and activities over a one-year horizon. The aim is to ensure that longer-term assets are funded with at least a minimum amount of stable liabilities.

The requirement is as follows:

Stable funding is defined as the portion of those types and amounts of eligible equity and liability financing expected to be reliable sources of funds over a one-year period in conditions of extended stress. The required amount of this funding depends on a bank's assets, off-balance sheet liabilities and activities.

The amount of available stable funding is summarised in the following table.

The amount of stable funding required depends on the broad characteristics of the risk profile of a bank's assets and off-balance sheet liabilities. Some examples are as follows.

Off-balance sheet liabilities are subject to the NSFR, based broadly on whether the commitment is a credit or a liquidity facility, or some other contingent funding obligation, without assigning actual percentages other than for irrevocable and conditionally revocable credit and liquidity facilities. National supervisors are able to specify the required stable funding based on national circumstances.

VI Financial Stability Board

i Introduction

The FSB is an international body that monitors and makes recommendations about the global financial system. It has its origins in the Financial Stability Forum (FSF), which was founded in 1999 by the finance ministers of the G7 countries.⁵ The FSF was re-established as the FSB in 2009, following calls in 2008 by leaders of the G20 countries to enlarge the FSF's membership. On 28 January 2013, the FSB established itself as a not-for-profit association under Swiss law, with its seat in Basel, Switzerland.

The Charter and organisation of the FSB

The Charter of the FSB came into effect on 25 September 2009, and was revised in 2012. It is not intended to create legal rights and obligations. It does, however, set out the FSB's objective, which is:

to coordinate at the international level the work of national financial authorities and international standard-setting bodies (SSBs) in order to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. In collaboration with the international financial institutions, the FSB will address vulnerabilities affecting financial systems in the interest of global financial stability.⁶

The mandate and tasks of the FSB are stated in the Charter to be to:

1. assess vulnerabilities affecting the global financial system, and identify and review on a timely and continuing basis, within a macroprudential perspective, the regulatory, supervisory and related actions needed to address them, and their outcomes;
2. promote coordination and information exchange among authorities responsible for financial stability;
3. monitor and advise on market developments and their implications for regulatory policy;
4. advise on and monitor best practice in meeting regulatory standards;
5. undertake joint strategic reviews of, and coordinate the policy development work of, the standard-setting bodies (SSBs) to ensure their work is timely, coordinated, focused on priorities and addressing gaps;
6. set guidelines for and support the establishment of supervisory colleges;
7. support contingency planning for cross-border crisis management, particularly with respect to systemically important firms;
8. collaborate with the International Monetary Fund to conduct early warning exercises;
9. promote member jurisdictions' implementation of agreed commitments, standards and policy recommendations through monitoring of implementation, peer review and disclosure; and
10. undertake any other tasks agreed by its members in the course of its activities and within the framework of its Charter.⁷

The FSB has also taken on the task of coordinating the alignment of the activities of SSBs.⁸

The chair of the FSB is Klaas Knot, president of De Nederlandsche Bank. In 2022, the main areas of work of the FSB were:

1. supporting international cooperation and coordination on financial stability issues, including lessons learned from the covid-19 pandemic, and related scarring in the financial sector;
2. enhancing the resilience of non-bank financial intermediation;
3. enhancing cross-border payments;
4. the regulation of global stablecoins and cryptoassets; and
5. addressing the financial risks from climate change.

ii Total loss-absorbing capacity principles for G-SIBs

G-SIBs

In November 2015, the FSB published a report on the adequacy of loss-absorbing capacity of G-SIBs, expounding the concept of total loss-absorbing capacity (TLAC) (referred to as Minimum Own Funds and Eligible Liabilities (MREL) in the EU). This consisted of two parts. The first set out principles on loss absorption and recapitalisation capacity of G-SIBs in resolution. The second part contained a term sheet for instruments that contribute to TLAC as an implementing measure of these principles in the form of an internationally agreed standard for G-SIBs.

G-SIBs are required to meet the TLAC requirement alongside the minimum regulatory requirements set out in the Basel III framework. Specifically, they are required to meet a minimum TLAC requirement of at least 18 per cent from 1 January 2022. Minimum TLAC must also be at least 6.75 per cent of the Basel III leverage ratio from 1 January 2023.

G-SIBs headquartered in emerging market economies are required to meet a 16 per cent RWA and 6 per cent leverage ratio TLAC requirement not later than 1 January 2025, and an 18 per cent RWA and 6.75 per cent leverage ratio exposure minimum TLAC requirement not later than 1 January 2028. The FSB monitors implementation of the TLAC Standard and undertook a review of the technical implementation at the end of 2019. The report concluded that progress had been steady and significant in both the setting of external TLAC requirements by authorities and the issuance of TLAC by G-SIBs. All relevant G-SIBs met or exceeded the TLAC target ratios of at least 16 per cent of risk-weighted assets and 6 per cent of the Basel III leverage ratio. As noted above, these figures increased in January 2022.

In December 2016, the FSB consulted on the Guiding Principles on the Internal TLAC Capacity of G-SIBs (internal TLAC). Internal TLAC is the loss-absorbing capacity that resolution entities have committed to material subgroups. It provides a mechanism by which losses and recapitalisation needs of material subgroups may be passed with legal certainty to the resolution entity of a G-SIB resolution group without the entry into resolution of the subsidiaries within the material subgroup. A material subgroup is either an individual subsidiary or group of subsidiaries that are not resolution entities, and that meet certain quantitative criteria, or are identified by a firm's crisis management group as material to the exercise of the firm's critical functions. Each material subgroup must maintain internal TLAC of between 75 per cent and 90 per cent of the external minimum TLAC requirement that would apply if the subgroup were a resolution group.

The Basel Committee published a standard for the prudential treatment of banks' investments in TLAC in October 2016. In principle, G-SIBs and non-G-SIBs are required to deduct non-regulatory capital TLAC holdings from Tier 2 capital. However, a materiality threshold applies of 10 per cent of the common shares and TLAC holdings of the issuer. Amounts above 10 per cent are deducted and lower amounts risk-weighted. For G-SIBs, there is a 5 per cent threshold for the investing bank's common equity for TLAC holdings held in the trading book and sold within 30 business days.

iii Stablecoins

In October 2020, the FSB published its Regulation, Supervision and Oversight of Global Stablecoin Arrangements report. This report sets out high-level recommendations for the regulation, supervision and oversight of global stablecoin (GSC) arrangements. It includes the following principles:

1. authorities should have and utilise the necessary powers and tools, and adequate resources, to comprehensively regulate, supervise and oversee a GSC arrangement and its associated functions and activities, and enforce relevant laws and regulations effectively;
2. authorities should apply comprehensive regulatory, supervisory and oversight requirements and relevant international standards to GSC arrangements on a functional basis and proportionate to their risks;
3. authorities should ensure that GSC arrangements have in place a comprehensive governance framework with a clear allocation of accountability for the functions and activities within the GSC arrangement;
4. authorities should ensure that GSC arrangements provide users and relevant stakeholders with comprehensive and transparent information necessary to understand the functioning of the GSC arrangement, including with respect to its stabilisation mechanism; and
5. authorities should ensure that GSC arrangements meet all applicable regulatory, supervisory and oversight requirements of a particular jurisdiction before commencing any operations in that jurisdiction, and adapt to new regulatory requirements as necessary.

In October 2022 the FSB published a report on recent market developments and proposing changes to the FSB High Level Recommendations.

iv Cryptoassets

We have referred above to the recent Basel work in this area. In July 2022 the FSB published a Statement om International Regulation and Supervision of Cryptoasset Activities. This states, inter alia, that cryptoassets and markets must be subject to effective regulation and oversight commensurate to the risks they pose, and that stablecoins adopted as a widely used means of payment should be captured by robust regulations and supervision of national authorities. Cryptoasset service providers must at all times ensure compliance with legal obligations in the jurisdiction in which they operate. This was followed in October by a consultative document on Regulation, Supervision and Oversight of Cryptoasset Activities and Markets. This sets out nine recommendations to authorities including:

1. that authorities should have appropriate powers and tools, and adequate resources to regulate, supervise and oversee cryptoasset activities and markets;
2. authorities should cooperate and coordinate with each other, domestically and internationally, with each other;
3. authorities should require cryptoasset issuers and service providers to have a comprehensive governance framework and effective risk management;
4. authorities should require cryptoasset issuers and service providers to disclose to users sufficient information regarding their operations, risk profile and financial condition; and
5. authorities should monitor interconnections within and outside the cryptoasset ecosystem, and require firms that combine multiple functions and activities are subject to regulation, supervision and oversight that addresses these risks.

v Climate change

An issue newly on the agenda of the FSB concerns the potential risks to financial stability arising out of climate change. In November 2020, the FSB published the Implications of Climate Change for Financial Stability report. The report identified two main categories of risk.

1. physical risk: this comprises the possibility that the economic costs and increasing severity of extreme weather events, as well as gradual changes in climate, might erode the value of financial assets or increase liabilities, or both; and
2. transition risk: this category refers to risks that relate to the process of adjustment towards a low carbon economy, which could affect the value of financial assets and liabilities.

In July 2021, the FSB published a Roadmap for Addressing Climate-Related Financial Risks. The Roadmap covers four main areas:

1. firm-level disclosures;
2. data;
3. vulnerabilities analysis; and
4. regulatory and supervisory practices and tools.

According to the Roadmap:

The steps set out in the roadmap are indicative and each step described to be taken is subject to the outcomes of necessary prior steps being satisfactorily achieved. Given this indicative status, they do not represent commitments either by jurisdictions or by international bodies to the individual actions or dates.

Individual aspects of the Roadmap are allocated to SSBs, including the Basel Committee. The Roadmap was accompanied by two further reports on Promoting Climate-Related Disclosures and the Availability of Data with which to Monitor and Assess Climate-Related Risks to Financial Stability. July 2022 saw publication of a progress report which stated that encouraging progress had been made in all areas. A final report on Supervisory and Regulatory Approaches to Climate-related Risks was published in October 2022 which provides a point-in-time snapshot of jurisdictions' approaches, as well as high-level recommendations to promote consistency as authorities continue to develop their approaches further. As part of the FSB Roadmap, the FSB will consider in 2024 whether and when to conduct a peer review of supervisory and regulatory practices.

Footnotes