Ahead of the curve podcast

Basel III: Not the endgame

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John Pucciarelli, Client Director and Stuart Smith, Co-Head of Business Development spend time in the studio discussing the potential impact of Basel III on banks and the broader macro economy. An insightful discussion filled with clear examples provides an insight into the implications of the new Basel regulatory recommendations.

Hello, Stuart. How are you? -I'm very good. Thank you.We have our earphones on today, so we're professional podcasters.I feel professional. -So do I.We tried it without them. This feels a lot more natural.You look great with them on. -It's nice to be in the same room.It's the first time we've done this in the same room.This is the first time you and I have been in this room.Yes. -This is a great room.It sounds great. It sounds great in here.Hopefully, it's going to sound great to everyone who listens to us.We have a really interesting topic today to discuss.It's something that we've been focusing on,from an Acadia perspective, for a little while.The reason why we do that is because it directly affects our clientsand will directly affect many of our clients.It's Basel III Endgame. What we're going to do today,you're going to fill in all the specifics because you're the expert.I know a little bit about this, too, so we can have a nice conversation.Basel III Endgame is what we're going to be talking about today.It's an important regulation. It's something that is going to affectall of our clients for the most part. It is a regulation in the United Statesthat's going into effect in July 2025. -July 2025.It's coming. I know that there's a lot of regulatory advocacythat's been happening. We've been talking about that a little bit,but why don't we just dive into what Basel III Endgame is,for the folks who are listening? Then we can discuss why this matters,and then we'll see where that goes. -Basel III Endgame, believe it or not,was kicked off after the financial crisis. It feels like that was forever ago.It has been 15 years now, yet we're still talking about itand still talking about the ramifications. Basel III Endgamewas a new set of capital rules intended to increasethe amount of capital banks held, make it more comparable,and roll it out in a global sense. It's fair to say the US is waybehind every other jurisdiction in the world.Some jurisdictions, like Japan and Canada, are already postingthose increased capital requirements. Most other jurisdictionshave a long-standing proposal in place, even if there are some detailsto iron out, like Europe, with a pretty well-defined go-live date.The US was the last major geography to come on board with thisand release its proposals, and that has given ita pretty accelerated timeline. Which is probably not an issuefor most of the big banks, but maybe more of an issueto some of the smaller banks. Fundamentally, and you can look back,the Fed itself has said that this probably meansabout a 20 percent increase in capital held by banks in the US.It's 20 percent on top of what they hold already.Yes. That sounds like a lot because there have been other reforms.If talk of UMR and Dodd-Frank, part of thatwas making sure that there was enough capital in the casethat there's another Lehman or another bear.This is on top of things that have already been put in place.I think that's an important point to make. When these kinds of regulationswere being discussed in other geographies, they were discussed very muchin the aftermath of the financial crisis. There was a huge amount of public angertowards banks, a feeling of pressure to make them payfor what happened, maybe in 2008, and make sure it couldn't happen again.I think it's fair to say that that feeling across those countriesis probably subsided now. Now, banks are, I think,understood for the important role they play and how importantthey are to the recovery of economies post-COVID.Now it does make it more difficult for the US to come forwardwith these regulations in the current climate,compared to maybe other places where they were being discussed pre-COVID,still in the aftermath of 2008. -It seems like not the best time for this.I know when these timelines were put in place,we probably weren't in an interest rate environmentthat we're in now. We didn't have inflation like we have now.I'm assuming all of that's going to play into the discussionsthat are going to be happening on Capitol Hill in the US.Absolutely. However, if the US does choose not to go aheador choose to do something different and pull back from it,there'll be a lot of pushbacks from the other world geographies.Other people have committed to this. It's going to have a big impacton the profitability of US banks. However, every other bank in the worldis taking the same thing. Why should they effectively put themselvesat a competitive disadvantage? Would we see a pullbackof those regulations or an ostracization of the US?It's very hard to see how that would play outand how the geographies would respond if the US choosesto do something different. We said that the US regulatorhas put through a fully gold-plated set of packages.They've taken what was already a tough set of capital metrics,and they've made them quite a lot tougher. -Stuart, I want to jump into the removalof IMM in the US, and what does it mean? Why do it?What are the consequences of it? Can you first explain what IMM stands for?IMM stands for the Internal Model Method. Historically, there have been this kindof two sets of models. These internal model approachesare for market risk or the internal model methodfor credit risk. That's the method that you use to calculate that.They contrast with the standardized approaches.The big thrust around Basel III Endgame has been to lift upthe standardized metrics to make them more risk sensitive,to increase the amount of capital that they require,and to make them more comparable across banks.Banks are playing on a level playing field.There has also been a large attack on the internal model approachor internal model method to make it less important.For instance, there's a flaw now that comes from the standardized approach,which means you can't go less than 70 percent on standardized,even if your internal model says it should be much less.The US has chosen to go one step further than that and simply said, "No,we will not have any internal model method approachesfor counterparty credit risk." Counterparty credit risk is normallyby far the biggest capital charge out of market risk and counterparty risk,and taking away that internal model method immediately means a substantial increasefor the US banks. -Something that I would sayis a huge consequence. What about XVA desksand their importance? They've been at the forefrontof counterparty credit risk and managing that risk for banks.What's the knock-on effect there? -I think if you take that whole communityof risk professionals and how that team of peoplehas historically been funded. They've been funded by the differencein the cost of capital between an internal model method approachand a standardized model approach. That effective source of fundingis disappearing for this group of people. Now that funding would pay forboth the smart quants who ran a lot of these modelsand devised a lot of them, as well as the infrastructurethat they ran on. What we're left with is a single model,which is going to run across everything, and less funding availablefor the smart mathematicians to do risk calculations within the banks.Now, it's fair to say that group was largely discreditedafter 2008. If you had all these amazing models,and they didn't predict what happened, what was the point of them?True. -On the flip side,simply saying we're going to get rid of themcompletely is equally difficult. -It doesn't seemlike there's yet a middle ground to be reached here,unless some of the advocacy that we've read about.Can you talk about some of the advocacy that's been going around?I think there's a great quote from Scott O'Maliawhere he said that the reliance on a one-size-fits-all modelwill be a major change that could lead to herd behaviorand drive concentrations of particular assets.He's really talking about when you have a simplified modeland everyone knows how it works, there are always gaps in that model.There cannot be gaps because it is simplified.In those gaps, they can be home for types of tradingthat may not be particularly safe. When you get that systemicallyacross a whole bunch of institutions, you can introduce a systemic risk.Then there's a question as to how the regulatorswould approach that type of problem. Back in the internal model days,they could have directed banks at that problemand said, "No, this is your issue. You go fix your modelingto cope with this risky behavior you're taking."However, by taking on more responsibility as the regulator,saying that this is the standardized model,it fixes everything. It must then fix everything,and if it doesn't, it's on you as the regulator for not resolving it.It moves the center of power for risk calculationsfirmly towards the regulator. However, with that comes a lotof responsibility on them to make sure it works.Just as a side note, you mentioned Scott. I worked at ISDA,and Scott was my boss at one time. It makes a lot of senseof what he's saying. I think it makes sensethat that is his position. They're echoing the industry.I'm not an expert in this field, but I've been talking about itfor a while. It seems to me that when you start moving market forcesaway from markets and into the hands of regulators.The regulators, overall, have done a very good jobwith the reforms. We saw, through Dodd-Frank and UMR,the creation of SIMM and all of the things that we've built at Acadia,as well as everyone else in the industry. This was to managethe systemic risk that was presented to us during the 2007-2008 crisis.However, this, to me, feels like a little bittoo much and an overreach, generally speaking.Now, you don't have to agree with me. That's just my instinct.I'm glad that I'm hearing that there's advocacy going onto try to bring all of these things to light.It sounds like ISDA is doing its work on this.We have our colleagues at LSEG who have been on the hilltalking about this at length as well, because it affects the cleared marketsas well as the uncleared markets, et cetera. I'm hopingthat we get some clarity around this soon. Do you have any sense of that at all?Have you heard anything? I know we've had some conversations.We had an event a couple of months ago, and I don't recallif there was a timeline. I don't think there is a timeline.Generally speaking, the regulators will do what they do in their own time.Congress obviously is going to be on vacationfor the holidays, so we probably won't know anythinguntil the next quarter of next year or the first half of next year.I think the first thing to say is that the regulation was put forward.Normally, it would come forward with a unanimous backingof the people proposing it. It didn't even get that.It wasn't even fully backed by the people who were proposing it.Only one person fully supported it, and most peoplesupported it with reservations. I think in some ways, it's a declarationthat they expect there to be a negotiation here.That yes, this is the most aggressive possible set of capital calculationswe can put forward, and we accept it's going to be pulledback a little bit from this. The other thing,which is a technical point, but maybe it's also justan important point about how it's been done,there should be data backing up the proposals that are made.It's not clear that there really is data in place.In fact, there are some new efforts to get more data from the banksand to bring this into that process and into that discussion.Part of that, inevitably, is going to be driven by the timelineand the desire to be live in line with the restof the geographies of the world in 2025. That gives the US less timeto go through this process than other countries have had.I think there are a few things going on there.I think there is a general feeling that there will besome form of compromise position, and put togetherwith the US political climate. I don't think I've ever seen a websitethat lets you send your representative a direct message saying, "Stop Basel III."That's democracy, or that's the way it's supposed to work.Whether or not they listen is another story,but we assume that they do. We give them the credit.I'm sure they do. I don't think you can ignore itwhen it makes that much press. It's well describedhow it's going to impact people in terms of their pricing,their mortgages, and in terms of how they do share dealing.It's going to impact people in a real way. -It's also a macroeconomic issue.Anytime I think about more capital being locked up,whether it's a good reason or not, and without data,like you just said, to me, that means less risk taking.I'm a capitalist, and that's just the way I've always felt about things.Risk is where you make those investments in building things.Governments talk about infrastructure and buildingroads and bridges and hospitals and airportsand all this other stuff. It doesn't come out of the blue.It comes out of investments made at a very high levelthat require risk and hedging of that risk.I'm probably simplifying this way too much.However, in my view, if capital is put asidefor no other reason than because there's a standardized method to do it,then there are a lot of consequences to that.We probably don't know them all, is my guess.The bet I think that's been made is that the amount of capitalwill be large enough to cope with anything.Rather than it being targeted and being precise,it is simply big enough that it will cushion any blow.It's a sledgehammer rather than a scalpel. I've used that before.It's interesting that you talk about the clear point.One of the other reactions to 2008 was that this interconnectednessis going to kill us. There are so many tradesthat go here, there, and everywhere. We can't make sense of it.Nobody knows who's going to go bust if Lehman goes down.The reality was it wasn't as bad as everyone felt it was at that time,just because no one really understood him. We deal with thisthrough central clearing. Central clearing has been a phenomenal success.It has had a huge growth. Half of a bank's trading derivativesgo through clearinghouses or a single clearinghousewith very stringent risk controls around that.One of the things that Basel III Endgame looks to changeis how capital is applied to those businessesthat are doing that clearing. If you're a big bank,and you're clearing for people, today, what you dois you get to charge the fees on from the clearinghouse to your clientand effectively ignore that pass-through. In the new regulations,that's all going to be included in your capital calculation.That can be a pretty significant difference in how much capitalyou're going to have to hold. All of a sudden, you're clearing business,which in the past was extremely capital-light.Which is what the intention was because we wantedto encourage more clearing to improve the stabilityof the financial systems, transparency, and all the other benefitsthat come from clearing. Now we're going to applya much larger capital cost to those businessesthat are going to look less profitable to the bank.Maybe they'll put their fees up to counteract that.In fact, that just makes their problem worse, because by putting their fees up,they're going to push their capital up again.There are some questions about how viable some of these clearing businesseseven are under that new regime. I think that's an area where I thinkit's highly likely that you could see some change,just because I think it's definitely not the desired impactto see people move away from clearing. That'll be an interesting area to look at.That is very interesting. I wonder what the thought processis from the regulatory side and the legislative side.I don't have any insight into that. I don't know if you do,but it seems counterintuitive to go fromwe want margin rules and more clearing, as the two pillars of the reforms,to now that there are these capital rules, it's going to cost more.Cost should be going down as more volume goes up,as economies of scale, maybe. I don't want to speakabout data that I don't have. However, on the face of it,what you're saying doesn't sound good to me.Actually, a lot of this doesn't sound really good to me.That's just my opinion. I don't speak for Acadia, LSEG, or anyone.I'm speaking for myself. I understand the need for more capital,and we don't want firms going under. However, I feel likethere is definitely an overreach here in a lot of spaces.Can we move to another part of this, which is non-bank financial institutions?Do you want to talk about NBFIs? -It sounds unrelatedin that they aren't impacted by Basel III. However, as banks become less profitableover time because they hold more capital, and because they're more regulatedin the types of activities they can do, it opens up the doorsto these non-bank financial institutions to do more.Who are they? Are they institutions that don't put on a lot of riskfrom a market perspective, meaning are they putting onreally large swap positions? Do they hold a lot of cash securities?What are they? -It's worth taking a step backand saying, "What are these things, and why havethey suddenly become important?" They have always existed.They've existed for as long, if not longer, than banks.In days gone by, they were pawnbrokers. They were loan sharks.They were the guy in the corner who would lend you £50.This was the way non-bank financial institutions worked.I bet they didn't have the name non-bank financial.They didn't have such good marketing. They weren't a particular problembecause they were small. They had risked themselves.However, if they went under, they went under. It was no great problem.There were no systemic problems. -No systemic problem.What changed is the information revolution.Now businesses like that can effectively become global entitiesin not a lot of time. You look at many payday loans.I'm not going to call them loan sharks, but the business model is not dissimilarto that of a loan shark. It's a short-term loanwith a high interest rate, which is then collected aggressively.Essentially, those firms were not regulatedin the same way as the banks. -That's sometimesa necessary part of business. You need short-term loans sometimes.The risk of those short-term loans doesn't applyto some of the larger institutions. There is a market needfor these types of institutions. There's nothing wrong with it.It's actually necessary. -If you look at the non-banked peoplein the world, of which there are a massive number,those are the kind of institutions that serve that unbanked populationof the world. If you want to get a loan, and you need a loan for some reason,and the bank won't give it to you, and this guy will,as long as you understand what you're entering into,there's nothing protected. -However, we're not talkingabout individuals. We're talking about corporations,some of which have been around for quite a while.These firms are not small to large shops. These are large multinational firmsthat themselves are highly interconnected and have huge potential risksassociated with them. Again, in the wake of 2008,this was sort of observed, this growth of this type of firmand the fact that it could portray a future risk.People were interested in what kind of risk that would be,and how it would play out. The FSB does quite a lot of surveyingin this area and was tasked with doing it by the G20.They track what they see as NBFIs,which have a particular business model, which makes them particularly exposedto systemic risks. They have some different categoriesthat they put in that. However, it comes under peoplewho have short-term funding risk problems, people who could very easily sufferfrom a run on their organizations, and people involved with the creationor securitization of credit. These are the types of firmsthat are particularly risky and could have systemic problems.When you look at that from 2006 until 2020,that's sort of the size of that business is doubled, and it continuesto grow pretty much linearly year-on-year. We see a huge explosion in the presenceof these types of entities. Various studies that have been donehave looked at how the increase in this type of volume of businessaffects the systemic and stability risk for the financial system itself.The answer is that it increases. Every timethe non-bank financial institutions increase, the market sharethat they have increases, and the stability goes down.I think it is somewhere that's very active for regulators.By pushing up capital on banks, by increasing the risk supervisionon those people, we are going to push yet more businessinto that non-bank sector again. There needs to be a counteracting weightto that to say that we don't want all businessesto end up on this side, which is unregulatedcompared to the way banks are regulated. How should these non-bankfinancial institutions be regulated? I think that will be a focusfor regulators going into next year. They need to make surethat they aren't just squeezing the risk out of all the banksand letting it pop out in a slightly different placein the market. -It seems to methat on the periphery,the attention of regulators always want to bring it back.If they start seeing numbers, like you just said, all of a sudden,even if nothing has gone wrong yet, it becomes a signal that has to flash.They have to deal with it. Are you saying that NBFIs are now in scopefor Basel III Endgame? -No. I don't think it would be appropriateto put them under that regulation. However, I think regulatorsare actively looking and understanding what it is they need to do.Probably some type of capital buffer is appropriate,but it's probably not going to be the same.The other problem they've got is maybe sometimes categorizingthese guys in terms of are we're going to call this persona loan maker, or are we going to call this persona trader or a broker-dealer, or an insurance firm?As new types of finance emerge, you almost have to categorize themand understand what they are before you can then decidehow to regulate them. In some ways, when you look at crypto,one of the challenges regulators have with cryptois just deciding what it is. Is it a cash product, is it security,or is it a proxy? Until you make that kind of decision,it's hard to decide which regulator's supposedto pick this thing up. -That's interesting to me,just observing what you've been saying, even around NBFIs.It's always a delicate balance, from an economic standpoint,of making sure you allow for the growth of a sectorand try not to stifle it. That's always the regulator's goal.They're not trying to kill business. They're trying to balance out.I'm defending them a little bit here, even though I come down on them.I do it to their face sometimes, too. I'm not just having podcast muscles here.They do need to balance that out, but that's going to bean interesting space to watch for next yearand going into 2025. Stuart, it seems to methat there is still a lot here to unpack. There's still a lot in flux.We're in London, just so everybody knows.As far as Basel III Endgame for the United States and the regulators,there's still a lot more to come. We'll probably have to do this podcastagain and come back and see where we've landed.Maybe we'll know in six months' time.Certainly, for us at Acadia, we'll continue to keep track of thisbecause it's very important. We shall see.Anything else? Any other last comments before we go?This is a great studio, by the way. -I agree.I want to do this again. -I think watch this space.I think, like you say, we'll be back, and we'll talk about this again.I think there's no way that this is the end game.There's something else that's going to come next,so we just wait and see what it is. -This is not the end game, for sure.It never seems like it is. Just keeps going and going.Anyway, thank you so much, Stuart. It was a pleasure talking to you.Thank you. -We'll talk again.Thank you all for listening. If you like this podcast,and you want to hear more podcasts from Acadia,please visit Acadia.inc or your favorite streaming devicesor channels to hear more. Thank you very much.