Bank for International Settlements’ Cecchetti Lays Out Case for Basel III, Calls for Greater Investor Vigilance

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Fourth Annual CFA Institute European Investment ConferenceAs G20 leaders met in Cannes to address Europe’s monetary and economic crisis, in Paris Stephen Cecchetti was calling for greater investor vigilance and tighter regulation of the shadow banking sector. Speaking at the fourth annual CFA Institute European Investment Conference, the Head of the Monetary and Economic Department at the Basel-based Bank for International Settlements defended new Basel III rules that tighten capital and liquidity requirements for banks against criticisms from bankers that the rules are curbing lending and holding back economic recovery.

Cecchetti began his talk by highlighting the imperfections of large banks. “While the financial pile-up had many causes, we must not overlook the critical role played by a number of very large global banks with insufficient capital, inadequate liquidity, and poor risk management practices,” Cecchetti said. “We are rewriting the rules of the road to prevent such an accident from recurring.”

On the subject of the much-maligned activities of financial regulators, Cecchetti told Conference delegates that “we know that the quality of regulation and supervision mattered, since the banking systems of some countries proved to be more resilient to the crisis than others.” A new framework for regulating and supervising systemically important financial institutions is now being developed by the Financial Stability Board and the Basel Committee on Banking Supervision. The new framework, Cecchetti explained, comprises three complementary components: greater loss absorbency, more intense supervision, and stronger resolution.

Stephen Cecchetti at the fourth annual CFA Institute European Investment ConferenceStill, Cecchetti hasn’t just got his eye on regulating the large banks. “No institution is too big to fail,” he said. Cecchetti is thus working to create a level playing field for both large and small financial institutions, and that must mean increased regulation for the shadow banking system. “There is a lot of work left to be done to ensure that the creators of systemic risk face obstacles,” said Cecchetti. “Owners and managers must be forced to face the costs of the systemic risks that they create. A combination of higher loss absorbency, streamlined resolution, and more intense supervision must reduce both the likelihood and impact of failure.”

New proposals from the rule-making Basel Committee require additional capital from banks to absorb possible losses. Using an example of a bank with a total common equity requirement of 9%, Cecchetti said that “national supervisors can use their discretion to add an additional counter-cyclical buffer of up to 2.5% under conditions when excess credit growth seems to be promoting a build-up of systemic risk. Taking into account Basel III’s tougher definition of capital, the result is a substantial and necessary increase in minimum capital requirements.”

Cecchetti defended Basel III’s introduction of a leverage ratio as a backstop to the risk-based measure. “The gains from this are twofold,” he said. “First, it can help contain the build-up of systemic risk that can arise when leverage expands quickly. Second, it guards against the mismeasurement of risks during booms.” While acknowledging problems with the implementation of the leverage ratios, in particular the fact that derivatives complicate calculation and measurement, Cecchetti said he was confident this measure could help identify problematic risks.

The economist also responded to critics who claim that the new proposed regulations will be highly detrimental. One report by The Institute of International Finance argues that the changes will increase lending rates by at least 300 basis points and that banks will need to raise $1.3 trillion in new capital, GDP will fall by 3% over the next five years, and seven million jobs will be lost. Nonetheless, Cecchetti said he believes “that changes in capital and liquidity regulation will have only a modest impact on credit availability.”

Investors have a critical role to play alongside the rule-makers, Cecchetti contended. While falling short of allocating all of the blame for recent events on investors, he pointed to the key role of equity and bond investors in monitoring and taking responsibility for their investments in large banks. “You must push institutions to behave more responsibly,” Cecchetti told the audience of more than 200 investment management professionals.

Using the example of Swiss bank UBS, which in 2006 had CHF 2.4 trillion of assets supported by only CHF 50 billion of shareholder equity capital, Cecchetti observed that “just because something is legal doesn’t make it wise. This is something that investors should have spotted.”

Another example arose in the management of sovereign risk. According to Cecchetti, under Basel II, big banks were supposed to use their own internal modeling to differentiate risks. But this led to cherry-picking when they assigned weights to sovereign exposures. The result was less control of risk. “Even if the authorities allowed this,” Cecchetti asked, “shouldn’t management, especially the chief risk officer, have insisted on using the results of his own credit evaluation? And shouldn’t sell-side and buy-side analysts alike have insisted that banks do their homework on this?”

In the end, the prize for successful banking regulation is a dull one: stability and predictability as a background for steady economic growth. “The Basel III reforms in general — and those for systemically important financial institutions in particular — will succeed if, 20 years from now, you analysts can look back on a prolonged period of sustained, predictable, even boring profits in the financial sector,” Cecchetti concluded.

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