March 2023 saw the worst outbreak of banking turmoil since the global financial crisis of 2007-9. There were three significant bank failures in the US – Silicon Valley Bank, Signature Bank of New York and First Republic Bank - and Credit Suisse experienced serious difficulties which resulted in it being taken over by UBS. The global standard-setting body, the Basel Committee on Banking Supervision (BCBS), has recently published a report on these events.
This post focuses on those aspects of the BCBS report that suggest possible areas for future development of the Basel Framework. It therefore does not look at those parts that summarise what happened and identify lessons for supervisory practice. The potential implications of the turmoil for the design of resolution regimes, deposit protection schemes, central bank facilities and public support measures are outside the scope of the BCBS report altogether.
Four main areas of the Basel Framework are highlighted in the report: liquidity standards, the treatment of interest rate risk in the banking book (IRRBB), the definition of regulatory capital, and the scope of application of the Basel Framework. It is important to note that no changes to the Basel Framework are imminent. The BCBS intends to follow up with further analytical work with a view to assessing the need to explore policy options over the medium term.
The Basel Framework’s quantitative regulation of bank liquidity comprises two complementary minimum standards: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR is concerned with short-term liquidity, requiring banks to maintain sufficient high-quality liquid assets (HQLA) to meet their liquidity needs in a thirty-day liquidity stress scenario. The NSFR looks further out, measuring a bank’s available amount of stable funding against its required amount of stable funding over a one-year period. The BCBS highlights issues with the way both of these worked.
As regards the LCR, a large part of Credit Suisse’s HQLA was reserved for purposes other than covering outflows in a thirty-day stress scenario. A lot was held to meet daily operational and intra-day liquidity needs, which intensified during stress as prepositioning of cash was increasingly needed to settle trades. And the speed and scale of deposit outflows also suggests that banks may not always have thirty days in which to address their liquidity problems. The BCBS concludes that the turmoil has raised questions about the scope of the risks covered by the LCR and the assumed outflow rates. Similar calibration concerns were noticed with the NSFR, as Credit Suisse’s NSFR during the relevant period never indicated that Credit Suisse had any liquidity difficulties. The role and frequency of stress indicators used by supervisors under Pillar 2 may also need looking at.
Concentrated exposure to IRRBB was a common factor in the problems experienced by the US banks. These banks held substantial quantities of long-dated fixed income securities in the banking book at amortized cost. As interest rates began to rise in 2022 unrealised losses on these securities increased rapidly. These banks were not subject to the Basel Framework IRRBB standard (see below) and there are different perspectives on how the application of that standard might have mitigated these risks. On one view, the Basel Framework treatment of IRRBB, based on Pillars 2 (supervisory review and discretion) and 3 (public disclosure), is inadequate, as providing insufficient information to assess the risks, suggesting that perhaps more granular reporting would be appropriate. It can also result in similar risks being treated very differently in different jurisdictions.
Treatment of held-to-maturity assets
The experience of the US banks illustrated two particular issues related to the build-up of unrealised losses in assets held at amortized cost on the basis that they were expected to be held to maturity. First, the selling of these assets (on a fire-sale basis) to raise cash in a liquidity crisis immediately realises the losses, causing a direct hit to shareholders’ funds and regulatory capital, potentially adding a solvency/regulatory capital crisis to the liquidity crisis. This raises the question whether it is appropriate for securities to be held at amortized cost or whether they should instead be treated similarly to available-for-sale securities, given that all kinds of securities may need to be sold in a crisis whatever the original holding intention had been. The BCBS is conscious, however, that such a change would have far-reaching implications for the volatility and pro-cyclicality of bank capital. The second, related issue, is whether securities held at amortized cost should be eligible for inclusion as HQLA for the purposes of the required liquidity ratios (see above), given that selling them to raise cash would crystalise any unrealised losses.
The role of additional Tier 1 (AT1) capital instruments
The BCBS makes a number of observations regarding the Credit Suisse AT1 securities, and not only regarding their write-down. For example, it notes that in order to avoid adverse signalling to the market, Credit Suisse continued to make expensive replacement issues of AT1 securities and to continue to pay discretionary interest on them despite the fact that it was reporting losses over several consecutive quarters. These behaviours raise the question whether, in practice, these instruments are capable of absorbing losses on a going-concern basis.
Regarding the write-down, the BCBS considers that a holistic review of issues relating to the complexity, transparency and understanding of AT1 might be valuable, to include looking at disclosure requirements, the types of write-down trigger permissible for securities to qualify as AT1, and the loss-absorbing hierarchy.
Scope of application
The Basel Framework is stated to apply on a consolidated basis to internationally active banks. Some jurisdictions choose to apply it more broadly, some of these on a “proportional” basis. The report reflects on the non-application to purely domestic banks and the non-application on a solo entity basis.
The BCBS believes that recent events have shown that the failure of even relatively small banks (to which the Basel Framework has not been fully applied) can have systemic and cross-border implications. One response would be to amend the criterion for full Basel Framework application to focus expressly on a bank’s potential to threaten global financial stability. Another possibility would be to pay additional attention to banks (of whatever kind) carrying on business that poses potentially greater systemic risk – e.g. high concentrations of uninsured deposits relative to HQLA buffers.
The BCBS also notes that the distress of Credit Suisse showed that a banking group may comfortably meet regulatory requirements at consolidated group level but have much more difficulty at solo entity level, and that the sum of the LCR requirements of each bank within a group may substantially exceed that for the consolidated group. The Basel Framework does not ignore the distribution of capital and liquidity within a group, but it leaves a lot of discretion in the hands of supervisors. There is a view that this approach requires further consideration.
The BCBS report identifies a number of substantial issues on which it is going to reflect further. Given the very real problems that have been identified, it would be surprising if the BCBS did not in due course propose amendments to the Basel Framework to address at least some of them.