In July 1988 the Basel Committee of Banking Supervisors (Basel) published a short groundbreaking document: “International convergence of capital measurement and capital standards”, better known as the Basel Capital Accord or Basel I. In 2004 Basel II was published, and now, after the 2007/09 global financial crisis (GFC), and many years of reform, there is Basel III (for more a more detailed precis see History of the Basel Committee).
Since the first Accord, while switching to the Germanic spelling of Basel was simple, the standard itself has grown considerably and is anything but simple. That first standard was a mere flyweight at 30 pages; the second standard a middling 347 pages; while the third standard is a heavyweight 1,715 pages excluding the core principles for effective banking supervision.
Fortunately, there are few paper copies anymore, otherwise with all the other PRA policies the scales are quite likely broken.
A substantial increase in the page count was justified. The first standard was a simple framework that set minimum capital requirements for credit risk. It was expected to evolve and, also reflecting lessons from the GFC, the current standard is considerably more comprehensive and sophisticated. It captures a wider spectrum of risks (market, operational, liquidity, leverage and large exposures), allows simpler as well as more risk sensitive and advanced modelling approaches, requires public disclosures to enhance market discipline, and requires firms make their own assessment of adequate resources through the internal capital adequacy assessment process.
A substantial number of the additional pages represent prescriptive technical detail, for both matters in the original standard and those added later. For example, the definition of capital has increased from around 8 pages to just under 40 pages (with another 20 pages of FAQs): there are now 14 clear criteria to be satisfied before common equity instruments can be recognised in regulatory capital.
Basel has recognised its standard has become more complex and members’ surveys indicate this has increased the compliance costs of implementation. There is however a risk that the standard is unnecessarily prescriptive, in the process becoming unduly long and complex, and which further adds to the compliance burden. Developing international standards is typically not a flexible or fast process and so any burden is potentially embedded for a considerable period.
The UK is committed to implement the Basel standards as a Basel member, and alignment with international standards is enshrined in FSMA 2000. While it is in the UK’s interest to do so, to help promote a level playing field for UK banks, it also means there is the risk the UK imports an unnecessary compliance burden.
Why might international standards be inherently (and potentially over) prescriptive
When developing international standards, there are several drivers of a prescriptive rather than a more principles-based approach.
The benefit of prescription is that it seeks to remove ambiguity by providing objectivity and clarity, thereby limiting the potential for inappropriate or incorrect judgements around implementation. This in turn helps promote a consistent application as it reduces the scope for different approaches being adopted, whether at an individual bank level or across different jurisdictions. This aids comparability, and limits both the potential for regulatory competition between jurisdictions and the potential for regulatory arbitrage by firms. A challenge, however, is that increased prescription can lead to lengthy and complex standards, perversely creating ambiguity and undermining the intent.
International standards are for international business. But the nature and size of these businesses can vary considerably. As such the content of the standard will likely need to accommodate a large variety of different business types; with boundaries needing to be clearly articulated.
The potential for over prescription is in the development process. This typically involves layers of committees, working parties, or other similar groups staffed by the members of the international standard setting body. The Basel Committee has 45 members from 28 jurisdictions which increases the risk that committees are large and unwieldy.
Firstly, this arrangement is likely to have an inherent tendency towards lots of technical and prescriptive detail. The lower levels will typically have multiple technical committees each dealing with a different topic and staffed by technical experts from national regulators. The experts are likely to lean towards ideal and comprehensive approaches. The consensual nature of reaching international agreements also means matters are more likely to aggreged for inclusion, rather than there being a rigorous filtering process that rejects certain items (ie party A ‘s proposals are included in exchange for allowing party B’s proposals to also be included). And then there is the potential for a cultural disposition towards conservatism and stronger prudential measures at the expense of the costs of implementation.
Second, once a prescriptive item is included in a standard by a lower committee there can be inertia to its change or removal. The higher committees likely have limited capacity and ability to challenge the technical detail and the potential volume of detail. The top-level committee will be very much focused on big ticket items and “red flags”, and members will take advice from their members of the lower technical committees. Prescriptive items in themselves may also lack significance to justify being raised for a higher committees’ consideration. Similarly, the size and complexity of standards also means that industry responses to consultations focus on the most significant matters – not the multitude of minor prescriptive matters.
Finally, it is difficult to undertake effective cost-benefit analysis. The benefits are highly subjective, being both in the future and a non-occurrence (eg no financial instability). The costs will depend upon the international standard but also other national domestic considerations. There are then practical challenges in gathering timely and appropriate data, which may also be subject to privacy and data protection laws restricting its sharing with the international standard setter. The data for Basel’s quantitative impact studies is provided voluntarily and on a best endeavours basis.
What to do?
Firstly, national standard setters should not over apply. As Basel applies to internationally active banks, an obvious step is one that the PRA has already taken, which is to develop a bespoke simplified approach for small non-international UK domiciled deposit takers. The exclusion of UK credit unions from the Basel standard is a more historic application of this approach.
It is probably not realistic to amend the committee structure supporting the development process, as it is arguably the best approach to develop complex material. The complexity of modern finance demands considerable technical resource, which the international standard setter does not possess. Moreover, each member should be permitted to contribute.
International standards typically adopt good principles of development, such as transparency, openness, consensus, effectiveness and relevance. For example, the Basel committee has publicly explained its standard setting process, it consults on its proposals and has undertaken impact assessments.
There needs, however, to be more recognition that, while the development process can capture excellent technical content, it might be too idealist and comprehensive and at the expense of less prescriptive approaches that might deliver adequate prudential protection but for a lesser cost. There should lead to more challenge in the development process to assess whether there are appropriate trade-offs between adequate prudential requirements and complexity, compliance costs and other practical issues. And it should be explicit in the principles and processes that govern the development of standards.
Taking the Basel consultative document for revisions to the standardised approach for credit risk, an additional objective (section 1.1) for the review could have been to reduce unnecessary prescription or similar.
There also needs to be more robust consideration of the level of prescription and compliance costs when evaluating the effects of policies, including evaluating the effectiveness of the development process. While the Basel committee discussed the complexity of Basel III and the associated risks in its evaluation of the impact and efficacy of the Basel III reforms, it raised but did not seek to answer the question whether a simpler standard could have achieved the same prudential outcomes. It was argued that the standard is inherently complex, that stronger prudential capital and liquidity outcomes, and that compliance costs will decline over time, were justification that the standard has achieved a reasonable balance.
Unfortunately, while it is often recognised that regulation (and likewise tax) becomes ever more complex and steps should be taken to reverse course, the opposite occurs.
