Current regulatory changes

Basel II reforms

As a consequence of the financial crisis, extensive work has now been underway for some time to reform the international standards that form an important cornerstone in the regulation of the banks in Sweden and many other countries, the so-called Basel II regulations. These regulations are developed by the Basel Committee(1) and mainly relate to the amount of capital banks must hold as a buffer to cope with losses incurred in the course of their business. The capital adequacy requirements are calculated on the basis of the bank's risks.(2)

The Basel II regulations are not binding, but many countries have voluntarily chosen to implement the regulations into their national legislation. This also applies to the EU, where the Basel II regulations form part of the legislation adopted at the EU level. This makes the regulations binding also for Swedish banks.

The reforms that are now being planned will in all likelihood be implemented in their entirety in the EU, and thus also in Swedish legislation. This means that Swedish banks, as well as other financial companies, will soon need to adapt to several new and more stringent requirements.

A brief description of the most important reforms adopted or proposed by the Basel Committee is presented below. This is followed by a review of the process for implementing the reforms. For detailed information on the Basel Committee's reform work visit www.bis.org/press/p091217.htm

What are the most important proposed changes?

• Composition of the capital.
  Stricter and more harmonised requirements will be introduced regarding what may be included in the so-called capital base. In the future, a larger part of the capital base will have to consist of common shares and retained earnings. The regulations governing other types of capital instrument that may be included in the capital will be harmonised and tightened up. Some types of instrument that may currently be recognised as capital will no longer be permitted. The Basel Committee will also analyse whether there is a need to raise the minimum level for the total amount of capital the banks must hold.
  
  
• Better risk coverage in the capital requirements.
  The capital requirements for risks that banks take when they, on their own account, trade in debt securities, shares and other financial instruments will be tightened up in various ways. An important component of this is that the capital should be calibrated to make the banks' securities portfolios resilient to more drastic and long-term price falls than previously. Another central element is that more capital will be reserved for so-called counterparty risks, that is the risk that, in a transaction involving a financial instrument, a bank's counterparty will be unable to pay or deliver the security on time.
  
  
• A complementary and non risk-weighted capital requirement (leverage ratio):
  With the aim of preventing the banks' level of indebtedness becoming too high in relation to their capital, a non risk-weighted capital requirement, or so-called leverage ratio, has been proposed. This requirement means that a bank's capital may not fall below a fixed and simple limit in relation to its total assets. There is no such limit today as the current requirement is only related to the degree of risk in the bank's assets. The higher the risk, the higher the capital requirement, and vice versa. The intention of the new leverage ratio requirement is not to replace the current requirement. Instead, it is supposed to function as a floor if today's more complex and risk-based requirements allow capital to fall too low.
  
  
• Measures to reduce procyclical effects:
  The proposal contains several components that aim to dampen the procyclical effects that the financial system may have on the business cycle. One aim is to remove or mitigate the procyclical effects that the regulatory framework itself gives rise to. The Basel Committee is therefore considering various alternatives to avoid increases in the capital requirements at times when the banks are weakest. Another aim is to ensure that the banks have sufficient financial strength to run their operations throughout the business cycle without disruptions. To achieve this, it is proposed that the banks should build up their capital buffers in good times so as to have something to fall back on when times are worse. The Committee also proposes that capital requirements should increase when there are signs of an exaggerated expansion of credit in the banking system as a whole.
  
  
• A global standard for liquidity regulation.
  One part of the Basel Committee’s reform package is a proposal to introduce, for the first time, a global standard that places quantitative requirements on the banks’ liquidity management. The standard consists of two main parts. First, there will be requirements governing the amount of liquid assets a bank must have to meet its short-term liquidity needs during a 30-day period of stressed funding conditions. Second, requirements governing the banks' long-term funding will be introduced. The banks will be required to have a certain amount of stable and long-term sources of funding that match the liquidity characteristics of the banks' assets.
  
  
• Measures to manage contagion risks in the financial system.
  The Basel Committee is considering several measures to manage the contagion risks that arise because the banks often have considerable exposures to one another. As the most serious contagion risks arise if one of the central players in the system experiences problems, the Committee is investigating whether banks that can be regarded as systemically important should be subject to stricter capital and liquidity requirements than other banks. Another measure that is being considered with the aim of limiting contagion risks is to require larger amounts of capital for the exposures that the banks have to one another.

The reform process

No decision has yet been taken on most of the reforms described above(3). At present, a process is underway in which the Basel Committee is conducting an impact assessment of the proposals and canvassing the views of banks, authorities and other stakeholders. The objective is that the reforms should be finalised and incorporated in national legislation by the turn of the year 2012-2013.

The most important checkpoints in the reform process are presented below:

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Notes
1)  The Basel Committee is a committee under the Bank for International Settlements (BIS) which, among other tasks, develops international standards for the regulation and supervision of banks. The Basel Committee has members from 27 countries, including Sweden. Sweden is represented by the Riksbank and Finansinspektionen (the Swedish Financial Supervisory Authority).
2)  See Lind, G., ”Basel II – new regulatory framework for bank capital”, Sveriges Riksbank Economic Review 2005:2, pp. 5-22, for a more detailed description.
3)  In some areas the Basel Committee has already adopted changes in the Basel II regulations. These changes mainly concern the capital requirements governing so-called market risks. This includes the reforms described above that aim to tighten-up the capital requirements for the risks the banks take when they trade in debt securities, shares and other financial instruments on their own account. The changes are to be incorporated into national legislation by December 2010.