Global Regulators Quietly Agree to Target Credit Bubbles

Banking regulators have quietly taken a major step towards harmonised global regulation by agreeing to raise worldwide capital requirements whenever an individual country declares a credit bubble.

Sharon Lorimer

Part of the larger “Basel III” banking reform package, the “countercyclical capital buffer” heralds a step change in the way national banking regulators interact and is the first concrete example of “macroprudential” regulation that seeks to moderate the economic cycle.

“This is very significant, because it takes the regulatory community into protecting the health of the entire system rather than just individual banks,” said Paul Tucker, deputy governor of the Bank of England, who represents the UK at Basel.

The agreement, struck last month, says that if a country decides its economy is overheated – based on the ratio of credit to gross domestic product – it can require banks within its borders to hold extra capital against potential losses.

Regulators in every other country would have to follow suit and impose a proportional surcharge on their own banks, based on the size of those institutions’ exposure to the bubble country.

Once the bubble pops, regulators could reduce or remove the buffer, allowing banks to use the extra capital to absorb losses.

All 27 members of the Basel Committee on Banking Supervision signed on to this first-of-its-kind agreement, including the world’s biggest economies.

“They’ve crossed a Rubicon,” said Barbara Matthews, a US-based regulatory consultant. “Up until now the Basel committee has been about ex-ante co-operation and making banks safe. They are now talking about reciprocity, and they are implementing a tool kit that blurs the line between regulation and economic policy.”

The agreement surprised many regulatory lawyers and observers who had expected fights to break out over how to combat bubbles and resistance to the cross-border provisions.

The deal is also remarkable for the trust implied by the reciprocal arrangements. If the UK imposes a surcharge, the US is honour-bound to do the same on the UK businesses of its own banks.

“Reciprocity is key. It only works if overseas banks entering a market have a similar increase in capital requirements,” said Paul Sharma, head of prudential policy at the UK financial regulator and another Basel participant.

It remains to be seen, however, whether any country will have the courage to use the new tools – in some countries, it is not even clear who will impose them.

Most analysts said they were unlikely to come into play until the rest of the Basel agreement takes full effect in 2019.

The agreement says that the bubble country can force banks to increase their minimum tier one capital ratio – a key measure of bank strength – by a maximum 2.5 percentage points (from the global minimum of 7 percent to up to 9.5 percent).

A bank based in another country that does 20 percent of its business in the bubble country would then receive a proportional surcharge of up to 0.5 percentage points.

While the buffers are designed to protect banks, they are also likely to raise the price of credit, which could help deflate a bubble.

Banking groups said they were concerned some nations would impose buffers more readily than others, creating an uneven playing field. They are also sceptical that once buffers are imposed, they will become permanent, either because regulators never cut them or investors react badly to a reduction.

“We have concerns whether these will really work as countercyclical in both directions,” said Charles Dallara, managing director of the Institute of International Finance.

“A country would have significant disincentives to impose the countercyclical capital buffer [because] ...the impact would likely be greater on its economy than on the banks,” said Greg Lyons, a US partner at law firm Debevoise.

The US is said to be particularly reluctant because it would have to declare a country-wide bubble, even though there might be large variations between regions.