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    FSI on Policy Options to Address Regulatory Fragmentation in Banking

    February 04, 2020

    The Financial Stability Institute (FSI) of BIS published a paper that studies policy options to address regulatory fragmentation in the banking sector. The paper identifies three main sources of this regulatory fragmentation and outlines possible further work in the policy domain. The identified sources of regulatory fragmentation that can lead to different prudential outcomes across jurisdictions are heterogeneous practices in the measurement of assets, differences in the scope of application of Pillar 1 Basel III requirements, and divergent approaches in the implementation of the supervisory review process under Pillar 2. The paper suggests that further guidance on the scope of application of the Basel framework and better clarity on certain features of Pillar 2 can promote more regulatory convergence.

    Regulatory divergence, or differences, in how jurisdictions apply Basel III and other global banking standards is a significant source of market fragmentation. Although substantial efforts have been made to ensure full, timely, and consistent implementation of international standards, prudential regimes may still diverge. Under Japan’s presidency of the G20 in 2019, FSB investigated whether regulatory policies and supervisory practices have led to market fragmentation and considered tools to address the issue. This paper leverages the FSB report and identifies specific sources of regulatory divergence in the banking sector. Full, timely, and consistent implementation of the standards, at least to international active banks, is a necessary condition to minimise unwarranted divergence. Yet domestic regulations that are assessed as compliant with Basel standards may still lead to different prudential outcomes across jurisdictions.

    The paper highlights that differences in how banks calculate regulatory capital are a key source of regulatory divergence. The valuation of loans drives the reported capital number of banks. Other hard-to-value assets can also affect a bank’s capital figure. As banks are highly leveraged, even small changes in asset values can have a disproportionate effect on capital. Thus, heterogeneous asset valuation practices may materially affect the consistency of bank solvency assessments across jurisdictions, as the regulatory capital figure is the starting point for assessing compliance with Pillars 1 and 2 of the Basel framework. A variety of instruments can be used to address unwarranted regulatory fragmentation. BCBS evaluates the implementation of its standards in all member jurisdictions and has already issued guidance on elements of the prudential regime where significant discrepancies exist.

    The paper suggests that additional policy work may be considered in areas where excessive heterogeneity remains, such as those relating to the measurement of nonperforming exposures and other hard-to-value assets that are consequential in the calculation of regulatory capital. To reduce variation resulting from the asset measurement practices that drive the calculation of regulatory capital, the design of consistently applied prudential backstops, particularly for the measurement of nonperforming exposures and Level 2/3 assets can reduce unwarranted variability across jurisdictions. On the second and third sources of discrepancies—that is, differences in the national implementation of some elements of Pillar 1 and Pillar 2 requirements—there is scope to investigate whether all differences are justified on the basis of national specificities or whether additional guidance may mitigate unwarranted regulatory fragmentation. Further guidance on the scope of application of the Basel framework and greater clarity on certain features of Pillar 2 can promote more regulatory convergence.

     

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    Keywords: International, Banks, Basel III, Pillar 1, Pillar 2, NPE, Market Fragmentation, Regulatory Capital, BCBS, FSI, BIS

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