In September of 2010, the Basel Committee on Banking Supervision specified additional details for capital requirements. These focused on target ratios and the transition periods during which financial institutions need to comply with the new regulations. The resulting framework, known as Basel III, was endorsed by the G20 at its November 2010 meeting in Seoul. While some areas continue to be fleshed out – most notably in relation to the regulation of systemic institutions – the core principles are in place to encourage banks to strengthen their underlying risk management capabilities.
Basel III was developed as a response to the deficiencies in banking and financial regulation revealed by the global financial crisis. Specifically, the third of the Basel accords aims to correct the following:
- Build up of excessive on and off-balance sheet leverage by the banking sector along with a decrease in the level and quality of the capital base.
- Significant contraction of liquidity and credit availability resulting from the spread of the banking crisis through the rest of the financial sector.
- Interconnectedness of systemic financial institutions through various complex transactions.
- The use of short-term and wholesale funding, used by the financial sector as a cause of deleveraging and flight to quality.
The reforms under Basel III are designed to increase the resilience of banks during periods of stress and address system-wide risks that can severely impact the financial sector. These reforms are broken down into four key proposals:
- Increasing the quality, consistency and transparency of the capital base to ensure a more resilient banking sector.
- Improving risk coverage of the capital framework to strengthen the resilience of banks and minimizing the risk of shocks being transmitted between financial institutions through complex transactions.
- Supplementing capital requirements with a leverage ratio to help contain concentration of too much leverage in the banking sector.
- Lowering procyclicality and promoting countercyclical buffers that can be applied in stressed environments, contributing to a more stable banking system.
Development of these new proposals has been continuing with extreme urgency and on a very tight timescale. Individual national agencies in Europe along with the EU are currently in the process of translating the proposals into domestic legislation, even as core details on systemic risk are still evolving. Implementation is designed to begin in 2013 and despite the fact that some fundamental issues are yet to be resolved, banks cannot afford to be idle. Recommended areas for action include:
Increased quality, consistency and transparency of the capital base
Banks are expected to improve the consistency of their common equity component of Tier 1 capital as regulatory adjustments will generally be applied to this component. Additionally, Tier 2 capital is to be simplified and Tier 3 eliminated. The goal is to improve the transparency of capital, with all elements of a bank’s capital required to be disclosed.
Some banks are already adjusting their balance sheets; however, raising new capital and retaining more earnings will continue to be challenging and impose a double strain on shareholders who will see dividends constrained alongside calls for additional capital.
Reduced on and off-balance sheet leverage
Banks need to constrain build up of excessive on and off-balance sheet leverage to avoid destabilizing their deleveraging processes. Accordingly, banks will be expected to reinforce their risk-base capital requirements with a backstop measure based on gross exposure to be incorporated into Pillar 1.
This backstop measure is designed to prevent the build-up of excessive leverage in the banking system. The implications are as yet unclear, in particular as to how individual institutions will be impacted. It could lead to reduced lending or it could incentivize banks to focus on high-risk/higher-return lending. Ironically, this raises the wider issue of shadow banking. There have been a number of public comments notable from the FSB on this issue. As banks deleverage it is likely that a public policy response will follow that brings these assets back within the scope of regulation.
As a result of the crisis, global regulators and policymakers have realized that liquidity is potentially as significant as solvency for the stability of the financial system. The Basel Committee has strengthened its liquidity framework by developing new minimum standards for funding liquidity:
- A 30-day Liquidity Coverage Ratio (LCR) will help ensure that banks have sufficient highquality liquid assets to withstand a stressed funding scenario specified by supervisors.
- Assets get a liquidity-based weighting varying from 100 percent for government bonds and cash, to weightings in the range of 0 to 50 percent for corporate bonds.
Because the introduction of the LCR will require banks to hold significantly more liquid, low-yielding assets, there will be a correspondingly negative impact on profitability.
There is a debate about whether the liquid, low-yielding assets i.e. sovereign debt should attract a risk weight under the Basel III formula. The irony is that this would reduce the amount of capital available to support credit origination and the knock on impact on national and the global economy. The political reality of this is that the ongoing debate between growth and financial stability will continue. A further market development is the increasing use of covered bonds to generate longer dated liquidity. Up to a point this will be successful but at some time these instruments will absorb so many good quality assets as collateral that the ability of banks to rebalance their asset portfolio will be limited and this cannot be a good policy outcome.
Partly as a result of liquidity requirements, banks may tend to change their funding profile, with a demand for additional longer-term funding. The Net Stable Funding Ratio (NSFR) is designed to encourage banks to use stable funding sources and reduce their dependence on short-term funding. The NSFR compares available funding with required funding, using weighting factors to reflect the stability of the funding available and the duration of the asset.
Banks will need to increase the proportion of wholesale deposits with maturities greater than one year; this is likely to lead to higher funding costs. Stronger banks with a higher NSFR will be able to influence the market price of assets, while weaker banks will see their competitiveness reduced. While this could be read as a description of one of the core objectives of Basel III, it also implies that competition may in fact decrease as a result.
Counterparty risk management
Significant strengthening of the framework for trading book and securitization risk has already been introduced as part of Basel 2.5 (July 2009). Basel III will introduce further changes to the treatment of exposure to financial institutions and counter-party risk on derivative exposures. In addition, the committee will be imposing greater pressure to drive standardized derivative trading onto regulated exchanges.
Basel III represents more than just another set of regulatory requirements for financial institutions across the globe. The policy makers are trying to find a balance between financial stability and economic growth. For management, the proposals will have fundamental impacts on capital allocation, pricing of products for customers and the wider business model and the returns to shareholders. Banks with a vision to excel in a post crisis world are taking action now to address Basel III requirements, strengthen their profit-making capacity and manage the new reality that Basel III will place on them.