Basel III: the price of a stable banking sector

Implications of banking regulation for banks and their corporate clients

Basel III: the price of a stable banking sector

The BIS’s new capital requirements for banks, also known as Basel III, draws the attention of various stakeholders. It’s not only the banks that are keen to take note of these additions to the Basel II Accord of June 2006, but their professional clients also want to understand the implications for them. This article provides some suggestions on how to cope with the consequences of Basel III.

In 1988, the BIS published its first global capital requirementsfor banks, the Basel I Accord. These guidelines were simple andstraightforward: a uniform and fixed capital requirement of 8%for most credit facilities granted by banks, while a lowerrequirement applied to a selection of asset classes. Additionalregulation for market risk was published in 1996.

Because Basel I could not accommodate the evolution of therisks of banks, a new accord, Basel II, was published in June2006 and became effective in the European Union in January2008. The aim of Basel II is to apply risk sensitive capitalrequirements. In general, the higher the risk of a bank’sbusiness, the higher the capital requirements for the bank andthe higher the pricing (while the reverse would apply as well).The comprehensive view on banking regulation is expressed bythe three pillars of Basel II: Minimum Capital Requirements(Pillar 1), Supervisory Review (Pillar 2) and Market Discipline(Pillar 3). Moreover, in addition to credit risk and market risk,operational risk is included. Subject to strict requirements,banks are allowed to use their own, internal risk models for thefulfillment of these capital requirements.

In Basel II, risks are expressed by means of Risk WeightedAssets (RWA). The minimum capital ratio is expressed as apercentage of these RWAs. Under Pillar 2, the requirementsaccording to Pillar 1 calculations are corrected for a variety offactors that are not included in Pillar 1, for instance concentrationrisk. This results in the final regulatory capital requirements.

The financial crisis highlighted several shortcomings of Basel II,however. Basel III, in essence, focuses on additional requirementsfor the composition and quality of capital of banks, theliquidity position and the leverage. The calculation itself of RWAremains unaltered in most cases (except for counter party risk oflarge financial institutions and apart from inclusion of mark-tomarketcounter party risk losses).

Implications of basel III

The (rather unique) combination of a recently implementedBasel II and an unprecedented adverse economic situationalready resulted in higher risk profiles of clients and facilities.Limitations in models and historical data as well as a gradualinclusion of the economic downturn in the underlying datapushed up risk profiles of bank clients and credit facilities.Moreover, many bank clients were downgraded due to theeconomic situation, implying a double impact. On top of this,Basel III has several implications:

  1. Tighter definition of ‘real loss absorbing’ capital
  2. Higher capital requirements
  3. Restrictions on leverage
  4. Stricter liquidity requirements.

We underline however the cumulative effects of Basel III.

The composition of capital is required to become more robust bymeans of stricter requirements for ‘real loss absorbing’ Tier 1and 2 capital. Capital instruments that do not meet thesecriteria, such as several types of mezzanine capital and Tier 3capital, will be gradually phased out for the calculation ofregulatory capital. Next to this, deductions from capital willapply for certain unconsolidated investments in financialinstitutions, mortgage servicing rights and certain deferredtaxes.

Basel III, on top of Basel II, provides the means for an institutionalized focus on the downside of risks

Minimum capital requirements for banks will increase from thecurrent 8% to at least 10.50% and even up to 13% in case ofadverse economic circumstances. ‘System banks’ potentiallywill be confronted with additional requirements, which are stillto be determined. On top of this, restrictions on remunerationwill apply in case a bank hits the floor of the conservation bufferand the counter-cyclical buffer, if applicable.

Under Basel III, non-eligible capital components should eitherbe replaced by Tier 1 or Tier 2 capital, or the bank would haveto reduce its risk weighted assets. Additionally, banks willneed more capital to cover the same risks (apart from anychange in risk profiles). This combination will put pressure onthe banks’ target for risk adjusted return on risk adjustedcapital and the anticipated dividends. In other words, bankswill need to meet the same dividend targets for a similar oreven restricted product portfolio that faces higher capitalrequirements.

Restrictions on leverage apply by means of a minimum leverageratio of 3% (of Tier 1 capital). This leverage ratio applies toon-balance as well as off-balance sheet items (the latter with aspecific credit conversion factor per product), while restrictionsapply on netting. Although indicative, it will restrict banks’activities irrespective of the calculation of RWA and implies arestriction in meeting targeted dividend payments. In case offocusing solely on low risk clients, the leverage ratio mightbecome an overarching restriction. In case of high risks, theminimum capital ratio might be hit while the leverage ratiomight not be breached yet. As a result of the leverage ratio,especially disproportionate derivative positions will be limited.

Following abundant liquidity in the market, the financial andeconomic crisis underlined that financial institutions areextremely vulnerable to unexpected and major withdrawals offunds. Basel III addresses this with a Liquidity Coverage Ratio aswell as a Net Stable Funding Ratio. Both the liquidity ratios andthe additional Pillar 2 requirements of Basel III imply a stricteradherence to an overarching principle of (approximately)matched funding (tenors for credit facilities, cash-flows in caseof derivatives, while it applies to FX positions as well). However,it is a mismatch that often generates attractive bank profits butcan put a bank at risk as well. The liquidity requirements areapplicable in combination with the aforementioned capitalrequirements and leverage ratio.

The new capital requirements will be implemented gradually,starting by 2013 and scheduled to be fully implemented as ofJanuary 2019. This long transition period underlines the need offurther fine-tuning. In any case, the intake of Basel III makesclear that banks generally will need to meet stricter and highercapital requirements, where liquidity and leverage requirementsform additional restrictions in a bank’s business. By and large, banks willneed to look for higher revenues and/or off-loading assets. It depends onthe situation on the global financial markets and the strength andprofitability of the bank to what extent banks will be able to get Basel IIIcapital to appropriate levels. The current low interest rates allow banks tobuild up retained earnings. However, as soon as the market interest ratesgo up again, business cases that rely on bank financing will change, whichwill put margins for banks under pressure.

“Banks will need to meet the same dividend targets, however, for a similar product portfolio that faces higher capital requirements”

Countering the implications of basel II and III

Basel III will result in restrictions in the supply-side of capital bearingproducts offered by banks. Countering the implications differs for banksand their clients:

For banks:

  • The financial turmoil as well as the stricter capital requirementsunderline the need for accuracy in models and relevant data. So far,Basel II implementation has not always been optimal, often resultingin over reliance on models. Basel III is an excellent incentive to correctfor these shortcomings. High quality data and high quality modelscombined with a fine balance in processes and systems are essentialfor Basel III as well.
  • The above-mentioned balance of models, processes and techniques isa prerequisite for optimizing the efficiency and the cost structure of abank.
  • Banks will need to balance their capital-raising, off-loading assets ora combination of both.
  • The first banks already started tapping the international financialmarkets by means of new forms of loss-bearing capital, though atsignificant prices. In-depth insight in specific conditions of fundingproducts (hybrid capital, professional funding, saving accounts,deposits) becomes highly relevant to meet the new capital standardsand liquidity standards.
  • Product innovation, like for instance working capital finance /supply-chain finance, and in products relying on netting.

For (professional) bank clients:

  • Given the exponential curve in rating versus price of credit facilities, astable, sound financial status of any bank client becomes even moreimportant than in the past. In anticipation of Basel III, margins on bankproducts already increased significantly. As such, bank financing is andwill be more expensive in any case, but especially for low rated clients.
  • Reduction of working capital pays off and can be achieved by means of:
    • Fine-tuning the limit size of unused credit facilities, in view of thecosts related to underlying capital requirements for the offeringbank;
    • Keeping a close eye on cash pooling and netting to preventunnecessary credit facilities(requiring product innovation by the banking sector);
    • An active credit risk management of debtors. Determining the riskprofile of (prospective) clients provides the means for early paymentincentives, late payment fees and limiting debtor outstanding as perrisk profile.
  • A creative use of bank facilities with a lower risk profile, like traderelatedfacilities and not-credit-substituting bank guarantees (see alsoabove, product innovation by the banking sector).
  • Syndicated loans and/or club deals will be easier to place.
  • Reduction of tenor of facilities, provided according to financing needs.
  • Financing based on tangible collateral: fixed assets have significantlymore value than floating assets and work in progress. Financialcovenants usually have a very low impact on pricing.
  • In case of multiple financial products acquired from the same bank,non-credit related fees might allow for compensation of a lower than(theoretically) required credit margin.Next to the above, we expect the market will look for other alternatives,like private equity, bond issues and an enhancement of securitizationpractices.

Conclusion

The financial turmoil made clear that capital and liquidity can becomescarce almost instantly, notwithstanding regulation and advancedmodeling techniques. Basel III, on top of Basel II, provides the means foran institutionalized focus on the downside of risks. This will not protectthe sector from bear markets, but clearly incorporates warning signals forpotential stress in the banking world as well as caps and floors in thebalance sheet. The trade-off for products and services offered by banks isless favorable: prices will rise in any case. Stability in the banking sectorhas a price, but this was significantly underestimated in the second half ofthe previous decade. Basel III puts the burden of a sound banking sectorwith the banks and their clients.