Will Basel III force disintermediation?

Implications for high risk/high yield banking activities

Will Basel III force disintermediation?

The new capital requirements specified by the Bank of International Settlements (BIS), also known as Basel III, have landed broadly. A great deal of attention has been focused on the implications of Basel III for the capital structure of banks. Various banks have since adjusted their capital positions to match the new preconditions. A number have even gone as far as acquiring new (hybrid) capital via so-called contingent convertibles (coco) in anticipation of the stricter requirements, allowing capital to behave like debt, except in certain (stress) situations in which it is converted to Tier 1 capital. Basel III, however also has implications for the other side of the balance sheet. This article aims to provide insight into the implications for the high risk/high yield activities of banks in Europe.

Starting with the introduction of Basel II, an increased amount of capital needs to be set aside for financing instruments associated with lower credit classes. Basel III extends this requirement and, apart from a stricter definition of capital, decrees that the risk weights assigned to certain (credit) instruments must be increased even further. This results in an increase in the capital reserves that must be held for these positions compared to Basel II. Banks will therefore have to increase their capital reserves to cover their risks. This will put the objectives of banks in relation to the risk-weighted yield on risk-weighted capital under pressure.

To illustrate this point, a model portfolio is shown here with a simplified representation of the difference in spread under Basel II and Basel III. This difference is the result of an increase in the capital reserves to be maintained. The spread according to the capital markets has also been included for comparison.

Under the same conditions, actual value can only really continue to be retained for a relatively small portion of the spectrum of credit portfolios (and investment activities). This discrepancy already existed under Basel II. Basel III simply raises the curve, particularly at the bottom of the spectrum, such as high yield debt and (private) equity activities, as well as – potentially – SME financing. Banks will therefore have to start looking for higher (risk-weighted) income or will have to remove certain assets from their balance sheet.

Basel III table

Split-off of portfolios and activities

The intent of Basel II and Basel III is to promote a more stable banking sector by reducing the risk inherent in the portfolios held by banks. An immediate consequence of the Basel III regulations would appear to be an implicit split between ‘commercial lending’ and ‘specialty lending’ activities, and unintentionally possibly a (lasting) limitation of available financing for the SME segment.

A split-off of portfolios and activities also means a loss of commercial interests. A decision to maintain high risk portfolios on the basis of commercial arguments over time however means i) loss of value by maintaining the portfolio and ii) a significant call on capital markets in order to continue to meet the capital requirements. Once Basel III comes into effect (adoption of Basel III Capital Framework by major G-20 financial centers by the end of 2011), this could lead to scarcity in capital and liquidity. A split-off decision by contrast presumes that those elements of the portfolio that cannot contribute sufficient value to the total portfolio will be divested, over the short term or over time. The choice therein consists of short-term or deferred pain; phase out or immediate disposal, in both cases however with loss of income and other commercial interests.

Disintermediation and the role of the capital markets

Capital market financing is commonplace in the US financing market, more so than in Europe. Just as it is in the US, perhaps the European capital markets could assume a more important role in the future in terms of the approaching disintermediation. Investment funds and investment companies could play a role of greater significance, particularly in the takeover of higher risk and complex financing and investment activities.3 It was already evident during the credit crisis that several pension funds jumped into the ‘credit gap’ and began extending credit to companies directly. Various asset managers anticipated this development and started to collaborate with pension funds for the purpose of engaging in private financing (and some case investment) activities.4 There is also another aspect to this. Banks, as wholesalers of risk are particularly well equipped to manage credit risk. Pension funds or asset managers are less suitable for this purpose, because they possess less (specific) knowledge about private lending, particularly in terms of managing these risks. Banks consequently offer added value in this respect and have a role to play just as they do in securitizations, for example. Innovative collaboration between the banking sector and (institutional) investors could offer interesting opportunities for splitting off the high-risk activities of banks.

Off-balance sheet structuring

Securitizations are well known examples of off-balance sheet structuring of bank assets. This involves the transformation of non-marketable risk factors into marketable financial instruments. The purpose of securitization is to transfer credit risks to the capital market. Securitizations remain an interesting means of transferring credit risks to the market. There are a few catches, however.

Under Basel III, banks will be required to maintain a considerable capital buffer for holding first loss and junior tranches.5 Furthermore, the EU’s Committee of European Banking Supervisors on 1 January 2011 published new guidelines for the application of the Capital Requirements Directive (CRD) to securitizations. This guideline, among other factors, obliges securitizers to at least permanently maintain a material net economic interest through means of vertical slice retention and originator interest retention.6 This therefore limits the opportunities provided by securitizations for splitting off assets.

A solution could possibly be found in a structure in which banks split off parts of their portfolios to independent funds that are financed by these (and other) institutional parties, and perhaps partly by the banks themselves. A number of elements must be taken into consideration from the perspective of the transferring bank in this respect, such as the accounting, the fiscal implications, management of the transferred credit risks and the degree to which economic interest is maintained, as well as the treatment of these elements under Basel III. The interaction of these aspects within the Basel III and CRD context determines the degree to which assets can in fact be removed from the balance sheet, whereby banks can substitute the potential loss in income from these portfolios. This interaction transforms the off-balance sheet structuring of the high risk/ high yield exposures of banks into a complex, but not impossible matter.

Conclusion

The financial crisis demonstrated that capital can become scarce in the blink of an eye. Basel III provides additional requirements over Basel II designed to better safeguard the composition and quality of the capital position of banks. Basel III aims to achieve a more stable banking sector this way. It, however, also brings about a change in the banking landscape due to the disintermediation that is expected to emerge. This produces scarcity in available capital, especially for high risk/high yield activities. Collaboration between (institutional) investors and banks would appear to offer interesting opportunities for ensuring the continuous supply of capital for certain activities, whereby banks can secure a portion of their income at the same time, without having to give it up to the market by default.