In 1988 the Bank for International Settlements (BIS) published its first set of global capital requirements for banks, the Basel I Accord. These guidelines were simple and straightforward: a uniform and fixed capital requirement of 8% for most credit facilities granted by banks, while a lower requirement applied to a selection of asset classes. Additional regulation for market risk was subsequently issued in 1996.
Due to the fact that Basel I could not accommodate the evolution of bank risk, a new accord named Basel II was published in June 2006 and became effective in the European Union (EU) in January 2008. The aim of Basel II is to apply risk-sensitive capital requirements. In general, the higher the risk of a bank’s business, the higher the capital requirements for the bank and the higher the pricing, while the reverse also applies.
The 2008 financial crisis highlighted several shortcomings of Basel II. Basel III*, in essence, focuses on correcting earlier mistakes and adding requirements for the composition and quality of the capital held at banks, the liquidity position and the leverage.
Implications of Basel III
The rather unique combination of the recently-implemented Basel II and an unprecedented adverse economic situation from 2007-08 onwards had already resulted in higher risk profiles of clients and facilities. Limitations in models and historical data, as well as a gradual inclusion of the economic downturn in the underlying data, pushed up the risk profiles of banks and their credit facilities. Moreover, many banks were downgraded due to the economic situation, implying a double impact. On top of this Basel III has several implications, which will impact the post-crash situation:
- A tighter definition of ‘real loss absorbing’ capital.
- Higher capital requirements.
- Restrictions on leverage.
- Stricter liquidity requirements
I would stress that the cumulative effects of Basel III. Among these, it requires the composition of capital to become more robust by means of stricter requirements for ‘real loss absorbing’ Tier 1 and 2 capital. Capital instruments that do not meet these criteria, such as several types of mezzanine capital and Tier 3 capital, will be gradually phased out for the calculation of regulatory capital. Next to this, deductions from capital will apply for certain unconsolidated investments in financial institutions (FIs), mortgage servicing rights and certain deferred taxes.
Minimum capital requirements for banks will increase, from the current 8% to at least 10.50% and even up to 13% in case of adverse economic circumstances. Systemically Important Financial Institutions (SIFIs) will potentially be confronted with additional requirements, which are still to be determined. On top of this, restrictions on remuneration will apply in case a bank hits the floor of the conservation buffer and the counter-cyclical buffer, if applicable.
Under Basel III, non-eligible capital components should either be replaced by Tier 1 or Tier 2 capital, or the bank will have to reduce its risk-weighted assets (RWA). Additionally, banks will need more capital to cover the same risks (apart from any change in risk profiles). This combination will put pressure on the banks’ target for risk-adjusted return on risk-adjusted capital (RARORAC) and the anticipated dividends. In other words, banks will need to meet the same dividend targets for a similar, or even restricted, product portfolio that faces significantly higher capital requirements.
Restrictions on leverage apply by means of a maximum leverage ratio of 3% (of Tier 1 capital). This leverage ratio applies to on-balance-sheet as well as off-balance-sheet items – the latter with a specific credit conversion factor per product – while restrictions apply on netting. Although indicative, it will restrict banks’ activities irrespective of the calculation of RWA and implies a restriction in meeting targeted dividend payments.
Following a period of abundant liquidity in the market, the financial and economic crisis that developed in 2007-08 underlined that FIs are extremely vulnerable to unexpected and major withdrawals of funds. Basel III addresses this with a revised Liquidity Coverage Ratio (LCR) as well as a Net Stable Funding Ratio (NSFR). Both the liquidity ratios and the additional Pillar 2 requirements of Basel III imply a stricter adherence to an overarching principle of (approximately) matched funding (tenors for credit facilities, cashflows in the case of derivatives, while it applies to foreign exchange (FX) positions as well). However, it is a mismatch that often generates attractive bank profits, but can also put a bank at risk. The liquidity requirements are applicable in combination with the aforementioned capital requirements and leverage ratio.
The new capital requirements will be implemented gradually, starting in 2013 and scheduled to be fully implemented by January 2019. This long transition period underlines the need for further fine-tuning. In any case, the intake of Basel III makes clear that banks generally will need to meet stricter and higher capital requirements, where liquidity and leverage requirements form additional restrictions in a bank’s business.
By and large, banks will need to look for higher revenues and/or off-loading assets. It depends on the situation on the global financial markets, as well as the strength and profitability of each bank, as to what extent banks will be able to get Basel III capital to appropriate levels. The current low interest rate environment allows banks to build up retained earnings. However once market interest rates go up again business cases that rely on bank financing will change, which will put margins for banks under pressure. Bank funding for corporates could suffer.
Countering the Treasury Implications of Basel III
Basel III will result in restrictions in the supply-side of capital-bearing products offered by banks. When countering the implications, corporates and their treasury departments should focus on the following aspects:
- In anticipation of Basel III, margins on bank products have already increased significantly. As such, bank financing is and will be more expensive in any case, but especially for low-rated companies.
- Reduction of working capital pays off and can be achieved by means of:
– Fine-tuning the limit size of unused credit facilities, which require bank capital as well.
– Keeping a close eye on cash pooling and netting to prevent unnecessary capital bearing credit facilities.
– Active credit risk management of debtors. Determining the risk profile of prospective clients provides the means for early payment incentives, late payment fees and limiting debtor outstanding as per risk profile.
- A creative use of bank facilities with a lower risk profile, such as trade-related facilities and not-credit-substituting bank guarantees.
- Reduction of tenor of facilities, provided according to financing needs.
- Financing based on tangible collateral: fixed assets have significantly more value than floating assets and work in progress (WIP).
- 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; such as private equity, bond issues and an enhancement of securitisation practices.
The financial turmoil on 2007-08 onwards made clear that capital and liquidity can become scarce almost instantly, notwithstanding regulation and advanced modeling techniques. Basel III, on top of Basel II, provides the means for an institutionalised focus on the downside of risks.
This will not protect the banking sector or its corporate clients from bear markets, but clearly provides warning signals for potential stress in the banking world as well as caps and floors in the balance sheet. The trade-off for products and services offered by banks is less favourable: prices will rise regardless. Stability in the banking sector has a price, but this was significantly underestimated in the second half of the previous decade. Basel III puts the burden of a sound banking sector with the banks and their corporate clients.
The author thanks Chantal Comanne for her meticulous assessment of the relevant regulation in the preparation of this article.
*In the case of Basel II, we refer to various relevant and closely related guidelines by the BIS and EU.
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