Basel III implementation: a half-term report

The Basel III capital adequacy proposals were always going to present massive challenges for banks. Given the scale of the credit crisis in 2008-09, any response likely to make a significant impact would need to be very fundamental indeed. The banking industry is certainly better capitalised and more liquid today than it was before the crisis – but at what cost? What remains to be done? What uncertainty remains? The answer to each of these questions is ‘a lot’.

Firstly, it is important to realise that Basel III could never have solved all of the world’s financial problems. Three of the poster children of the crisis – Bear Sterns, Lehman and American International Group (AIG) – were not banks, were never subject to banking regulation and would not have been subject to Basel II, Basel III or any of their successors. AIG was an insurance company, whereas Bear Sterns and Lehman were US broker/dealers. In the US the latter are not subject to the Basel banking rules, although in the UK the Basel rules are applied to both banks and investment firms – the UK equivalent of broker/dealers.

The industry is generally coping well, although there is a great deal of uncertainty during the transitional period. Under Basel III alone there are 11 different ratios, each being phased in over a period extending to January 2019. One of these, the net stable funding ratio (NSFR), itself remains uncertain. Add to this the plethora of parallel initiatives and the picture becomes very complex.

To make matters worse, the desired ‘level playing field’ which Basel III aims to achieve is already looking somewhat rocky. Areas such as systemically important financial institutions (SIFIs), accounting rules including netting (which drives the leverage ratio) and governance arrangements already vary by jurisdiction. Resolution regimes also vary, which creates uncertainty over how a future failure might play out.

Willem Buiter, chief economist at Citigroup, famously said that financial institutions are international in life, but national in death. In Europe, Basel III is translated into law by the Capital Requirements Directive (CRD IV), although this is only partly a directive – which must be transposed into 28 different legislative systems – and partly a regulation, which applies directly in each member state.

A mixed picture

So how are banks coping with all of these changes? The picture is mixed with weaker banks already finding it difficult or more expensive to raise additional capital. New instruments such as contingent convertibles (CoCos) add to the uncertainty. The name is confusing as only 35 out of 91 CoCos issued actually convert into equity; most are subject to write down arrangements. These were originally priced to the first call date but now look more like perpetuals. Those issued by Deutsche Bank and Santander (at par) have touched 75% and 85% respectively of their face value so far this year.

A further issue for derivative dealers is pricing the Basel III Credit Valuation Adjustment (CVA). This is intended to mark to market (M2M) credit risk, but the rules remain very unclear; hence pricing long-dated trades is hard. Marking to market is a process which involves valuing all traded instruments at daily prices and ensuring that regulatory capital is available to support current and potential future losses. The liquidity rules are already forcing a change from short- to long-term funding, thereby further increasing costs.

One common theme is the importance of accurate data regarding collateral – both that transferred between counterparties and the contractual terms of the collateral arrangements. A number of rule changes result in counterparties having to post increased amounts of collateral. Optimising its use is important to profitability, which is coming under increased pressure from the rising costs of capital and risk/compliance costs. Reduced dividends put pressure on share prices, making it harder to raise capital.

The inevitable result of these changes – and a necessary price to pay for increased financial stability – is further rationalisation of the industry, as firms exit areas where the capital and other costs adversely affect their profitability. The costs of remaining in ongoing business lines will also increase. A careful eye needs to be kept on the level playing field to prevent further costs of doing business internationally.

In summary, good progress is being made but there remains much uncertainty as business models change and an ever-increasing need for international cooperation among regulators. As always, the costs fall on the financial services industry.

872 views

Related reading