Basel III is Changing the Banking Landscape

Regulatory reform is already changing the banking industry and new regulations will clearly affect its structure. Some key questions – related to specific regulations, potential implementation and timing – remain to be answered, but one thing is certain. In five years’ time, banks could look very different, as business models, core products, activities and markets will change to adapt to the new regulatory requirements.

The Landscape

The Basel Committee on Banking Supervision published new capital standards – commonly referred to as Basel III – in December 2010 that addressed weaknesses with the Basel II framework and require banking organisations to have greater transparency on capital. Basel III clearly outlines higher minimum capital levels and sets out new expectations for a common equity Tier 1 ratio. The new minimums, which will be in full force as of January 2013, are:

  • Tier 1 common equity ratio – 4.5% of risk-weighted assets.
  • Tier 1 capital ratio – 6% of risk-weighted assets.
  • Total capital ratio – 8% of risk weighted assets.

In addition, the Basel Committee established a leverage ratio of 3% that will be tested during the parallel run period of January 2013 to January 2017.

Basel III also calls for banking organisations to hold a higher quality of capital by taking goodwill, deferred tax assets, and hybrid securities, for example, out of Tier 1 common equity. The Basel Committee also introduced the requirement for banking organisations to hold a capital conservation buffer of 2.5% above the framework’s minimums that can be drawn down, if necessary, but with the requirements that shareholder distributions will be suspended until the buffer is re-established. The capital conservation buffer will be phased in with a transition period of 1 January 2016 and January 2019. Additionally, the Basel III framework establishes a new countercyclical capital buffer of zero to 2.5% that can be imposed by the regulators to address macro prudential and systemic risks.

In the US, regulations that will implement Basel III are under development, and regulators have already issued a notice of proposed rulemaking (NPR) that would amend the Basel II framework and eliminate the need for transitional floors during the parallel run period.

Many banks’ earnings could be adversely affected by new laws and regulations, and new requirements for living wills and stress tests should further heighten the focus on capital adequacy. Regulators, banks and industry insiders are all focused on what they are calling a jigsaw puzzle and trying to see how all the pieces will fit together.

What’s a Bank to Do?

So what can institutions do now to get ahead of planned changes? As with all pending changes to the regulatory framework, we see a sense of urgency among our clients and other companies to be prepared and to think through what the changes could mean for them. Here are a few things banks could enact now:

  • Conduct gap and impact analyses. It is critical to consider the impact of regulations on enterprise wide and line-of-business strategy and capital requirements, potential loss of revenue streams, increases in infrastructure and compliance costs, and potential opportunities, and then come up with a plan. Although the specific capital requirements are not clear, banks should conduct a detailed analysis.
  • Evaluate potential changes to compliance requirements. From a regulatory compliance standpoint, the biggest challenge is the uncertainty. How do you make plans or know what the expectations will be while compliance requirements keep changing? Banks should consider the cushions they will need to put in place to meet tightened regulatory expectations.
  • Assess potential operating model changes. As the role of legal entities increases and higher compliance costs and capital requirements result in lower returns, banking organisations will likely need to consider business and operating model changes. These regulatory concerns also should impact how banking products are designed, delivered and priced.
  • Conduct a strategic rethink. Evaluate what constitutes an acceptable return on investment (ROI). Bank balance sheets have never been more liquid, but the direction to move the business remains very much in a state of uncertainty. Banks have generated all of this money and invested it, but there is not a whole lot of profitability. Banks need to consider what will make money profitable under the new constraints. Another key question – what will the institution’s identity be?
  • Get board members more involved. In what should be a change for many organisations, boards will need to know more about the business, get more engaged around capital and liquidity planning, and engage in discussions around acceptable levels of risk. Boards need to get more involved in capital planning, and, most specifically, in reviewing and approving risk-appetite statements and risk tolerance. They should make sure regulators can understand the organisation’s risks and vulnerabilities and the amount and quality of capital they are holding. Boards can drive the creation of living wills, as well as the triggers for when they should be activated.
  • Create a process for commenting on potential regulations. Banks need a mechanism to offer their input as these regulations are released for public comment. Decide whether or not your organisation will want to weigh in. If so, what will the stance be?

Implementation Challenges

Banks that operate in multiple jurisdictions could be in an particularly difficult position. There are also some heightened sensitivities and unique challenges related to derivatives, proprietary trading, and possibly stress testing that banks should consider.

International

An important development for international banks is that, to limit the global spread of another crisis, each local regulator is placing a much greater emphasis on the quality and quantity of capital and liquidity of the legal vehicles in the local jurisdiction.

Regional and community

The current environment – marked by tighter underwriting standards, business uncertainty and the overall economic deleveraging – will put earnings pressure on regional and community banks, particularly those with large commercial or residential real estate exposures. These banks could have a difficult time raising the capital required under Basel III and will face pressures on their business model that may not be faced by some of the larger, better capitalised institutions. The likely consequence will be consolidation, especially as boards of directors and senior management evaluate their strategic plans.

The costs of compliance could be burdensome. Direct costs also will increase because of added information and processing systems, the increased economic costs of greater capital, more liquid balance sheets, and higher execution costs. Given all the uncertainty it is difficult to identify all the specifics.

Consider the Path Ahead

Even with long transition periods, banks should think about all of these different scenarios now. Basel III will have a significant impact on assets and can grossly inflate the banks’ balance sheets. In the old world, on or off the balance sheet treatment made a difference. But now it really doesn’t.

Resecuritisations and mortgage servicing rights will inflate the balance sheet – and the larger the balance sheet, the more extensive the requirements.

Banks should be ready now for changing regulatory expectations that will impact business models and the competitive landscape. Banks that make quick decisions will get first-mover advantage and should be best positioned in the market.

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