Basel III: Is the Cure Worse Than the Disease?

Even in the midst of an avalanche of new regulations, the proposed capital and liquidity rules under Basel III are attracting a lot of attention. The fear factor is palpable among banks, regulators and national governments – what no one wants is for these new regulations to sign the death warrant of a shaky global economic recovery, fostering a ‘double-dip’ disaster.

Basel III is the successor to the New Basel Capital Accord (better known as Basel II), drawn up by the Basel Committee on Banking Supervision, an international alliance of the central banks of the world’s economic powerhouses. The Basel II Accord set out guidelines for minimum capital adequacy requirements for banks to promote the financial health and stability of the financial sector. Obviously it did not do its job, resulting in the biggest global financial crisis since the Great Depression.

Consequently, this reform package is the Basel Committee’s third attempt at getting it right. Gordon Burnes, vice president, marketing at OpenPages, a provider of integrated risk management solutions, points out that the main difference between the two is that Basel III has a system focus, rather than an entity focus. “Global regulators are thinking about the system as a whole, as opposed to individual financial institutions, because Basel II didn’t contemplate the knock-on effects of an individual entity’s failure on the overall system,” he says.

Basel III’s aims are fourfold:

  1. Increase the quality, quantity, and international consistency of capital.
  2. Strengthen liquidity standards.
  3. Discourage excessive leverage and risk taking.
  4. Reduce procyclicality, a serious weakness in the Basel II Accord.

Importantly, the fourth point includes proposals for ‘countercyclical capital buffers’, a tool for strengthening the global banking industry. Patrick Fell, director of the regulatory practice at PricewaterhouseCoopers (PwC), explains: “Basel III is intended to be more countercyclical than Basel II, which means that the regulators want banks to set aside more capital in good times to cover bad times. From the point of view of lending, in an ideal world this would mean that the global economy would be less susceptible to booms and busts.”

According to the Basel Committee, such a buffer would force banks to increase capital when excess credit was building up in the market, a move that would be a brake on lending and create a greater cushion to protect against financial difficulty. The Committee sees countercyclical buffers as a way to manage the flow of credit into the economy and expects for them to only be triggered every 10 to 20 years.

In a statement on 26 July 2010, Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, said that the Committee is on track to deliver a complete package of capital and liquidity reforms, stressing that it includes “design and calibration”, in time for the November 2010 G20 Leaders Summit in Seoul.

Critical Reaction from Financial Industry

But there is much concern across the financial industry that the cure will be worse than the disease, a point made by Gordon Nixon, president and chief executive officer (CEO), Royal Bank of Canada (RBC), speaking at the British Bankers’ Association (BBA) annual conference in July.

Nixon believes that these proposed rules, for all their good intentions, will negatively impact even the healthiest bank’s balance sheets in terms of capital, leverage ratios and liquidity, and as a result compromise economic growth. He said: “The proposals are so complex and onerous that we run the risk of an agreement that lacks transparency and integrity, or one that results in non-uniform implementation.”

Basel III has redefined capital and risk assets, effectively turning “swans into ugly ducklings”, according to Nixon. “Canadian banks, as an example, would be lifted from their position as well-capitalised, liquid financial institutions and recast as undercapitalised. Banks that passed the ‘real life’ stress test may fail the theoretical one – a pretty good indication of a flawed methodology.

“Basel III leverage rules use a very restrictive definition of capital and an overly expansive definition of risk assets,” continued Nixon. “The net result of doing so increases the leverage and would encourage banks to get rid of low-risk assets, such as insured mortgages, and replace them with higher-risk assets – hardly a way to reduce risk. Rational investment decisions made based on existing capital rules are, in some cases, now inconsistent with the proposed rules. And specific capital deductions in a host of areas will push banks to restructure in a way that could increase their risk profile.”

Although Nixon’s reaction may be more severe than some, the industry as a whole has voiced similar concerns. In mid-April, ratings agency Standard & Poor’s (S&P) warned that if the Basel III proposals were adopted as proposed, they run the risk of creating unintended consequences for parts of the financial system, which could include constraining banks’ lending activities and their ability to trade on derivative markets, hampering the inter-bank lending market causing displacements in markets for high-quality liquid securities, and encouraging banks to shift to short-term lending.

The transitioning period is also causing concern. Many industry experts and regulators believe that too fast a move to the new regime will have a detrimental effect on the global economy. S&P credit analyst, Richard Barnes, says: “There is still uncertainty about what the final shape of the rules will be and the transition period to them, but [the Basel Committee] is working to a fairly ambitious timetable to finalise things later this year. Although the timetable is solely for addressing the capital and liquidity situation, there are structural reforms such as resolution regimes, living wills, etc, which are going on in parallel.

“The transition period is such a hot topic because there’s a push from various quarters to allow quite a generous transition period so that the current fragile economic recovery doesn’t get derailed by banks having to adjust quickly to the new rules. Therefore, there is likely be a relatively long transition period which will enable banks to move to a new regime without having to adjust their balance sheets too sharply,” adds Barnes. The Basel Committee is making all the right noises on this issue, providing a protracted implementation timescale (see box).

Basel III: Transition to the Leverage Ratio

The Basel Committee has agreed to divide the transition period into the following milestones:

  • The supervisory monitoring period commences 1 January 2011. The supervisory monitoring process will focus on developing templates to track in a consistent manner the underlying components of the agreed definition and the resulting ratio.
  • The parallel run period commences 1 January 2013 and runs until 1 January 2017. During this period, the leverage ratio and its components will be tracked, including its behaviour relative to the risk-based requirement. Bank level disclosure of the leverage ratio and its components will start 1 January 2015. The Committee will closely monitor disclosure of the ratio.

Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration. Pillar 1 deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk.

Figure 1. Basel II Pillars

Source: Basel Committee on Banking Supervision

Will Basel III Have an Impact on Corporates?

Although an extended transition period will lessen a ‘shock’ effect on the global economy, the result of banks having to hold back a certain amount of capital which cannot be used for anything else means that there is not as much liquidity in the system. As Openpages’ Burnes succinctly puts it: “If you drive up the cost of capital, you will drive up the cost of lending, which will have a knock-on effect on global growth.” He points to a report by the Institute of International Finance (IFF), a global association of financial institutions, released in May, which made the argument that higher capital requirements would significantly reduce global economic growth. But he is not entirely convinced by this argument.

“It is to be debated because one could also argue that investors may charge less to invest in a more stable financial system,” he says. “The impact on corporates is that this is one part of a global wave of increased oversight by regulators on systemically significant entities, and that it won’t just be in the areas of capital that regulators will focus their attention. They will also look at areas of other areas of risk management within a company, for instance how is it assessing risk on a regular basis, how is it reporting on risk, how is it managing that data, and is it complying with the rules and regulations.”

PwC’s Fell examines Basel III from a different perspective, picking out the rules that deal with liquidity – liquidity ratio, leverage ratio and net stable funding ratio – which he believes could have a more direct impact on corporates. “The leverage ratio is potentially very important because it says that a bank’s total balance sheet cannot exceed more than a multiple of its capital,” he explains. “The latest Basel proposal envisages that a bank’s sheet can’t be more than, say, 30 times its capital, which is potentially a squeeze on banks’ ability to lend.”

The other important area is the net stable funding ratio, which requires banks to have more stable funding on their balance sheet. So, rather than taking in ‘hot’ internet-based deposits, banks should look for longer-term deposits from stable customers. According to Fell: “The bank liquidity regime is relevant from a treasurer’s point of view because banks may need to push out the terms of their borrowing and deposits to meet their new liquidity constraints. Treasurers may have to rebalance the terms and rates of their assets if they are to take advantage of this bank demand for longer-term deposits.”

Olivier Berthier, solutions director, transaction banking at Misys, argues that an issue that cropped up in the initial Basel III consultative paper was with the treatment of trade finance instruments. “There was nothing that excluded very low risk trade finance instruments from the increased regulation and constraints of Basel III and its objective to tackle excessive leveraging. Because of their off-balance sheet treatment, these traditional instruments would now be subject to a flat 100% credit conversion factor, a much worse situation than even their treatment under the Standardised Approach with Basel II.

“As it was the case with Basel II, it may be possible to define something specific for trade finance – because of the relatively low risk profile of these transactions – to justify less than the 100% conversion under Basel III. But the extra effort of such an advanced approach will be again reserved for the biggest players that can afford it, which means that local banks, particularly in the emerging markets, will likely be forced to follow a standardised model. As a consequence, the price for these transactions, the fees, the risk, the collateral, and the deposit expected from the corporate treasurer, might end up being that much bigger.”

Harmonised Implementation is Key to Success

Although there is a universal consensus that banks need more capital set aside to avert a future catastrophe, the debate is over what amount is deemed sufficient and the period for transition. Another big issue is how these regulations will be rolled out across the globe. Coming back to a point made by RBC’s Nixon, these complex and onerous regulations may result in a “non-uniform implementation”.

In a 26 July 2010 letter to the G20 Ministers of Finance, the IFF voiced its concerns over what it saw as problems with recent national and regional actions that are “not fully consistent with the degree of co-ordination that is necessary to assure a real improvement in global stability”.

“Regulators need to make use of appropriate flexibility to assure general international consistency in application of new regulations,” wrote the IFF. “The IIF supports the finalisation in 2010 by the Basel Committee of a properly calibrated and evaluated package of capital and liquidity reforms, introduced with appropriate transition periods, phasing and grandfathering… In particular, it would avoid serious unintended consequences that would derive from inconsistent regulation, such as an uneven playing field, unfair competition among financial centres, and incentives to regulatory arbitrage.”

Susannah Hammond, editor, regulatory affairs, Complinet, a provider of connected risk and compliance solutions, said: “One of the overall drivers is the need for a globally consistent approach on capital, so that there aren’t strong banks, in capital terms, in half of the jurisdictions and then weak banks in the other half of the world. This is going to be a difficult thing for the regulators to do. Basel II, for example, was implemented at different times in different places, and the three pillars that underpin Basel II were interpreted slightly differently in each jurisdiction.”

There is already a lot of divergence and nations are reverting to focusing on their own domestic battles. At the height of the crisis, the G20 was very much together in terms of regulatory coherence, but 18 months later the playing field is fragmenting.

PwC’s Fell harks back to the heyday of Basel I, the first global attempt to standardise the levels of capital in 1988. “The strength of Basel I, in particular, was the international consensus. With Basel II, it was more difficult but there was still there some level of harmonisation. Now with Basel III, it’s important that that consensus continues so we get comparability and a level playing field; we cannot have arbitrage between financial centres.”

OpenPages’ Burnes emphasises the threat of arbitrage. “Although these regulations require global co-ordination, it is going to be very tricky because there is much disparity between different countries. In the US, in particular, we have seen the downside of regulatory arbitrage and that is a real problem we have to avoid. You can’t have one territory that has lax regulation and allows a large global financial services player to operate in a completely under-regulated fashion because that would be not healthy for the global economy.”

Global co-ordination is absolutely critical, however fraught with discussion and debate it is.

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