Basel III to FRTB: the old one-two

The Basel III capital adequacy regime struck a mighty blow at the banks mid-section, stinging many investment banks with not inconsiderable painful costs. The Fundamental Review of the Trading Book (FRTB) – which the market is increasingly referring to as Basel IV, could be the knock-out blow that sees many of them fall flat onto the canvas.

Basel II was mainly aimed at capitalising appropriately against wholesale counterparty credit risk and some operational risk, to ensure that banks are appropriately capitalised and funded. Basel III extends this, introducing contingency for market and liquidity risks, to ensure banks can survive any future financial crisis unaided.

In summary, Basel III’s impact is as follows:
• Regulatory capital has become more stringent; core equity being the only valued form of capital. Additional capital buffers are also introduced.
• Risk coverage relating to capital use has been overhauled to ensure that expected positive exposure (EPE), wrong-way risk, credit valuation adjustment (CVA), margin period of risk, etc. are appropriately measured.
• Introduced short- and long-term liquidity ratios.
• Introduced leverage ratio and measures to reduce procyclicality to control excessive credit exposure. Expected loss is now a prerequisite calculation.

Included in the above has been a drive by regulators to either separate investment and retail banks, or an insistence that subsidiaries of banks become self-reliant from a capital and liquidity perspective. The host of regulations associated with Basel III will continue in their implementation through to at least 2020. Furthermore, what the market is beginning to call Basel IV – which includes the restriction of the use of internal models as prescribed in FRTB – will be introduced.

The impact on the banking sector has been dramatic. This might have been intended, but the extent to which Basel III is transforming financial services may not have been quite so deliberate.

Market liquidity: Dropping the guard

In its Q3 results for 2011, a large Tier 1 (the major full-service investment banks) highlighted the comparative impact to return on equity (RoE) that a shift from Basel II to Basel III would have on their existing business model. It saw a decline overall of 10% in RoE related to its investment bank, with an 11% decline in its fixed income business. In Q4 2015 that same bank wrote down over US$5bn of asset value in its investment bank and greatly reduced its fixed income capability.

Extrapolating this across the market, the opportunity for hedging is much reduced. This may be an intended path, but it actually reduces market efficiency and impacts pricing significantly.

Leverage ratio forces banks to be more discerning on how they utilise a constrained balance sheet. As banks are less able to finance the market, buyside institutions are regularly becoming both users and providers of debt and equity market liquidity.

The availability of high quality liquid assets (HQLA) is compromised. While governments have been applying ongoing quantitative easing (QE) to stimulate growth by buying back their own issuance, banks have been required to take larger reserves of HQLA to support their liquidity ratios to mitigate against future liquidity shocks. This has resulted in a reduction in yield on debt securities, impacting banks by reducing revenue and increasing costs.

Impact on banks: The need to be sure-footed

A direct consequence of implementing banking regulation and the ongoing difficulty in maintaining margins has been reflected in share value. A number of banks are reducing their capital intensive investment banking activity, without being able to improve revenue in their core loan businesses. In part this is a result of QE measures by central banks, but also as a direct consequence of Basel III’s liquidity coverage ratio (LCR), which leaves no (or even negative) value in short term deposits.

While the investment bank is down-sized, the cost of compliance to regulation remains.

Meeting the demand: Bobbing and weaving

While governments want a sustainable and secure banking sector, they also strive for growth. Growth of the loan book in and outside the banking sector is happening. However, with more lending than ever being provided by non-banks, there is a danger of Basel III becoming progressively ineffective.

For some reason, the authorities and Basel III seem to not risk weight commercial banking to the same extent as investment banking when it comes to counterparty credit. Banking book assets seem to be the only growth area for banks, but – currently – do not necessarily generate the revenues required. In part this is due to the limits set against procyclicality, but in general loan books have grown and outstanding loans are now above the levels seen in 2007 just prior to the crisis.

Where leverage ratio has reduced banks’ ability to provide liquidity, the slack in that demand is being taken up by non-bank organisations. Shadow banking and peer-to-peer (P2P) lending sees counterparty credit risk move away from the now heavily regulated banking sector.

We also see the return of moral hazard – where bad debt is serviced by more debt – in China, the area from which credit-driven demand has spurred much of the recovery. Much of the debt here and in other regions of growth may well prove to be unserviceable. Should that be the case – and given the ‘low’ to ‘no’ inflation environment and indolent or induced growth in most major economies – this seems very likely.

The banks’ customer and our pensions – collateral damage

There is no or negative value in short term deposits. Customers of banks will eventually see this impact them as charges, or banks (as we have seen) reduce the number of depositors; strangely an anathema to any traditional banking business model.

Pension funds are also seeing their returns on investments under pressure. Exacerbating the issue of low-yielding assets is the impact of Basel III, which forces them to apply additional collateral as margin against cleared and non-cleared over-the-counter (OTC) derivatives.

Evidentially we see a huge pensions deficit in the UK, while pension funds in other jurisdictions look at less conservative means of increasing revenue – and add additional risks to pensioners.

Longer-term impact

Banks have been the traditional providers of liquidity to markets, but are now restricted in that service. We are seeing a circumnavigation of Basel III and a redirection of risk away from heavily-regulated banks to non-banking sectors.

To survive, banks need to concentrate on three areas:
• Pricing all cost and risk into each transaction.
• Managing their asset and liabilities centrally.
• Working with their customers and counterparties to deliver more efficient use of their balance sheet.

All this is difficult to do, so there will be a reduced banking sector with improved margins, unable to provide market liquidity on its own. As rates eventually begin to rise, there is likely to be a restrained response from the buyside, pushing yields higher very quickly. Governments will find themselves funding their deficits at a much higher cost.

Basel III to IV and the sucker punch

The premise of Basel III and its 29 core principles was to ensure that the world would never again be subject to a banking crisis that forced governments and taxpayers to ultimately own the aftermath of unquantifiable risk taking.

In some ways Basel III is achieving what it set out to do: Leverage is constrained within the banking system; banks have greater reserves to support liquidity requirements in times of stress and are required to be better capitalised than they have been in the past. As a result they will be safer institutions because of Basel III, but there will be fewer of them and those that remain will have to be very efficient. The survivors will thrive as their margins eventually improve, but – if the rules remain as stringent as they are at present – they will be unable to be wholesale suppliers of liquidity and risk mitigation to markets to the extent they were before.

This reduction in service is likely to continue. Once sense is made of Basel IV’s FRTB and (extremely clever) people work out how to adopt this regulation to their market risk portfolios, we will see a further quantifiable impact on capital. The cost for this will need to be incorporated into the price of a transaction, which may effectively mean that much of this business becomes unviable.

Risk, however, will not go away. With risk now dispersed across bank and non-bank sectors, or concentrated in central clearing, we have the same opaque view on risk as before. Buyside institutions will be unable to hedge their exposures to the extent they were able to so in the past, and will have to contain those risks on their own balance sheets, as the cost of the derivative transaction becomes uneconomic.

Procyclicality still exists, as banks and non-banks look for yield through ever-increasing commercial and retail lending.

One of the intended consequences of Basel III was a banking sector made up of smaller banks which were not “too-big-to-fail”. What we will most probably end up with is a number of very large banks, which are able to efficiently absorb cost and introduce higher margins, and a string of non-banking institutions that carry unregulated lower yielding debt exposure, against which growth is not paced.

Now that is a very big unintended consequence.

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