Capital Management in Banking: The Way Forward

The future of banking is becoming clearer. The final Basel III rules were published by the Basel Committee in December 2010 and have provided much-needed clarity and direction for the industry. The rules are set to redraw the banking landscape and it is clear the future is one of more capital, more liquidity and less risk. And, inevitably, one with lower returns on capital, higher costs of doing business and slower growth, with ultimate effects to be felt by shareholders and end consumers.

Basel III will have a profound impact on profitability and force many banks to transform their business models. It will also require firms to undertake significant process and system changes, and banks can expect greater scrutiny by investors, regulators and other stakeholders regarding balance sheet usage.

The good news is that most banks are expecting to meet the more stringent requirements without raising additional capital as reported in recent bank earning releases. In addition, the Basel III framework does not begin to come into operation until January 2013 and its full effects will not be felt before January 2019, when the new regime’s transitional period ends. Despite the long timeline, it is critical that firms start to reset their business models now to adapt to the new capital and liquidity standards. By doing so, they can not only start to tackle Basel III’s many challenges but also keep abreast of the competition.

The markets have already started to price the impact of Basel III, with some already paying more attention to bank’s proforma capital adequacy levels under Basel III rather than to the current standards. As the equity markets better understand the return on equity impact of the new standards and bank strategies become more clearly articulated, investors will be in a better position to analyse and compare risk-adjusted performance and drive stock valuation differences in due course.

The Key Changes

Basel III establishes tougher capital standards through more restrictive capital definitions, higher risk-weighted assets (RWA), additional capital buffers, and higher requirements for minimum capital ratios. Primary sources for RWA inflation include trading market risk, securitisation exposures and over-the-counter (OTC) derivatives counterparty exposure. As well as rethinking their business models, many banks will need to achieve upgrades in the areas of stress testing, counterparty risk, and capital management infrastructure.

Banks with large capital markets businesses will undoubtedly feel the reforms’ impact most heavily. Higher capital requirements will primarily come from trading books, securitisations, securities lending, and OTC derivatives.

Basel III also establishes new liquidity standards that will drive changes in banks’ balance sheet composition to limit illiquid assets, restrict wholesale or unstable sources of funding, and manage higher funding costs. These new standards will have a broad impact across most banks, particularly those that focus on commercial and wholesale banking activities.

Business Model Implications of Basel III

Basel III’s increased capital and liquidity requirements will have significant systemic and idiosyncratic effects across the banking industry and capital markets. Higher capital and funding costs should incentivise banks to move toward different business models. Some examples of anticipated changes and opportunities include:

  • Shrinkage of securitisation market and structured credit businesses putting pressure on originate-and-sell lending businesses.
  • Reduced volumes in OTC derivatives and migration to clearinghouses.
  • Emphasis in customer facilitation activities with reduction of trading inventories particularly of less liquid assets such as low credit quality, commodity and emerging market instruments – thus reducing the liquidity of those market segments and resulting in block trading opportunities.
  • Expansion of businesses dedicated to trade clearing, trade processing and servicing.
  • Transfer of proprietary trading to hedge funds.
  • Increased competition from less regulated firms and potential loss of human capital to new entrants.
  • New structuring opportunities for banks considering contingent capital instruments.
  • Pricing strategies will be altered in those businesses that over the medium term are not able to deliver acceptable returns.
  • Cost efficiency will be more than ever a key differentiator.

With regard to liquidity, banks are bound to face greater competition – and increased costs – in respect of retail deposits. Emphasis on deposit gathering will result in increased competition, product innovations and enhanced customer services. Repo financing and lending of securities positions will become more costly. Wholesale loan products, including committed credit and back-up liquidity lines, will be rationalised, pushing more borrowers to the securities markets. The cost of funding is likely to increase for all institutions, with materiality depending on balance sheet management and funding strategies.

Finally, firms will be obliged to invest in substantial upgrades in IT infrastructure, reporting systems and data management. The upgrade of capital management practices should help banks bridge risk and strategy to address business model challenges and opportunities.

Capital Management Strategies

Banks should assess the impact of the new rules on their capital adequacy through a comprehensive capital planning and optimisation/mitigation process. Banks with large sales and trading businesses have estimated a total RWA average increase of 60% from current levels under Basel III. This substantial increase will be compensated by mitigation efforts estimated at 25% of total RWA in average.

The size of the capital increase impact, the need to deliver promised RWA savings and the limited room for volatility surrounding compliance with minimum Basel III capital targets all reinforce the need for RWA optimisation programmes.

Liquidity and Funding Strategies

For many institutions, Basel III’s liquidity challenge is likely to be greater than its capital challenge. Supply constraints – such as the availability of deposits, reliance on wholesale funding sources and high-quality liquid assets – are likely to be a key issue. The impact of the liquidity proposals is less known, and banks have not yet disclosed proforma impact as liquidity standards will only start to be phased in by 2015.

In anticipation of the Basel III impact on liquidity, firms should seek to reduce the number of their businesses with an unfavourable liquidity treatment; raise the liquidity of their investments; raise their retail deposits; increase their additional long-term debt and capital; reduce their committed credit and liquidity facilities; reduce their wholesale credit; and adjust their pricing to compensate for the higher cost of funding.

A Planned Response to Basel III

Large banks will, in all probability, seek to manage their businesses to Basel III’s requirements prior to the proposed deadline of January 2019 for full implementation. Firms should, therefore, look to tackle the balance sheet consequences of the new regime sooner rather than later. Before setting out on this challenging journey, they should equip themselves with a roadmap that sets out both short- and long-term goals for upgrading their capital management strategies and practices.

One of the immediate next steps management should consider is the development of a capital plan under the new Basel III regime, which considers potential impact on capital level, liquidity position and overall key financial metrics. The plan should also contemplate capital and liquidity management strategies to be employed to ensure compliance with the new requirements, including changes in capital models and related infrastructure.

Management should seek to anticipate changes in their firm’s business model, product offering, and client pricing strategies. Companies should also communicate with investors to ensure transparency in relation to Basel III’s impact and the bank’s mitigation strategies.

Looking further ahead, if banks are to achieve an effective upgrade of their capital management governance and processes, a successful integration of Pillar 2/ICAAP programmes and the new rules will be critical. Firms need to continue to assess how much capital is required to cover all of their material risks and to generate forecasts that utilise forward-looking stress scenarios. Given the new regime’s inclusion of conservation, countercyclical and systemic buffers, banks should reconcile their current management buffers with the projected buffers under Basel III. Firms should also benchmark their ICAAP governance and processes, including IT infrastructure and reporting components, to supervisory expectations.

Banks Beware

While banks should begin to prepare for the new framework without delay, they also need to be mindful of areas that require further clarity. Although the leverage ratio is broadly defined and the implementation timetable has been proposed, there is still a lot of important detail to be filled.

More information is also awaited in relation to the countercyclical capital buffer that banks will need to meet. There are as yet no guidelines as to how such buffers may be applied and how and when they may be released. An approach for systemic banks by local regulators has yet to be agreed, with the eventual solution perhaps including an additional capital surcharge, such as that proposed by Swiss regulators.

Liquidity standards need to be completed and calibrated. Given its large potential consequences in business models, the constraints related to the net stable funding ratio will demand particular attention. Banks should also keep in mind the need to integrate their response to Basel III with other initiatives, such as impact of the overall regulatory reform, migration of derivatives to clearinghouses, improving trade settlement arrangements, achieving more effective netting of interbank exposures; developing recovery and resolution plans; and establishing greater clarity over the management of the various separate legal entities within a banking group.

While the picture is becoming clearer, the future of banking is still shrouded in uncertainty. Although firms may be tempted to play a waiting game, they should in fact already be taking steps to ready themselves for the demands of Basel III.

13 views

Related reading