Capital Requirements and Unintended Consequences

The new Basel III and the related Capital Requirements Directive (CRD IV) regime threatens to have a disproportionate impact on lending to smaller businesses; undermining efforts to initiate Europe’s economic revival. In this article the British Bankers’ Association (BBA) warns against the dangers of unintended consequences.

Next month sees the crucial vote in the European Parliament to finally ratify the latest changes to the CRD IV. Banks around the world are facing up to the related Basel III capital adequacy requirements to hold more capital and more liquidity, which incidentally most of the BBA’s internationally active members are well on the way to meeting.

The fallout from the credit crunch and the financial crisis in 2008 is still being felt strongly across most of Europe. Not surprisingly regulators and standard setters are promoting major changes, supported by governments of all political persuasion. Capital is being increased both in ratios and in absolute terms; significant liquidity requirements are being introduced; deleveraging is taking place; and there are major enhancements to risk controls.

But some of these regulatory requirements are constraining certain types of lending. These include the capital weighting for lending to small and medium-sized enterprises (SMEs), the capital treatment of trade finance, and a reduction of the 180 day default definition on mortgages to 90 days.

To amplify these points a little further, while SMEs – particularly those at the smaller end – have a higher failure rate than large companies, they are also easily the biggest firms, by number, in any country, the biggest employers and where the growth comes from. If these capital rules are not to have an excessively adverse impact on these SMEs then further reflection on their impact is required.

Turning to another issue, when banks offer trade finance the arrangement is for an average of three months. However, the new rules require a reservation of capital as if that relationship were for 12 months. It is difficult to see why this is necessary, as it adds unnecessary costs of doing business to that company. Mortgages are also adversely affected; if the banks have to reduce their definition of a mortgage in default from 180 days to 90 days, the net effect is to increase the risk of individuals being evicted from their homes earlier, which nobody wants to see.

Clearly governments can assist with targeted tax cuts, investment reliefs and special programmes to assist.  However, the balance between regulatory change on the banks and the impact on financing business and the economy is critical and insufficiently explored. Each part of the regulatory environment tends to operate more in a silo than co-operatively and coherently across the piece. Yet as all of that regulation impacts the entities with finance to the economy, coherence is surely an essential part of the process.

Meanwhile the bigger picture is that finance for the economy is vital, and Basel II and other similar capital adequacy rules, such as Solvency II covering insurance, could restrict it. The current debate both in the UK and many other countries is whether banks are or are not lending. It is clear that there is a significant reduction in demand, and in periods of recession risk appetites inevitably change. Businesses that were financeable in good times, may no longer occupy an attractive part of the market in bad times and may well need to cut their costs rather than borrow more money. Invariably this is interpreted as the simple refusal of a bank to lend, rather than the uncomfortable reality for a business whose customers have melted away, or whose collateral is no longer worth what it once was.

None of this means that the banking industry never makes mistakes, nor that sometimes we lend when we shouldn’t or do not lend when we should. Nevertheless, the critical issue at the moment is one of lack of confidence. Businesses and the banking industry are holding more deposits from all sizes of companies than has been the case for the last 20 years. Businesses are run by people and so tend to reflect what people are doing, and in the face of uncertainty that is paying back their debts and saving their money.

Confidence will return at some point and then the real concern on lending will lie with financing the upturn. It is simply not possible to make the degree of change in the regulatory rules and increase substantially the fixed cost of being in business as a bank without it having an impact on both the supply and the price of credit.

The recent report in the UK on finance options for businesses by Tim Breedon, chief executive officer (CEO) of Legal & General, whose taskforce published in March anticipated that the expected constraint on the availability of finance from banks as the regulatory change process continues and the new rules bite, could create a finance gap for business of between £84bn and £191bn between now and 2017. Even if this calculation is wrong and the real gap is only half that estimated, that is between £40bn and £95bn over the next five years. It still presents to all of us a very clear description of the connection between the many changes that are being made for stability purposes now and in the future, and the need to finance economies and underpin economic growth.



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