Following the financial crisis, it became clear that the concept of Basel II, which became effective in February 2008, had severe shortcomings and that there was a need for greater change in banking regulation and supervision. On 12 September 2010, the Basel Committee on Banking Supervision (BCBS) endorsed a new regulatory capital and liquidity regime – Basel III.
Addressing Liquidity Risk
The focus of the new regime is mostly on the liability side of the bank’s balance sheet. It will address the issues revealed under Basel II, including over-leverage and liquidity risk caused by mismatches of the asset tenor relative to the funding tenor. Basel III will also change the requirements for the bank’s core capitalisation, which will have to be maintained at a level relative to their risk weighted assets (RWAs).
Table 1 provides an overview of the differences between Basel II and Basel III for the minimum required levels of capital.
Using a phased approach, the additional requirements don’t just affect capital quality and capital requirements, but leverage, liquidity and net stable funding ratio requirements will also be introduced for banks. The objective is to increase the loss-absorbing capital capacity of the banks relative to their RWAs and to strengthen the banks’ balance sheets so that they are better able to withstand periods of economic downturn.
Although the definition for capitalisation will be strengthened and the ratios will also be raised under Basel III, the definition of RWA is largely based on the current Basel II requirement, except for some elements of counterparty credit risk and equity. In essence, the RWA definition means that the banks will have to maintain higher degrees of capital buffers against riskier assets according to risk weights. Low-risk assets could be held with minimum capital levels and therefore allow a higher gearing. However, ratings and risk weightings have not always proved to be reliable in assessing true underlying credit risk – as shown by the structured finance and securitisation bubble.
The new standards will be implemented and become effective through a staged approach between 2013 and 2019.
What Effect Will Basel III Have on Corporates?
The effect of Basel III for an individual bank, and how it will translate into products and pricing offered, will be dependent on its current capitalisation ratios, as well as its business profile and the composition of its asset portfolios. In general, banks will likely have to allocate more capital (deleverage) and liquid assets across their business, as well as use more stable sources of funding, to meet the new Basel III requirements. This is expected to lead to a general increase in capital and funding costs for banks. Although banks may try to improve their operational efficiency, fine tune their models and optimise their asset segmentation, it’s likely that they will pass some of the additional cost to their customers to preserve the same level of returns. This will imply that, for corporates, on and off balance sheet banking products that require a higher capital allocation or have a relative higher weighting in the ratios for a bank will likely become more expensive. However, it can also be argued that Basel III requirements will alter and reduce the risk profile of a bank and therefore they may settle for lower returns.
Corporate treasurers may be affected by the consequences of Basel III on banks in a number of ways, obviously mostly on the borrowing side, but other product categories will also be affected.
An interesting point may be that bond financing or, more generally speaking, non-bank financing for corporates may gain further attractiveness under Basel III relative to bank financing. This is a trend that has already been observed during the recent crisis.
First, there is a difference in the liquidity treatment for the determination of the liquidity coverage ratio (LCR). Banks will have to hold 30 days liquidity net cash outflow in liquid assets. High-quality corporate bonds are considered to be liquid assets in the context of the LCR, since they can be easily converted into cash, whereas bank or non-public debt is less liquid and therefore is treated less favourably.
Second, the LCR may also have an unfavourable effect on the revolving style of corporate credit and liquidity facilities. Commitment for stand-by revolving committed credit facilities is expected to become more expensive, particularly liquidity back-stop facilities for commercial paper programmes given their unfavourable treatment under the LCR, which can require banks to hold up to a 100% liquid assets buffer for any undrawn part, depending on the nature of the facility.
Third, it is also expected that corporate bank lending will face a relatively higher increase in interest margins compared to non-bank lending because of Basel III. Because the non-bank debt market may also attract other types of investors that are not subject to the new Basel III requirements, these investors may have a competitive advantage compared to banks. This may particularly impact the smaller corporates that either do not have access to this market or do not have a good credit standing, and therefore are predominantly dependent on bank debt as source of debt financing. For those corporates that do not have a credit rating it will become important to have an understanding how a bank perceives their credit risk and also make sure a bank perceives it correctly. They also should have notion about how a bank will price the associated credit risk in relation to the term and the characteristics of the credit facility, and the effect of collaterals and securities provided. The attractiveness of the deal will play an important role for the bank. In any case, bank finance will likely become more expensive, particularly for corporates that have a lower credit standing.
Corporate short-term investments will also be impacted by Basel III. In relation to the LCR and the net stable funding ratio (NSFR), a corporate bank deposit, depending on the conditions, is typically considered as a less stable type of funding for a bank and will have a lower weighting compared to other sources of funding for a bank. Therefore corporate deposits, especially the ones with a very short term, will likely be less attractive to banks under Basel III than previously.
The NSFR and the related matched funding requirement are also expected to lead to relatively higher prices for facilities and loans with longer terms.
Another product category that will be notably hit by the new requirements is off-balance sheet products, particularly trade finance products such as letters of credit (LCs). Any of these off-balance sheet commitments will have a high credit conversion factor against the threshold for the leverage ratio.
Overall there is uncertainty about the consequences of Basel III and how banks will respond to it. Banks shall alter their strategy and may redefine their ‘sweet spots’. It will also very much depend on the extent a bank can already meet the additional Basel III requirements and whether or not it will have to raise additional capital. Also, non-bank financial institutions may start to play a more active role as they are beyond the scope of the Basel III requirements, which may give them a competitive advantage.
In response to Basel III, banks will increasingly assess the total return on a customer in relation to its credit risk position and the capital a bank will have to allocate. Using a bank’s asset side of the balance sheet under Basel III will likely come at a higher price for corporates, who will either have to be compensated by a higher interest margin or reward ancillary business to the credit providing banks. It will be likely that bank relations will be more and more driven by credit, particularly for corporates that (have to) rely heavily on bank finance as a source of overall funding. It will therefore become even more important for corporates to understand their total banking wallet and how these products affect the capital that banks have to allocate for Basel III.
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