Basel III and the regulatory measures taken after the 2008 financial crisis are well underway. Almost all the measures suggested in reports, such as the Turner Review in the UK, Timothy Geithner’s recommendations submitted to the US Congress, the de Larosiere Report in the EU and others, have been acted on. At the same time the knock-on economic downturn in Europe and the US requires the banking sector to support the economy by actively lending to firms and individuals. In this article we will take a look at some of the changes that financial firms need to make to adapt to the new status quo.
First, a brief recap of some of the Basel III measures that financial institutions (FIs) are expected to implement. These measures are needed to be put in place to make sure firms behave more prudently, reducing the chances of insolvency and therefore the likelihood of the crisis being repeated. However in the event that there is a further crisis, they also ensure that the cost to the taxpayer is much lower. The following are some the issues that firms have to address:
- Increased amounts of common equity replacing lower forms of capital. This includes the addition of compulsory capital buffers above the minimum standards.
- Higher capital charges, particularly in relation to credit risk and securitisations, significantly raising the cost of existing business. Requirements to hold liquid assets that serve as a buffer. Firms must clearly state their liquidity risk appetite and manage their liquidity accordingly.
- The eventual imposition of a new leverage ratio, limiting the amount of gross assets that a firm may hold in proportion to their Tier 1 capital. This measure will behave very differently to the capital ratio as it will not allow many exposures to be netted against available collateral.
- Governments and regulators, both in Europe and across the globe have adopted a much more interventionist stance. Regulatory bodies are generally better resourced, have enhanced powers and are pushed to be more aggressive than previously.
Through the results of the EBA’s Basel III monitoring exercise, we can gain a clearer understanding into how Europe’s banks are progressing at meeting the issues outlined above. The latest edition takes 144 banks’ results as of 31 December 2011 and then applies the full Basel III regime to them. By looking at the difference between the calculated results and the minimum Basel III standards, we gain an idea of how far away European FIs are from the new global minimum standard. One of the most interesting findings in this report includes relates to the 44 largest European banks (referred to as Group 1), comparing the requirements imposed on them under the present rules to full Basel III rules. The report highlights include:
- The average common equity Tier 1 capital to risk weighted assets (RWAs) ratio would change from 10.3% at present to 6.9%. There would be 12% of banks below the minimum 4.5% level. However, 51% of banks would not have enough capital to meet the capital buffer requirements. In order to meet this second requirement, €199bn of high quality capital will need to be found.
- In terms of total capital (that is including allowable high quality capital that is not common equity), the capital ratio drops from a healthy 14.2% to 8.0%. Taking into account the requirements of the conservation buffer and capital surcharges, Group 1 banks have a capital shortfall of €434bn.
- The main reasons for the fall in ratios was split evenly between the impact of changing the definition of capital, and the effect of charging higher risk weights on exposures.
- The leverage ratio of 3% or more would not have been met by 49% of Group 1 banks. The average leverage ratio was 2.9%.
- The key liquidity coverage ratio (LCR) has an average value of 72%. This compared to a minimum of 100% under the Basel III regime. Total Group 1 and Group 2 banks had a shortfall of high-quality liquid assets of €1,170bn.
The conclusion has to be made that although the full regime will not entirely be in place until 1 January 2019, these results show there is a long way to go before the European financial sector is fully compliant with Basel III. So what impact is the new regulatory environment having on the wider financial sector?
It is important to understand that the financial sector is faced with the additional problem of being expected to perform its role in encouraging economic activity and help pull economies out of recession. A reduction in lending would lead to a reduction of economic activity, hence prolonging the tough economic climate and the resultant recession. This economic imperative in the short term may take priority over the regulatory measures. Another issue is the need for banks to rebuild confidence in their institutions as a result of bad debts from lending before and during the financial crisis. These two challenges are underpinned by changes in capital, liquidity and leverage requirements, which sees many firms re-examining their business models.
From an investor’s viewpoint the financial sector may not look attractive either. Clearly with more capital required to perform existing business, the return on capital for investors will be lower than before. The Basel III changes make it clear that the level of implicit taxpayer/government guarantee the sector enjoys is also much reduced. However, by far the biggest source of investor uncertainty is the pace, frequency and unpredictability of regulatory reforms.
Financial institutions are aware of these pressures. Much of the uncertainty surrounding the pending changes would be helped if a firm’s management, reporting and risk control infrastructure addressed the firm-wide issues at the level of the chief executive officer (CEO). This should allow risk, finance, credit, regulation and compliance to reflect a single coherent view. The impacts of regulatory change would then be clearer to all and easier to communicate through a firm’s operations
As referenced earlier, the deadline for full Basel III implementation is not until January 2019, but due to commercial pressures, firms that can effectively show they meet the requirements earlier will have a large competitive advantage over those that can’t. This is easier said than done, as there is still a long list of suggested amendments to financial regulation. The sheer volume of regulatory changes is creating uncertainty in the sector and making it difficult for financial firms to raise the capital and liquidity needed in order to ease the aforementioned pressures. Ultimately decision- and policy-makers need to make choices towards balancing the amount of lending the sector can perform against the amount of liquidity and capital it needs to hold in order to be financially sound.
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