The Basel III capital adequacy regime is starting to unravel in terms of timing, if not yet in terms of substance, after the implementation delay announced at the turn of the year. This article looks at the implications of the delay, what it means for banks and bank funding for treasurers, and the challenges ahead.
After four years in preparation, a recent short meeting at the Bank for International Settlements (BIS) in Basel, Switzerland, decided that the liquidity targets that previously had to be fully met by the end of 2015 would only have to be met for 50% by then. Full 100% compliance was delayed until 2019. The so-called liquidity coverage ratio (LCR), applicable to the world’s top 200 banks, will still be phased in from 1 January 2015, but will not now take full effect until four years later.
This delay is a major change and was warmly welcomed by the banks and some treasurers, who no doubt feared a further immediate squeeze on bank lending. It was especially welcome in the European Union (EU), whose transposition of the Basel III capital adequacy rules originally demanded compliance even earlier than the BIS deadlines. The announcement of the US’ intention to delay its implementation of the rules at the turn of the year – not surprising, since Basel II implementation has proved to be a struggle – prompted the European Banking Federation (EBF) to lobby for a universal delay.
What Was the Problem with Basel III?
Basel III has become problematical given the lack of realism behind the European Banking Authority’s (EBA) framework for European banks to strengthen their capital, under which the EU’s top 100 banks originally had to submit plans for approval in mid-2012.
This was the second round of the famous ‘stress tests’ last year, after the first one concentrated solely on real estate lending. The first round concluded that all of the 100 top European banks were reliable except Hypo Real Estate from Germany and the regional Spanish savings bank groups, like ‘Brogan’, which were rapidly agglomerated into the failing Bankia caja collective, formed at the end of 2010 and since bailed out by the Spanish government.
This EBA’s positive endorsement of the industry was regarded as too good to be true last year, notably because it overlooked potential losses on sovereign risk bonds. The second set of stress tests required banks to show how they would comply with capital targets including Basel III.
The plans – all approved – showed how Basel III compliance would be achieved via a mixture of:
- Capital raising in the markets.
- Disposal of non-core assets and businesses.
The plans have now been shown to be unworkable, primarily because:
- Capital markets are shut to bank shares at the moment.
- There is no market in the EU among banks for one another’s non-core assets and businesses: everyone is a seller. This drives down the price, undershooting the disposal values stated in the stress test plans and failing to strengthen capital.
- Merger and acquisition (M&A) activity in banks has also fallen, rather than risen, since the stress tests with the struggling Bankia in Spain perhaps providing a lesson that amalgamating everything may not always be the answer: Bank chief executive officers (CEOs) are also understandably unwilling to dispose of assets at below the values stated in the plans.
The only other route to compliance is to make bank business more expensive for corporate clients and other customers, and to cut its supply. But to do so exacerbates any recession and this realisation is what is making politicians put pressure on the BIS to dilute the Basel III rules, both in substance and in the timing of its implementation.
Basel III Impacts Every Component in the Capital Adequacy Calculation
Basel III is more stringent than its predecessor Basel II in four important areas, covering:
- Liquidity rules.
- Direct reduction of the bank’s current eligible capital.
- Recalculations upwards of the bank’s total assets-at-risk.
- Increases the percentage of total risk assets that must be held as Tier I and Tier II capital.
Examples of the Results of Basel III Compliance
Below are some examples of the likely impact of Basel III compliance.
Figure 1: Impact of Basel III on Liquidity and Eligible Capital.
Figure 2: Further impacts of the Basel III Capital Adequacy Regime.
At the end of the pipeline, as a consequence of Basel III, are dramatic increases in the cost of credit, caused by the simultaneous and compounding rises in every component of the capital adequacy calculation.
Bank Impacts of Basel III
All business lines will find larger amounts of capital imputed by financial control to their business unit (BU) profit and loss (P&L) account, for existing business. The reaction of the business units is predictable:
- Increase margins from customers on credit facilities.
- Reduce lines where it is possible to do so, to reduce the capital charges into their own BU P&L.
The secondary results of this situation will not be far behind:
- Customers seek alternative providers.
- Inadequate lines exist to carry out the daily business; payments get queued, potentially adversely impacting treasurers and other end user clients; necessitating more operational staff to manage the queues and more credit staff to agree excesses.
Operating costs and operational risk increase, then requiring more capital to support that side as well.
Impact on Treasurers
The impact of Basel III on corporate treasurers on the loans side is clear: shorter supply and higher price will be the result of the new capital adequacy regime.
On the deposit side it is more subtle because the rule about re-depositing a percentage of the face value of the deposit only applies to what are known as ‘unstable’ deposits. At the start of the process that was taken to mean all deposits of below 100 days’ duration.
As such there should be a two-tier market with much higher returns for those willing to deposit for a term above the threshold. However that would be a very one-dimensional outcome. One can also expect to see a demand by corporates to retain liquidity at the much shorter end:
- Relative rise in the importance of Certificates of Deposit (CD) compared to term deposits. The bank would issue a CD for 101 days that is negotiable and is liquid: there would have to be active trading for the corporate to take the liquidity risk in case of needing to cash it before maturity.
- Rise in the importance of money market funds (MMFs) compared to term deposits. The fund would buy 101+ day maturity CDs or deposits but unit holders could liquidate at 24 hours’ notice.
Of course any solution like that presents complications and not just benefits:
- Liquidity risk on the CD or the fund it is held in, if it cannot be sold or if the fund cannot sell it so as to allow the investor to withdraw funds.
- Yield curve risk: risk of loss (or profit) due to the move in absolute interest rates and/or change in the shape of the yield curve, if the investor wants to cash in before maturity.
At any rate banks will for sure price liabilities at different rates, so as to reflect whether the asset is counted into the Basel III ‘unstable’ or ‘stable’ bucket for computation of central bank reserves.
One could even see a parallel market developing in deposits below 100 days, similar to Basel Tier 2 capital markets: the wording of the contract allows the deposit to be counted as ‘stable’, even if its maturity is too short on the face of it. Banks have raised Basel Tier 2 capital as bonds with various wordings for the degree of subordination of the debt in the case of the bank’s failure, in return for which the investor gets a higher yield than on senior debt of the same maturity. Likewise the wording of a short-term ‘stable’ deposit would have to freeze its repayment under certain circumstances, in return for which the investor gets a higher yield than on an ‘unstable’ deposit of the same maturity.
Impact on the Wider Economy
The main point is that the new capital adequacy regime leads to a contraction of bank credit – for corporate treasurers at all but the largest firms and for the wider economy as a whole. This shrinkage exacerbates the current recession. Basel III thus becomes a matter of public policy.
Politicians have not cared half so much about savers as about borrowers during this recession. That attitude might change if the combination of very low absolute interest rates and a further deduction for the cost of redeposit results in savers being charged for depositing money – i.e. negative interest rates.
Were savers then to withdraw money and spend it, it might boost the economy. Were savers, as is more likely, to place it in cash in a safe deposit box, banks would have less money to lend and that would make the recession even worse.
Up to now politicians have agreed that institutions must be well capitalised to ensure that they do not need more government funding in future. That view is melting now that this policy conflicts with the more immediate aims of economic growth.
Conclusion: BIS Decision on Liquidity Rules
The change of BIS policy on liquidity rules is the first sign that European politicians are asking whether the balance has gone wrong between getting banks to support the economy and making sure they are robustly capitalised. The wind has changed and the BIS is bending.
The impact of the Basel III LCR changes and the delay will be felt by corporate treasurers, wider finance professionals and the economy generally so updating your ‘new normal’ Basel III plans, if you have any, might be a good idea.