By Phillip Mann – firstname.lastname@example.org
At the time of the financial crisis, the regulation in operation known as Basel II failed to address and circumvent risk exposures across the financial services industry sufficiently with permanent and damaging consequences for all. Basel III has since been set up to replace Basel II.
The global financial crisis, in part caused by large banks lending more money than could be repaid in the short term, leading to a run on major banks across the globe, has led to the development of Basel III. The result of which has been banks agreeing to hold an increased amount of capital in the form of what is known as tier-one capital. More stringent capital and liquidity requirements for banks is the core designation of Basel III with the objective of protecting the international banking system against future financial failures such as those against which Basel II failed. Basel III regulation stipulates that banks and financial institutions will be required to integrate internal and external risk assessments on a more frequent and comprehensive basis. Additionally, banks must put in place various procedures towards providing more transparency within banking systems that should be more unified globally in fundamental principles of operation. Disclosure requirements have also been increased and tightened substantially.
Basel III has been developed as an improvement of the previously implemented Basel II regulations, with a view to providing a revised set of improved and more effective risk-management and capital-requirement standards. Basel III (also known as the Third Basel Accord) is currently a global, voluntary regulatory set of standards regarding bank capital adequacy, stress testing, and market liquidity risk. It has been designed to strengthen bank capital requirements through decreasing bank leverage and increasing bank liquidity. This regulation was proposed and set by the Basel committee on Banking Supervision as a thorough financial risk regulation framework and method of implementation. The objective of the regulations has been to utilise capital adequacy and risk management measures in order to provide improved protection for bank depositors and to minimize financial failures across the banking industry. As part of the regulation, banks will essentially have to hold excess capital against market, credit and operational risks. Further to this, the framework will detail numerous reform guidelines targeted at improving risk management and regulatory supervision. Basel I and Basel II were focussed on the required level of bank loss reserves to be held by banks for various classes of loans and other investments. Basel III, on the other hand, is focussed towards the risks for the banks of a run on the bank and requires differing levels of reserves for different forms of bank deposits and other borrowings. Therefore, Basel III has effectively been designed to work in the main alongside Basel I and Basel II, not as a replacement to the two sets of rules.
Across the G20, Basel III is strongly backed politically, where it is perceived as a sensible and realistic way to ensure that banks always have in place sufficient liquidity such that the leverage levels that banks have been exposing themselves to be lowered satisfactorily. However, ferocious and still building industry lobbying has pushed global regulators into gradually watering down the new rules aimed at restraining banks’ reliance on debt and these regulators have, as recently as January 2014, been adding an increasing number of exceptions and amendments. The majority of banks, even in dominant financial centres such as Germany and the US, have found it both a struggle and a difficult balancing act to meet the rising regulatory pressures. The timing of making these regulatory defined changes has coincided with an economic period of lower profit margins and increasing costs of operations. Furthermore, the final schedule of implementing the numerous and complete set of regulatory changes remains undefined as yet, with the transition period to meet minimum capital requirements already being delayed to as far as the end of 2018.
Basel III was set up to solve a distinct problem within the banking system, however, it is showing only very weak signs of full and proper adoption as major banks and lobbyist groups urge the regulators to make amendments based on their diverse set of objectives. If the regulation evolves to a stage far from its original purpose, will it succeed in its aims? Industry participants argue that the very nature of successful regulation is an iterative to-and-fro procedure between involved parties and regulators. Other, less optimistic, observers speculate that Basel III risks being amended to a point where it is no longer fit for original purpose (more a middle ground and talking point around which banking needs and regulatory aims are amiably shaped without a full consideration of consequence and wider impact). Whether this will this really protect consumers and capital deposits against past financial system shortcomings will remain questionable for these parties.
The three core elements of Basel III are capital requirements, a minimum leverage ratio and liquidity requirements. Regarding the first of the three, capital requirements, original Basel III rulings from 2010 required banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of “risk-weighted assets” (RWA). Basel III has since introduced “additional capital buffers” which include a “mandatory capital conservation buffer” of 2.5%, as well as a “discretionary counter-cyclical buffer.” This addition to the measure has been set up to allow regulators to stipulate a further buffer of another 2.5% of capital by banks during periods of high growth in the credit market. The second major requirement, the minimum leverage ratio, calculated as Tier 1 capital divided by the bank’s average total consolidated assets, is to be maintained in excess of 3%. However, this level was revised in July 2013, when the US Federal Reserve Bank announced that the minimum Basel III leverage ratio would be 6% for eight systemically important financial institution (SIFI) banks and 5% for their insured bank holding companies. The leverage ratio standard has been set up to serve as an additional check on banks’ indebtedness and essentially supplements the main Basel III capital ratio. While the main capital ratio will focus on risk-weighted assets, the leverage ratio is based around comparing banks’ capital to their total assets. The objective of the leverage ratio is to prevent banks from favourably lowering their capital requirements by understating their risk through ambiguous reporting. Finally, for the third major requirement regarding liquidity, Basel III has set up two ratios: the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The first of these requires banks to hold a sufficient amount of high quality liquid assets to cover their total net cash outflows over thirty days, while the second requires the available amount of stable funding to exceed the required amount of stable funding over a one year period of extended stress.
Capital requirements are at the heart of Basel III regulation. Investors and financial market participants sought a safe haven for capital following the financial crisis and the collapse of Lehman Brothers. Cash has been a more popular choice for investors, both retail and institutional, for the last few years and it is easy to understand why: the lower volatility risk reduces the chances of losing capital (aside from inflation) and, with some accounts and deposits still offering decent returns, they provide a more attractive place for funds. For example, in some countries such as Australia, deposit return rates have remained high through the years of the recovery and have provided investors with liquidity and have spurred on a growing movement of cash savers. However, with the implementation date for the Basel III regulatory framework on the horizon the attitude and approach to cash management, particularly for banks, is set to see a phase shift.
One major problem and point of discussion for banks with regulators about Basel III has been tier-one capital requirements. Tier-one capital can be defined in many detailed and complicated ways but essentially it is the deposits and savings accounts of both Small to Medium Enterprises (SMEs) as well as individuals, in addition to cash instruments with a maturity of a year or longer, such as a one year fixed term deposit. In order to meet Basel III capital requirements, banks are planning to begin to offer more attractive interest rates for tier-one capital and longer-term deposits as compared to returns on short-term deposits. Banks need to attract these deposits in order to meet the stipulated level of their net safe funding ratio (NSFR), and this will necessarily attract improved returns. The downside of this is that, in other areas of depositing and instruments, the rates of return will fall. Deposits from individuals and small and medium enterprises will be more valuable to banks, but corporate and public sector deposits and shorter dated term deposits will be deemed less valuable and less attractive and, therefore, see lower returns. Banks are understandably concerned by this potentially inevitable shift, especially when factoring in that many banking businesses have built a large part of their deposit base from short-term high rate accounts such as Rabo Bank and ING. These kinds of banks have survived by attracting deposits in this way and lack the capacity to buffer their accounts from implementing the required upcoming capital structure changes. Banks are faced with the challenge of attempting to preserve their deposit reserves and have been looking at building alternative asset streams and altering their product mixes in order to meet legislation changes. When Basel III is fully operational, rate changes will start to show wider impact, and it is estimated that hundreds of millions of dollars of fast capital movement will be experienced within the financial services industry.
In June 2013, the Basel Committee released a consultation paper on Banking Supervision. The committee has seen a mass of complaints in response since that time. These complaints are predominantly concerned with warnings of the ratios being damaging through being too punitive. Regulators have since increased efforts to balance the demands on banks to boost capital reserves against a vital need for lending provision to the economy to keep growing. Major global banks are calling for further amendments to the new leverage ratio ruling. These banks include BNP Paribas, Bank of America and Citigroup, they are arguing that the measures will hamper job creation as well as economic growth. They believe the measures will make it more expensive for governments to sell their debt and incentivise banks towards investing in riskier assets.
As 2018 nears, it appears that regulators worldwide are reducing the stringency of elements of the Basel III regulations towards meeting the intense demands of banking and industry lobbyists. Most recently, in January 2014, there was a meeting of central bankers and supervisors, which was arranged to reconsider the international standard for the leverage ratio. Concessions are being offered to banks on this measure of financial strength that was originally set up and designated as the least susceptible to being manipulated by banking professionals. The changes to date have come as a welcome relief to major investment banks. These institutions have understandably been concerned with how they will be able to raise billions in extra capital to meet the new requirements. The amendments to the regulations have eased the extent to which certain off balance sheet exposures may be brought back on to the balance sheet with regards to calculating leverage ratios. These exposures and products can often constitute major proportions of bank balance sheets. In certain circumstances, margins posted against some derivative instrument exposures may be accounted for in a favourable way. Further to this, the rules have been amended to allow the limited netting of repurchase agreements (commonly known as repos) that are mechanisms for banks to generate cash from short-term securities and will ease the regulatory burden significantly. This change is intended to help facilitate a boost in financial trade activities for banks. Regulators have yet to set the minimum required ratio formally, and many bankers would have preferred alterations to have gone even further in regards to holding capital against safe assets as part of liquidity safeguards. The estimated effect of these alterations is expected to raise the leverage ratio for large global banks to a more accommodating level of just over 4 per cent from the previous 3.8 percent. Additionally, as the standard is not set to start full implementation until 2018 industry experts are suspect that further easing may materialise in the meantime.
One particularly prominent case of the compromising on elements of Basel III regulation has been with Citigroup. It has been recently announced by the Federal Reserve Board that Citi has been approved to exit parallel Basel III reporting for US regulatory capital purposes, effective from the second quarter of 2014. As part of this regulatory negotiation, Citi will increase its estimated risk-weighted assets (RWA) associated with operational risk from the $232 billion reported as of December 31, 2013 to $288 billion. The estimated effect of this adjustment is a resulting pro forma Basel III Tier 1 Common Capital ratio of approximately 10.1%. Citi’s target has been to operate at an estimated Basel III Tier 1 Common Capital ratio of 10% to date, which has reflected a level compliant with the Basel proposed supplementary leverage ratio (SLR) requirement of 5%. While these changes have impacted the denominator of Citi’s Basel III Tier 1 Common Capital ratio, it does not affect Citi’s Basel III Tier 1 Capital or the SLR. As a result, even with the higher operational risk RWA, Citi will remain compliant with the proposed Basel III Tier 1 Common Capital ratio. Additionally, as of December 31, 2013, Citi’s estimated SLR was 5.4%, compared to the proposed requirement of 5.0%. This case in point is a prime example of how the regulations can be compliantly restructured through effective compromise and negotiation.
This amendment for Citigroup by the US Federal Reserve highlights a significant hurdle to execute Basel III fully. International agreement on the standard is difficult to achieve especially in light of differing national standards. Priorities are varied for banks across geographic borders and lenders are attracted in differing levels across these borders towards taking on riskier loans in order to earn higher returns. As authorities have underlined and emphasised the intention of the leverage ratio as a strict “backstop” to reinforce the main capital requirements the recent changes remain only a mild relief to lenders. Even under the amended rulings, the levels remain far less generous than existing US accounting standards. As of yet, the US has not finalised its leverage ratio ruling and fierce debate is expected over the upcoming months as to whether to adhere to the Basel definitions. US regulators have agreed to wait for the Basel Committee before deciding as to whether they want to incorporate the Basel definitions in the final US leverage ratio rule. Nevertheless, many US based banking participants are advocating that the US should plan these measures and actions independently, especially in light of what is appearing as a weakening of Basel measures. These industry participants are arguing that while the largest banks are stronger than five years ago in terms of their capital levels, they are still not strong enough to sustain a recovery driving phase in combination with strict and difficult leverage and capital ratios.
Currently, to many industry participants it may appear that the tide is turning in terms of Basel III (and other post-crisis based) regulation softening. However, it is also the case that by the keeping the discussion open and the levels unset as of yet that the regulators do, in fact, still maintain the ability to toughen up Basel III even further should they deem it necessary. Although, at this time, it appears that Basel III is becoming more of a framework of discussion rather than a set of stringent banking fail-safe rulings, global regulators are keenly monitoring and investigating how lenders are set to respond to a planned limit on bank debt levels. This is one particular area where the supervision committee could potentially turn firmer when it comes to enforcement, as it is perceived to be the best measure to prevent irresponsible behaviour by regulators. There is a possibility and intentionally left room within the regulation to enforce tougher measures in this area. The committee has publicly announced that it will make adjustments to the threshold by 2017 at the latest and regulators have stated that the regulations regarding banking compliance with leverage ratio requirements have been designated as one of the tougher, meaningful and important areas for the Basel committee. Consequently, at this stage it remains unclear as to which party, if any, will concede the middle ground on Basel III regulatory reforms.