Basel III – Impact on Banks and Corporations
July 1, 2016 - Monocle Research Department
In the wake of the Global Financial Crisis, the G20 and Basel Committee for Banking Supervision introduced a raft of new banking regulations, known collectively as Basel III.
Basel III has five key objectives: increased and better quality of capital, broader risk coverage, capital build up during credit booms, leverage, and liquidity.
The impacts of these five key objectives of Basel III on banks’ balance sheets imply significant changes to banks’ business models. As a result corporations will need to assess the impact of Basel III on the funding they access from banks.
Basel III has five key objectives
At the time of its publication in June 2006, Basel II was widely regarded as transformational for the banking industry internationally. Basel II provided a framework which allowed banks to hold capital against a more granular measurement of risk exposures, both within and across asset classes.
Unfortunately, the timing of Basel II’s implementation at the beginning of 2008 proved to be particularly inauspicious, coinciding closely with the onset of the Global Financial Crisis (GFC).
Post the GFC the G20 and Basel Committee for Banking Supervisors (BCBS) introduced a raft of new regulatory proposals and measures, collectively known as Basel III. While these measures will considerably bolster the safety not only of individual banks, but also financial stability, broader economic implications inevitably flow from new constraints on banks’ business models.
2. Global Financial Crisis (GFC)
It’s often noted that regulators are forever doomed to fight the last crisis. It’s clear that the financial crisis starting in 2007 has resulted in severe hardship in many countries. Jobs have been lost, inequality has grown, and the negative impact on economic growth will be felt for many years to come. Understanding the origins of financial crises is imperative, even if the next crisis is unlikely to share quite the same features as the last.
Global Financial Crisis key events
By their nature, crises tend to proceed from an unforeseen mix of inter-related contributory factors. Key events that can be identified in the build up to the GFC are:
- Gramm-Leach Bliley Act of 1999.
- Easy credit and leveraging during the early and mid 2000s.
- Community Reinvestment Act of 1977, which encouraged home ownership, and subprime lending after 2000.
- Rating agencies’ ‘AAA’ stamp on securitisations.
- Boom and bust of the shadow banking sector, fuelled by AAA stamps.
- June 2007 collapse of 2 Bear Stearns hedge funds.
- Failure of wholesale funding markets.
- March 2008 sale of Bear Stearns to JP Morgan.
- September 2008 bankruptcy of Lehman Brothers.
Basel III Impact on Banks
The severe losses on securities during the GFC prompted the G20 and the BCBS to introduce stiffer capital requirements, in terms of both increased capital requirements and far better quality of capital on banks’ balance sheets. Market risk capital requirements were ramped up by around 4 times with the introduction of Stressed VaR and the Incremental Risk Capital (IRC) charge, and counterparty credit risk addressed through the Credit Valuation Adjustment (CVA).
Further revisions to the framework were also introduced in respect of a non risk-based leverage ratio and two liquidity ratios. Banks will also be required to build up an additional capital buffer during credit booms to counter procyclicality.
The impacts of these key objectives of Basel III on the balance sheet mean that there will be major challenges arising for banks’ business models.
South Africa’s banking sector is well capitalised from a banking book point of view, with a capital adequacy ratio of 15.09% at December 2011, comfortably above the 10.5% -13% range banks internationally must ramp up to by 2018 (12% – 14.5% in SA). Trading book capital requirements however will result in ongoing assessment of capital allocation to these activities, particularly in respect of capital requirements and the new liquidity ratios.
The new non risk-based leverage ratio should not present a problem for SA banks. The financial leverage ratio for the SA banking sector amounted to 14.4 times at December 2011 (total banking-sector assets divided by total banking-sector equity attributable to equity holders). Basel III seeks to limit banks’ leverage ratios to 3% tier 1 equity of total assets.
Meeting the liquidity ratios
The real challenge for SA banks lies in meeting the new liquidity ratios, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The LCR seeks to ensure that a bank has enough liquid assets to meet 30 days’ stressed outflow, while the NSFR seeks to ensure that a bank has stable funding for assets with a duration greater than one year.
Given the present structure of SA’s economy and financial system these ratios are currently extremely difficult for any SA banks to meet. The Bureau for Economic Research estimates that banks face a funding shortfall of around R240 billion on the LCR and R680 billion on the NSFR.
Banks should in future be able to meet the LCR however. The South African Reserve Bank (SARB) is to introduce a committed liquidity facility for this purpose. The facility will cost banks up to 40 basis points against collateral at the SARB.
Meeting the NSFR will be more difficult. This will certainly require significant structural adjustments to banks’ balance sheets. Lending rates will increase on longer maturity products, and banks’ appetite for products such as mortgages curtailed.
Basel III also introduced the notion of Global Systemically Important Financial Institutions (SIFIs), and Domestic Systemically Important Banks (D-SIBS). The latter may become relevant in future given the concentration of SA’s banking sector.
4. Basel III Impact on Corporations
From a capital perspective, Basel III will likely impact banks’ investments in, and loans to, private equity, hedge funds, and venture capital. Higher capital requirements, particularly the increase in required common equity tier 1 capital, will cause many banks to reassess whether exposure to such risky assets is economic on a risk-adjusted return basis.
For corporations more generally, the question that should now be asked by treasurers is what impact the liquidity ratios will have on the type of funding they access from banks. The proposals as currently envisaged will substantially increase lending costs on commercial paper, working capital, and longer dated funding. Treasuries will also need to factor in the increased costs of shorter dated funding, and increased reliance on capital markets in future.