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Basel III, the new rules

Under Basel III‘s new rules, capital efficiency is no longer a mere function of return and leverage. The ability to collect information and process trades directly impacts the volume and breadth of activities a bank carries out. The convergence of multiple regulations has meant that banks are conducting enterprise-wide risk aggregation on an unprecedented scale. This is necessary in order for banks to re-qualify trades versus hedges and optimise capital utilisation. Over the medium and long term, regulation has become an incentive for banks to diversify in wealth management and retail banking…

In an attempt to fix what was identified as the key deficiencies of the previous regulatory frameworks, Basel III consists of 5 main areas of change: Quality and consistency of banks’ capital base, enhanced risk coverage and methodologies, maximum leverage ratios, countercyclical measures and minimum liquidity ratios.  Under Basel II, a loose definition of capital had led to a decreasing of the actual share of equity below minimum levels, through perpetual debts and other schemes made possible by the diversity of accounting rules around the globe.  Basel III is attempting to fix this through a stricter definition of capital, raising quality and volume requirements simultaneously.   As if justification was needed, the regulators commissioned impact analyses on major economies and published modest loss figures ranging from 0.1% to 0.32%* of GDP as a median impact over 17 countries.  On the other hand, bankers generally estimate the increase of their risk weighted assets (RWA) between 50% and 100%, due to new risk assessment methodologies proposed. The negotiation is most likely to be settled through phasing and transition arrangements.

Other Perspectives on Basel III

Beyond the purely quantitative impact of Basel III on banks’ equity value and GDP figures, the effect of the new rules should be looked at from the perspective of the clients of the financial industry.  How does Basel III eventually impact the life of a medium-sized company?  Another aspect which seems to be overlooked is the combination of multiple macro- and micro-prudential regulatory packages.  How does Basel III combine with the Dodd Frank Act (DFA) and MIFID, for example?

By raising the costs of capital, regulators necessarily make lenders more selective. By increasing risk weights, the selection naturally favours highly rated institutions and collateral-rich counterparties. Inevitably, small industries and trade companies should feel a greater impact. In a November 2010 interview** John Ahearn, Global Head of Trade Finance for Transaction Services at Citi, estimates that ,under Basel II, funding small and medium sized enterprises (SMEs) required three times more capital than lending to a triple A institution.  Higher costs of capital in Basel III will make it worse, he says.  To compound the issue, the leverage ratios act as de facto caps on the total amount of business a bank can do and might further rigidify selective lending.  The ratios could also lead to focus on shorter term loans since RWA models factor an element of forward volatility, itself computed involving the square root of time. Thus longer durations theoretically increase risk.

When capital drives business decisions, banks embark in RWA savings campaigns, the impact of which cannot be predicted by quantitative analysis. In particular, lenders will reconsider the quality, availability and liquidity of collateral. In the presence of leverage caps, the speed at which collateral is released and deals are settled, directly impacts the volume of transactions a bank can handle. Capital efficiency is no longer a mere function of leverage, but speed, allocation and workflow efficiency also matter.

Another important perspective when measuring the impact of Basel III, is to no longer consider it a standalone regulation, but approach it in the context of the other macro- and micro-prudential endeavours, in particular the DFA in the US and MIFID in Europe. An important part of DFA is the Volcker rule, which bans proprietary trading and involvement in hedge funds from banking activities.  The banking industry derives a very substantial share of its net profit through proprietary trading and broker dealer activities, especially since 2008 where lending activities were reduced by the credit crunch while abundant liquidity and high volatility were incentives to trade. It has been somehow surprising that banks would naturally surrender a very crucial activity of their portfolio without trying to oppose the ruling more vehemently.

Basel III’s Impact

In reality, banks can massively rationalise what they do through enterprise-wide risk aggregation. If approached in terms of cross-asset sensitivity, a substantial share of proprietary positions, which offsets exposure arising from lending and financing activities, can be re-labelled as a hedge. Only positions in excess of the hedge shall then be deemed “proprietary” and shaved off. Banks find a great incentive to mine all proprietary and business books in search for matching sensitivities.  Moreover, a hedge is an exposure which sensitivity covers another exposure under a forward-looking “what-if” scenario. 

As Basel III encourages to stress-test sensitivities across-divisions under adverse market scenarios as a mean to better assess liquidity and funding needs, it makes it easier to identify hedges and stress them further to net out existing positions as much as possible. In addition, reducing the overall RWA through internal matching not only spares some of the dealing activities but it minimises the costs of collateral management and hedging operations. At the cost of comprehensive overhauls of IT infrastructure, we can expect a number of Chief Investment Officers to rename as Chief (cross-asset) Hedging Officers”. The impact on IT is unprecedentedly important; the more cross-asset and cross division the reconciliation, the better the chances of capital optimisation.

A remaining part of proprietary activities will still need to depart from banking institutions though. Since they can’t spin it off into hedge funds they control, there is a view that banks could engage in wealth management activities to compensate for the lost value. In line with DFA, the forthcoming EU regulations and MIFID promote principles of fiduciary responsibility which make investment advisers directly accountable for managing portfolios along risk profiles dynamically assessed with their clients. The skills and techniques required in terms of portfolio management and governance are actually closer to private banking business than conventional asset management.

In search of alternative sources of revenue and margin, and as the demand for asset management services is expected to continue to grow in the aftermaths of the banking crisis, one can expect a new generation of wealth management services to originate from banks. As in the meantime Basel III and other macro-prudential supervisory rules aim at decreasing the reliance of the banking sector on wholesale funding, there is a strong incentive to re-approach retail banking services from a wealth management perspective.

Just as the impact of major natural events is measured in terms of the changes they force on the environment, Basel III should be looked at from the perspective of its qualitative impact on businesses which depend on banks, and entangled in other regulatory initiatives as well.

*Source BIS and ECB

**Source Citi



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