With the start of 2018 mere weeks away, Basel III is set to be fully implemented across the EU and America. The roll-out has been gradual since its conception in 2010 to allow banks to restructure their balance sheets and capital structure. Basel III is a follow-up, voluntary, set of regulations from Basel II, which is aimed at improving bank liquidity, funding stability and capital structure, to better prepare banks for the next financial crisis. But are banks complying?
Basel III’s focus is mainly three areas: Capital, Liquidity and Leverage. It specifies new capital target ratios and redefines what would constitute each tier of capital and ensures that firms have a strong enough financial base to weather another financial crisis. Basel III is analogous to a bitter medicine – nobody likes to take it but it’s good for you.
The new capital target ratio requires firms to hold 7% Common Equity Tier 1 (CET1) capital- which means that if they were to lend out $100, they had to be holding $7 capital (broken down into 4.5% CET1 and 2.5% capital conservation buffer). At a broader level, requirement for Tier 1 capital was set at 8.5%, including CET1 of 7%. Basel III also sets new standards for ST funding and sketches out requirements for LT funding. An additional problem was with the rather complex redefinition of what would constitute Tier 1 or Tier 2 capital. Whilst it might seem quite complex, the principle behind it is quite straightforward; have enough in reserves to maintain bank credibility that enough cash can be returned to customers, preventing panic.
The ‘Liquidity Coverage Ratio’ is a requirement that banks hold enough liquid assets, or assets that they may liquidate at short notice, to cover net cash outflows over a period of 30 days. The intention behind it is much the same as requiring having to hold more top-tier capital. On top of this ratio, Basel III also put forth the ‘Net Stable Funding Ratio’ (NSFR), a policy that requires the available amount of stable funding a firm had, to be more than the amount the firm was required, over a one-year period of extended stress.
A lot of this was largely predicated on the redefinitions of capital. The Committee for European Bank Supervisors (EBS) estimated that the capital shortfall for top-tier banks would be between €53bn for the CET1 minimum requirement and €263bn for CET1 target level of 7%. Tier 2 Banks need €9bn for their minimum CET1 percentage and €28bn to achieve the target level of 7%. T1 capital ratios for Tier 1 Banks would, on average, decline from 10.3% to 5.6% whilst total capital ratios would decrease from 14.0% to 8.1%. Tier 2 Banks’ T1 capital ratios would decrease from 10.3% to 7.6% and total capital ratios would decline from 13.1% to 10.3%.
From this we can see that Basel III is already making a difference. And given the impact on high-tier firms, probably for the best. McKinsey estimate that pre-tax ROE will decrease between 3.7 – 4.3% from pre-crisis levels of 15%. There is no doubt that firms’ bottom lines would be affected in the midst of restructuring and reducing balance sheets, and since it’s voluntary, would anyone be interested in adopting such measures?
In one word, yes. There are signs that banks are adopting these new measures. As of the latest data from the EBS, the average LCR is already 134.2% and 170.1% respectively for Tier 1 and Tier 2 banks. 99.2% of banks show an LCR above 100%. This success can be attributed to the structural adjustments undertaken by firms and re-framing of the LCR framework. Furthermore, 87.5% of banks surveyed have met minimum NSFR requirement of 100%.
While the effectiveness of such safeguards will not be discernible until the next financial crisis, there is little doubt that adopting these new measures will better prepare firms for financial distress and also cushion the next big crisis – even though one can’t predict the next crisis. With so much uncertainty in today’s market, perhaps it is for the best that banks prepare for the next financial fall-out.