Capco Blog

Basel III: Could unintended consequences create opportunities?

During September 2010 meetings in Basel, international banking regulators announced higher capital requirements on banks as part of a broader package of reforms to prevent future financial crises. To smooth the way for increases in required capital levels, BIS had issued a paper entitled “An assessment of the long-term economic impact of stronger capital and liquidity requirements,” in August asserting that increasing capital levels beyond those that now exist under the Basel I/II regime will create a long-term economic benefit. This benefit, the BIS emphasized, will accrue from avoiding future banking crises and will more than offset the economic costs of the regulation. Business leaders often are wary when government rule makers suggest that strengthening regulatory requirements will be a "free lunch," especially when dealing with so complex and important a topic as bank capital and liquidity requirements. This case is no exception.

Basel III highlights
Under Basle III, banks will be required to increase their Tier 1 capital to at least 6 percent of risk-weighted assets (RWA). Most of this capital will need to be in the form of common equity – at least 4.5 percent RWA for maximum market shock absorbency. The current minimum Tier 1 capital ratio set in the Basel II accord is 4 percent, with a common equity minimum of 2 percent. Banks will be allowed to phase in these new standards over a period of years. By 2015, banks will complete the phase-in of the common equity and Tier 1 capital standards and need to begin building the 2.5 percent "conservation buffer" of capital that must be fully in place by January 1, 2019. The conservation buffer is viewed more flexibly than the minimum capital requirements above, but comes with some strings attached. For example, any bank that fails to keep the capital above the buffer will be forced to restrict payouts such as bonuses, dividends and share buybacks.

Be aware of the potential for ripple effects
Despite good intentions, the new requirements may have a number of unintended consequences. The most troubling are the potential impacts of the higher levels of required capital on management behavior. For example, at weaker institutions, the higher capital requirements may serve to mask weak management practices and lax risk-management cultures, while better managed banks may have less opportunity to grow because of capital constraints.

The proposed counter-cyclical capital buffer could create other negative impacts. For example, regulators may impose the buffer to slow credit growth prematurely, thus affecting growth across the economy. Or the uncertainty that the counter-cyclical capital buffer creates around required capital levels might lead institutions to hold excess capital during periods when it is not imposed, thus restricting long-term credit availability.

Another unintended consequence stems from Basel III’s narrower definition of common equity, which, indirectly, further increases capital requirements by disallowing certain items that are currently counted as part of capital. For example, Tier 1 capital at U.S. banks could be reduced by up to 2 percent because mortgage service rights will not be allowed to count toward equity.

Unanswered questions also linger regarding exactly how much capital banks will want to hold to meet the requirements of the new accord. While some U.S. banks meet the new, higher requirements at current capitalization levels, exactly how Basel III will impact capitalization levels is unclear, because desired capitalization is usually set by considering an array of factors, including required regulatory capital, desired capital cushions over required levels, perceived optimum capitalization ratios, and the cost and availability of new capital. Given the change in capital requirements and some of the associated uncertainties around treatment of the capital buffers, it is possible that U.S. bank capitalization ratios could increase beyond that required by the accord. This uncertainty is magnified in Europe because most European banks currently have lower Tier 1 capital levels than their U.S. counterparts, and they may need to raise proportionally more funds to meet the new requirements. For example, German banks estimate that they will need to raise U.S.$130 billion just to meet the requirements. In fact, Deutsche Bank was the first out of the gate recently when it announced a U.S.$13 billion rights issue on the same weekend that the Basel III accord was reached.

The Basel III accord also will reduce returns on capital by requiring that more capital be held per risk-weighted dollar of lending. This will be exacerbated by the accord’s introduction of a liquidity coverage ratio, which will force banks to carry increased amounts of low-yielding, highly liquid assets on their balance sheets. Because there is a competitive free market for capital across industries, this is likely to have several noteworthy consequences: borrowing costs will increase and, as a result, the demand for bank credit in the economy will decrease, potentially slowing economic growth; the amount of capital supplied to the banking sector by the market will decrease because bank investments will become less appealing; and the amount of capital flowing to unregulated sectors that compete with banks will increase, potentially making it harder to regulate the financial services sector. The requirements for increasing capital and liquidity could also invite other types of risk taking and risk arbitrage, at which banks are clearly proficient, to reduce the financial impact of the new regulations. If bank managers believe that their profitability and risk trade-off is suboptimal, they are likely to find innovative ways to change that equation. This sort of innovation often creates the "next" crisis, as was the case with securitization.

Charting a new course – but which direction?
The change in capital requirements prompted by Basel III will impact strategic decision making at banks around the world. Basically, the response options for individual banks consist of: raising additional capital, which can be difficult in an environment where overall industry profitability is negatively impacted (existing shareholders are likely to be unhappy at the prospect of dilution); reducing assets or selling businesses to reduce capital requirements; and changing the mix of businesses or the nature of relationships with affiliates to reduce RWAs – remember, most of the new capital requirements are based on RWAs, not total assets. Each of these options carries its own set of consequences for economic growth and the evolution of the financial services sector. Additional complexity will come from national regulatory reform, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S., proposed amendments to the Capital Requirements Directive (CRD II) by the European Commission, and other national regulatory reforms that are happening around the world.

Strategic responses by banks to the adoption of the new regulatory regime are likely to vary dramatically according to variations in existing capabilities, management skills, and corporate commitment. This could produce distinct winners and losers under the new system as some banks’ strategies will be more clearly successful than others. The institutions that fare better will be those that understand how to optimize their capital efficiency under the new regulatory regime through changes to their funding mix, use of risk collateral, acquisition and sale of businesses, and changes to the nature of relationships with customers and affiliates. Those that do not have a good understanding of these factors may end up being targets of those that do. Interestingly, the largest banks may not be prime beneficiaries of this upheaval. Regulators are still grappling with the too-big-to-fail problem and may discourage the largest banks from growing even bigger through acquisitions. As a result, healthy mid-tier banks or even aggressive smaller banks may have a chance to get ahead by quickly acquiring weaker rivals or pieces of larger institutions.

Taking Basel III a step at a time
Basel III’s long phase-in period and the potentially high cost of compliance pose a dilemma for banks. Should they rush to implement their compliance efforts for the new accord or delay as long as possible, hoping for more clarity and to avoid unnecessary expenditures if the requirements change? The Basel III implementation timeline – which starts in 2013 and gives banks between five and 10 years to comply – is so long that the next crisis and the associated regulatory response could easily happen before full implementation is complete. A winning strategy may lie in focusing early efforts on developing more comprehensive risk measurement and risk-adjusted return-on-capital capabilities. This approach allows banks to address certain requirements that are likely to persist regardless of future refinements to the rules. These strategies may include investing in state-of-the-art banking platforms to improve performance measurement, developing stronger risk-management capabilities, building up M&A targeting and integration capabilities, and developing a long-term vision for capital efficiency and compliance across the organization. It will take commitment and some nifty footwork to successfully seize competitive advantage in this area. Yet the new Basel III capital requirements may make such moves very worthwhile.


I agree with much of what is said, in particular the observations about the need for banks to optimize capital efficiency in the BASEL III environment. A valid objective, the question is how to achieve it.

I am wondering whether anyone would agree with me that to the extent available at reasonable cost with the right scale, total return swaps might be used to optimize capital efficiency as they allow a bank increased use of economic capital with the applicable regulatory risk based capital requirements but without the leverage capital requirement and no balance sheet position (at least not for the notional). So, incremental returns are generated for shareholders through greater economic capital utilization. That helps to attract capital, creates capacity for incremental growth, mitigates the need for dilutive new share issuance…

For customer related business, TRS would effectively be off balance sheet funding for a bank who then could supply matching TRS for customers, rather than use matched repos, for example. While the matched positions represent comparable exposures, the TRS trades are so much more capital efficient than matched repos, for example.

I have been intrigued by the use of TRS for a long time and have always believed in their efficiency. In fact, one of the authors of the FRBNY’s July 2010 Shadow Banking report agreed with me that TRS does effectively align economic capital to real risk, while regulatory requirements for balance sheet positions can be distorting, a result that does not promote economic growth.

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