Basel III is a term bantered about a lot these days, when people in finance ponder financial reform and try to list solutions to enormous risks banks took in the last decade. Basel III is no longer a proposal or a thesis of scholarly recommendations for how banks can clean up their crisis-torn balance sheets. Basel III is a set of risk-management guidelines that large banks are expected to follow. The leading nations (under the auspices of the "Group of 20") that help manage global economic and financial issues agreed Sept. 12 to implement Basel III.
Basel III, in its most basic form, provides capital and balance-sheet rules for banks around the world. The nations who agree to follow the guidelines also agree to enact, execute and enforce regulation within their own countries that adhere in principle to Basel III.
Basel III, of course, follows Basel I and II. Basel II never really got off the ground because its deadlines had not arrived. It was never fully enforced, because the financial crisis of the past few years interrupted. If Basel I and II couldn't minimize the severe impact of the crisis among banks, the logical goes, then a stronger, more effective Basel III could. Despite recent agreement among nations to roll out Basel III, it is not without critics, who believe Basel III might not be sufficiently tough enough to keep banks from accruing too much risk in the future or who believe its guidelines don't address the broadest set of banking and financial-system issues.
Basel whatever (I, II, or III) in spirit suggests that banks can protect themselves from unforeseen risks (bad loans, bad trades, market downturns and swings, interest-rate volatility, etc.) by having an adequate capital cushion. This is not about having capital to invest in business growth, new business or new acquisitions. This is about having capital as a balance-sheet cushion, a way to soften the blow when extreme risks or market catastrophe occurs--the kind we certainly experienced the past few years. The Basel guidelines offer a way to ensure that even unexpected losses will be bearable, a way to ensure that the banks' creditors, liability-holders, depositors, and lenders will be comfortable through a crisis (and be paid if debt is due).
Some global banks successfully endured the crisis because they managed risks carefully, avoided risky businesses and trading, and minimized losses. Other banks, despite heavy losses in mortgages and corporate loans, survived it well because they had ample capital--amounts far in excess of minimum requirements. The losses didn't hurt too much.
Whatever the capital requirements, banks manage business activity and growth around them. Given a level of equity capital, banks will determine the level of business they can conduct (lending, trading, brokerage, advisory, etc.) to ensure ongoing compliance. Other banks may approach requirements differently. They determine the amount of capital they need to do the business they seek to do. This assumes, of course, they will have access to markets to increase capital, if necessary.
(Some large banks manage capital requirements based on two guidelines: (a) minimum requirements based on Basel and bank regulation and (b) requirements based on their own calculations or perceptions of risk. They do this, in part, to capture activities that might occur in subsidiaries or entities not subject to bank regulation.)
Some finance experts argue that the greater the capital cushion, the better the bank can confront unsettling financial situations. Some, however, argue that while a capital cushion is necessary, there shouldn't be too high of a minimum requirement. Too much of a minimum cushion, they argue, stifles business growth and encourages banks to maintain balance sheets with large amounts cash reserves or liquid minimum-risk securities (U.S. Treasuries, e.g.) and not enough in consumer or corporate loans. Or it may discourage the bank from taking on incremental business.
Basel III, as before, requires banks to adjust all assets on a risk-adjusted basis and sum them up. (An unsecured corporate loan, for example, is not risk-adjusted, but collateralized loans or Treasury securities are "discounted" because of reduced risk.) Basel III requires banks to have a minimum amount of capital ("Tier 1 capital"), relative to the total risk-adjusted assets, based on new rules. The requirements will start from the existing 4% and step up eventually to 6% by 2015. Afterward, it will require an additional "buffer" of 2.5% by the end of this decade--more than doubling today's requirements by 2019.
Basel III also does something Basel I and II skipped. It will introduce limits on balance sheet leverage. In the past, a bank could have unlimited leverage if it chose, for example, to stockpile assets with risk-free Government securities. It will also penalize bank trading done away from central exchanges or risk-reducing clearing organizations.
The new requirements are outlined and quantified in painstaking detail. But what does this all mean? What are the implications to banks, bankers, and even those interested in working in financial institutions?
1. BALANCE SHEETS. Banks over the past decade have always been "balance-sheet sensitive." Basel III will make them more attuned to balance-sheet dynamics. Almost every large deal, trade, transaction, contingency, loan, or asset purchase or funding agreement will be analyzed to assess the impact on the balance sheet and capital requirements. More than before.
Before they do big deals or engage in large trading activities or expand into new businesses, banks today assess activity in "balance sheet/capital committees." They ask whether the new business is worth going onto the balance sheet or whether it will increase capital requirements.
Some impose internal balance-sheet or capital-usage penalties, hurdles or high-return requirements. The business unit receives a "penalty" cost or internal tax for using the balance sheet. Some banks call it an "asset tax." Some banks require extra "rewards" or returns for the incremental capital required. Banks have been implementing these penalties or extra requirements for the past two decades. But sometimes they overlooked these internal penalties when business surged.
With more stringent Basel III requirements, they will implement tougher requirements on business units and more "penalties" or "costs" for using capital or the balance sheet. Or they may require business units to justify harder why incremental business makes balance-sheet sense.
2. COMPUTING. Calculating assets (loans, trades, deposits, derivatives, reserves, securities, receivables, etc.) around the world, adjusting them for risk and doing so on an ongoing basis can be a systems and procedural nightmare for banks. As they had started to for Basel II, banks will devote more resources (including capital, ironically), personnel and technology to not only perform calculations and ensure compliance with requirements, but also to anticipate what they will be as business grows, changes and expands.
Over the past decade, calculating what goes onto the balance sheet for new banking products (derivatives, illiquid securities, infrequently traded securities, leveraged loans, etc.) has not been easy. Banks will seek to have a real-time system of knowing how much they are in excess of requirements at all times and in projecting the impact of new activity.
3. MARKET PERCEPTION. Banks have always managed to stockholders' expectations and will continue to do so. The market itself will have a view of banks' compliance with Basel III, even if (a) many large banks are already in compliance and (b) if the new requirements won't need to be met for years to come. Shareholders and equity markets will want to know if banks today can meet the eventual requirements and if banks have excess amounts even above the minimum for 2012 or 2015. Sending a signal to markets that a bank might have trouble meeting requirements or doesn't have excess could knock down the price of its shares. Banks know this and will manage to tomorrow's requirements, not what they need today.
4. MANAGEMENT. Especially those involved in corporate banking and trading, where activities have significant impact on balance sheets, bankers and traders will need to understand the impact of the rules more than ever. Sometimes in the past, a corporate banker, investment banker or trader relied on a compliance or regulatory colleague to worry about capital requirements. They booked trades or new loans, underwrote new securities, or accrued new activity until they were told to slow down or stop.
Going forward, they won't need to memorize the rules, but they'll need to have a keen awareness of the impact of complex business activity on the balance sheet. They will need to be more involved in bank-wide discussion of whether capital is being deployed in proper ways--to maximize returns and to ensure there is excess beyond the Basel III cushion requirement. These discussions can be complicated and political, especially if banks don't have procedures or methodology to address capital issues and requirements for new businesses.
Bankers most familiar with the guidelines and the impact of current or new business on balance sheets tend to fare well in these discussions or at least get their business points heard more clearly and logically.
They also tend to show senior management they are thinking along similar lines.