Basel III is an international accord whose objective is to standardise some banking safety requirements in a worldwide economy. The failure of Lehman Brothers, Northern Rock, and persistent troubles in Greece, Spain, Italy, Ireland and Portugal underscore how shock waves from one nation's problems can reverberate worldwide. Basel III may not be a panacea: It will not necessarily prevent a subsequent global financial crisis, in our opinion, nor will it completely insulate financial institutions from the unsettling effects of one. However, what Basel III will do is require banks to better prepare themselves for the unknown, including requiring them to bolster their balance sheets by holding additional capital.
For Basel III, capital requirements are front and centre. Basel III will implement tougher capital requirements on banks – and both the quality and quantity of capital is being addressed. With regard to quality, banks will need to maintain Tier 1 common capital ratios now – eliminating the sometimes questionable ability of hybrid capital to absorb loan losses. The definition of core capital is also being tightened, and will exclude some items such as deferred tax assets. Second, the quantity of capital needed is going up. Minimum common equity will now need to be 7% of risk weighted asset by 2019, up from the current 2% standard. Tier 1 capital will need to reach 10.5%, up from the current 6% rate. The leverage ratio requirement remains rather modest at 3%, and should not be an issue for any of the US banks. Institutions deemed to be systemically important will have to hold an additional buffer on top of these levels.
Unresolved Issue: Systemically Important Financial Institutions
The definition of Systemically Important Financial Institution, or SIFI, has not yet been announced. SIFIs will have to hold additional yet-to-be-determined capital, so the classification could have a major impact on the individual firm's competitive positioning and need to build additional capital. The leading proposal would be for each nation to determine the additional capital required. But we wonder: Will the Basel III committee look to the worldwide impact of a firm failing, or the countrywide impact? The latter would greatly increase the number of systemically important firms. For instance, Wells Fargo (WFC) may be considered systemically important to the United States, but its failure would be unlikely to compromise the worldwide system.
Unresolved Issue: Liquidity Requirements
The new liquidity requirements have longer time horizons before implementation. The liquidity coverage ratio will start in 2015, and the net stable funding ratio will be implemented in 2018. Currently, the Bank of International Settlements is in an observation period in order to assess their impact on credit and financial markets before implementing them, in an attempt to minimise their unintended consequences.
Click below to read our regional analysis on the sector:
-- Australasia and Basel III
-- Core Europe and Basel III
-- Peripheral Europe and Basel III
-- The Americas and Basel III
-- The UK and Basel III
Conclusion
Basel III's impact is going to be felt worldwide. Some banks are better prepared for the adoption than others but, the generous adoption timeline is giving every bank a chance to meet the various deadlines without necessarily resorting to an equity raise, in our opinion. Basel III is trying to create a level playing ground for the world's banks, but that is unlikely to happen. Financial regulators' views of the Systemically Important issue, and how much extra capital the bank may have to hold, could affect their competitive positions domestically, and internationally. Therefore, would look to invest in countries where the regulators are also keeping an eye on their bank's competitive positions--in other words, not giving the banks incentive to take excess risk due to capital requirements that are too high. We would also want to avoid countries where an economic crisis would make it too expensive for banks to raise long-term debt to meet the stable funding ratios requirements. This pretty much eliminates the PIIGS countries.
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