Third Try for Basel

Will the new Basel III international capital standards be more effective than previous versions in preventing bank meltdowns?

Back in 2006, when the Basel Committee on Banking Supervision was revising its initial standards for the amount of reserve capital that banks had to hold against their lending activities, it looked like the changes would be a boon to some banks and corporate clients. Under the so-called Basel II standards, banks would no longer have to hold the same amount of capital for all commercial loans, for example. Less risky loans would require less capital, potentially letting some banks increase leverage and making borrowing cheaper.

Of course, Basel II, which wasn’t supposed to be fully adopted in the United States until 2011, never made it to the finish line — the worldwide financial crisis intervened.

Now, the successor of Basel II has almost the reverse purpose of its predecessor. Basel III isn’t supposed to make capital standards more flexible for individual institutions and loan types, as Basel II was. Rather, its purpose is to provide banks with greater insulation from risk across the board, especially in the event of another banking crisis. But will Basel III be any more of a success than Basel II?

Under Basel III, standards for capital, leverage, and liquidity are much stricter. By 2015, banks will have to hold more loss-absorbing common equity, equal to 4.5% of their assets, up from the present 2%. Four years after that, banks will have to hold an additional 2.5% of so-called Tier I common equity as a “capital conservation buffer.”

In rare circumstances, when credit growth is excessive, the Basel standards also include a “countercyclical buffer” of another 2.5% of common equity. At the same time, the standards will gradually pare down the kinds of capital that count as Tier 1 common equity.

But even if imposed as is in the United States, Basel III may suffer the same fate as Basel II. The Basel III transition period is lengthy — one of the deadlines is as far out as 2022. “We don’t know what the world might look like by then,” says Cory Gunderson, managing director of the financial-services practice at consulting firm Protiviti. “The financial industry tends to find itself in crisis every 7 to 10 years. The odds of other issues coming up while the [Basel III] effort is being fully transitioned are pretty high.”

Basel III capital

In addition, some observers question the effectiveness of higher minimum capital requirements. Some banks threatened by the financial crisis had plenty of capital reserves, points out a recent paper by lawyers from Clifford Chance, which was supplied to CFO by regulatory information service Knowledge Mosaic. United Kingdom-based Northern Rock had Tier 1 capital of more than 11% before suffering a bank run and coming under public ownership, for example. Of other large U.K. banks, only Royal Bank of Scotland had Tier 1 capital of less than 8%. (Those ratios aren’t directly comparable with Basel III’s, since the new standards will remove many previously qualifying forms of capital from Tier 1 calculations.)

The effectiveness of Basel III capital standards may also depend highly on the risk weightings that will be assigned to various types of assets. Some critics call the current weightings, which guide banks in determining how much capital to hold, arbitrary and out of date. A mortgage-backed security (MBS), for example, was previously weighted at 20% — a bank would have to hold just one-fifth the amount of capital for an MBS as it did for a whole loan. Stricter risk weightings are on the agenda, but the time frame and particular weightings that Basel III will set are uncertain. The Basel Committee has said that higher risk weightings would be imposed on trading, derivatives, and securitization activities by the end of 2011.

Fortunately, Basel III doesn’t rely solely on capital reserves. The international standards also establish liquidity ratios that will undergo an observation period before they are finalized as standards. They could be key to keeping investment banks from evaporating overnight again. The liquidity coverage ratio would ensure that a bank maintains an adequate level of “high-quality, unencumbered assets” to meet net cash outflows for a 30-day period. The net stable funding ratio would ensure that assets such as investment bank trading inventories, off-balance-sheet exposures, and securitization pipelines are funded with a minimum amount of stable liabilities — Treasuries with maturities of one year or more, for example.

“The financial crisis was at least in part a liquidity crisis,” points out Luigi De Ghenghi, a partner at law firm Davis Polk & Wardwell. “From a capital perspective some banks had no risk of failing, but they had liquidity issues as the interbank lending market dried up and it became hard to refinance capital-market indebtedness. A capital cushion is the ultimate fail-safe, but a liquidity ratio would be a means of monitoring how close you’re coming to running into real trouble.”

United States banks may vigorously contest the liquidity ratio rules, however. That’s because the rules will have a big impact, as the Clifford Chance lawyers note: “The overall result for many banks will be to increase by a factor of several times the proportion of their total balance sheet which is required to be held in the form of highly liquid assets. Since highly liquid assets are invariably low-yielding assets, this imposes a significant cost on the relevant bank.”

Banks are also worried about the need to raise equity capital as the years go by and the bar on Tier 1 common equity moves higher. While most major U.S. banks met or exceeded Basel III capital requirements as of the second quarter, they may still need to raise equity in the next few years, says Gunderson. “If XYZ bank already has a 4% cushion over the ‘well-capitalized’ standard, it will probably want to maintain that cushion going forward,” he says. “The market expectation will trump regulations.”

For some U.S. regional banks, a deadline to exclude public-sector capital injections (à la the Troubled Asset Relief Program) from Tier 1 capital by January 2018 could cause problems. Some regional banks have as much as 25% of their Tier 1 capital in the form of TARP funds, according to a recent report by Matthew H. Burnell, senior analyst at Wells Fargo Securities. “We believe it is unlikely that regulators would permit these institutions to repay TARP in the near-term without raising a sizable amount of replacement capital,” wrote Burnell.

Meanwhile, CFOs of nonfinancial companies are concerned over how Basel III will affect their own access to capital. Most think stricter rules on capital, leverage, and liquidity will at the least increase their banking costs, according to a recent survey by CFO.

But while the ultimate effectiveness of Basel III won’t be known for years, many experts see it as progress. “Basel II was a menu approach — it allowed countries to select what their standards were, so you had all sorts of international arbitrage even within an organization,” says Protiviti’s Gunderson. And Basel III has the virtue of simplicity. “I always thought that Basel II was a mistake because it was so complicated and no one really understood it,” says Sandy Brown, a partner at Bracewell & Giuliani, who served at the Office of the Comptroller of the Currency in the 1980s. “Basel III is a simpler approach.”

That simpler approach could work. Will the third time be the charm for the Basel standards?

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