The Basel III changes and global bank reform

 

Dr Simon Ashby asks whether the latest in a series of banking regulations, Basel III, will prove too costly.

Simon Ashby is a Senior Research Associate at the Financial Services Research Forum and Nottingham University Business School, an Associate Professor of Financial Services at Plymouth Business School and Vice-Chairman of the Institute of Operational Risk.

A version of this article originally appeared in the FT publication Investment Adviser on October 3 2011.

If at first you don't succeed...

The journey towards reforming global bank solvency regulation had been a slow and tortuous one, at least until the onset of the financial crisis. It took almost 10 years to agree and finalise the Basel II Accord, yet in barely over a year regulators have managed to roll out the third iteration of this seemingly ill-fated series: Basel III. Are regulators now close to solving the problem of bank failures and the prevention of future financial crises? Or will the costs of this new regulation outweigh the benefits?

The first Basel Accord, agreed in 1988, marked the beginning of modern global banking regulation. This relatively simple agreement was designed to lay the foundations for bank solvency regulation around the world and has been adopted, in some form or another, by most nations.

However, as banks and financial markets grew in complexity in the 1990s it quickly became apparent it was no longer up to the task – not least because banks were becoming increasingly adept at structuring their assets and liabilities to circumvent its requirements. In addition, banks pushed for new regulations that took account of the supposedly sophisticated risk models they had built – models that were designed to provide a highly accurate picture of their risk exposures, allowing banks to take more risk and hold less capital while still keeping the risk of failure to an acceptable minimum.

The result was Basel II, which, reflecting the changing world of banking, represented a quantum leap in sophistication and complexity. Notably, this agreement was built on three fundamental pillars of regulation:

• Risk-based minimum capital requirements

• A detailed supervisory review of bank capital requirements and the effectiveness of risk-management arrangements

• Market disclosure

Via increased transparency, Basel II was in theory designed to support the effective operation of market forces while at the same time ensuring the costs of regulation were proportionate to the risks banks were running. Unfortunately, it failed on both counts.

Firstly, although all High Street and commercial banks were required to disclose information and hold capital, certain banking institutions escaped scrutiny. This especially applied to the so-called “shadow" banks – virtual banking organisations created as vehicles to hold a range of financial securities.

Among these securities were the now notorious collateralised debt obligations (CDOs), the packages of mortgages and other debts that were parcelled up and sold on to other banks and shadow banks – many of which in turn re-parcelled them to sell on yet further down the chain. Such shadow banks were not subject to Basel II, an oversight that allegedly augmented their popularity as some banks, through so-called “regulatory arbitrage", used them in easing their regulatory burdens.

Secondly, Basel II did little to improve the quality of bank risk-management and may even have contributed to worsening it. Banks were so engrossed in the development of capital models that helped reduce their regulatory liabilities that they lost sight of the risks accumulating on their balance sheets.

So now we have Basel III, designed in light of the lessons regulators have learned from the financial crisis and, it is hoped, ready to serve as a means to correct the failures of its short-lived predecessor.

The main changes, to be phased in from 2011 to 2019, are as follows:

• A change in the definition of the assets that can be counted as regulatory capital. Basically, most regulatory capital must now be in the form of common share capital or retained earnings.

• Increased capital requirements that cover a wider range of risk types (e.g. the risks associated with securitisation and counter-party credit risk). This includes a new counter-cyclical capital buffer, designed to encourage banks to build up their stock of capital during more favourable economic periods.

• A new leverage ratio that restricts the amount of money banks can borrow.

• New rules on bank liquidity. These will require banks to hold more cash on a day-to-day basis as well as over the longer term.

• New rules on risk management and governance. These are intended to improve the ways in which banks assess, monitor and control their risks.

• Enhanced disclosure requirements relating to the securitisation of assets and the sponsorship of off¬balance-sheet vehicles (a.k.a. shadow banks).

Will Basel III succeed?

One of the key concerns about the latest reforms is their costs. Banks are only just beginning to recover their financial strength following the global crisis, and it now looks likely that they will be faced with extra pressures on their balance sheets – pressures to further increase the stock of capital they hold while at the same time reducing their reliance on debt finance. To make matters worse, this is all happening at a time of renewed financial uncertainty, with the European sovereign debt crisis and the heightened risk of countries such as Greece, Portugal and Ireland defaulting.

It is well worth stressing that greater capital requirements should not be viewed as the be-all and end-all. The authors of a recent study for the Financial Services Research Forum, hosted by Nottingham University Business School, compared suggestions that larger reserves will avoid future crises to favouring bigger airbags over safer driving. Even so, just how can banks raise the capital required by Basel III?

One obvious solution is simply to reduce their liabilities. Essentially, this means lending less and investing less money in the financial markets. But this is unlikely to represent a good option for economic growth or household wealth and also does little for the banks themselves, which have to take a degree of risk to make a profit and satisfy their shareholders.

This is probably why banking is now witnessing the emergence of a new fashion in the form of liability management – or “LM", as it is sometimes termed. This is basically a sort of debt restructuring. Via bond buy-back deals, it allows banks to exchange their old debt for new longer-term debt or, even better, for equity or forms of near-equity such as subordinated bonds or the increasingly in-vogue “coco" (contingent coverage) bonds that convert to equity at a pre-specified point of financial distress.

Yet whether these new developments in bond markets will usher in an era of renewed financial stability or simply sow the seeds for a new crisis remains to be seen. Though banks can no longer use shadow vehicles and devices such as CDOs to minimise their regulatory liabilities, only time will tell whether the funding devices they are inventing to diminish the effects of the new regulations will have adverse repercussions. Should investors prove reluctant to purchase these new bond instruments, it may also be the case that banks will be forced to take ever-higher levels of risk to generate the returns they need to meet the costs of the new Basel III requirements.

If there is another financial crisis, then, who or what might be the real culprits – the banks, their regulators or perhaps even a combination of both?

Of course, we must hope the question need never be asked, let alone answered. As we have already seen with Basel II, however, the unintended consequences of regulation can sometimes be worse than the problems it is designed to solve.

The Financial Services Research Forum

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