27 November 2010

Banks’ Response to Basel III

At this month’s G-20 summit in Seoul, South Korea, global leaders endorsed the new rules on bank capital and funding announced by the Basel Committee on Banking Supervision on 12 September 2010 (the Basel III). Although these rules are not solving the fundamental issues of financial services industry, they still have an impact to banks’ profitability and to the way banks operate.

Recently McKinsey published an interesting analysis on the topic: “Basel III and European banking: Its impact, how banks may respond, and the challenges of implementation”. According to this analysis, by 2019 the European banking sector will need about €1.1 trillion of additional Tier 1 capital, €1.3 trillion of short-term liquidity, and about €2.3 trillion of long-term funding, absent any mitigating actions. The need for additional capital is equivalent to almost 60 percent of the current Tier 1 capital outstanding, and the liquidity gap forms roughly 50 percent of all outstanding short-term liquidity. Banks’ pre-tax ROE (return on equity), before any mitigating actions, would decrease by between 3.7 and 4.3 percentage points from the pre-crisis level of 15 percent. Despite of the fact that these estimates might rather be considered as conservative (i.e. the actual impact of Basel III is rather smaller than bigger) interventions by the banks’ managements are more than likely. Some have started already. So, what will be their response?

The first thought that I heard after presenting the new Basel III rules was that: “We need to revise our pricing.” Read: credit will be more expensive for the customers. The second consideration is of course that: “Well, in fierce competition we may not be able to pass the cost rise on to customers.”

The next question is: “Can we make (some of) the regulations disappear or at least to be more relaxed?” The answer is that: “Yes, it’s still possible. Not everything is set by now. Also, any regulation that is not going to be implemented soon (let’s say within the coming three years), may be implemented... well, never.” We should remember there are wrong intensives and a revolving door between bankers and their regulators. Also the argument that credit will be more expensive and/or less credit will be available for the customers still works emotionally.

Then, after acknowledging that the above actions may not and are not likely to be sufficient for restoring anything close to pre-crisis profitability, banks might consider the following:
  • Improved data quality and more sophisticated (but not necessarily more precise) risk modelling approaches – the argument goes that: “As we will be able to better measure the risks, our capital requirement should be lower.”;
  • More centralised capital management and liquidity management (then the buffers on subsidiary level are minimised, and the total need for capital and liquidity smaller);
  • Balance sheet restructuring, and ongoing, improved balance sheet management;
  • Revision of business portfolio;
  • Revision of business strategies.
According to the abovementioned analysis by McKinsey, these measures have a potential to considerably decease the impact of Basel III to banks’ profitability.

If the already listed measures still shouldn’t be enough, loopholes like withdrawal of the most risky assets to special investment funds might be considered. Lobbing for additional loopholes that are specific to the given bank’s business model is a further activity. The implementation period of Basel III is long enough, and the regulations seem to duplicate each other and in at least some cases could be argued as contradictory.

Last but not least, financial innovations are always an option... I don’t want to say that financial innovations are bad – far from that. I want to say that on principle, making money should mean making sense too.

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