Basel 3: A Solution or A Challenge?

Too put it simplistically, the capital structure of an enterprise is determined by preference for the level of debt versus equity. It depends on whether the enterprise is more risk-averse or rather risk loving. In the latter case, it would prefer a higher degree of debt. Of course, cost motives also play a role.

Now in the case of a bank, capital structure is not purely driven by preferences. In determining the level of equity and debt, banks have to fulfill certain requirements put forward by the government. Banks have a vital role in the economy, namely facilitating spending and investment. If a bank would go bankrupt, it has far-reaching implications, affecting millions of people. This we have seen with the recent financial crisis. Thus the governments try to prevent the worst-case-scenario from happening. However globalization came up along the way. These days, banks are active across national borders. This raises the need for international regulation with respect to the banking system.

This need was answered by the development of Basel Committee on Bank Supervision. This is an international advisory authority on bank regulation, raising issues critical to the health of the banking system. The Basel Committee has developed capital adequacy standards that national regulators can implement, named the Basel Accords. The accords all address the need for bank capital regulation. This means that they request rules that require banks to hold certain levels of capital.

With the financial crisis of 2008, the Basel Committee on Banking Supervision found an opportunity to restructure the approach to risk and regulation in the financial industry. They developed the Basel 3 framework to augment the framework of Basel 2 in 2010. In 2013, the European Union implemented the Basel 3 agreements in the EU legal framework. The primary goal is to improve the ability of banks to absorb asset losses without affecting the whole economy. Next it aims to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. Below you can find a breakdown of the Basel 3 proposals in order to achieve these objectives.

So we have pointed out that Basel 3 is a very recent accord. Nevertheless a lot of criticism has been formed and the potential impacts have been researched extensively. We will set out here a summary of the impact on the individual banks and on the financial system as a whole. 

Impact on individual banks
-Reduction in competition
-Pressure on profitability and ROE
-Increase in long-term funding
-Increase in group reorganizations

Impact on financial system
-Reduction in risk of individual bank failure
-Reduction in lending capacity
-Reduction in investors' willingness to invest in bank debt or equity
-Room for arbitrage when Basel 3 is implemented internationally in different ways

We briefly illustrate the points made above. Starting at the top, weak banks will find it harder to raise the required capital, leading to a reduction in competition. Next the need to reorganize and deal with regulatory reform puts pressure on the margins. The two liquidity ratios in Basel 3 focus on short-term and long-term liquidity and funding will drive firms away from short-term funding. Finally, increased supervisory will lead to a reorganization of groups. Now we are at the impact on the financial system. An increased buffer in capital and liquidity should reduce the risk of bank failure. Further increase in capital and liquidity regulation may lead to a reduction in capacity for banking activity. ROE and profitability of banks decrease so there is less room for dividends. Finally, international regulatory arbitrage may remain to disturb the stability of the financial system.

"In the EU we are noticing that there is a credit crunch that you would not normally expect in a more positive economic environment. So, while consumer confidence is increasing, OEMs' ability to keep up with this demand may soon diminish as working capital reserves are exhausted and banks resist lending due to the ongoing overhaul of the European banking system.. Though full implementation of Basel III is not expected in the EU until 2018, it already appears to be influencing banks' credit strategies."

References:

1. Basel 3: Issues and Implications - Report of KPMG
2. Implementing Basel 3 in Europe - European Banking Authority
3. EBN