Basel III: The Rules Become Real

An article by New York Institute of Finance instructor Tracy Williams.

For those who work in or work with financial institutions, it's impossible to avoid discussions of financial regulation. It's everywhere. It can be the drudgery of banking, deal-making, trading, lending, and investing. But in an environment that is hustling to rid itself of the stark memory of the financial crisis, it's inescapable. 

Financial regulation, Dodd-Frank and Basel III are hot summer topics this year, because it's time for the deliberation to stop and for the rules to become real.  Large banks, such as Bank of America, Goldman Sachs, and Citigroup, have sprinted tirelessly to get ahead of the 900-plus pages of Basel III regulation-- rules drafted by the Basel Committee on Bank Supervision, which includes 27 nations, and intended to have more meat than the rather languid rules of Basel II and Basel 2.5.

Basel III regulation consumes the minds of CEOs and global heads of legal, risk, and compliance.  Trying to gain a fierce grip around the Basel III monster requires resolve, patience, an obsession to detail and resources to hire people and invest in infrastructure to keep up with everything.

The essence of 900 pages of guidelines and rules is that capital is king, that enormous of amounts of bank capital act as a safe financial cushion in times of crisis, whether the crisis is caused by in-house failures or by system-wide troubles.  Basel III details explain the calculations banks must make to determine the precise amount of capital they must maintain for the level of business (measured by the level of assets--assets on and off the balance sheet) they are engaged in.  

To avert confusion of what is an asset and what comprises capital and to discourage banks from using financial tricks to circumvent the rules, Basel III painstakingly defines "assets" and "capital." It also permits other regulatory bodies (such as the Federal Reserve) to further define assets and capital further and add their own pages to the existing rules. In other words, the Federal Reserve can choose to make the requirements tougher, as it did in early July.

Capital requirements differ for different kinds of banks, for banks of various sizes, and for large banks (like JPMorgan Chase, Wells Fargo, or Bank of America) that have what many say is extraordinary impact on the global financial system.

This month, the Federal Reserve took bold steps in the Basel III roll-out by tweaking the leverage rules, causing bank CEOs and compliance officers to squirm even more. The Federal Reserve proposed stricter leverage limits:  No matter how risk-averse a bank's balance sheet can be, the Federal Reserve proposes that the largest banks (those with assets exceeding $700 billion) must maintain $6 capital for $100 of assets, implying a maximum leverage (total assets-to-capital ratio) of 16-to-1.  (Basel III is more lenient at $3 capital/$100 assets, permitting leverage to rise to about 30-to-1.)

What irks banks most nowadays are (a) the vast amounts of resources, time, and people they must deploy to comprehend and keep ahead of the rules and (b) the uncertainty of what's to come from further rules imposed by the Federal Reserve and other regulators. What has frustrated banks the past few years, until they began to accept it as a matter of the way things are in the new world of banking, was the impact of increased capital requirements and reduced leverage on banks' returns on equity.  More capital and lower leverage, quite simply, imply lower ROEs.

Outside the offices of senior bank managers, what does Basel III mean to everybody else--bank shareholders, finance professionals, bank clients, counter-parties?

1.  If there is another tumultuous financial crisis, most banks complying with Basel III will be better able to endure it.  Governments won't likely need to inject billions in new capital to give the banking system a spark.

2.  If one large major bank struggles and implodes, its collapse won't likely cause system-wide panic, won't threaten the global financial system, or won't cause hundreds of its counter-parties and clients to tumble with it.

3.  Regulators and market-watchers might forecast better which large banks are vulnerable and could be threats to cause damage to the financial system. They may be able to diagnose a sickness in the system before it causes a global plague.

4.  Banks, not able to exploit leverage and constrained by rules from taking exorbitant risks, must settle for returns on capital in the 10-15% range, if they even manage themselves efficiently and maintain large market shares.  Days of regular 20%-plus returns will be almost impossible to achieve. With relative higher amounts of capital on the balance sheet, they won't be able to use debt to get boosts in ROEs.

5.  Economists and business leaders appreciate concerns about risks, weak balance sheets, and burdensome leverage and debt levels.  Some fear, however, good banks might become too strapped by rules and will become less willing to take prudent risks--risks that include lending to corporations, small businesses and start-ups that provide swift thrusts to a lagging economy. 

Others fear an irony.  Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.

6. Banks will hire and might be willing to pay a premium for expertise in compliance, reporting, risk management, and systems.  Complex regulation will require experts to interpret rules, gather data, calculate requirements and report to regulators--in real time, all the time, for the rest of time.

Banks would have preferred to hire new people for revenue-generating businesses or deploy capital for new businesses and expansion. But they have accepted they must build stronger compliance and risk-management structures and show shareholders, regulators and politicians they are taking new regulation seriously. (In 2012, JPMorgan Chase reported it would need 3,000 employees and nearly $3 billion in costs to comply with new, ongoing regulation--over 14,000 different rules from all forms of regulation, not just Basel III rules.)

7.  Senior bank managers will spend more time acting as arbiters among business units scrambling for a precious piece of the bank's balance sheet.  There will be more defined rules for capital allocation:  Who will get to use increments of capital for business purposes? And who will be able to maximize the amounts allocated to them?

8.  Banks will obsess over their capital numbers.  They must develop strategies for how to comply with rules today and in 2018-19, when most rules take effect.  Should they issue more equity in large amounts now to increase capital and proudly show excess amounts before rules are in effect? Should they maintain excess amounts to show markets, shareholders and regulators they are flush with capital, amply above requirements?  Or should they not raise capital, but choose to scale down businesses, assets and risks, based on current levels of capital? 

9.  Bank boards, sector leaders, subsidiary heads and senior managers will knock themselves out, figuring out how to squeeze more return from the balance sheet, how to nudge ROE upward one more percentage point. They face monstrous challenges to do so without increasing risk levels and credit exposures, without the privilege of growing assets any way they could in years gone by. Solutions to this problem won't come easily.

Basel III has rumbled into town. Many rules go into effect in 2014. It's a reality, no longer an academic concept or a discussion paper in volumes by professorial types in Europe. Banks knew these days were coming and have been preparing for them, but they still know it will be a constant, everyday struggle to tame the impact of 900 pages of guidelines.

About New York Institute of Finance

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