Basel III for Dummies!

Readers’ Comments:

“Though not a banking nor a treasury experienced professional, I have always had an interest in Basel Regulations, so thank you for sharing this!”

“Interesting – good video and the debate is ongoing.”

“A valuable perspective I must say…”

“I was attending the Supply Chain Financing Conference at the International Chamber of Commerce, Paris October 2012. A huge discussion point during the breaks of the actual conference was the need for corporate treasurers to start speaking out against the problems in the new regulations of the financial industry. Thus I fully support your work in Treasury Peer” Henrik Amby, Treasurer

“Many thanks. I liked the succint presentation of the key ideas and metrics associated.”

10 January 2013 update here.

18 November 2012 Philippe Roca has been kind to provide an update of the Basel III progress below the videos.

Basel III Related Blog Articles

Introduction

Together with our good friend Philippe Roca at the Corporate Funding Association (CFA) we’ve compiled the Treasury Peer’s Basel 3 for Dummies. The purpose is to provide you with a quick insight into this very important regulation. At its present construct it severely disrupts bank financing to corporates reallocating banks’ lending from the private to the public sectors. The Basel III framework has been developed by the Bank of International Settlements in Basel, Switzerland and pushed further by various other regulatory bodies. This text has several and significant shortcomings as do all “Dummies” since we have had to condense several hundreds of pages.

When you read this text please remember it only describes the Basel III framework so do not forget the adverse effects for corporates added from the Tobin tax and the risk of high large margin calls required for hedging by the new OTC derivatives regulation. Additionally we have the general crowding out effects from sovereigns hovering cash from the investors.

Basel III is divided in two main areas:

1. Regulatory capital
2. Asset and liability management

AREA 1: Regulatory Capital

Banks shall progressively reach a minimum solvency ratio of 7% as of 2019:

• Solvency ratio = (Regulatory Capital) / (Risk-Weighted Assets). [RWA = Risk-Weighted Assets]
• The minimum requirement used to be 2% prior to Basel 3, with many national banking authorities requiring much more leading to that most banks used to have a Tier 1 ratio exceeding 7%
• According to the Basel III impact study, at the end of 2009, the average solvency ratio (Core Tier One) of large banks was 11.1%

So, what is the problem, if banks already exceed the minimum solvency ratio set by Basel III? The devil is in the details and here is where we find the problems caused to the corporate sector:

• The definitions of the Regulatory Capital and the RWA have changed:
  • Calculated according to the Basel III definitions, the Core Tier One ratio would have been 5.7% instead of 11.1% according to the old definitions
  • The 87 “large banks” who answered the impact study would have been short of €600bn of equity at the end of 2009. New stress tests are disclosed regularly and the shortcomings differ, but they are still there. This means that banks will either/or have to raise more capital or decrease its present lending, which will create a crowding out of capital in the financial markets either way
• There are new definitions of core equity leading to that it is reduced with up to 40% for large banks increased the crowding out effects even further. Major changes in the definition:
  • Some financial instruments are not any longer eligible as Regulatory Capital
  • Intangibles and deferred tax assets shall be deducted from the Regulatory Capital
• There are changes in how RWA is calculated in average increasing it with 23%. Major changes include:
  • Sharp increase of RWA amounts from trading activities (stress tests on value at risk, securitisations…) leading to many banks decreasing the trading leading to fewer banks quoting prices. This has already led to reduced liquidity and increased costs and risks for corporates in managing its financial exposure from import and export etc
    • This encourages particularly banks to perform their swaps through clearing houses
    • This may weight on complex derivatives businesses
  • Loan portfolios require being marked-to-market even though it is not required by accounting standards. This increases pro-cyclicality
• Basel III introduces a “Leverage Ratio” such that the amounts of assets and commitments should not represent more than 33 times the Regulatory Capital, regardless of the level of their risk-weighting and of the credit commitments being drawn down or not
• The Financial Stability Board recommended in July 2011 that the 29 identified systemically important financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of course these “SIFIs” are the main large corporates’ banking counterparts. This provision has been “enacted” by the G20 in November 2011.
• The European Commission has added:
  • Minimum solvency ratio shall be 9% for the EU banks (instead of 7%)
  • The EU banks shall comply with this level in June 2012 (instead of 2019)

AREA 2: Assets and liabilities management

Banks will have to comply with two new ratios:

• Liquidity Coverage Ratio (LCR)
• Net Stable Funding Ratio (NSFR)

LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next 30 days:

• high-quality highly-liquid assets:
  • Recognized at 100%: cash, sovereign debt of countries weighted at 0% (which include the PIIGS as they are part of the Eurozone), deposit at central bank
  • Recognized at 85% and must not represent more than 40% of the assets: sovereign debt weighted at 20% (countries rated below AA-), corporate bonds and covered bonds rated at least AA-
• net cash outflows = cash outflows – cash inflows
  • cash outflows:
  • 100% of any repayment in the next 30 days
  • 5% of retail banking deposits
  • 75% of deposits from non-financial corporates and public sector entities
  • 100% of deposits from other financial institutions
  • between 0% and 15% of secured funding backed with “high quality highly-liquid” assets
  • 10% of credit lines to corporates, sovereign and public sector
  • 100% of liquidity lines (back-up, swing lines) to corporates, sovereign and public sector
  • 100% of credit lines to other regulated financial institutions
• cash inflows:
  • 50% of loan repayments by non-financial counterparties (it is considered that banks, even in difficult times, will have no choice than to renew at least 50% of the maturing loans)
  • 100% of loan repayments by financial institutions
  • 100% of bonds repayments (whoever the issuers)

NSFR: long-term financial resources must exceed long-term commitments (long term = and more than 1 year):

• Stable funding:
  • equity and any liability maturing after one year
  • 90% of retail deposits
  • 50% of deposits from non-financial corporates and public entities
• Long-term uses:
  • 5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting (see comment above for LCR) with a residual maturity above 1 year
  • 20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year
  • 50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual maturity above 1 year
  • 50% of loans to non-financial corporates or public sector
  • 65% of residential mortgage with a residual maturity above 1 year
  • 5% of undrawn credit and liquidity facilities

Our conclusions:

Hedging is penalized decreasing the liquidity in the markets leading to increase in costs to hedge the operational financial risks of corporations. This is further emphasized by the penalization of the interbank markets through requirement of more capital, and additional constraints on liquidity on interbank transactions.

Corporate credit by banks is penalized:

• More capital required in general
• Back-up facilities for commercial paper programs require that banks will have to have 100% of liquid assets in front of 100% of undrawn facility. The cost of carry will obviously be invoiced to the client and the ability of the bank to borrow long term will determine the availability of back-up facilities
• Restrictions in maturity mismatch (including for repayments) are introduced. This may mean that the risk of borrowing short term to finance long term investments will be transferred to the corporate sector.

Other businesses areas threatened:

• Trade finance (introduction of the leverage ratio)
• Consumer finance (leverage ratio)
• Project finance (NSFR)
• Public sector finance, except governments (leverage ratio + NSFR)

Overall, the main revolution for banks is in the liquidity ratios (LCR and NSFR), whose definitions are very severe for the corporate sector. For example, the average French banks’ LCR would have been around 58% at the end of 2009 if calculated to the Basel III definitions. Also consider:

• Access to central bank liquidity is not considered by Basel III ratios
• French banks used to push life insurance products vs deposits – life insurance, even invested into certificates of deposits, gives no credit at all to liquidity ratios

Overall, Basel III aims to sharply deleverage the economy threatening economic growth at the same time as the debt crisis puts a pressure on governments to spend less. There is also some level of naivety in the provisions of the definition of “high-quality highly liquid” assets, which banks shall hold abundantly in their balance sheets to face their short term liquidity commitments. In fact the banks are pushed to hold huge amounts of sovereign debt…

The need to deleverage the economy is obvious however the way Basel III is designed has led to that the corporate sector to a large extent must rely solely on funding and hedging from outside of the banking sector. The basic role of redistributing financial risk and fund trade has in fact mostly been pushed out from the banks.

Listen to video presenting the philosophy of the Basel Framework:

Recent update

18 November 2012, Philippe Roca shares this update of Basel III and adds a couple of comments

Since “Basel III for Dummies!” was originally launched, the project of this new regulatory mainframe has not changed. The content of the blog article was confirmed by brilliant presentations which some treasurers of Treasury Peer™ were lucky enough to attend May 2012 in London.

Banks are still negotiating the asset and liability management ratios (short-term “Liquidity Coverage Ratio – LCR” and long-term “Net Stable Funding Ratio – NSFR”). At this stage, it cannot be taken for granted that they will obtain these ratios to be softened. Yet, some definitions should be made more precise, which can be also a way to soften a couple of things. Read blog on the positive outcome (Jan 10 2013).

Treasurers often mention additional capital requirements for banks due to Basel III as a feature which hardly penalizes corporate lending. The additional capital requirements are not due to a change in the risk-weighting of loans to corporates but merely to the change in the definition of instruments eligible as regulatory capital for banks: this aspect affects similarly all the activities of the banks, and not especially corporate lending. Basel III changes risk-weighting for inter-bank lending and for some market transactions, it has not changed it for corporate lending. However the underlying attitude in the standard risk weightings imply that, at same rating, sovereign risk is lower. This attitude could have been expected to influence the general risk perception.

The implementation of assets and liabilities management requirements is probably more revolutionary for the banks’ business model than the additional capital requirements.

Other regulatory projects on top of Basel III

The Basel Committee does not impose regulation: individual jurisdictions have to elect whether they implement or not the bodies of rules proposed by the Committee and to what extent. The European Commission has adapted the Basel III regulatory mainframe with Capital Requirements Directive IV (CRD IV). Basel III itself was not completely taken as such into CRD IV and some concessions were made to banks over a couple of topics (for instance for the treatment of investments in insurance companies).

The Financial Stability Board made recommendations in July 2011 to the G20, and these recommendations were adopted by the G20 in November 2011. These recommendations gave birth on June 6th 2012 to a proposal of the European Commission to the European Parliament “establishing a framework for the recovery and resolution of credit institutions and investment firms”: banks would have to build recovery and resolution plans and have them validated by the banking supervisors. This directive would introduce bail-in in 2018. This tool would enable the banking authorities to write down the unsecured debt of a bank and to convert this debt into equity if it appeared to be necessary to avoid bankruptcy for an ailing bank; the portion of unsecured debt converted into equity would be left at the appraisal of the banking authority. All the liabilities (including derivatives) of the bank could be converted into capital except:

• deposits guaranteed by public authorities
• liabilities secured by assets (pledges, collateral arrangements), given that haircuts would be subjects to bail-in
• liabilities owed by the bank as a fiduciary in a fiduciary arrangement
• liabilities with an original maturity of less than one month
• tax and social liabilities.

In March 2012, the European Commission also published a new directive which is to come in force as of January 1st 2013 in order to contain risks on OTC derivatives (EMIR – “European Markets Infrastructure Regulation”). This directive is a consequence of the G20 meeting in Pittsburgh in 2009. The purpose of EMIR is to reduce counterparty risks on derivative transactions, by an increase in collaterals and reporting obligations. It is the equivalent of the Dodd-Frank act.

In October 2012, the Liikanen report suggested that banks should run proprietary trading and significant trading operations into separate entities to cut them from deposits and governments’ guarantees. It is an equivalent of the Volcker rule in the US and of the Vickers report in the UK.

How banks have been adapting their business model

Under the pressure of markets and of the European Commission, in three years, banks have caught up the gap between their solvency ratios as of December 2009 and the Basel III objective which was set for 2018. This was made through various ways:

• capital increases
• reduction in dividends and bonuses (in 2014, the bonuses paid in the London City should be lesser by 85% to those paid in 2007)
• deleveraging (sales of assets, lesser offer in credit…)

But deleveraging was not encouraged only by the additional capital requirements resulting from Basel III. Deleveraging was already made necessary by the liquidity ratios introduced by Basel III and by the difficulties of banks to raise long-term senior unsecured funding:

• fall in project finance volumes and in the credits granted to local public sector (needs for long-term senior unsecured funding hardly available to banks) – for these categories, when credit is made available, the credit spreads have soared up
• sharper selection in lending:
  • side business expectations (which makes credit not quite available to SMEs and smaller mid-caps)
  • perspective to receive deposits from the borrowers

Banks encourage corporates to issue debt on capital markets and to reduce banking credit; credit facilities are less than ever expected to be drawn down; and the excess of cash raised on the capital markets are expected to be deposited into banks. Thus corporates which can contribute to the banks’ liquidity will get credit facilities from them. That is one of the reasons why some corporates see their supply chain or their clients struggling to get financing if their size is not sufficient to get funding from the capital markets.

For regulatory reasons (LCR and upcoming bail-in tool), banks are now requesting from their clients that term deposits benefit from a 32-day notice for early repayment.

Due to the lack in confidence, banks have been collateralizing more and more their long-term funding with their best assets:

• covered bonds eligible to Basel III as liquid assets
• ECB refinancing operations
• liquidity swaps with insurance companies
• some corporates are even proposed to make deposits benefiting from collaterals from banks

The upcoming bail-in tool encourages such behavior. It makes the position of banks’ senior unsecured creditors increasingly subordinated. Banks struggle to issue long-term senior unsecured bonds on the markets. When they manage to do so, they pay credit spreads which are much more in line with BBB-rated corporate issuers (which is actually the average intrinsic credit rating they are given by Moody’s, before the impact of systemic support). In these conditions, it may be difficult for the banks to sustain providing long-term credit to corporates and, even more, to SMEs.

End of 18 November 2012 update. Thanks Philippe Roca for sharing.