Banks have struggled with the implementation deadline of Basel III regulations, due to differing approaches to the two key liquidity and capital measurements. So, what is the outlook for the implementation of Basel III?

Three years after the endorsement of Basel III, and past the date when the rules were meant to start being implemented (January 1, 2013), the liquidity coverage ratio (LCR) and the net stable funding ratio (NFSR) under Basel III still induce headaches for bankers. They are expected to reduce return on equity as financial institutions will have to keep a chunk of their liquidity aside for crisis situations in which wholesale funding markets shut down.

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The LCR and NSFR ratios determine how the bank will cope if cut off from funding temporarily and how well the maturity profiles of assets and liabilities match. But the current definition of the rules creates scope for different interpretations among local regulators, resulting in inconsistency that has disrupted and slowed down the overall commencement of the adoption of Basel III.

According to the Financial Stability Board, only six of the 28 global systemically important banks identified by the board will have been Basel III-compliant at the agreed start date of January 1, 2013.

Although the Basel Committee has substantial political influence thanks to its members, it does not have enforcement powers. As Johann Kruger, head of accounting and regulatory advisory at Lloyds Bank, says: “Every country that subscribes to the rules will implement [them] in their own form.”

The issue is so serious that, on December 3, the European Commission admitted it would miss the January deadline. Europe’s local regulators are still debating the final shape of the Europe-specific Basel III rules, called the Capital Requirements Directive IV, including the amount of capital that banks are required to hold. There is even a proposal by the European Banking Federation to defer the implementation start date until 2014.

The EU regulator wants as little leeway as possible for national governments to require either less or more capital because it wants a level playing field in Europe, according to Mr Kruger. “It plans to achieve this by including the most important Basel requirements in a regulation, which must be implemented as is, rather than as a directive, which allows an element of national discretion. But there is a possibility that there may be a difference between what the local regulator requires and what regional institutions actually do,” he says.

High-quality assets

The Basel guidelines define high-quality liquid assets as those that can be converted easily into cash without a loss of value, or at least with very little loss. A preliminary list of LCR-eligible assets focused mainly on cash and sovereign bonds, but after regulators from Australia, Denmark, Hong Kong and other countries complained that the definition was too narrow, the Basel Committee added high-quality corporate bonds as eligible assets. Now, the committee is considering expanding the definition further, for instance by allowing corporate bonds with ratings of BBB or even BBB- to be eligible for the LCR.

These high-quality assets are then divided into two levels: level one assets include those at the central bank, cash and non-0% risk-weighted sovereigns or central bank debt securities. Level two assets must not comprise more than 40% of the overall stock of a bank and “the calculation of the 40% cap should take into account the impact on the amounts held in cash or other level one or level two assets caused by secured funding transactions (or collateral swaps) maturing within 30 calendar days undertaken with any non-level one assets,” states the Basel Committee.

For stress scenarios, the LCR, which is meant to be implemented by 2015, requires financial institutions to keep enough high-quality assets to counterbalance net cash outflows for 30 days. This is calculated by dividing the amount of eligible high-liquid assets by the total sum of cash outflows for a month. Complementary to the LCR is the NSFR, which concerns long-term funding of one year. The Basel Committee says the purpose of the NSFR is to create “additional incentives for a bank to fund its activities with more stable sources of funding on an ongoing structural basis… to provide a sustainable maturity structure of assets and liabilities.” Both ratios must equal at least 100% of the banks’ high-quality liquid assets.

Regardless of the exact shape, the LCR and NSFR, together with the new capital ratios under Basel III, change the economics of banking. The LCR, by requiring buffers of low-yielding assets, changes the costs of doing business.

Basel III requirements overview

Collateral questions

To make matters worse, the implementation of the NSFR and LCR are further complicated by the advent of new rules in the EU and US requiring most swaps business to be cleared through central counterparties. These tend to require higher quality collateral than in the bilateral, over-the-counter derivative trades.

“A focus on holding large pools of government bonds in the liquidity buffers ties the balance sheets into non-lending assets. It substantially increases demand for government bonds, which are also needed for the new central counterparties and increased collateralisation of the swap market,” says Patricia Jackson, partner and head of financial regulatory advice for Europe, the Middle East, India and Africa at Ernst & Young.

If a bank cannot get enough stable funding, it would have to contract longer term lending, which poses the question: is there enough stable lending available? A bank’s stable funding is a depositors’ illiquid assets, says Ms Jackson.

Like many others, she argues both the LCR and the NSFR increase the costs of banks providing a maturity transformation service for the economy. “The LCR penalises short-term deposits and the NSFR constrains lending unless sufficient sticky longer-term deposits or funding can be found,” she says.

One senior central banker says that to work out what impact all this will have, three things need to be clear. "One is the scope and scale of derivative books that will be cleared through CCPs. More multilateral netting should reduce collateral needs compared with bilateral clearing, but that partly depends on the number of CCPs. Fewer would be better, provided they are themselves safely operated and regulated," says the central banker.

The second factor that will help determine Basel III’s impact is clarification on what initial margin is needed for derivatives that are not eligible for central clearing. The third is the precise composition of the LCR.

“That is why we are taking the time to consult and carry out impact studies on this,” says the central banker. “To the extent that the final collateral requirements on banks will be higher, this will show how far banks were previously operating in an under-collateralised world, with resulting excessive exposures to each other. The important point to emphasise is that none of these measures are static. The real question is how they will drive change in the banking sector to make it safer."

Composition of holdings of all eligible high-quality liquid assets (all banks)

Tighter deposit management

It is clear the demand for safe assets will increase, but fewer of them have been available since the onset of the US subprime and later eurozone sovereign crises. This increases the price for safety and could create fresh imbalances in global markets. The equation representing the supply and demand imbalances in safe assets is made more complex by the fact that different players, such as conservative investors, pension funds, insurance companies, central banks or sovereign wealth funds, have different safety perspectives. This increases the mismatch between asset and liability, and short-term funding and long-term lending.

One senior asset and liability manager says the LCR and NFSR make it necessary for banks to distinguish between operational and non-operational balances as non-operational balances do not have a liquidity value that could be used for maturity transformations under Basel III.

Non-operational balances are listed on balance sheets along with operating assets and, while they can be used for diversified risk management, they are actually not essential for business operations.

“You cannot lend it out and earn interest on it. The only option left is to put it at the central bank where, due to the low-interest rate environment, banks don’t earn anything on the deposits. In this case, a bank would end up with a balance sheet extension. So non-operational balances could contaminate operational balances,” says the asset manager.

Consequently, the impact of Basel III on maturity transformation services will reduce profitability and return on equity, and raise the cost of funding. Finding high-quality assets is therefore becoming an issue. Arnaud Picut, product manager, regulatory compliance, at software provider Misys Global Risk, doubts the industry is going to find miracle new safe assets.

“The current market trend shows the available portfolio of assets remains more or less the same. But they will be analysed, priced and rated differently. The main safety criteria are low credit and market risks, high market liquidity, limited inflation risks and low exchange rate risks. These can be found in a new pool of assets, including EU, Japanese, emerging market and US debt, as well as a pool that includes commodities and currencies,” he says.

Some experts encourage investors to look at what they call semi-safe havens, adds Mr Picut. These include low-volatility sectors, such as healthcare, consumer staples, utilities and telecoms, high-grade fixed-income investments, such as municipal bonds, or funds that have high dividends and minimum volatility built in. A growing mismatch between assets and liabilities, in Mr Picut’s view, makes Basel too costly and damaging if banks try to fit only their current products in the liquidity buffers.

Technical opportunities

But financial institutions do not need to helplessly surrender to a future of low profitability and return on equity. Appropriate data management could work wonders in assisting banks to be both Basel III-compliant and profitable. Put another way, financial institutions can choose to go beyond merely complying with the regulation and instead seek greater business efficiencies by flowing liquidity data directly into management decision-making.

“Clients want a different interface between software and the risk engine,” says Mr Picut. “Previously, these were more or less batched interfaces. Now they want something smarter. There is no real revolution in risk and compliance. The market trends are related to the computation of prudential ratios with fresh data – from yesterday, not last month – and interpreting risk analysis in business decisions.

“For most banks, the challenge is not to compute Basel III or implement some more sophisticated risk methods, but to deliver more accurately the current ratio with a fresh and more comprehensive set of data; to take the relevant business decisions based on risk and compliance reports.” 

Mr Picut goes on to explain that the concept of smart interface is the capability to deliver a connector that can detect a business event occurring in the source (for example, core banking software), interpret the event and automatically generate the different ratio, limit, warning and report linked to the event. This ‘smart process’ could be embedded directly into a business decision workflow process.

Beyond processes

Even with smarter processes, banks will need to make radical changes to face up to the challenge of Basel III. Further reviews of trading books, securitisation and operational risk are expected, and resolution structures and rules regarding structuring of trading activity are being developed and implemented, says Ms Jackson. This is creating huge uncertainty about the future profitability of the industry, increasing short-run economic costs. Deleveraging is almost certainly larger than projected by the authorities, she says.

“The change we have seen in the banking market as a result of Basel III is just the tip of the iceberg. Once rules implementing Basel III come into play, banks will increase the degree of change in the market and business models,” says Ms Jackson.

The adjustment of margins has not really started in some markets, she adds, but once the rules are implemented, some banks may rethink their strategy and retreat from certain business areas, such as propriety trading, which would open the door for shadow banks.

If the cost of funding increases, trade finance and other business areas will be impacted. This will increase the hurdle rate for companies engaging in new projects, which restricts economic activity, warns Mr Kruger. “If the funding cost becomes a serious obstacle to trade finance, then the reaction will be to find alternative ways to fund the transaction, possibly the shadow banking sector,” he says.

This could lead to the build up of risks outside the banking system and possibly even pave the way for a future crisis. Ms Jackson therefore calls for a sustainable new form of securitisation to enable deleveraging without damaging economic activity. “This would have to be quite distinct from pre-crisis securitisation, with limited tranching and much more transparency, and guaranteed due diligence on loans in pools,” she says.

Clearly, much remains to figure out for regulators and financial institutions before another deadline is missed and before Basel III encourages the change in the sector that is needed to make banking safer.

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