Constrained times ahead for banks as regulators piece together Basel III

SINCE the banking crisis occurred, every major regulatory authority, central bank and government has been developing ideas for improving bank regulations, with some already imposed. Meanwhile, the Basel Committee on Banking Supervision, which produced the original 1988 Basel Accord regulating capital requirements for banks and its subsequent revision, Basel II, ploughs on with a new round of changes. These, known as Basel III, are intended to come into effect in 2012. Their overall nature and scope are huge, and likely to be game-changing for many types of financial institution.

It’s a detail often ignored that it was not Basel II that brought the industry to its knees in 2008 but the fact that banks had become more and more expert at avoiding the relatively unsophisticated strictures of the original 1988 accord. When Basel II was first implemented in 2007 the over-riding objective from the large banks’ point of view was to reduce the level of capital supporting their business, giving them higher return on capital and therefore higher share prices. Basel II was knowingly structured to assist them with that objective on the basis that their risks were apparently well-understood and managed.

Hardly was the ink dry on Basel II when the crisis broke. The bank regulators’ first thought was, paradoxically, to force the banks to hold more capital. Since then various regulatory bodies – in Europe, USA, and globally through Switzerland’s Bank for International Settlements – have been debating the changes to be made to existing Basel II rules, as well as applying other additional safeguards which had not previously been considered necessary during the Basel II process. Of the many changes mooted a few of the more far-reaching can be mentioned here.

A great deal of attention has lately been given to the operation and composition of bank boards during the credit-crunch. The presence of non-financially competent or qualified non-executive directors (and chairmen) has been well-documented and exhibits strong correlation with bank failures on both sides of the Atlantic. All regulators have vowed to step up their examination of both executive and non-executive responsibilities and competencies. The FSA has long been interested in the quality and experience of executive and non-executive management in financial institutions and the signs are that this oversight will become even more intrusive in the future.

When it comes to the debate about separating “narrow banking” from “casino banking” it is clear there is a long way to go and a great deal of lobbying to be done to avoid a new Glass-Steagall Act. However it is conceivable that most banks will move along the lines recently proposed by Barclays which attempts to put a divisional structure into place, effectively separating pure commercial banking (deposit-taking and lending to individuals and companies) from investment banking. This sort of reorganisation will also make it much easier for banks to accede to requests by supervisors to implement “living wills” or the instructions to follow if part of the bank needs to be wound down in a future stress scenario.

During the crisis there were problems with the behaviour of bank capital, particularly hybrid types of capital instrument. Regulators are now concentrating more on Core Tier 1 capital (shareholders’ equity plus retained earnings) as being the base of the system without any “innovative” financial instruments involved. Regulators have also significantly upped their expectation of what the normal level of base capital should be, from the pre-crisis level of 5-6 per cent of total risk-weighted assets to 8-10 per cent now.

This area of the debate is also likely to lead to greater emphasis being put by regulators on the strength and solidity of “stand-alone” national subsidiaries of global groups. In other words capital will need to be moved down to country level from the holding company. This development in the banking industry is echoed in the discussions which recently occurred between Prudential and the FSA where, conversely from the FSA’s viewpoint, capital was required to be able to move between subsidiaries and parent more easily. There may be conflict between regulators ahead on this issue, since their various takes are far from aligned.

Overriding the debate about the definition and adequacy of capital in a risk-weighted world is the return to the stage of the pre-Basel I “Leverage Ratio” – total assets (non risk-weighted) divided by tangible net worth. This was how bank risk used to be measured in the good old days and, given the extreme leverage levels seen in Lehmans, Northern Rock and other failed banks, the re-imposition if this ratio is likely to constrain balance sheet growth and hence new business volume in the future.

All of these requirements for increased capital relative to a given level of balance sheet and business volume, together with the probable proposal for counter-cyclical provisioning against profits, are likely to have a detrimental effect on bank profitability and share price growth in the long term.

The outlook is no rosier as regards bank taxation, whether you blame envy at bankers’ remuneration, the need to replenish government coffers by any means or plans to build up reserves in preparation for the next banking crisis. Whichever, it’s likely that all financial institutions will have to make additional contributions to assuage the general concern about bank profitability and to atone for their share of responsibility for the crisis.

Current tax proposals are based variously on size of balance sheet, volume of transactions, profitability and (more controversially) bankers’ pay and bonuses. It is notable that the issues of a bank levy and bonus controls are specifically included in the coalition agreement produced by the new UK Conservative-Liberal Democratic alliance. However it has to be said that if all countries do not agree on this approach there will be scope for tax arbitrage between financial centres globally.

There are several other areas of banking business and operations which are also likely to be impacted by current supervisory level discussions but have not been covered here. They include risk management of OTC derivatives, explicit specification of liquidity requirements and revisions to the risk-weighting charges of various on and off-balance items.

One way or another banks are going to have their future growth, operational reach, organisational structure, profitability and employee remuneration constrained by governments and regulators alike. The chances are very high that all of these changes will impact negatively on banks’ profitability and return on capital.

Ross Tanner is director of City Products at BPP Professional Education.