Basel III: European banks are worried
In the wake of the global financial and economic crisis, a consensus gradually emerged: banking systems needed a reform. In the fall of 2007, the International Settlement Bank’s “Basel” committee on Banking Supervision set out to make proposals, called Basel III, in order to improve standards and safety. The first elements were published in April 2008 – six months before the Lehman Brothers demise. Since then, more recommendations were made public. The general framework was endorsed by the G20 summit in November 2010 in Seoul, and the text was officially released on the 16 December.
The Framework sets out higher and better-quality capital, better risk coverage, the introduction of a leverage ratio as a backstop to the risk-based requirement, measures to promote the build up of capital that can be drawn down in periods of stress, and the introduction of two global liquidity standards.
The rules will be introduced over a six year period, starting in 2013. In addition to publishing the rules in mid-December, the Basel committee released a study on the impact of its new bank capital and liquidity rules. The study looks at two sets of banks: Group 1 comprises 94 well-diversified, internationally active banks. Group 2 comprises the remaining 169 banks surveyed. The study looked at how well banks would comply with the new Basel III capital and liquidity standards had they been fully implemented in December 2009 (or nine years ahead of time). Banks will have had to have a combined minimum Tier 1 ratio of 4,5% and capital conservation buffer of 2,5% totalling 7%, more than triple the existing Basel accord. Banks must also build up short term liquidity buffers (Liquidity Coverage Ratio) and long term liquidity buffers (Net Stable Funding Ratio) as well as comply with a leverage ratio.
As far as the capital rule is concerned, the study finds that banks from Group 1 had a shortfall of 577 billion euros. (791 billion dollars). Which may compare with the sum of profits after tax and prior to distributions in 2009 was €209 billion. Group 2 banks had a shortfall of 25 billion euros (34 billion dollars). As for the short term Liquidity Coverage Ratio, Group 1 banks had 83% coverage, while Group 2 had 98% coverage, meaning both groups failed to comply with the 100 % requirement. The total shortfall of highly liquid assets was 1.73 trillion euros (2,37 trillion dollars). For the one year horizon Net Stable Funding Ratio, Group 1 banks had 93% coverage and Group 2, 103% coverage. The total shortfall under the long term liquidity buffer rule (100% coverage) was 2.89 trillion euros (3,96 trillion dollars). Basel III also sets a minimum leverage ratio of 3%. The average ratio for Group 1 is 2.8%, meaning leverage was higher than allowed under the rules. The average ratio of Group 2 is 3.8%, meaning on the contrary that they easily comply with the new rules. More than 40% of Group 1 banks and 20% of Group 2 banks would have been constrained by a 3% ratio. As the estimates assumed full implementation of the final Basel III package and made no assumption about banks profitability or behavioural responses – such as changes in bank capital or balance sheet composition, the results of the study are not comparable to industry estimates. These estimates usually include actions to mitigate impact from the rules.
Whatever the results of the Basel study, European banks are worried. Experts from McKinsey say that Basel III could have “some unintended consequences, including an impaired interbank lending market and a reduction in lending capacity”. The significant changes to the composition of Tier 1 capital and changes in capital ratios could result in a capital shortfall of 700 billion to 1.200 euros for European banks, they say. The imposition of a leverage ratio could make it worse. The new standards for liquidity and funding management could also severely impact funding, McKinsey says. “We believe that European banks may need to find between 3.5 and 5.5 trillion euros in additional long term funding, while they currently have only about 10 trillion euros in long term unsecured debt outstanding. Without mitigating action, the new costs for additional capital and funding could lower the industry’s return on equity (ROE) in 2012 by up to 5 percentage points, or 30% of the industry’s long term average 15% ROE”, experts from McKinsey add.
This is already bad enough. But European banks also fear that the new rules will put them in dire straights when competing with other firms in the world. China has already said that the rules would not apply to Chinese banks. Will American banks be subject to them? Europeans do not know. While President Obama committed himself to impose them on Wall Street, “there is a suspicion in Europe that the US Congress might not have the means, or the will, to do so”, says one expert, who prefers to remain anonymous. Furthermore, “the new rules don’t go down well with the traditional European economic model”, points out Jean Christophe Mieszala, general manager of McKinsey in Paris. When American companies tap the capital market for 70% of their financial needs – banks’ loans making only 30%, the reverse is true for European companies. The new leverage ratio would then (i) put a burden on European financial institutions relatively heavier than on US’ banks and (ii) modify the level playing field at Europe’s expenses. Finally “The Basel III rules could mean that banks might not have the means to finance the real economy”, he concludes. Considering that GDP growth is already constrained by other factors, such as high structural unemployment, high budget deficits and an aging population, this could deal a new blow to the economic future of old Europe.