There is a lot of speculation that Fed would start scaling back its $85 billion a month worth asset purchase program, which it started during September 2012. Although, the Fed accepts that the timing of the QE3 tapering remained crucial and mainly revolved around the improvement in labor markets with a considerable reduction in the unemployment rate to below 7%, however, the Fed faced numerous other challenges over the past many months which made it impossible to time the cutback on the stimulus yet.
During the July FOMC meeting, the Fed downgraded its assessment of economic growth noting down weaknesses in the consumer prices and mortgage rates which hit 2 year highs, and maintained that it would want to watch more data to ascertain if the economic conditions are indeed improving, before making any changes to its monetary policy. However, the recent flurry of better-than-expected economic data, showing remarkable recovery in manufacturing and services, hitting multi-year highs, and the increase in consumer prices, and the weekly initial jobless claims at multi-year lows, all indicating to a stronger economy, most analysts remain concerned the Fed would probably reduce its bond buying program, as early as September. But there are clear evidences that the economy still needs nurturing and require liquidity support, and this can be seen from the July payroll which came well short of expectations with lack of quality jobs and a labor participation rate of 63.4%, the lowest since 1979. Given Fed's large scale Treasury and Mortgage backed security purchases, any reduction in asset purchases at this stage would lead us to a big question as to who will fill in the Fed's shoes upon its stimulus exit and compensate for any liquidity crunch the tapering may create? In a normal scenario, the answer would be apparent - the big global banks. However, the present situation is quite different. Let's take a detailed look.
Financial crisis and Basel III enforcement drive:
Ever since the recent financial crisis, which saw the demise of the big investment banks such as Lehman Brothers and Bear Stearns among others, triggering billion dollar write offs out of the credit markets, there has been a greater push by the G20 to apply the regulatory framework, imposing stricter rules on the banks and financial institutions and consequently, the Basel III framework took shape in 2010. The regulation requires the banks and financial institutions to maintain high quality buffer capital which should be available to absorb any losses materialized, by defining a 'Tier 1' capital mainly comprising capital from the common equity issued by the institution. The phase-in of a minimum Tier 1 capital requirement of 6% and a minimum total capital requirement of 8%, based on risk-weighted assets, are due by January 2015. Moreover, the banking institutions should maintain a capital conservation buffer which would kick in by January 2016, and would reach up to 2.5% by January 2019. Basel III also imposes a 3% leverage ratio to de-leverage the banking institutions and safeguard the economy from any crisis due to any hazardous leveraging attempts for short term gains. Another major requirement is to maintain sufficient high quality liquid assets (HQLA) to survive a 30 calendar day long liquidity crisis scenario.
Basel III may affect lending and could trigger liquidity shortfall:
As part of the Basel III enforcement rules, the U.S. banking regulators' recently announced 6% leverage ratio compared to the global standard of 3%. Eight big financial institutions which are key to the economy and have a major international presence have been given until January 2014, to begin implementing the rules. These eight banks comprise of JPMorgan, Wells Fargo, Goldman Sachs, Bank of America Corp, Citigroup Inc, Morgan Stanley, State Street Corp and Bank of New York Mellon Corp. The amount of leverage ratio is not well received by banks and seen as a restraint to their proper functioning, as it involves maintaining 6% of the total balance sheet assets. There is a serious concern that stricter regulations and higher capital requirement could affect lending and eat into the bank's profits. The American Bankers Association warned, "The real test for Basel III is whether the rule makes it easier or more difficult for banks to serve their customers and if it makes it harder, that's not what our still-recovering economy needs." What this implies is the banks would need to look at unwinding the business areas which are yielding lesser when compared to the massive balances required against those businesses in accordance with the Basel III rules, or restructure certain activities like derivatives, running from their broker-dealer subsidiaries. Consequently, banks would either look to pass on the increased cost of capital to the clients or worst-case scenario - the banks may need to take bold decisions to discontinue these businesses. This may significantly impact the level of client lending which further impacts the economy.
It is now becoming increasingly evident that the safeguarding efforts undertaken by global financial regulators to prevent another financial crisis with stricter regulations are turning out to be a major restraint for the financial institutions, from purchasing Treasury securities to other high yielding fixed income instruments. Recent data from the Federal Reserve have shown that the repo market has shrunk to $4.6 trillion daily outstanding in July from $7.02 trillion back in the beginning of 2008. The repo market is believed to be deeply impacted by the Basel III regulation due to the cut-down on netting practices between the dealers, and instead they would be forced to include the collateral and other funding details on the balance sheet, and the banks would therefore stay away from participating in those trades, to comply with the leverage rules set by the Basel Committee. Since the underlying collateral securities used in the repo markets are mainly Treasury securities, the reduction in the repo trades would result in reduced Treasury transactions, which could have significant impacts on the liquidity of the world's highly liquid market. A major part of the bond market volatility witnessed over the past couple of months, which saw the bond market losing over 2.5%, could be attributed mainly to the regulatory strains, albeit the Fed's tapering concerns aggravated the sell-off. Although the primary Treasury dealers trade $600 billion worth Treasury instruments each day, the prices at which the dealers buy and sell Treasury securities have doubled compared to the pre-recession period. This could further lead to a liquidity shortfall due to the de-leveraging and risk reduction activities in accordance with the Basel III regulation.
In Europe, the major worry is the amount of debt the banks hold with weak balance sheets, which is far greater than the U.S. counterparts. The regulatory leverage rules would force these banks, most of which are smaller banks within the peripheral countries such as Spain and Italy, to liquidate the unyielding businesses and shrink the balance sheets. These banks will face enormous difficulties to raise capital and will have no choice but to liquidate those activities, to comply with the regulation. Another significant concern being the proposed financial transaction tax (FTT), levying a 0.1% charge on all derivatives, stocks and repo trades; which is getting a lot of criticism. The FTT when implemented could potentially collapse the European repo market and could potentially trigger another financial crisis. According to a research by the Royal Bank of Scotland, the European banks, which have a Basel III leverage requirement of 3%, will need to cut €3.2 trillion assets from the balance sheets by 2018, to comply with the regulatory requirements. This would significantly impact lending to the small and medium-sized businesses. However, Europe's largest banks will also have to shrink their assets by €661bn and raise a further €47bn of capital to meet the regulations. Two ways the banks are trying to meet the extra leverage capital is by reducing the liquid assets or by raising capital. Some of the big banks are already struggling to meet the leverage capital requirements. Barclays, for example, is raising £5.8bn from shareholders through a rights issue and planning to sell up to £2bn of risky bonds that can be converted into equity, and shrinking its balance sheet reducing the leverage by up to £80bn, over the next 12 months. Such a move shocked the investors and has drawn renewed focus upon the health of the major financial institutions and their strategy towards complying with the stricter regulatory demand amidst the banks' struggle to provide shareholders with the target profits. Other major banks such as Credit Agricole, Deutsche bank and Societe Generale, are also planning to reduce liquid assets to shrink their balance sheet assets. Currently, the challenge of regulatory compliance is taking precedence over the market participation, which could severely affect the lending side of the business.
Inconsistent Basel III implementation across regions and difficulty selling Basel III compliant bonds:
Some of the Asian banks are ahead of the U.S. and European counterparts and were the first ones to enforce the Basel III rules, issuing Basel III compliant bonds. However, they are facing enormous challenges selling these bonds to financial institutions, mainly because the risks are not very well understood by the buyers and consequently banks are heavily dependent on the wealthy individual investors. "One Basel III deal sold in late 2011 by ICBC Asia, the Hong Kong arm of the Chinese state-owned lender, was downgraded by Fitch recently because the agency changed its view of how the Hong Kong regulator would treat the new style bonds." And given the Basel Committee has a further consultation period until September, there remains uncertainty as to what qualifies for a Basel III compliant bond and whether the regulators may intervene and amend the rules further going forward. Also under the regulation, these bonds need to be converted into equity and converted into cash easily in times of crisis and consequently carry that extra risk for the investors, which makes it difficult to sell and accompany the extra premium. This is still an unknown territory for the majority of the global banks and the complexity of raising capital will become more evident when the U.S. and European banks start their campaign early 2014.
Although the Basel III regulations intend to make the financial institutions more resilient to the financial crisis, the current global economic conditions demand sustained liquidity. With Foreign investors mainly the BRIC, Japan and Switzerland, who hold 50% or $4 trillion of the U.S. Treasuries are undergoing economic crisis, leading to currency depreciation and sale of reserve dollars, the Fed and the big banks should continue to play a vital role in providing the necessary liquidity required by the market. Any cut-down on the Fed's Treasury purchases of $40 billion a month, would see a total chaos in the bond market and the Treasury prices will come under massive pressure. The path to the regulatory compliance for the banks as well as the regulatory standard convergence across different regions remains long, and the uncertainty over the economy makes matters worse, as the global banks would face enormous challenges once the Basel III phase-in starts during January 2014 and continue until 2019. This calls for continued support of the Fed's monetary policy, until the key indicators show consistent economic recovery.
As for the investors, any delay in tapering could restore confidence in the markets and give the much needed faith that the Fed is fully aware of the wider ramifications of its stimulus cut back and that the Fed would continue its monetary support until conditions improve considerably. However, if the Fed decides to pursue the path towards QE tapering sometime this year, the ill effects of the stricter regulation will be greatly felt and the global banks will come under severe pressure, and this could cause extreme volatility in the market and a massive spike in Treasury bond yields and substantial stock market correction is inevitable.