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Michael Bodman
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I am the principal of Portfolio Muse blog and its independent publisher: Portfolio Economics LLC. My research starts with macroeconomics before proceeding to specific investment ideas. While I focus on portfolio strategy, asset allocation, and ETFs, I also analyze individual stocks. Before... More
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  • Basel III: Playing Cat And Mouse With Big Banks  0 comments
    Apr 9, 2014 1:29 PM | about stocks: AIG, JPM, GS, SPY, BRK.B, WFC

    The Basel Accords are international policy recommendations. Basel III is the most recent update. The Basel Accords aim to ensure that banks have sufficient capital to meet monetary obligations and absorb financial losses.

    The Basel Accords are named after Basel, Switzerland, where the Bank for International Settlements is located and the accords are developed by participating nations. In the United States, the Federal Reserve recently developed final rules implementing Basel III for U.S. banks.

    Basel III has five main components:

    • New definitions of bank capital;
    • Improved measures to cover counterparty credit risk;
    • Appropriate levels for the leverage ratio;
    • A framework that is more countercyclical to the credit cycle; and
    • A new liquidity standard.

    This article summarizes these five components and discusses the implications of Basel III for bank stocks and the economy.

    New requirements for the capital base at financial institutions

    One of the lessons learned from the 2008 financial crisis was that banks did not have sufficient capital reserves to meet financial obligations and absorb losses. Moreover, banks' capital reserves often consisted of low quality assets. Basel III establishes a new, stricter definition of bank capital.

    Since credit writedowns and losses are absorbed by a bank's retained earnings, which is part of a bank's tangible common equity base, Basel III requires that common stock and retained earnings constitute the main ingredients of core reserves.

    This new requirement is designed to improve the quality, consistency, and transparency of capital reserves. Basel III also requires a capital conservation buffer on top of core capital reserves.

    Counterparty credit risk

    The crisis also showed the extent to which banks were exposed to counterparty credit risk. Credit Default Swaps (CDS) had sweeping effects throughout the financial system during the crisis. CDS are credit derivative contracts.

    A CDS buyer receives credit protection on a reference asset, while the seller guarantees the creditworthiness of the reference asset. In this way, default risk is transferred from the holder of the reference asset to the seller of the swap.

    However, the financial crisis demonstrated that CDS protection buyers had a false sense of security. Buyers of protection were exposed not only to underlying reference assets but also to the counterparty risk of credit protection sellers, such as American International Group (NYSE:AIG).

    In response to rising concerns in this area, Basel III strengthens requirements concerning management of counterparty credit risk. To promote sound credit valuations, Basel III recommends an additional capital charge for potential mark-to-market losses.

    Leverage ratio

    Years before the financial crisis, Warren Buffett warned: "financial derivatives are weapons of mass destruction." The market for derivatives continues to grow.

    The derivatives market is so big that it is hard to fathom. According to a recent article in the Atlantic, in 2012, the notional amount of derivatives for J.P. Morgan alone was about five times greater than the size of the entire U.S. economy.

    Excessive leverage (i.e., borrowed money) was widely considered to be a contributing factor in the financial crisis. Basel III introduces standards for appropriate levels of the leverage ratio and changes the components of the ratio to include derivatives.

    Previously, only on-balance sheet items were included in the denominator of the leverage ratio. Under Basel III, the denominator now includes all assets, including derivatives and off-balance sheet items.

    Countercyclical requirements

    Basel III introduces measures to enhance the ability of banks to weather the business cycle. Banks will need to maintain a buffer to conserve capital during the ups and downs of the economy. The basic idea is to protect against excess credit expansion in good times -- a factor contributing to systemic risk.

    New liquidity standard

    Basel III introduces a new liquidity standard designed to promote greater resiliency in the financial sector. The liquidity measure ensures that financial institutions have sufficient liquid assets to survive a stressful, short-term crisis lasting one month. To support longer-term resiliency, the liquidity standard offers incentives for banks to use more stable sources of capital to fund business undertakings.

    Bank stocks

    Banks have resisted increased regulation on the grounds that it stifles innovation and harms profitability. Proponents of Basel III maintain that increased regulation is necessary to protect against potential problems in the banking industry and the economy.

    Over the past eight years, neither J.P. Morgan Chase (NYSE:JPM) nor Goldman Sachs Group (NYSE:GS) has outperformed the market, as measured by the SPDR S&P 500 ETF (NYSEARCA:SPY). The following graph shows the results:

    The outlook for bank stocks is uncertain. But the banks are gaining admirers. As reported in a recent article by MSN Money, Warren Buffett of Berkshire Hathaway (NYSE:BRK.B) is bullish on big bank stocks. Wells Fargo (NYSE:WFC) is one of Berkshire Hathaway's largest holdings. Buffett's bullishness comes despite the new regulations under Basel III.

    Discussion

    While it would be good if Basel III could prevent another financial crisis, economic history shows the following pattern:

    • Crisis;
    • Regulation;
    • Innovation;
    • Deregulation;
    • Asset-price bubble;
    • New crisis; and
    • Reregulation.

    The cat-and-mouse game played out between big banks and their regulators runs in cycles. It is not likely that this time, it's different. Rules can accomplish only so much, especially when considering the size and complexity of the global banking system.

    This post was originally published by Portfolio Muse blog at www.portfoliomuse.com

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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