We wrote yesterday about the impact of Basel III on the government bond market. Our conclusion was the path of least resistance was for banks to buy sovereign debt rather than to lend. The global nature of capital allows rapid cross border capital flows; therefore, in our view, capital will seek the banks and the countries that have the “safest” banks. In order for banks in “other countries” to compete they will need to shore up capital immediately…not in the 10 year time frame Basel III envisions. We wholly disagree with those who are dismissing the impact of Basel III. The popular phrase has been that Basel III “kicks the can down the road,” but because some banks already meet the guidelines, the road is short and we have already arrived at implementation.
Non-compliant banks have two choices when attempting to meet the Basel III guidelines: first, they can raise equity capital like Deutsche Bank (NYSE:DB) is in the process of doing, or second, they can shed risky assets and buy “safe assets” such as government bonds which receive no “haircut” under the risk weighted assets calculations (Bank of America’s (NYSE:BAC) announcement that they will sell risky assets is the first sign of this activity). The shakiest banks will find the path of least resistance to be shedding risky assets, which will likely depress the prices of the riskiest assets, which in turn will lead to more capital needed. We find this analogous to the market to market rules that exacerbated the sub-prime crisis.
To be clear, only a disorderly sale of risky assets will result in a downward spiral like the sub-prime crisis…given the massive amounts of liquidity, we do not envision rapid and forced sales of risky assets.