The new BIS III proposal, comprising of minimum capital and liquidity requirements, is the next, and likely last step, in current global financial sector reform. Given recent events, the unsurprising stated objective of this reform program is to “improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy”. The November G-20 meeting is the target date for completion of this process which requires global co-operation and discussion.
These proposals constitute a sharp reversal from the general relaxation of criteria between BIS I and BIS II. In July 2009, the Basel Committee introduced guidelines for increased capital requirements on trading book positions. Key changes proposed here are: tightening of Tier 1 capital eligible instruments towards common shares and retained earnings; constraining the build-up of leverage by introducing a leverage ratio based on gross exposure; the requirement for counter cyclical provisioning; and introducting a 30-day and longer-term structural global minimum liquidity standard. Behavioral changes are also being encouraged, for example, through differentiated capital requirements for OTC vs exchange traded instruments, higher capital requirements for deteriorating counterparty credit exposure and harmonization and rationalization of use of credit ratings.
The newly introduced liquidity requirements (liquidity coverage ratio and net stable funding ratio) are squarely aimed at improving funding quality and stability. Preference is for higher quality (at least AA) and longer duration instruments (>1yr).
The introduction of BIS III is against a backdrop of already higher capital requirements. The proposed changes will further raise the capital to be held. For the larger banks, the (guess-)estimated negative impact on current Tier 1 ratios ranges from 300 – 500 basis points. Details reveal that regulatory guidance goes further to specify reducing discretionary distribution of earnings (as dividends, share buy-backs and staff discretionary payments) when capital buffers have been drawn down. Funding criteria likely means a race for longer-term deposits, contributing to higher cost of funding.
With higher retained earnings capital, sector profitability is under pressure. Rationally, increasing lending margins, identifying new sources of revenue and lowering costs would mitigate the decline in RoE. The first is clearly difficult as de-leveraging continues and loan demand remains weak. Noteworthy though is the recent years trend of margin compression in developed markets as related transaction revenue was booked as fees in the ever extending value chain. The real and full cost of credit risk requires reassessment. New revenue sources are the immediate obvious choice despite government mandated service fee reductions in the US.
Ultimately, whether the increased capital buffer proves sufficient will be determined by the source and severity of the next crisis. Right now, on a weaker economic outlook, the trend shows governments and regulators much more amenable to bank concerns on the negative impact of BIS III proposals on the banks themselves, borrowers and the risk of worsening economic conditions. The importance of global co-operation and co-ordination further complicates the development of required consensus as observed repeatedly in the recent past. Consequently, whether proposed the BIS III contributes to substantial bank sector reform is yet to be seen.