The Basel III Backlash Begins

By Ted Howard

Banks and corporates enlist every monster under their beds to frighten regulators out of clamping down.

If the global financial crisis was the US’s gift to the world then Basel III is a returned favor. That’s the view of bankers and other experts of the Bank for International Settlement’s Basel III proposals. And US regulators aren’t pushing back.

“You can tell the Fed’s being steamrolled [by the Basel Committee] by looking at the language of the proposals,” said a banker at this month’s NeuGroup Bank Treasurers’ Peer Group meeting. “They are biased toward European preferences. But the US is not in a strong position.”

“If Basel III is adopted as is, banks will have to make fundamental changes to their business model,” according to H. Rodgin Cohen, a partner at Sullivan & Cromwell. “Basel III will place US banks at a significant disadvantage. And if the US legislative proposals don’t drive banks out of the derivatives business, Basel III could.”

BEGGING TO DIFFER

Of course, there’s a strong argument that bank business models should be changed, and radically, and that the Basel III proposals are just the bitter medicine the sector needs to bring it back into line as the handmaiden of industry, rather than its master. Of course, most of the comments on Basel III came from banks, which, as one might expect, disagreed. Fifth Third, for example, writes:

“The capital and liquidity proposals, separately and in conjunction with each other, are likely to lead to a decrease in the availability of credit and an increase in the cost of credit, particularly to the small business sector and consumers in the United States. This outcome is contrary to the public policy objective of increasing lending in order to stimulate economic growth.”

These arguments advanced by many banks, tacitly assume that a return to pre-crisis credit conditions is not only feasible, but desirable. After all, excess credit creation was the distal cause of the meltdown, while liquidity crunches were the proximate knockout punches. And despite still operating under the old regime, net bank credit has not expanded appreciably, although this is in large part due to lack of demand. The Basel Committee, to judge from the stringency of its new proposals is under no such misapprehension. They require higher levels of capital and liquidity (see sidebar below).

But while some banks base their argument on the ripple effect of tighter capital, others are more straightforward, suggesting that the rules, if implemented, would directly affect their ability to make money. “We believe the proposed rules would, in combination with the liquidity proposal, have unintended or unforeseen consequences as financial institutions seek alternative ways to conduct profitable business,” claimed KeyCorp in its letter. Given the disastrous consequences of such forays in the last five years, it’s hard to imagine regulators giving the banks too much leash.

Liquidity impact

The Basel III proposals are the first to articulate specific liquidity requirements for banks, at least at this level of detail. The Basel Committee proposed that a bank “maintains an adequate level of unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30-day time horizon under an acute liquidity stress scenario specified by supervisors.”

For capital requirements, the Basel Committee proposed upping the percent of common equity banks must hold —currently, in Basel II, a bank’s tangible common equity—essentially, common shares—can be as little as 2 percent of its capital. As a consequence, it’s been possible for some banks under the current standard to display strong Tier 1 ratios with limited tangible common equity, the dangers of which the crisis exposed. Therefore the Basel Committee announced (for consultation) “a series of measures to raise the quality, consistency and transparency of the regulatory capital base. In particular, it says it is strengthening that component of the Tier 1 capital base which is fully available to absorb losses on a going-concern basis to reduce systemic risk.

TREASURY IMPACT

The Basel Committee also received several letters from non-financial institutions, each of which raised concerns that the new banking rules would hurt their ability to do their everyday banking business.

“We … are concerned that the capital proposals are in many respects overly conservative and that, especially when considered cumulatively and in conjunction with the liquidity proposals, they are so restrictive that they actually could harm the banking sector—and, by extension, the global economy,” said GE Capital in its letter.

GE went on to explain further how the new bank rules would impact its access to credit among other bank services.

“…we also believe that if the final Capital rules opt for the most limited definitions of capital, the broadest set of deductions from capital and the most pessimistic assumptions about counterparty exposures, the result will be that the rules will drive away the very capital that they seek to require as institutions returns would be dramatically diminished. This in turn could hurt access to additional capital when needed, depress lending and have other unintended and harmful macroeconomic effects.”

And like others with a treasury view, GE is worried about the pace of transitioning to the new rules:

“Market disruption could occur if, for instance, a large number of institutions in the same region find themselves needing to raise capital simultaneously to meet higher capital requirements without an adequate transition period. Institutions also might be forced to reduce or even halt lending and other methods of providing needed credit to the world economy if increased capital requirements are implemented abruptly.”

DERIVATIVES WHAMMY

Representatives of treasury also had a problem with the proposals on derivatives use. Two letters in particular, from the Association of Corporate Treasurers (ACT) and the European Association of Corporate Treasurers (EACT), expressed concern that the Basel Committee’s new proposals on derivatives would be just as much of a roadblock to global business as the lack of access to capital.

Specifically the Basel Committee proposed new rules to beef up the capital requirements “for counterparty credit risk exposures arising from derivatives, repos, and securities financing activities,” which it feels will “strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the next through the derivatives and financing channel.” These requirements, the Basel Committee hopes, will push OTC derivative users to engage central counterparties and
exchanges.

But such derivatives rules applied to non-financial institutions, argues ACT, will introduce cash-flow volatility problems, something that treasuries the world over already struggle with. ACT argues:

“A requirement for margining of all derivatives by [non-financial corporations] would introduce cash-flow volatility which would require companies to hold much more capital or to curtail their business activity in view of the extra risks it would bring. This applies to the companies’ use of derivatives in cash-flow hedging and in their financing.”

For its part, GE Capital felt the Basel Committee was penalizing the use of derivatives rather than trying to fix the system.

First, CCPs may not exist for many types of trades, such as currency forwards, currency swaps, certain interest rate swaps and amortizing trades. If exposures to counterparties for these trades are risk-weighted more heavily than CCPs even though CCPs are not available, it effectively would unfairly discriminate among institutions based on the types of instruments they use for hedging. Moreover, since the use of Credit Support Annexes (CSAs) is widespread today, counterparties already control exposure and mitigate risk based upon the creditworthiness of institutions and collateral posting requirements. Finally, CCPs typically impose margin requirements irrespective of the credit-worthiness of an institution, which can require a significant amount of an institution’s liquidity to be posted to the CCP, which may be a disadvantage compared to directly dealing with other counterparties.”

EACT was likewise unimpressed The effect of the proposals adopted as they are currently “would be to remove the economic benefit of the exemption that we are optimistic will be granted in the regulatory approach on OTC derivatives.” It had outright disdain for central clearing. If adopted, according to the EACT, these include:

LAST CHANCES TO SQUAWK

The Basel Committee is now conducting further study into the impact of the new rules, under a process known as a Quantitative Impact Study (QIS). This is in conjunction with analysis being done by the Financial Stability Board. Banks had until May 1 to submit estimates of the impact of Basel III under the QIS. The rest of the year will be taken up with the study of all the inputs, according to Professor Axel A Weber, president of the Deutsche Bundesbank. “Throughout 2010 the proposed measures will be calibrated on the basis of an extensive quantitative impact study,” he said in a speech to an audience at the International Capital Markets and Emerging Markets Roundtable.

The hope of course is that, with the heat of the crisis over and the recovery “assured” banks will be in a better position to press their cases. But some aren’t that hopeful. Said Sullivan & Cromwell’s Mr. Cohen, the bank regulators “are as accessible as a 15th century monastery pre-Gutenberg bible; no one knows what’s being discussed.”