How Basell III is Impacting the Industry
Regulatory control over the financial industry can come in several forms. In some cases, the efforts will be in the form of prudential rules which, more or less, dictate business standards. In other cases, the regulators will impose capital rules which impact behavior through cost. Unlike a number of the various regulatory rules around the world, capital rules have been unified on the Basel Accord.
Beginning in 1988, the Basel Committee set out to establish minimum capital standards which were adopted by the G10. Over the years, the Basel I rules were seen as inadequate and the Committee began drafting and implementing a more sophisticated and comprehensive set of rules known as Basel II. The financial crisis halted the efforts of full global implementation of Basel II and in the aftermath, Basel III was devised to continue the efforts and to address some of the concerns raised by the crisis.
The key area that Basel III seeks to address, in addition to the rules set out in Basel II, is the ability of institutions to withstand financial shocks. This translates into, among other things, higher required levels of capital. These increased requirements will likely impact all aspects of financial services, including Securities Lending
Even though Securities Lending is an offbalance sheet activity, any indemnification provided by Agent Lenders requires that capital be held against lending activity. Capital is calculated by determining the amount of risk weighted assets ("RWA") that a business generates. The RWA takes into account the credit quality of the counterparty as well as an estimate of the net unsecured position on a trade, known as the Exposure at Default ("EAD"). Depending on the size and sophistication of a firm, internal models can be used to determine both the credit assessment and EAD of a trade as long as the models are approved by the regulators. If a firm is not able to provide its own internal assessments, a supervisory haircut is applied to each trade.
As mentioned above, the changes that Basel III made to Basel II mostly involved increasing the amount of capital that a firm needs to hold to support its business. This is achieved by increasing the minimum Tier 1 Capital from 4% under Basel II to 7% and giving regulators the ability to assess an additional 2.5%, bringing the total Tier 1 Capital ratio hurdle for some banks to 9.5%.
These higher hurdles increase the cost of indemnification for Agent Lenders, which, combined with other constricting rules, will require that they rethink pricing strategies for their clients' activities. Agent Lenders will need to calculate whether or not fee splits cover the cost of the capital needed to support the level of indemnification. In some cases, in order to sustain adequate capital ratios, the Agent Lender may have to become selective about to whom and on what types of loans they offer the indemnity. In addition to the pricing aspects of lending programs, Basel III will also impact demand. As all firms would be operating under these higher capital costs, borrowers will become more selective about what trades they can afford to enter into from a return on capital perspective. They will have minimum returns that their trades will need to meet in order to justify the capital usage. Low spread trades, such as General Collateral loans, may not meet these hurdles. In addition to capital constraints, other pending regulations, such as liquidity coverage and leverage ratios and large exposure rules, will change the level and type of demand in the market. Borrowers may become constrained on the overall size of their portfolios and will be more selective about the types of assets they are willing to borrow and the tenor of these loans. While the final capital rules for Basel III and other regulatory initiatives are not yet finalized, the timeline more or less is. Regulatory reporting under Basel III requirements will begin in 2015, with implementation occurring in 2019. Despite these extended dates, most firms are already beginning to adjust their business models to adapt to the new environment. The next several years could herald changes to the Securities Lending market as firms adapt to both capital and prudential regulatory changes.