Basel III implementation – Is the industry running out of time?

Back in December 2010, the Basel Committee published the Basel III global regulatory framework. In November 2011, the G20 Leaders emphasized the importance of implementing Basel III fully and consistently in order to improve banks’ resilience to financial and economic shocks.

Regulators and banks are now facing a tight timeframe to implement the framework. National regulators have until January 1, 2013 to issue final regulations that will phase-in Basel III in their regulatory and legislative systems, and the actual implementation of the rules is due to start1 in 2013 and complete by January 1, 2019. (See graphic: Basel III Implementation & Timeline).

Can regulators and banks meet this tight timeframe? What will they need to overcome first?

The banks’ challenge

Capital and liquidity shortfalls

Banks have been looking — and are being pushed by regulators — to de-risk and de-leverage their balance sheets to meet Basel III’s capital and leverage ratio requirements. Over the past few months, banks around the world have been in the news due to their capital raising and balance sheet restructuring efforts in preparation for Basel III. However, regulators and other international bodies see the need for more to be done.

According to a report published in September by the Bank for International Settlement (BIS)2, banks will need to raise an additional €396 billion in order to comply with the full capital requirements.

The Banker Top 1,000 20123 study shows that despite efforts made by banks so far, the global capital-to-assets ratio remains stable at 5.36% against 5% last year. Banks in Western Europe have the lowest aggregate capital-to-assets ratio at 4.25%, a small reduction from 4.28% last year. Unsurprisingly the IMF4 expects European banks — many of which are headquartered in Western Europe — to de-leverage their balance sheets by $2.6 trillion by the end of 2013 — almost 7% of total assets.

More recently, liquidity ratios (Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)) are grabbing the spotlight. The increased focus could be attributed to the fact that we are already in the observation period for both the LCR and the NSFR. These ratios aim to strengthen a bank’s ability to withstand shocks in the market and hold sufficient stable funding to match their medium-to-longer-term lending profile. As a result, banks that rely too heavily on short-term wholesale funding will be disadvantaged on both ratios.

According to the BIS study, liquidity shortfall is estimated at €1,800 billion for the LCR, and at €2,500 billion in regards to the NSFR. To breach the gap, banks are expected to take a number of actions including the following:

  • Look to attract — and compete more aggressively – for retail and operational wholesale deposits
  • Change their assets’ liquidity profile to include higher portions of liquid assets such as government bonds
  • Reduce the maturity of some lending so it falls below the one-year cut-off in the NSFR ratio

These adjustments will be expensive, whether through having to pay higher interest to attract the right type of balances or receiving a lower yield on assets.

The availability and eligibility criteria of high quality liquid assets may pose further constraints in some jurisdictions. For example, some markets may not have issued significant quantities of government bonds, due to the fact that they may be running in surplus. At the opposite end of the spectrum, the instability that we see today in the euro zone may actually further reduce the availability of eligible assets.

However, banks are not alone in managing tough challenges in the lead-up to Basel III implementation. Regulators also face substantial hurdles in achieving their targets.

The regulators’ challenge

Will history repeat itself? Basel I, II and II.5

The Basel Committee published the Basel I Capital Accord in 1988 to set minimum capital requirements for banks. The G10 countries were expected to have this implemented in local law and regulations by 1992. Today, more than 100 countries have adopted the standards.

Basel II followed in 2004, setting out more risk-sensitive capital requirements and introducing two new pillars (supervisory review and market discipline). Basel II was due to come into force from the end of 2006. However, as of the end of May 2012, only 21 of the 27 Basel member countries had implemented the rules. The US, China, Argentina and Turkey are currently in the process of implementing the rules.

Basel II.5 was introduced to address the early lessons from the 2007/08 crisis and was due to be implemented at the end of 2011. Currently, only 20 of the 27 member states have final rules that are in force.

We are now approaching Basel III and history appears to be repeating itself. According to a report published in June by the Bank for International Settlement (BIS),5 so far only three countries — Saudi Arabia, India and Japan — have finalized rules that will phase in Basel III. However, the majority of regulators in the remaining jurisdictions believe they can issue final regulations in time to implement by the deadline of January 1, 2013.

A patchwork solution? Global vs. national targets

Implementation is further complicated by potential inconsistencies in the national rules phasing in Basel III.

The Basel Committee has set out a plan to monitor the member’s implementation of Basel III. As part of this, it was agreed that the first &lquo;regulatory consistency&rquo; review – also called level 2 review — is currently under way for the EU, Japan and US. The final report is expected to be submitted to the Basel Committee in September and will be published shortly thereafter.

However, recent news headlines suggest that different jurisdictions may be implementing parts of the rules inconsistently, whether by strengthening or weakening the original requirements. Here are some examples:

  • Europe (Capital Requirements Directive/Regulation IV (CRD/R IV)) — According to the latest proposals and negotiations, EU member states will have autonomy to increase capital requirements by way of tackling any “bubbles.”
  • China — The implementation framework for Basel III is stricter than the international standard, requiring higher core tier-1 capital adequacy ratio (5% vs. 4.5%) and a higher leverage ratio requirement (4% vs. 3%).
  • US — Proposals for Basel III contain a standard and a supplementary leverage ratio. The supplementary leverage ratio adopts the Basel III standard thereby enhancing the existing US leverage ratio to include off-balance sheet exposures.

The liquidity ratios (LCR and NSFR) pose additional challenges. The Basel Committee has acknowledged that the rules relating to the ratios might change subject to the feedback obtained during the observation periods. In response, national regulators are taking different approaches:

  • Europe is expected to introduce requirements for the LCR and NSFR within CRD/R IV, in line with the Basel III timeline of 2015 for LCR and 2018 for NSFR. However, there will be an observation and review period for the LCR. As of 2013, institutions will be required to have appropriate liquidity coverage and will be required to report to national authorities the elements that are needed to verify the adequate coverage. The European Commission will have the power to specify the liquidity coverage requirement based on the outcome of the observation period and international developments.
  • The US regulators have announced their intention for US banks to comply with the ratios but have not yet issued or consulted on the details around the liquidity requirements.
  • In Asia-Pacific, the situation is somewhat similar to the US; some of the regulators have announced their intention for banks to comply with the ratios but have not published any details. An additional complication for the region is that certain markets have a relatively limited supply of high quality liquid assets as defined in Basel III (i.e. government bonds and other eligible capital markets instruments).

Any inconsistencies in applying the Basel III framework could lead to regulatory arbitrage, which means that some institutions (and indirectly their underlying clients) may benefit or be penalized depending on the stance taken by regulators in different jurisdictions.

Conclusions

The Basel Committee believes that the full and timely implementation of Basel III will be crucial for restoring confidence in the banking system, which in turn will have a significant effect on the state of the global economy. For banks and regulators, the next few months will be critical in determining the success of Basel III.

As banks and non-bank financial institutions consider how best to operate under Basel III, J.P. Morgan is ready to support our clients with a range solutions that will help them succeed in an increasingly complex and challenging operating environment. Give your relationship manager a call to discuss how we can help you to achieve your objectives.


1 Respecting observation periods and review clauses

2 Results of the Basel III monitoring exercise as of December 2011, Basel Committee for Banking Supervision, BIS, September 2012

3 Top 1000 World Banks 2012, The Banker

4 IMF Global Financial Stability Report, April 2012

5 Report to the G20 Leaders on Basel III implementation, Basel Committee for Banking Supervision, BIS, June 2012

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