Last year, we raised concern about a new round of banking regulations, known as Basel III, that was put in place for banks at the start of this year. The overall affect on banks is to require more capital and harsher terms for real estate loans. The new regulations began to be implemented January 1st of 2013, so we thought now would be a good time to touch on this subject again.
For those unconcerned and uninitiated about Basel III, from my eyes it has the potential to slow real estate and small business lending from banks, local and national. Basel III’s purpose was to set precautionary measures on banks and were made to protect the economy from financial crises similar to that of our last recession. There was a real danger of the international banking system collapsing in 2008. The Federal Reserve and other countries’ central banks stepped in to bail out the affected institutions, in some cases even taking over investment banks to ensure their continued operation. The prevailing thought was to keep the banks and those industries open to prevent a total international financial meltdown. Basel III was intended to ensure banks accept a level of responsibility for the financial economy they operate within and to act as a safeguard against further collapse.
The Basel III reforms arose from the concern of the world’s leading countries, politicians, central bankers, business leaders, and economists that entire national economies and to a great extent the material well-being of all their citizens had been put at risk by the high-risk behavior of a handful of major banking institutions mainly located in USA, Switzerland, England, and other industrial powers. They had grown so big, particularly when you looked at the size of their assets and risks compared to their national economies, that they had become “too big to fail”. If they were not rescued, their collapse would cause even more severe national and international economic damage through job losses, housing repossessions, reduced GDP and lending of credit. In addition, the burden and need of saving these giant institutions would and will continue to cost ordinary taxpayers heavily.
Although Basel III was initiated and championed by the finance industry, the industry has lobbied since aggressively against certain aspects of the Basel III reforms. Lately though there seems to be mounting evidence that the industry sees and agrees with the requirements as beneficial in the long term. That’s good, since the industry needs help in improving and rehabilitating the industry’s reputation among the investment community, depositors, law-makers, and consumers.
Basel III put in higher capital and liquidity requirements that require three times the equity buffers previously required under the old Basel II accords. In addition, Basel III puts harsher requirements and restrictions on banking activities such as trading for their own profit and forced structural changes for most international and large banks. The whole purpose was to force the financial industry to have a much stronger foundation of solid assets that are designed to withstand sudden market disruption as experienced in late 2008. And to do this, they must have greater stores of spare capital on hand to tide them over temporary difficulties.
Basel III was designed to eliminate – or at least greatly reduce – the danger of another financial crisis. These guidelines were produced by the Bank for International Settlements that is referred to as the “central bankers’ bank” – based in Basel, Switzerland (from where the Basel Accords draw their name). These financial and accounting guidelines are intended to make the world’s banks – and especially the systemically important international institutions stronger and safer. These global standards were initiated January 1st of 2013 and must be fully implemented by 2019.
It was the financial industries interconnectedness, massive trading, and lack of oversight and vulnerability of the financial sector that caused the crisis. For those outside the financial industry, what does this mean? Many banks, investment banks and hedge funds of many countries had built up excessive on and off-balance sheet leverage. In the eagerness to achieve profits there was an aggressive erosion of the level and quality of the capital base being held to protect and potentially prevent risk (derivatives come to mind). During this time, regional and international banks were holding insufficient capital liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses, which in turn resulted in the financial meltdown of 2009. All this was created by aggressive liberal lending standards that many financial institutions were using. Politicians were calling for more aggressive liberal standards for lending to increase home ownership rates for decades. Home ownership shot up to 69% nationally from its previous average of 65%. It doesn’t sound like a lot, but a devastating effect on the financial world.
The overall purpose of the Basel III regulation package as well as the previous two agreements was to ensure that the financial sector remains in a position to fulfill their primary function of providing credit to individuals and businesses and maintaining their liquidity by maintaining a safety net of capital. The hope of the reforms is to improve the banking sector’s ability to absorb shocks arising from future financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
The underlying principle or purpose of Basel III is clear and simple. First and foremost the financial community is there to serve the broader economy. The self serving attitude of bankers engaging in high risk, high profit investment strategies, secure in the knowledge of a government bailout, has to stop. The federal government established the Federal Reserve to have “A strong and resilient banking system to be the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors.” The banks are to provide and offer critical services to consumers, small and medium-sized enterprises, large corporate firms and governments who rely on them to conduct their daily business, both at a domestic and international level.
Some of the unintended favorable consequences of the new rules are already emerging. Banks are seeing their capital boosted much more quickly than either they or the regulators expected. That’s good news, correct? Yes and no – many banks have been forced to shed assets and cut back on lending rather than go to their shareholders to ask for more capital to help boost ratios the regulators require. It may be making the banking system more sound, but have these capital requirements had the necessary effect on lending? Locally and regionally in Texas the answer is yes, however on a national basis the capital requirements have slowed the lending process. As well as Texas is doing, we are dependent on the rest of the nation. Small business loans as well as more aggressive real estate lending are part of the rebuilding process.
So yes, Basel III and other financial regulatory related measures (Dodd-Frank, etc.) adopted by the national and international regulators have forced the banks to maintain a much bigger capital base. The long term result is that the banks will be forced to adopt a more responsible outlook that reflects on their contribution to society at large in their actions as well as to their own internal goals. A great example is that bonuses will only be paid out for longer-term, sustainable performance rather than for short-lived profits. Most importantly, Basel III outlines that banks small and large have been warned to devise a system for closing their doors without help from taxpayers if they get themselves into trouble.
How does it work?
This is probably more than most want to know; as stated previously, the main elements of Basel III are designed to render the financial sector as immune and protected as possible from future upheavals both from within and outside national borders, as well as protect the banks from themselves and aggressive practices. They start with the integrity of their capital base. Individual banks must in future hold more, high-quality capital to protect them against unexpected losses to help them ride through any traumas in the financial markets. There are four main elements in the package.
First, more capital is required. Banks and financial institutions must hold core tier one capital – the highest-quality assets – equal to seven percent of their assets after they’ve been adjusted for risk. The biggest institutions – the so-called systemically important financial banks (a bank, insurance company, or other financial institution whose failure might trigger a financial crisis) must carry an extra 1-2.5+% in capital, giving them a total of up to 9.5% of risk-weighted assets. If they don’t, they face restrictions on the payment of bonuses and dividends that might otherwise affect the firm’s overall integrity. If the bank is thought to be failing or “non-viable”, the capital can be written off or converted to common shares at the discretion of the local regulator. The purpose of this is to force losses on the risk takers and shareholders rather than on taxpayers or the central banks. Other regulatory guidelines are put in place to further shock-proof a firm if needed. If authorities judge that a bank has put itself in danger by lending too much, they can order it to boost common equity by up to 2.5%. Again, this is a large amount of capital when you begin to look at the weighted risk of certain loans such as real estate, which went from a 100% risk to 150% risk.
Second, management of risk. Among other measures all banks must conduct much more rigorous analysis of the risk inherent in certain securities such as complex debt packages and the capital needed. Derivatives and their capital requirements should garner much more analysis and capital potentially.
Third, leverage. Leverage of capital at banks has always been regulated. However Basel III focuses on reducing the ratio of assets that banks, especially the biggest national and international institutions, have built up in relation to deposits. Basel III raises much tougher standards than before. In the future banks must include off-balance sheet exposures when they measure leverage.
Fourth, market discipline and disclosure. To improve the understanding of the risks banks may be running, they must make far more complete disclosures than before the crisis. This particularly applies to their exposure to off-balance sheet vehicles and corporations, how they are reported in the accounts, and how banks calculate their capital ratios and include those risks under the new guidelines.
What does this mean for the banks in layman’s terms?
As stated above, all banks and financial institutions must have enough cash and easy-to-sell assets on hand to survive a 30-day crisis in the financial markets, even though the turmoil was caused by outside forces.
You have read about the bank stress tests. Basel III demands stronger stress tests. Under new standards, banks and financial institutions must retain sufficient high-quality liquid assets to survive a 30-day scenario when its funding comes under pressure whether through its own or another’s actions. For you and me, it means that small business and real estate loans will require stronger capital or equity in loan to value needs. No more interest only or less than 20% equity on loans.
To avoid an excessive reliance on short-term financing that is vulnerable to abrupt changes in the markets; Basel III established a new net stable funding ratio designed to meet any mismatches in a firm’s liquidity profile. Thus, a bank’s obligations are carefully compared with its sources of financing.
To help bank supervisors analyze the status of a bank’s liquidity, Basel III has drawn up what most consider harsher and stronger industry-wide measurements known as “monitoring metrics”. Once again, the systemically significant banks whose failure is deemed to be particularly dangerous will be required to “gold-plate” their liquidity ratios. Again, the idea is that banks manage their leverage and risk appropriately and have capital to serve as a buffer. Overall, purpose of the metrics is to increase their capacity to absorb losses without endangering the rest of the banking community.
So, what does this mean for you and me? First realize that banks in the US have more capital today than ever before in banking history. That foundation of capital strength is needed as the economy continues to struggle towards growth.
We are blessed in Texas with quality job creation and a strong economy, which in turn has helped the large and regional banks to be able to maintain and raise their capital standards, which in turn allows them to have more aggressive lending practices.
The ability to fund new businesses without a track record will be challenged. Banks and regulators want to see a strong track record and capital to sustain any hiccups along the way in a business’s growth. Again in Texas, because of the strength of the markets, it should allow lending that other regions of the nation are not seeing presently.
Nationally the banking and ‘shadow banking’ industry are recovering. But lending in Florida, Nevada and other states that were hit so hard by the financial bust will continue to be challenged. This challenge opens up the opportunity for businesses to look to Texas and its growing economy.
So, Basel III seems to have stabilized the market both regionally and nationally. But we are only a few months into the new guidelines. Time will tell.