Despite Talk of Basel III's Demise, It's Not Going Away

Wither Basel III?

To hear some critics of the latest international banking standards tell it, the accord is on life support, felled by delays from the global banking regulators charged with implementing it and resistance from large and small institutions alike.

Basel III, the latest in a series of international accords, was first published in 2009 by the Basel Committee on Banking Supervision to offer new regulatory standards on bank capital adequacy, market liquidity risk, and stress testing for large, global financial services firms. Twenty-seven countries, including the United States and the European Union, have signed on to adopt the standards.

Building upon past multi-national agreements, and in response to the still-lingering global financial crisis, the proposed Basel III approach, in broad terms, would require the world's largest banks to increase their holdings of high-quality Tier 1 capital to 7 percent of their risk-weighted assets by 2019.

Years in the making, these new standards have already met delays. Capital requirements have been pushed back a year, to Jan. 1, 2014. The deadline for a liquidity coverage ratio provision, requiring banks to stock up on the easy-to-sell assets needed to survive a 30-day credit squeeze, was delayed four years, with full compliance, measured by stress testing, now not required until 2019.

Critics are also becoming more vocal in their opposition of the standards as they are currently written. Thomas Hoenig, a director of the Federal Deposit Insurance Corp., has said that if international efforts to craft new capital rules for banks don't go back to the drawing board for a significant overhaul, the United States should abandon the Basel III effort while it still can. “Its complexity reduces rather than enhances capital transparency,” Hoenig said during a speech in September. Nor will it help smaller institutions because “applying an international capital standard to a community bank is illogical.”

Congress may also soon attempt to kill efforts to adopt Basel III in the United States. In an effort to eliminate bailouts and subsidies for “too-big-to-fail” banks, Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) have circulated draft legislation that forces the United States to pull out of Basel III and instead impose a harsher capital standard of 10 percent. Institutions with more than $400 billion in assets would need to add an extra 5 percent.

“There are several paths here, and one could be to just scrap the whole thing,” says Mike Stevens, senior executive vice president for the Conference of State Bank Supervisors.

Back to the Drawing Board

While Stevens doesn't necessarily see that end game as a likely scenario, he does expect there will be “significant changes and accommodations” to address concerns, in particular those of community banks. “The core risk they want to get at is more capital and higher quality capital,” he says of Basel's drafters. “I think there is a path that doesn't completely alter the banking industry and disadvantage community banks.”

According to Stevens, international and domestic regulators should take a fresh look at minimum capital standards and risk-based capital assessments with the needs of community banks in mind. “You could see them make some modifications to the current rule as a Band-Aid or patch as they figure out the rest of it,” he says. “There are a lot of possible paths in terms of what to do with the risk weights and risk-based capital.”

“These international agreements, when you look back at the origination of them, date back to the 1980s. Thirty years later we have the same issues. Maybe we still don't have it right.”

—Mike Stevens,

Senior Executive Vice President,

Conference of State Bank Supervisors

Stevens questions whether Basel III's efforts to raise international capital standards, as proposed, would be successful anyway. “These international agreements, when you look back at the origination of them, date back to the 1980s,” he says. “Thirty years later we have the same issues. Maybe we still don't have it right.”

Still, many say global banking safeguards are needed. Jeremy Estabrooks, an attorney with the Practical Law Company, is confident that Basel III will prevail, although not necessarily in its current incarnation. “It's not just a matter of whether these new rules are too cumbersome or burdensome for banks. Now, it is more that this is a real risk to certain lines of business and the economy.”

Estabrooks adds, however, that the problem with talk about killing Basel III is finding suitable alternatives. One big challenge is ensuring a level playing field for banks both internationally and domestically.

“I don't think Basel III is going to get scrapped in the U.S.,” says Charles Horn a partner with the law firm Morrison & Foerster. “For the U.S. to back out of Basel at this point would send a very troubling message internationally.”

Horn foresees “significant relief” for smaller, community banks, mostly on the risk weightings for the assets on banks' books. “I'm not as sure that there is a great deal regulators can do to redefine the components of capital for community banks in one way, but define them in another way for larger banks,” he says.

BASEL III COMMENTS

Below are comments made by FDIC Vice Chairman Thomas Hoenig to the International Association of Deposit Insurers at a research conference in Basel, Switzerland.

[A well-intended illusion] is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength. For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized. The reality is that each dollar of their total assets is funded with far less equity capital, leaving open the matter of how well capitalized they might be.

Here's how the illusion is created. Basel's Tier 1 capital measure is a bank's ratio of Tier 1 capital to risk-weighted assets. Each category of bank assets is weighed by the supervisory authority on a complicated scale of probabilities and models that assign a relative risk of loss to each group, including off balance sheet items. Assets deemed low risk are reported at lower amounts on the balance sheet. The lower the risk, the lower the amount reported on the balance sheet for capital purposes and the higher the calculated Tier 1 ratio.

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm's return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This "leveraging up" has served world economies poorly.

Source: FDIC.

He expects that Basel III is going to be applied as written to the largest banks with, perhaps, some modifications to reflect specific issues and concerns, such as the Dodd-Frank Act requirement that banks and regulators not rely on credit ratings anymore.

“They may have to shift some of the deadlines around," Horn adds. "What they intended to do was come out with the rules at the end of last year, then give everyone two years to start coming into compliance. Now, they are going to be at least six to eight months beyond that. Realistically, they are going to have to extend the compliance dates to give people more time.”

A study released earlier this month by SNL Financial, which provides business intelligence on financial institutions, found that while implementation of the proposed Basel III rules remains on hold, in the fourth quarter of last year U.S. banks stalled in what had been steady progress toward its capital standards.

SNL measured Basel III's capital impact by examining “conservative” and “moderate” scenarios that took into account provisions outlined in the proposed rules. To conduct the analysis, SNL developed a model that calculates capital ratios under Basel III, treating it as though it were already fully implemented.

It found that while the capital bases of banks—particularly institutions with more than $15 billion in assets—seem fairly well-prepared for the implementation of Basel III, the industry's capital shortfall in relation to the proposed capital rules increased in the fourth quarter.

The nation's largest banks continued to make progress toward the Basel III requirements but, as a whole, banks with less than $250 billion in assets would fall short. SNL's analysis found that smaller banks, those with less than $15 billion in assets, accounted for a significant portion of the shortfall despite their smaller size.

Among the explanations offered: “Most did not believe they would have to comply with the Basel III rules, or at the very least, believed that their trust preferred securities, which would lose their regulatory capital status under the proposed rules on a phased-out basis, would remain grandfathered as regulatory capital under the Dodd-Frank Act.”

While many critics say that the Basel III standards are too onerous, the research suggests these concerns are overstated. Even with the Q4 shortfall, the study found that banks falling short of the minimums can build their capital to required levels in a short time frame. “Even in our conservative estimate of what company's balance sheets look like, it would only take, on average, 2.46 years for these institutions to come into compliance, and Basel III isn't slated to come into full effect until 2019,” says Marshall Schraibman, an SNL Financial analyst.