Financial
regulation, Dodd-Frank and Basel III are hot summer topics this year,
because it's time for the deliberation to stop and for the rules to
become real. Large banks, such as Bank of America, Goldman Sachs, and
Citigroup, have sprinted tirelessly to get ahead of the 900-plus
pages of Basel III regulation-- rules drafted by the Basel Committee on
Bank Supervision, which includes 27 nations, and intended to have more
meat than the rather languid rules of Basel II and Basel 2.5.
Basel
III regulation consumes the minds of CEOs and global heads of legal,
risk, and compliance. Trying to gain a fierce grip around the Basel III
monster requires resolve, patience, an obsession to detail and
resources to hire people and invest in infrastructure to keep up with everything.
The
essence of 900 pages of guidelines and rules is that capital is king,
that enormous of amounts of bank capital act as a safe financial cushion
in times of crisis, whether the crisis is caused by in-house failures
or by system-wide troubles. Basel III details explain the calculations
banks must make to determine the precise amount of capital they must
maintain for the level of business (measured by the level of
assets--assets on and off the balance sheet) they are engaged in.
To
avert confusion of what is an asset and what comprises capital and to
discourage banks from using financial tricks to circumvent the rules,
Basel III painstakingly defines "assets" and "capital." It also permits other regulatory bodies (such as
the Federal Reserve) to define assets and capital
further and add their own pages to the existing rules. In other words, the Federal Reserve can choose to make the requirements tougher, as it did in early July.
Capital
requirements differ for different kinds of banks, for banks of various
sizes, and for large banks (like JPMorgan Chase, Wells Fargo, or Bank of
America) that have what many say is extraordinary impact on the
global financial system.
This month, the Federal Reserve took bold steps in the Basel III
roll-out by tweaking the leverage rules, causing bank CEOs and compliance officers to squirm
even more. The Federal Reserve proposed stricter leverage limits: No
matter how risk-averse a bank's balance sheet can be, the Federal Reserve
proposes that the largest banks (those with assets exceeding $700
billion) must maintain $6 capital for $100 of assets, implying a
maximum leverage (total assets-to-capital ratio) of 16-to-1. (Basel III is
more lenient at $3 capital/$100 assets, permitting leverage to rise about 30-to-1.)
What irks banks most nowadays are (a) the vast amounts of resources, time, and
people they must deploy to comprehend and keep ahead of the rules and
(b) the uncertainty of what's to come from further rules imposed by the
Federal Reserve and other regulators. What has frustrated banks the past few years, until
they begin to accept it as a matter of the way things are in the new
world of banking, was the impact of increased capital requirements and
reduced leverage on banks' returns on equity. More capital and lower
leverage, quite simply, imply lower ROEs.
Outside
the offices of senior bank managers, what does Basel III mean to
everybody else--bank shareholders, finance professionals, bank clients,
and finance students pondering careers in banking?
1.
If there is another tumultuous financial crisis, most banks complying
with Basel III will be better able to endure it. Governments won't
likely need to inject billions in new capital to give the
banking system a spark.
2.
If one large major bank struggles and implodes, its collapse won't
likely cause system-wide turmoil, won't threaten the global financial
system, or won't cause hundreds of its counter-parties and clients to
tumble with it.
3.
Regulators and market-watchers might forecast better which
large banks are vulnerable and could be threats to cause damage to the financial system. They may be able to diagnose a sickness in the
system before it causes a global plague.
4.
Banks, not able to exploit leverage and constrained by rules from taking
exorbitant risks, must settle for returns on capital in the 10-15%
range, if they even manage themselves efficiently and maintain large
market shares. Days of regular 20%-plus returns will be almost
impossible to achieve. With relative higher amounts of capital on the
balance sheet, they won't be able to use debt to get boosts in ROEs.
5.
Economists and business leaders appreciate concerns about risks, weak
balance sheets, and burdensome leverage and debt levels. Some fear,
however, good banks might become too strapped by rules and will become
less willing to take prudent risks--risks that include lending to
corporations, small businesses and start-ups that provide swift thrusts
to a lagging economy.
Others fear an irony. Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.
Others fear an irony. Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.
6. Banks
will hire and might be willing to pay a premium for expertise in
compliance, reporting, risk management, and systems. Complex regulation
will require experts to interpret rules, gather data, calculate
requirements and report to regulators--in real time, all the time, for
the rest of time.
Banks
would have preferred to hire new people for revenue-generating businesses or
deploy capital for new businesses and expansion. But they have accepted
they must build stronger compliance and risk-management structures and show shareholders, regulators and politicians they are
taking new regulation seriously. (In 2012, JPMorgan Chase reported it would take 3,000 employees and nearly $3 billion in costs to comply with new, ongoing regulation--over 14,000 different rules from all forms of regulation, not just Basel III rules.)
6.
Senior bank managers will spend more time acting as
arbiters among business units scrambling for a precious piece of the
bank's balance sheet. There will be more defined rules for capital
allocation: Who will get to use increments of capital for business purposes?
And who will be able to maximize the amounts allocated to them?
7.
Banks will obsess over their capital numbers. They must develop
strategies for how to comply with rules today and in 2018-19, when most rules take effect. Should they issue more equity in large
amounts now to increase capital and proudly show excess amounts before rules are in effect? Should they maintain excess amounts to show
markets, shareholders and regulators they are flush with capital, amply
above requirements? Or should they not raise capital, but choose to scale down
businesses, assets and risks, based on current levels of capital?
8.
Bank boards, sector leaders, subsidiary heads and senior managers will
knock themselves out, figuring out how to squeeze more return from the
balance sheet, how to nudge ROE upward one more percentage point. They
face monstrous challenges to do so without increasing risk levels and
credit exposures, without the privilege of growing assets any way they
could in years gone by. Solutions to this problem won't come easily.
Basel
III has rumbled into town. Many rules go into effect in 2014. It's a reality, no longer an academic
concept or a discussion paper in volumes by professorial types in
Europe. Banks knew these days were coming and have been preparing them,
but they still know it will be a constant, everyday struggle to tame the impact of 900 pages of guidelines.
Tracy Williams
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