Basel III Impact on the Financial System, New Capital Requirements, and Banks Lending Activities - Case Study Example

Basel III – Issues and implications Name: Lecturer: Course: Date: Table of Contents Table of Contents 2 Introduction 3 1. Basel III background and impact on banks and the financial systems 3 a) Basel III background 3 b) Implications on individual banks 5 c) Implications on the financial system 6 2. The new capital requirements impacts on banks’ lending activities 7 3. The “countercyclical capital” model and the new “leverage ratio” and their overall effects 9 a) Countercyclical 9 c) Leverage ratio 11 Conclusion 12 References 12 Introduction The XYZ Bank seeks to investigate the implications of the implementation of Basel III. Based on Cosimano and Hakura (2011) paper on bank’s behaviour in reaction the new Capital Accord for banks, this report presents a discussion on the Basel III background and its impact on individual banks and the global financial systems. It further discusses the impacts of new capital requirements relative to the lending activities of banks across the globe. Additional discussions are on the model of “countercyclical capital” and the new “leverage ratio” in addition to their possible effects on banks and the banking system. 1. Basel III background and impact on banks and the financial systems a) Basel III background The 2007/2008 global economic crisis intensified a need for elemental restructuring of the risk management and regulatory mechanism of the financial systems (Cosimano & Hakura 2011). Considerable turmoil surfaced to the global financial system during the global wide crisis as several banks in different states became insolvent. In response, the Basel Committee on Banking Supervision (BCBS) agreed on reforms aimed at “strengthening the regulations for the global capital infrastructure in the hope of securing a financial sector that is more flexible. It was named “Basel III” (KPMG 2011). In 2009, the G20 Summit that was hosted in Seoul approved the implementation of the Basel III agreement. The summit also approved lengthened transitional periods to allow for full execution of the Basel III liquidity and capital rules (Linklaters 2011). Ultimately, the Basel Committee on Banking Supervision made public its report dubbed “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (KPMG 2011). The report was essentially a reaction to the 2007/2008 financial crisis and introduced a set of reforms that strengthened the rules for liquidity and capital (Cosimano & Hakura 2011). It also improved the strength and flexibility of individual banks and the financial system in entirety. Basel III was later phased out in 2013 and is expected to run to 2019. Basel III requires that banks should maintain a minimum ratio of capital. This would also maintain stability as it ensures that banks constantly have sufficient capital that can soak up losses that come about during times of stress. The suggested capital ratio is 8% at all times. Basel III further requires banks to have “capital conservation buffer” that demands an additional 2.5% of the equity to be maintained. Hence, this constrains banks from giving out dividends when the buffer fails to be maintained. This means that no bank can consider it to be discretionary. Overall, Basel III embodies a significant strengthening of the capital requirements compared to its predecessor Basel II (KPMG 2011). b) Implications on individual banks Under Basel III, the banks that are relatively weak would be forced out. In periods of unfavourable economic conditions, since the regulatory mechanism is tougher, the relatively weak banks are likely to find it hard raising the requisite capita. This would lead to a decline in competition (Cosimano & Hakura 2011). Under Basel III, considerable pressure is placed on the bank’s profitability and return on equity. The anticipated increase in capital requirements, cost of funding, as well as the need to restructure and address the regulatory reforms places pressure on the banks’ profit margins as well as their operating capacity. Again, it increases the possibility of the investor returns that tends to decrease during periods when banks have to push for increased investment for rebuilding and restoring buffers (KPMG 2011). Under Basel III, there is shift in demand to long-term from short-term funding. By introducing two liquidity ratios intended to resolve the short-term and long-term character of the funding and liquidity, Basel III encourages banks to source for long-term funding arrangements rather than short-term funding arrangements due to the larger margins anticipated (Linklaters 2011). Basel III has also reorganised legal entity. It has raised the need to supervise proprietary trading of the banking institution, in addition to the handling of the minority investment in financial institutions (Linklaters 2011). c) Implications on the financial system Basel III has lessened the risk of a universal banking crisis. This is since the improved liquidity and capital buffers, alongside the centring on improved risk management standards and capacity have led to lessened risks of bank failures as well as minimised interconnectivity between financial institutions globally. Basel III has also lessened the lending capacity. While the objective of the lengthened implementation time-line is mainly to alleviate the implication, considerable increases in the requirements for liquidity and capital are likely to result to the declined banking activity capacity. Alternatively, it can lead to considerable rise in the cost of providing such lending. The Basel III has also led to lessened investor enthusiasm towards seeking bank equity and debt. Consequently, the investors have become less attracted to the bank debts and equities as the dividends may be lessened to enable the banks to restructure capital bases, return on equity as well as profitability, which may diminish drastically. Additionally, once certain Basel III proposals are implemented, such as the proposals for non-equity instruments, the debt instruments are likely to absorb losses before a possibility of liquidation. Lastly, erratic implementing of the Basel III suggestions may complicate international arbitrage. This is particularly so when various jurisdictions get to apply Basel III in divergent ways. For instance, because of the different regulatory requirements, Basel III is implemented differently by different states. This implies that international regulatory arbitrage may upset the stability of a country’s financial system (Cosimano & Hakura 2011). 2. The new capital requirements impacts on banks’ lending activities The Basel III embodies substantial strengthening of the capital requirements in comparison to the Basel II. Although the minimum capital ratio for Basel II was also 8 percent, it required 2 percent as a common equity. In addition, Basel II allowed many complicated hybrid instruments to add up as Tier 1 capital, which have however been phased out under Basel III. These have significant implications on people or businesses that have to borrow from banks (Noss, J & Toffano, P 2014). The Basel III recommends more stringent capital requirements that intensify cost pressures for those lending from banks. Additionally, there is a change in the banking scene, as key players have scaled back in several areas and in turn invested in others, while responding to the shifting liquidity and capital requirements (De Nicolò 2015). The Basel III has significantly impacted the costs of lending. A mix of increased minimum liquidity requirements, and augmented capital requirements, specifically within the equity element of Tier 1 capital has served to reduce bank’s return on equity for banks. In response, banks have to reduce the rates on retail deposits (Noss, J & Toffano, P 2014). Traditionally, as the case for Basel II, negotiating loan agreements depended on the principle that those lending from the banks need to indemnify lenders for any resultant increased regulatory costs they incur, such as when they introduce a change in regulation or law. However, Basel III has made it possible for banks to plan in view of that leading to reduced n returns or even the associated regulatory costs (De Nicolò 2015). Under Basel II, the capital charges vary across its lifetime, when the RWAs are calculated by basing on the credit ratings that shift through time. However, this has changed under Basel III as it introduces liquidity requirements and countercyclical buffers that become re-set during the lifetime of a loan (Noss, J & Toffano, P 2014). The Basel III has also reduced total lending by due to its capital requirements. The banks are at liberty to reduce their total lending. The banks attempt to fulfil stricter capital requirements lessen their credit supply and lending activities. Indeed, evidence provided by Aiyar et al. (2014) in a study that they used a Bayesian hierarchical model to approximate panel VAR models established that the increased capital requirements by Basel III to reduced the growth rate in lending by 4.6% -- in response to 1% point increase in capital requirements. A related study by Bridges et al. (2014), which had focused on the impacts of capital requirement on lending, estimated a reduced total lending of about 3.5 percent in reaction to a 1% point increased capital requirements. A related study by Noss and Toffano (2014) that was conducted in the UK also estimated that an increase in the capital requirements affected banks’ lending activity despite a credit boom by some 4.5% in response to 1% point increase in capital requirements. Basel III has also reduced lending to the risky borrowers by leading to ‘flight to quality.’ The banks may, as an alternative, reduce credit supply the most bank-dependent borrowers and the riskiest borrowers, a practice known as flight to quality. Martynova (2015) argues that when the capital requirements are high, as encouraged by Basel III, the banks are stimulated to minimise their lending, particularly to the risky borrowers. Additionally, small to medium-sized businesses that depend significantly on banks for credit are denied loans, as they find it harder finding alternative funding sources. A similar argument is shared by Popov and Udell (2012) in their analysis of the sensitive economic conditions and credit supply to in 16 European countries after the 2007/2008 global financial crisis. They established that the stricter capital requirement had restricted lending to riskier business that had fewer tangible assets. This graph below presents a summary of the direct impacts of capital requirements, as entailing risky lending substitution, cost of equity, risk of bank assets and buffer against losses (Figure 1). Figure 1: Direct impacts of capital requirements 3. The “countercyclical capital” model and the new “leverage ratio” and their overall effects a) Countercyclical The Basel III proposed reforms that ensured the capital requirements are countercyclical. These would counteract the procyclical effects of capital regulation as they required the banks to maintain higher capital ratios during financial booms. As a result, during financial downturns, the banks would still maintain a vantage position that could absorb the increased losses while still sustaining lending to the borrowers (Kowalik 2014). Hence, the countercyclical capital regulation is aimed at addressing the complications arising from the “procyclical capital regulation.” They augment capital ratios during the normally favourable economic times while preparing the banks to absorb losses in times of economic recessions. Consequently, it has a potential to reduce capital ratios during recessions, enhancing the capacity of banks issue loans. Essentially, the countercyclical capital requirements are rooted in the idea that bank equity capital can easily be raised during economic booms compared to in times recessions. The countercyclical capital requirements have a potential to increase the banks’ capacity to lend during economic recession. Still, their impacts are dependent on the scale and timing and of their implementation. Timing consists of durations for imposing and relaxing regulations, in addition to how fast new minimum requirements have to be met. On the other hand, magnitude describes the extent to which requirements become changed (Kowalik 2014). The countercyclical requirements assist banks in avoidance of a credit crunch during the times of recession, although implementing them may be costly. When the economy grows considerably, the countercyclical capital requirements raise the necessary capital ratios. During this time, magnitude and timing are important. Banks will, therefore, consider adjustment to the higher capital ratios costly for banks. At this rate, the banks would favour increasing their capital ratios by reducing their lending. In turn, this would lead to a credit crunch and decrease economic growth (Kowalik 2014). c) Leverage ratio The Basel III introduced a non-risk-based leverage ratio (LR) requirement aimed at restricting the increase in excessive leverage within the banking sector. In turn, this would prevent destabilisation of the deleveraging processes likely to bring harm to the broad financial system. Essentially, it is a non-risk-based capital measure consisting of the items on- and off-balance-sheet (Europa 2015). Given that the leverage ratio is by nature non-risk-based, it can motivate banks to increase their risk-taking. As a consequence, the special feature brings about theoretical concerns and empirical evidence of the European Union banks that an LR requirement needs to strictly bring about restricted further risk-taking proportionate to cause the advantaged associated with increased ability to absorb losses, hence stabilising the banks (Bank for International Settlements 2014). On the other hand, the banks that are highly leveraged tend to possess lower rates of a capacity to absorb losses. Ultimately, they tend to be less pliant to shocks (Europa 2015). The LR requirement also caps sum amount of leverage that can be attained by banks. The LR requirement makes sure that banks possessing huge share of low risk-weighted assets have an extra capacity to absorb losses (Bank for International Settlements 2014). Hence, LR presents an advanced measure that can contain the aggregate risk as well as offer protection against losses within the financial system that is partially covered under a risk-based capital framework (Europa 2015). Conclusion Basel III requires that banks should maintain a minimum ratio of capital. This would also maintain stability of banks and the banking systems as it ensures that they constantly have sufficient capital that can soak up losses that come about during times of stress. The anticipated increase in capital requirements, cost of funding, as well as the need to restructure and address the regulatory reforms places pressure on the banks’ profit margins as well as their operating capacity. Basel III has therefore lessened the risk of a universal banking crisis. References Aiyar, Shekhar, Charles Calomiris and Tomasz Wiedalek (2014c), “How does credit supply respond to monetary policy and bank minimum capital requirements?”, Bank of England Working Paper No.508 Bank for International Settlements 2014, Basel Committee on Banking Supervision, viewed 5 Jan 2015, Bridges, Jonathan, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia and Marco Spaltro (2013), “The impact of capital requirements on bank lending”, Bank of England Working Paper No. 486 Cosimano, T & Hakura, D 2011, "Bank Behavior in Response to Basel III: A Cross-Country Analysis," IMF Working Paper May 2011 De Nicolò, G 2015, "Revisiting the impact of bank capital requirements on lending and real activity," International Monetary Fund and CESifo, viewed 5 Jan 2015, Europa 2015, Special Features: The impact of the Basel III leverage ratio on risk-taking and bank stability, viewed 5 Jan 2016, Kowalik, M 2014, Countercyclical Capital Regulation: Should Bank Regulators Use Rules or Discretion? viewed 5 Jan 2016, KPMG 2011, Basel III: Issues and implications, viewed 5 Jan 2015, Linklaters 2011, Basel III and project finance, viewed 5 Jan 2016, Martynova, N 2015, "Effect of bank capital requirements on economic growth: a survey," De Nederlandsche Bank NV, Working Paper No. 467 March 2015 Noss, J & Toffano, P 2014, “Estimating the impact of changes in bank capital requirements during a credit boom,” Bank of England Working Paper No. 494 Popov, A. and G.F. Udell (2012), “”Cross-border banking, credit access, and the financial crisis”, Journal of International Economics 87, 147-161 Read More