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Basel III: a burden or an opportunity?

email this aricle - Basel III: a burden or an opportunity? - 19 September 2011 print this article - Basel III: a burden or an opportunity? - 19 September 2011
Bart Vandekerckhove,
business analyst,
Product Strategy,
FinArch

Introduction

Currently, influential leaders of financial institutions, technology vendors, market infrastructures and multinational corporations are meeting at the 25th edition of the Sibos Conference held at Toronto.

Basel III will most likely be the talk of the day. With the rules revised in June 2011 and the issue of the CRD IV in Europe in July 2011 and Dodd-Frank in the US, bank management is getting anxious over implementing the rules.

Since the unfolding of the financial crisis, which took place just before the 2008 edition of Sibos, much has been said on the root causes. In short, excess liquidity led to increased risk taking in the form of higher leverage, lower quality exposures, higher reliance on market funding, low quality capital levels, and less liquid assets. In an attempt to overhaul the short-comings of Basel II regulation, the Basel Committee on Banking Supervision (BCBS) introduced a series of far-reaching new regulations with an emphasis on capital and funding. Some numbers show just how far reaching the new rules are:

• Following, the CRD IV proposals, the European Commission estimates that, to comply with the new regulation, European banks alone will need an extra €460 billion of capital by 2019. This is significantly lower than the € 1.1 trillion of additional Tier 1, estimated by McKinsey in their Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation study, issued in November 2010.

• That same study by McKinsey, estimates that all things remaining equal, Basel III will reduce the Return on Equity (ROE) of European banks by an average of four percentage points and that of US banks by about three percentage points.

In the current prolonged period of depressed returns typically following a financial crisis, such a prospect can be very discomforting for bank management. However, an early and well-thought adoption of Basel III regulation will give competitive advantages, such as lower funding costs and improved risk management. From this perspective, large banks have started raising capital, issuing CoCo’s (Contingent Convertibles), exchanging debt and so forth, in order to increase their capital base and change their funding structure. In Europe, they are further supported by the CRD IV proposals which allow for some countries to implement the capital rules faster than provisioned by the Basel Framework.

Management of banks subject to the new rules will have to make important decisions concerning their business models, balance sheets and IT investments. The decisions they make today will determine whether they will be among the winners in the future.

Leverage your IT-investments

To comply with Basel III, IT investments are likely to be significant. The implementation of the regulations will require intensive investment in data quality, data analysis and data reporting and the increased complexity due to the feedback between the different ratios will necessitate a flexible and robust IT architecture. The aggregate costs of these investments will vary depending on the IT-investments following previous Basel-Framework implementation.

However, where many banks limited their IT investments to mere compliance with Basel II regulation, this time they can leverage their investments in data quality, analysis and reporting to gain competitive advantage via strategic choices and day-to-day risk management. This could considerably reduce the negative impact of Basel III on the loss in ROE.

The new liquidity ratios, the increased Risk Weighted Assets (RWA) and the heightened minimum capital levels will have a profound impact on profitability. As a result, banks will have to rethink their business models and restructure their balance sheets. IT investments that go beyond compliance will support management in their decisions.

The new liquidity rules will significantly affect liquidity and funding management as banks will have to cut back their reliance on the money markets for their funding, increase the share of liquid assets and increase the duration of their liabilities to match it to their asset side. Banks will have to monitor their liquidity positions and future positions on a daily and consolidated basis, and match their funding strategies to the results of these calculations. Stressed simulations should help banks in drafting contingency funding plans and make them more resilient to periods of stressed liquidity. The quantitative impact study of the BCBS demonstrates a shortfall in liquidity assets to meet the Liquidity Coverage Ratio (LCR) of €1.7 trillion and one of €2.9 trillion to meet the Net Stable Funding Ratio (NSFR) for the worldwide banking sector. These shortfalls will increase funding costs and, together with an increased share of liquid assets, this will reduce the banks’ margins. Therefore, a good understanding of the banks liquidity will be crucial and IT will help with that.

Banks will also have to reassess the profitability of their business lines following the increased capital requirements. On the one hand, capital requirements are increased for the trading activities, for counterparty credit risk - including Credit Value Adjustment (CVA) risk, securitisation collateral, lending to highly leveraged counterparties and large financial institutions and speciality lending. On the other hand, Basel III requires more and more qualitative capital, favouring common shares, reducing Tier 2 and removing Tier 3. Add to this that banks have to include off-balance sheet exposures in the leverage ratio for their full value, have to keep “skin in the game” in the securitisation programmes and the new liquidity requirements, and certain business lines can become unprofitable if the bank does not take appropriate actions. Some actions that can be taken are:

• Using Funds Transfer Pricing (FTP) for more accurate price setting
• Improve RWA calculations: o Correct mapping of CVA loss provisions
• Targeting higher quality customers
• Shifting to less risky activities
• Improving loss provisions
• Balance sheet restructuring:
• Selling business lines that are too costly
• Reshaping pension benefit plans
• Selling minority interests in other financial institutions

These actions will only be successful if they are based on qualitative data, sound processes and high quality reporting and their profitability depends on a timely implementation.

Conclusion

The coming years will hold a great challenge for financial institutions to reconcile the new Basel regulation, implement sound risk management and boost profitability. Banks are in for a difficult exercise of strategic decisions and balance sheet optimisation, which requires tools far beyond those provided by Excel. Those banks that decide to go for the extra mile in order to leverage the IT-investments required to comply with Basel III, will find themselves among the market leaders in the future.

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