Basel III: a mess of regulatory conflicts?

I chaired a meeting recently between counterparty banks.  The focus of the discussions was Basel III and, specifically, three new regulatory ratios required for banks to manage:

Liquidity Coverage Ratio (LCR): designed to ensure that financial institutions have the necessary assets on hand to ride out short-term liquidity disruptions. Banks are required to hold an amount of highly-liquid assets, such as cash or Treasury bonds, equal to or greater than their net cash over a 30 day period (with the full 100% minimum coverage in force from 2015).

Leverage Ratio (LR): limits a banks method of financing to meet its financial obligations. There are several different ratios, but the main factors look at debt, equity, assets and interest expenses.  Under Basel III, LR will require that banks hold capital equivalent to at least 3 percent of their assets, without any possibility to take into account the riskiness of their investments, with this rule binding from 2018 (a quarter of large global lenders would have failed to meet this had it been in force at the end of 2012, according to data published by the Basel committee in September 2013).

Net Stable Funding Ratio (NSFR): an essential component of the Basel III reforms to promote a more resilient banking sector, NSFR is designed to ensure that banks maintain a stable funding profile in relation to the characteristics of their on- and off-balance sheet activities. In particular, the NSFR it limits a banks reliance on short-term wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet items, and promotes funding stability.

Now this is a little bit technical for my general blogging, but the dialogue was fascinating and builds upon the debates related to the Banking Union and Asset Quality Review (AQR).

For most of the banks, LCR is not a great concern as most banks are complying via Legal Entity Identifiers (LEIs), although there is some concern that this creates buffers on buffers resulting in an over-coverage of liquidity for banks at a group level, which is costly.

LR is of more concern because it is still very uncertain how this will operate in practice.  For example, there may be major flaws in this ratio, as it could create more risk-seeking behaviour due to restrictions on leverage.

The real issue of Liquidity and Leverage restrictions is that it is asking banks build up big buffers on the one hand, which are then penalised under leverage on the other, as cash holdings is currently seen as part of the LR but should not be.

Then, when we come to NSFR, further challenge is thrown into the banks operating model.  For example, it will probably lead to corporates placing money into savings funds instead of depositing money at banks.  Equally, the regulators see no value in counterparty banking, and do not value FI (Financial Institution) current accounts as of value in a bank's ratios, when they clearly do have value.  Inconsistencies in valuation and accounting are going to lead to competitive issues and challenges within this as well.  For example, European banks’ loans and mortgages are calculated as being on balance sheet in EU regulation whereas American banks treat it as off balance sheet as they are part of origination.

There will also be challenges for strong versus weak banks as, if you’re seen as a safe haven, then assets will flow into the bank during a liquidity crisis.  That is good for liquidity but may cause a challenge with leverage or vice versa.

The real challenge is that NSFR is not business as usual for some banks and, combined with LCR, is creating higher capital requirements than even banks with high tier 1 capital reserves had perceived necessary.

Similarly, it is easy to manage these ratios in isolation, but the impact on the balance sheet when you see these all combined is almost impossible to grasp.   You may be able to manage one ratio efficiently but, in doing so, it will impact your ability to manage others which become volatile as a result.

This is causing frustration with many, as there is no operational guidance being given from the regulators about the flexibility and latitude allowed within these ratios and how they will be operated.  Part of this is accused by each regulatory development is being developed in isolation.  This means that regulators have not got the whole picture and it may make sense for each regulatory requirement from each perspective but, as a whole, they do not work.  This is reflected by the fact that there is a great uncertainty amongst the banks about what the regulatory intent is overall and, as a result, many banks are interpreting what they are thinking differently.

Furthermore, a banks’ ability to create a comprehensive management system for these rules and regulations is far-fetched, as it is very difficult to get their own internal business units to unite to adhere to all the rules and to maintain that adherence.  For example, transfer pricing is a big issue, and how to be consistent between higher value and lower value deposits.

This is a core challenge: the silo versus enterprise structure of bank; and bear in mind that it is even harder at a multinational level where you have geographic separation layered on top of business segregation.

This means that banks will need to build a new business model that can monitor the buffers very closely at an enterprise level for, if silo-based, it is a bit like driving a truck on a road with a dirty windscreen versus, if you have the enterprise view, it is more like driving with a map and rally car.  Most banks are in a silo category, and this will make them uncompetitive as they will need to hold larger capital buffers to ensure compliance due to not having the data quality.  This is particularly true as systems were built with no idea of these regulatory requirements, and so the data is not structured for enterprise level reporting of liquidity and leverage.

A final key is that banks will need to move from Return on Equity (ROE) to Return on Assets (ROA), with the focus on ROA as that impacts the balance sheet and how that is utilised.

The bottom-line is that the optimisation of capital and liability structures is critical and having the business model and systems in place to support that is a way off for many banks.