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The side effects of Basel III on banks

By Dagmar Recklies

Much has been written about the effects of the new Basel III / CRD IV regulation on Banks. I don't want to elaborate on that in much detail, since there are excellent summaries available elsewhere, e.g. Basel 3 in 5 questions: Keys to understanding Basel 3 from Finance Watch. My focus in this article will be a slightly different one: Besides the primary effects of Basel III like tighter equity requirements and implicit restrictions for business models, there will be some side effects on banks. As I see it, these secondary effects of the new regulatory requirements too may have a significant impact on banks' profitability and agility – at least for the implementation period.

To make one thing clear in the beginning: You may certainly debate the suitability and appropriateness of any particular aspect of Basel III in terms of its objectives. Nevertheless, I do not oppose the whole framework. Neither do I feel much sympathy for the banks or want to defend them. I just intend to show some side effects of the new regulation that are not so much in the center of the public debate.

In order to make my point, I have to start with a very brief summary of the new regulation under Basel III /CRD IV:

• The objective of this new regulation is to reduce the incentives for banks to take on risks excessively and thus to create a more resilient financial system.

• Tighter requirements for equity do not only force banks to attribute a higher amount of equity to a given volume of risk weighted assets, they also require a higher quality of equity, i.e. a higher proportion of Tier 1 capital. In the result, equity will become a scarce resource for many banks. If equity becomes their limiting factor, they can either try to raise new equity – which is expensive – or reduce their assets. Both strategies will reduce the earnings potential and the relation between earnings and equity – the RoE.

• The leverage ratio limits the extent to which banks can grow their business on the basis of external debt. It states that the total exposure of a bank (i.e. all assets and off-balance assets) should not be more than 33 times the Tier 1 capital.

• There are new liquidity requirements, covering short term liquidity (Liquidity Cover Ratio, 30-day-period) and long-term liquidity (Net Stable Funding Ratio, 1-year period).That means that banks have to hold a certain amount of liquid assets and thus limits banks' options to manage their assets for maximum profit, since liquid assets normally do not yield much profit.

• The Single Rule Book will mostly eliminate existing differences in regulation that come from national discretions in Europe.

In addition to that, Basel III will bring a variety of problems for banks. For the time being, two of them are uncertainty and complexity. I completely agree with different commentaries that write  that the lack of clarity in regulation has never been worse¹ and that the new regulations shows unprecedented complexity and interdependence². Some of the new requirements are still under debate. Banks do not know when they will become effective and what exactly they will require. Many of the new measures are interdependent directly or indirectly (at least since they all influence the structure of the balance sheet and bank's investment and funding decisions). Hence, it is fairly difficult to prepare for the Basel III regulation in time and in an integrated manner.

So it is time to come to the point – What are these side effects?

The main issue is that Basel III will keep banks fairly busy in a variety of ways. It will absorb huge amounts of resources – not only financial ones but also in terms of manpower, management attention, IT-capacity and last but not least budgets for external consulting services. Thus it will incur additional indirect costs besides the direct costs of higher equity etc.

Many banks will have to raise new equity. This is not done quickly. The management board has to decide which for of equity to acquire. After that it needs preparation, marketing and execution. Such an issue of shares or similar papers incurs significant one-off costs, e.g. for lawyers, servicers etc.

All these new regulatory measures require new or adjusted calculations, some of them being very complex. This leads to new requirements on data mining, data analysis, linking of data and quality of data. The complexity of reporting and operations will increase. Depending on the existing IT-systems, these new requirements will probably lead to substantial implementation efforts – first in conception and then in IT-implementation and testing. Banks will have to attribute significant capacities in various departments to this task.

Since Basel III limits banks' options to allocate their equity and funds to particular investments, products or businesses, banks have to rethink their strategies and business models. As McKinsey writes: Implementing the new rules will require three distinct initiatives: strategic planning for the Basel III world, capital and risk strategy, and implementation management. Some of the decisions to be taken are:

• To comply with the new requirements by raising new capital or by reducing business activities – and which

• In which way to restructure the balance sheet, the funding mix and the product mix

• How to improve profitability in order to maintain RoE – options for business growth are limited; cost reductions and price adjustments might be an answer.

This will again absorb resources and personnel capacities. Larger banks probably have some sort of strategic planning unit, which can take on large parts of this burden. In smaller banks, however, top management team has to focus their attention on these issues in addition to all their other duties. Alternatively, they could assign at least part of this job to a small team of specialists, who would not do much else for some time.

The high workload caused by the Basel III implementation will also limit banks' ability to reduce costs by reducing their staff. During the implementation period, this option will be limited to some those business units that are planned to be downsized under the new strategy anyway. Departments like finance, IT, or legal will more probably feel the need to hire some additional specialists, who might be fairly expensive and hard to find during the next couple of years.

When we think about implementation costs, we also have to think about opportunity costs. This applies for both, direct costs in terms of money and the consumption of internal human resource / management capacities. The money and time banks spend in order to comply with the new regulation cannot be spent for other initiatives. Regardless of the question if a particular growth strategy or innovation project would still be feasible under Basel III, a bank simply might not have the resources to go for it. Hence, Basel III limits banks' business opportunities not only directly but also indirectly.

As already mentioned, new capital requirement will potentially compress banks' RoEs. Some banks will be more affected than others. The RoE is an important measure of profitability. It is used by external investors as well as for internal reasons, such as goal-setting and calculation of bonuses. Due to the aforementioned changes, RoE will temporarily loose its validity for those purposes, at least to a certain degree. Investors, analysts, and all others have to recalibrate their understanding of the measure RoE; e.g. what level of RoE is desirable / necessary for which type of bank. It will take some time until banks RoEs will level off at a new normal level. Until than banks will face higher needs for explanation regarding their financial results and the factors that are influencing their RoE.

In summary, banks will face significant implications from the new Basel III requirements besides the well-known effects on equity and profitability. These result from the complex implementation process, which will consume substantial time and resources. Thus, the implementation will have secondary effects on profitability and will further limit banks' strategic options.

Since most banks have made their experience with the Basel II implementation, they should now be able thoroughly plan this process and assess the associated costs.

Besides my own experience and observance, some of these ideas were taken from a McKinsey Paper Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation. Although this paper is from 2010 and regulation has developed on since then, most of its content and conclusions are still relevant. So it makes an excellent further reading.

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Literature on Basel III

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¹ Basel III, Resolution, Bail-in, Bailout, Ring-fencing, and Banking Union: What Does the Future Hold for Banks and Their Investors? by Graziella Marras
http://blogs.cfainstitute.org/marketintegrity/2013/02/25/basel-iii-resolution-bail-in-bailout-ring-fencing-and-banking-union-what-does-the-future-hold-for-banks-and-their-investors/

² Basel III and European banking: Its impact, how banks might respond, and the challenges of implementation, McKinsey&Company,
http://www.mckinsey.com/clientservice/Financial_Services/
Knowledge_Highlights/~/media/Reports/Financial_Services/Basel%20III%20and%20European%20banking%20FINAL.ashx

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