cpd types

Copenhagen Economics recently issued a paper entitled "EU Implementation of the Final Basel III Framework: Impact on the banking market and the real economy".

This work was sponsored by the European Banking Federation and other banking sector organisations with the aim of lobbying the EU for a softer approach to the finalisation of the implementation of the Basel III capital requirements.

The grounds were that the requirements would necessitate the raising of a large block of new capital because of the tightening of the standards by which banks calculate their need for capital. The contention is that Basel III will cause banks' Internal Ratings-Based models to deliver a much higher Risk-Weighted Asset figure for each piece of lending, guarantee, trade finance and financial instruments business the bank contracts.

This would occur, Copenhagen Economics contend, even where the quality of the counterparty had not deteriorated and even though banks would not need to alter the fraction of Common Equity Tier 1 capital that they must hold as a percentage of their Risk-Weighted Assets.

In a simple example, Basel III would inflate the Risk-Weighted Asset value of a given piece of business from 100 to 125, a 25% increase. The bank must then hold 12.5 of capital and not 10, and earn its Return on Capital target on all 12.5. The interest margin on the loan behind that Risk-Weighted Asset would thus have to increase by 25% as well.

Such a re-pricing would, according to the authors, have a deflationary effect on the economy as a whole, reduce GDP growth, and impose financial burdens on businesses and consumers.

That is potentially worrying for corporate borrowers, as it would increase borrowing costs and possibly reduce supply as well: if banks could not raise new capital, they would have to reduce lending.

Basel III has been promised for some time so it may come as a surprise that it has not been converted into an EU Capital Requirements Directive yet. Arguably some banks have already positioned themselves for Basel III.

But major regulatory initiatives that promise a higher cost of borrowing or a reduction in supply can never be good, and will have to be factored into Key Performance Indicator frameworks.

Another read of the Copenhagen Economics paper is that it distracts attention from why banks currently run a surplus CET1 position, holding 12-14% of CET1 capital against their Risk-Weighted Assets (as calculated by themselves), as opposed to just passing the regulatory bar set at 8-10%. Rather than share investors piling in to buy up the shares of these banks with such successful business models, bank shares are trading at a major discount to their book value. Market capitalisation (price per share x shares in issue) can be 80% lower than the same bank’s stated capital in its accounts.

Why is this? Because share investors do not believe the Internal Ratings-Based models through which banks convert their business into a Risk-Weighted Assets figure. Basel III promises to make these Internal Ratings-Based models more conservative – and believable. If they were believable, banks would be able to hold capital just above – instead of well above - the regulatory bar level.

In that case the banks would claw back everything that Copenhagen Economics claim Basel III is going to take away.

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