Introduction
The global economic crisis has provided regulators with an opportunity to fundamentally restructure the approach to risk and regulation in the financial sector.
The international members of the Basel Committee on Banking Supervision have collectively agreed on reforms to “strengthen global capital and liquidity rules with the aim of promoting a more resilient banking sector”. This is what is generally known as Basel III.
One striking feature of the transition to Basel III is the extended period allowed for implementation. Some features of Basel III may only be fully implemented by 2019 and some features such as the steps intended to be taken to minimise risks relating to systemically important financial institutions i.e. the To Big to Fail issue, may never be implemented.
What is the reality of Basel III
Initially, national regulators from various jurisdictions disagreed on many aspects of the implementation of Basel III. In the end the basic principles were agreed upon but not without some compromise.
During the discussions, regulators in the West were focused on the need for increased buffers for both capital and liquidity. While in the East, more focus was placed on the need for comprehensive risk management, enhanced stress testing and alignment of risk and capital management with the core part of a firms strategy.
The result of these differences is “supervisory discretion”. This implies that some jurisdictions may apply a more detailed and rigid interpretation of the requirements of Basel III than in other regions. Some regions may not ever implement the full suite of Basel III requirements.
Will there be an uneven playing field in the regulatory space going forward, most definitely.
What are the key differences and how will it impact strategy
Some banks set ambitious deadlines to achieve compliance with Basel III. Early implementation is seen by many as a competitive advantage, a way to demonstrate soundness to regulators as well as the market. These banks see potential reputation risk at play and if perceived as to slow to implement the requirements of Basel III they may be viewed as unsound.
Under the new Basel III framework, common equity requirements are in some instances more than double than before. This leads to a significant reduction of available capital required by a bank to do business. In addition, increased charges for the risk weighted assets of a bank may further restrict the extent to which they may do business. Therefore, the combination of additional capital requirements as well as higher charges for the risk inherent in the assets created by banks, will in due course impact on the return on equity (ROE) by banks. The extent of this impact is uncertain but it will be due to the roll out of Basel III and depend on the operating models of each bank.
The riskier a banks business or the assets it creates, as perceived by regulators, the greater the capital requirements will be under the Basel III regime and the higher the costs incurred by a bank will be. In response, banks business models will be reshaped by these more stringent requirements. As the business models of banks adapt to the impact of Basel III they may have to revert to a regime similar to one that operated over a century ago. This is a model under which there was limited competition that resulted in much less innovation in financial services.
This adaptation by banks may however open up opportunities for competition from an unlikely source. The shadow banking sector and its ability to innovate may fill in the gaps arising in the market left by banks. This innovation is already clear in the retail sector as retailers such as Tesco create Tesco Bank and Walmart enter the pre-paid card market. As major retailers enter the market for financial services previously occupied exclusively by banks, the question arrises whether consumers should avail of their services because these retailers are of course unregulated and do not need to abide by the provisions of Basel III. As more consumers switch to avail of these services, it is unclear whether its a lower cost choice or if its because they are disgruntled and no longer trust banks. Either way, it is more competition for banks who may end up loosing customers and revenue if they do not innovate.
Alongside the proposal for increased regulation in the areas of capital and liquidity is a debate around the degree of intensity of supervision that supervisors will apply under the Basel III framework. Enhanced supervisory practices are expected to be a major focus going forward as Basel III is implemented. In addition, the choice of regulator to effect change in banks business models as a way to drive structural change in the industry or to enhance their supervisory efforts to make sure that economic failures are contained are expected to have a huge impact upon each institution.
Amidst all the debate around Basel III, it’s worth noting that the fundamental approach to determining credit risk-weighted-assets has not changed. The approach by regulators remains a risk-based capital regime. Therefore, regulators will continue to focus on risk management and governance as key requirements to underpin a robust financial sector.
Conclusion
Clearly, market consensus is that Basel III will not be the answer to all the problems experienced since the financial market crisis blew up the world. It does however go a long way in addressing excessive risk taken on by banks. It follows that institutions that are affected by the implementation of Basel III must keep a flexibility about themselves to accommodate years of fine tuning and still more future reforms. Banks earnings will diminish if they do not become more creative and markets that are deserted will be occupied by competitors from unlikely industries who are unrestrained by Basel III.
Banks should be weary of competition in the financial sector particularly as the higher cost of being regulated as a bank kicks in as Basel III rolls out. Retailers who begin to offer services in competition with banks should note that it’s only a matter of time before regulators step in and begin to regulate their activity with similar constraints as banks.
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