Basel III favours some regions, financing solutions over others
With any one-size-fits-all approach, the problem lies in establishing a level playing field across different national and regional regulatory frameworks.
The Basel Committee on Banking Supervision has set a deadline for the end of this year for compliance with the stricter Basel III regulatory framework. Said framework aims to steer the financial industry, and especially banks, away from the practices that led to the 2008 Financial Crisis. Banks all over the world will have to abide by these new rules, yet with any one-size-fits-all approach, the problem lies in establishing a level playing field across different national and regional regulatory frameworks and across different types of financing and financial tools.
Basel III favours some regions, financing solutions over others
For nearly all banks, the new rules require higher capital requirements contrary to the promises made by the Basel Committee, but the effects vary from region to region. Apart from the lack of a level playing field, one should not lose sight of the regulatory framework and efforts currently underway for the entire financial sector, including shadow banking. Depending on market expectations, regulatory efforts in non-banking areas, and a willingness of regulators to cooperate internationally; a more even level playing field may arise, bringing bank and non-bank financing to regulatory parity.
Thus, the structure of European capital markets differs from American and Asians markets where most capital is integrated into the real economy by bank loans. Consequently, stricter rules on banking exacerbates repercussions on the European economy. The new requirements put European banks on a structural disadvantage. Basel III would exacerbate an already bad situation by raising capital requirements, reducing banks’ ability to lend by imposing a leverage ratio favoring riskier investments, and favoring U.S banks, which benefit from a stronger position in their home market and more lenient regulators.
The leverage ratio, which says that a banks’ core capital shall be more or equal to 3% of the sum of all exposures favors riskier lending, unless the yield from safer lending (e.g to SMEs) can be increased, or alternatively, unless regulators are allowed to introduce risk weighing to determine the sum of all exposures. At the same time, the new liquidity coverage ratio (LCR) – covering total net cash outflows over 30 days – and the net stable funding ratio (NSFR) – to determine the ability of banks to refinance themselves over a year – have two main repercussions. On one hand the LCR and NSFR incentivize investments in higher quality assets such as government bonds for compliance reasons, but on the other hand put loans for long term (e.g infrastructure) projects at a disadvantage as these do not count towards the NSFR.
This in turn will put the financing of the EU economy in jeopardy. It was possible to introduce all these regulations because different national regulators did not manage to speak with one voice in Basel to ask for regulations that better accommodate the particularities of financing the European economy. This has created an EU-wide disadvantage for future competitiveness and innovation.
ASEAN is not Europe – and it matters
The situation in the ASEAN region was different from the beginning where the banks from the largest economies – Indonesia, Malaysia, Singapore, Thailand, Vietnam, and the Philippines – were sufficiently capitalized, allowing them to comply with the stricter capital and liquidity requirements of Basel III. In some details, the banks were already 100% compliant before the implementation of the ratios (though national differences make it difficult to compare the reported ratios across different banking systems).
This is due to the predominance of retail funding, a large share of government bonds in the investment portfolio, and different economic consumption and financing patterns – not at least due to the lessons learned from the 1997 Asian Crisis. Thus, LCRs (and the 60% minimum requirements) as well as NSFRs never really posed a problem for continued financing of ASEAN economies during or after implementation.
Moreover, each country has been introducing the Basel III regulation differently in response to local challenges, which explain why the focus has been less on the already implemented capital requirements, but rather on increasing transparency and strengthening risk management. The only stumbling block for ASEAN regulators appears to be the bail-in and total loss absorbing capital (TLAC) guidelines; these have caused issues in Europe as well.
While the goal should be binding rules for all countries, the deliberation noted above shows that effects vary, tilting the level playing field in favor of capital markets and to the disadvantage of economies relying on bank loans for refinancing. The new liquidity rules and capital requirements cannot deliver a global level playing field that accommodates regional differences. However, there are three caveats that may alter the situation.
Will the rules be enough?
The answer to this question is no. The rules target banks, while TLAC seeks to resolve “too big to fail” banks and measures to regulate the shadow banking system are still under way. At the global level, in November 2015 the G20 approved the TLAC standard, which global keystone banks will have to meet regarding their capital structure. Extending TLAC to non-banks – a topic that is often discussed among regulators – to strengthen their loss absorbing capacity and facilitate restructuring or resolution processes would help to even the level playing field among different regions while increasing the resilience of the financial system. But to achieve this, regulatory requirements for banks cannot be superimposed on other players since business models, risk profiles, and resolution procedures are fundamentally different.
What do markets expect?
Basel III and TLAC requirements will end up applying to all banks, and not only to global keystone banks as originally foreseen. Due to market discipline, non-global keystone banks and financial institutions will be obliged to increase their capital requirements in order to meet market expectations. If TLAC is flexible enough to adapt to existing national resolution frameworks, and can account for some jurisdictions having already developed recovery and resolution plans for credit institutions with similar requirements, this could support a global level playing field. ASEAN banks, and first and foremost Singapore, are already extending Basel III requirements to merchant banks to comply with market expectations.
Regulating shadow banking
The stricter the requirements on regulated banks et. al., the more activities they will shift to unregulated financial entities, who when highly interconnected can become a source of systemic risk. After the 2014 G20 agreement in Brisbane to regulate shadow banking, proposals are under way from the IOSCO, FSB and BSC, which could help impose similar regulatory constraints on shadow banking.
Whether market expectations and new regulations in the non-banking financial sector will level the playing field among different regions, and their preferred financing options, all while enhancing the resilience of the global financial system remains to be seen. However, as the regulation of the banking system has shown, to better achieve a global level playing field in the long term, international cooperation among regulators outside of the Bank for International Settlements is necessary.
Different financing structures and preferences require some regulatory flexibility, which has to be coordinated so as to not put certain financing options at a disadvantage or to create a fragmented financial system. While regulators have not followed such a path when regulating “their” banks, this issues of derivatives oversight, and adjusting the current framework to include non-banks remain. Capital requirements and liquidity are one way to address the problems in the banking sector, yet financial volatility also requires more flexible exchange rate regimes and stronger reserves positions. That said, regulation should not favor one way of financing over another, as it is the case at the moment. Future regulatory frameworks will need to address this mismatch so as to alleviate some of the problems the current regulatory framework intended to resolve.
