September 20, 2016    5 minute read

Are Banks Still Shackled by Regulations?

Basel Rules    September 20, 2016    5 minute read

Are Banks Still Shackled by Regulations?

The struggle to comply with Basel III:

Post the 2008 financial crisis, the Basel Committee on Banking Supervision (BCBS) published the Basel III, a more refined and updated version of their previous Basel’s I and II. The Basel III required banks to maintain:

  1. Certain minimum capital requirements and
  2. Proper leverage ratios

The capital requirements stated that banks are to be required to maintain a minimum common equity (solvency ratio) of 7% by 2019. This 7% rate consists of a 4.5% common equity requirement and a 2.5% capital conservation buffer. On the other hand, European banks were required to maintain a solvency ratio of 9%, which came into force by 2012.

6% Minimum leverage ratio for ‘too big to fail’ banks

The maintenance of a minimum leverage ratio, called for banks to maintain a leverage ratio which would be at least 3%. During the summer of 2013, the Fed had announced that the minimum leverage ratio would be 6% for Systematically Important Financial Institutions (i.e. “Too Big to Fail” institutions) and 5 % for their holding companies.

Since then banks have: expanded their regulatory and compliance divisions, raised millions if not billions of dollars to meet the capital requirement of Basel III.

The possibility of a Basel IV?

Despite the fact that, Basel III will not fully come into force before 2019, regulators are now thinking of increasing capital requirements under Basel III, which could potentially be coined as the new Basel IV.

The main reason for tightening the capital requirements is that regulators found inconsistencies in the risk-weighted assets (RWA) across different banks. This difference occurs as banks use their calculations and judgement to determine how risky loans and other assets might be.

Therefore, the BCBS aim to reduce this inconsistency in capital requirements in two ways. Firstly, they seek to analyse the riskiness of the bank’s assets (such as their loan books) and propose a “Standard Approach” for the calculation their RWAs. This approach requires the risk weight of the bank’s assets to be calculated by external rating agencies rather than being calculated by the banks themselves. The BCBS believe that this will bring banks on the same page.

Secondly, they aim to overhaul the way banks calculate operational risk. Instead of allowing banks to use their models, banks will be advised to stick to a standard approach set out by global regulators.

Therefore, if the Basel IV comes into existence, banks will be faced with an immense pressure of raising ever increasing amounts of capital, which they must use to “bail themselves out” if they were to get into trouble.

Implications of the Dodd-Frank Act:

Since the 2008 financial meltdown, the US has grown at a historically slow pace. Many academics and economists blame the Dodd-Frank Act for this slow growth. Why is that so? Well, many economists believe that the Dodd-Frank Act has placed heavy regulatory costs on community banks. Also, their new restrictive lending schemes made it difficult for community banks to finance start-ups, which are considered to be an engine for economic growth.

At the same time, Wall Street banks have been heavily impacted by another section of the Dodd-Frank Act namely The Volcker Rule. This rule prevents banks from undertaking short-term speculative trading in futures, options, derivatives and securities for their accounts. Also, this rule also limits the relationship banks can have with hedge funds and private equity firms. Banks must also comply with reporting requirements, which requires them to disclose all the details of their trading activities.

The Dodd-Frank reform: light at the end of the tunnel?

Recently, there has been a proposal by Rep. Jeb Hensarling to overhaul the Dodd-Frank Act. This revamps for reducing the authority of Consumer Financial Protection Bureau (CFPB), by replacing its single director with a five-member commission. Along with that, Hensarling also aims to kerb the powers of the Financial Stability Oversight Council to classify any firm as being systematically important.

Hensarling’s proposal also provides banks with the option of avoiding stringent regulatory control by increasing the amount of capital they hold.

Further increase capital holding? But, by how much? The current laws dictate that most banks have to maintain a minimum leverage ratio of greater than 3%, while “Too Big To Fail” institutions need to keep a leverage ratio of 6% or greater. Under Hensarling’s plan, banks are required to maintain a minimum leverage ratio of at least 10%. If that weren’t enough, his proposal also involves revoking the Volcker Rule, which limits banks to take part in short-term speculative trading.

10% Proposed minimum leverage ratio for ‘too big to fail’ banks

In conclusion, are banks willing to support this new Republican proposal? Can this help banks increase their profitability while being subject to “less stringent” regulatory rules? It’s difficult to say, but as of now, it seems highly unlikely that this bill may come into play shortly.

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