An uncertain market environment and upcoming Basel III regulations add to the worries of investment banks. Over the past few years, rules have been rewritten and became stricter. It was, in particular, the crisis of 2008 that made regulators reconsider current standards in place, recognising the need for a more robust risk and liquidity framework, which acts on a preventative level.
Thus, regulators have moved towards a more subjective, outcome-focused approach to prevent another crisis on a global scale. In the money market, banks obtain short-term funding through the repo market or by selling short-dated commercial paper to finance operational activities.
There are three key aspects of Basel III regarding banking regulation:
Net Stable Funding Ratio
Banks will have to reduce their short-term wholesale funding and hold more deposits to obtain a more stable source of operational funding, resilient in a better way to shocks. It’s being derived from dividing the available amount of stable funding (ASF) by the required amount of stable funding (RSF). This new ratio will decrease the ability of banks to raise funding by issuing commercial paper of up to 270 days maturity. It will extend the amount of long-term debt being held compared to hard to finance assets.
The Liquidity Coverage Ratio
In case balance sheet liabilities will run into a 30-day stressed period, banks are required to hold more highly-liquid assets to cover potential price risks.
The Ratio is calculated by dividing with the Stock of High-Quality Liquid Assets (HQLA) by the Net Cash Outflows over a 30-day period. HQLA can be central bank reserves, cash, sovereign bonds or individual high-grade corporate bonds.
A positive effect of the coverage ratio will be that demand rises in the money market for high-quality, highly liquid assets.
The Supplementary Leverage Ratio
It raises the cost of holding low-risk assets and hold time deposits, meaning it will reduce the banks’ willingness to take time deposits like Certificates of Deposits.
Despite Basel III not being due until 2018, investment banks have been reporting the new ratios to regulators since 2015. This pre-run of implementation was necessary for internal compliance procedures being increased to the new standards until 2018.
Essentially, by restricting the build-up of leverage regarding banks, destabilising processes that can threaten the financial system can be avoided.
Impact on Business Activities
According to McKinsey, Basel III would reduce the return on equity (ROE) average in Europe by approximately 4% and about 3% in the United States. The changes in terms of ROE and a new environment increase the efforts of banks to cut costs and to adjust their client pricing. Effective management is critical to implementing the new rules.
Short-term retail loans will see an increase in cost, mainly driven by the new target ratios of Basel III. In the corporate banking world, structured finance or unsecured loans will be hit very hard as they carry relatively high risk. Because the ratios mainly have an effect on liquidity, this will substantially change investment banking. The ratios will require holding more capital for counterparty risk, especially regarding OTC instruments. Cash is King, but a more expensive one as profitability will decrease due to a higher cost of holding inventories.
Over the coming years, one will be able to observe the performance of banks under the new rules, and the real impact of the capital ratios can be evaluated, potentially leading to a more sustainable growth model for financial stock performance.