Basel III Takes Shape

Story Highlights:

• Pending financial reform worldwide has weighed on banks for the better part of two years, yet lacking details, banks have been understandably conservative.
• Monday's latest, more moderate and widely accepted iteration of the Basel III global banking accord continued the recent trend of easing uncertainty.
• The economic recovery has rolled on even as regulatory issues have weighed on capital markets.
•  With these issues now increasingly out of the way, banks sitting on piles of cash will hopefully loosen their purse strings—further supporting sustained economic and market health.

Pending financial reform worldwide has weighed on global banks for the better part of two years; yet, with few details, banks have been understandably conservative, accumulating large capital cushions and lending less. The last few weeks have begun to shine light on the new financial landscape. And as mentioned yesterday, Monday's latest, more moderate and widely accepted iteration of the Basel III global banking accord represented an important milestone.

But first, a little background. The Basel Committee establishes uniform capital standards and measurement for international banks. The Committee is comprised of each participating country's head central banker and bank regulator. Basel's legal signatories include 11 large developed countries (the US, UK, Germany, France, Japan, etc.), but to maintain credibility, many more countries ascribe to the rules as well.

The Committee's first codified capital standards, released in 1988, were dubbed Basel I. Basel I was ratified and adopted by participating countries in the early and mid-90s. To address criticism Basel I was too general and easily circumvented, Basel II was negotiated in the early 2000s and agreed upon in 2006. As 2008's financial panic hit, Basel II was still being phased in. Yet the crisis had the Basel Committee scrambling to prevent what came to be widely viewed as "excessive risk taking" (always a slippery definition) by global banks.

The latest amendment, Basel III, is currently undergoing a period of negotiation and comment. The first set of new capital rules proposed in December were largely viewed as too harsh. In particular, a new liquidity requirement dubbed the Net Stable Funding Ratio (NSFR) required banks to maintain specific levels of "stable" funding, such as deposits. Analysts estimated the NSFR would have had banks scrambling for trillions of dollars at a time when the industry was still in recovery mode.

The latest proposal, released Monday, scrapped the old NSFR in favor of renegotiating something less stringent. Other more moderate revisions included a wider definition of capital and a minimum 3% Leverage Ratio—lower than feared. Further, the phase-in period was significantly extended to January 1, 2018—giving banks and investors time to phase in the new rules and judge their potential impact. Rules regarding how to handle "systemically important" institutions in times of crisis are a work in progress, to be finished later this year.

The pending agreement is a move in the right direction—less severe. And with wide acceptance, fewer major changes are likely in the pipe. The final framework isn't expected to be fully fleshed out until late 2010, and we may see a bit more moderation between now and then. Notably, Germany is still withholding their blessing on behalf of domestic banks. Generally, however, the easing uncertainty is good news, particularly when combined with the completion of US regulatory reform and European stress tests.

The economic recovery has rolled on despite regulatory issues weighing on capital markets. With these issues now increasingly in the rearview mirror, banks sitting on piles of cash will hopefully begin to loosen their purse strings—further supporting sustained economic and market health.