Three Breaks for Basel III

What do you get when 27 central bankers meet up in Switzerland two years after a massive financial crisis? Leaving aside the obvious dorky jokes about pulling away the punchbowl, you also get a boatload of new rules. That’s what we got from the Third Accord of the Basel Committee on Banking Supervision, aka Basel III—the 2010 agreement on new international standards for bank regulation. The rules were tough, and many banks have complained they interfere with lending. So banks cheered on Sunday, when the committee watered down its infamous Leverage Ratio, theoretically giving banks more room to lend. In our view, however, this is perhaps the least significant of the three changes announced—for most of the biggest US banks, the rule was never a big near-term headwind. The other two likely do more to clear the lingering regulatory uncertainty surrounding Financials stocks.

In theory, financial regulation exists to promote an orderly, transparent financial system that lends to business and households, supporting growth. Since 2008, however, regulators have focused more on crisis prevention, often at the expense of their traditional aims. Measures designed to make the financial system “safer” can carry negative side effects. Some make it more difficult for banks to secure funding or lend to a large swath of the economy. Others give them fewer options when troubles arise. These are the unseen effects of regulation.

The initial draft of Basel III had several potential unintended consequences. Since then, however, regulators have watered down several pieces, suggesting they’re aware of the possible negative impacts downstream—and shifting back from a crisis prevention mentality to a more traditional approach. Three such changes came Sunday.

Stealing most headlines were adjustments to the Leverage Ratio—the capital provision designed to prevent a buildup of leverage in the banking system. Other capital measures, like the Tier 1 ratio, are often criticized for being too complex and carrying too many exemptions to accurately reflect banks’ solvency. The Leverage Ratio was Basel III’s purported solution—the ratio of a bank’s total liquid capital to total assets. Basel III set the minimum ratio at 3%. The updated version keeps it there but eases some requirements for the calculation of total assets.

For example, banks can now “net” some positions in repo and reverse repo transactions with the same counterparty—effectively canceling money they owe to and are owed by the same firm. Cash they hold as collateral for margin and other securities financing transactions no longer count toward total assets—banks don’t need to hold additional cash to offset ... um ... cash. Credit derivative exposure can be capped at the level of maximum potential loss after accounting for hedges, which should more accurately reflect their actual risk. And off-balance sheet assets now get the same risk-weighting allowances as on-balance sheet items.

Banks are happy—the changes make the 3% target easier to hit, and European banks say it should allow them more freedom to lend as they prepare to meet the 2019 deadline for full adoption. In reality though, the likely impact is small. The Leverage Ratio isn’t the biggest roadblock to eurozone lending—an honor more justly awarded to the ECB’s threats to trigger capital raises and, potentially, bail-ins at banks failing its upcoming stress tests. That likely discourages lending more than capital rules taking effect years from now. On our side of the pond, most big US banks were already close to compliant with the original rule, and those with shortfalls likely would have made it by retaining earnings—the likelihood US banks cut lending to meet the target was exceedingly low. No doubt they’ll enjoy the additional flexibility, but we wouldn’t expect it to unleash a flood of new loans.

More significant are the two less-heralded rule-changes. The Net Stable Funding Ratio (NSFR), which governs how banks raise funds relative to the amount of foreseeable obligations over the next year, also got a makeover. The NSFR was borne out of regulators’ desire to limit banks’ dependence on wholesale funding (e.g., commercial paper), which they see as more prone to flight than deposits. It requires banks to have “stable funding” greater than or equal to the amount they’ll require over the next year. The updates released Sunday include a much broader definition of what constitutes “stable funding,” and they ease the writedowns required on certain sources of capital. Writedowns on deposits backed by deposit insurance go from 10% to 5%, and those on larger deposits not backed by insurance go from 20% to 10%. More wholesale funding sources are now permissible, albeit with a 50% writedown. And in the denominator, some risk-weighting requirements were eased (while some were toughened).

Not only is the NSFR now easier to meet, but it’s a symbolic U-turn by regulators, an admission wholesale funding isn’t as unstable as many alleged during the financial panic. By giving it more weighting as “available stable funding,” they encourage banks to tap these financing sources again, broadening fundraising options. Sort of like they encouraged banks to resume securitizing loans late last month—it seems regulators now realize the tools scapegoated in 2008 aren’t inherently bad, but actually quite useful for fundraising and risk management and perhaps even necessary for a fully functional financial system.

The other change is a small insertion into the Liquidity Coverage Ratio, which orders banks to hold enough “High Quality Liquid Assets” to be able to meet 30 days’ worth of obligations in the event of a bank run. Guidance released last year alleviated one key concern about this rule, allowing banks to draw on these buffers in times of crisis without being treated as bankrupt if they slip below the minimum in the process. The latest addition addresses the other lingering question: Would stressed banks be allowed to tap their central bank for emergency funding before being deemed bankrupt? The answer is yes. Banks can now include untapped “Committed Lending Facilities” from central banks—arrangements where banks pay an up-front fee in exchange for a guaranteed line of credit. So far Australia is the only major central bank to have this facility, but with Basel’s blessing in place, others can’t be far behind. Essentially, this will allow the Fed to continue playing the role it was created to fill 101 years ago: Lender of last resort. A system where the Fed and other central banks can do this is likely a more orderly, predictable one—exactly what you want when the going gets tough.

Not that Basel III or any of its provisions guard against future crises. De-risking the financial system is the impossible dream. But those who assume a watered-down Basel III means the system is less safe than it would be under a more punitive regime ignore the many benefits of having a more flexible system. More flexibility means banks can make fewer reactionary moves to stay in compliance with arbitrary capital thresholds when problems erupt, which should limit the risk of contagion and frozen credit. While that’s more of a longer-term benefit, it makes it easier for banks to plan and adapt to the new rules in the here and now, which should help clear some of the regulatory uncertainty lingering over Financials.