Introduction
Owing to the stringent repercussions of the 2008-2009 financial crises, the Basel Committee of Banking Supervision (BCBS) set out on a financial voyage to make amendments to their existing guidelines on capital adequacy. The efforts led to the establishment of a new capital sufficiency structure known as Basel III (Eubanks 2011, p.24). The G20 group endorsed this framework on November 2010 at the G20 summit in Seoul (Eubanks 2011, p.24). Despite its establishment, several areas need further development for full efficacy. As major authorities adopt the framework, attention is slowly shifting to the methodologies of its implementation. In addition, there is widespread concern as to its impact on businesses and other financial institutions. In particular, banks will be highly affected by the new recommendations and proposals.
Implications of Basel III recommendations
The proposals contained in the Basel III framework harbor the following potential implications on banks. Increased quality and quantity of capital, reduction in leverage due to the introduction of backstop leverage ratio, an increase in the balance sheet funding that will be long-term and an increase in short-term liquidity coverage (Wittenbrink 2011, p.37). Most institutions will be constrained in terms of capital and liquidity in the medium term. Therefore, they will be obliged to focus on capital management, liabilities structure, the pricing of products and the business, and the capital inefficiencies that advance from Basel II (Wittenbrink 2011, p.37). Basel III has resulted in a rise in minimum capital ratios, a move that will need careful attention from firms. Under Basel III, firms will be able to improve their capital planning through proper alignment of economic capital mechanisms (Wittenbrink 2011, p.39).
First, increasing the quantity of capital required has several implications on the operations of banks. Banks will be required to increase the amount of operating capital from the current level (Wittenbrink 2011, p.41). The additional amount required will have to be obtained from either common equity or from retained dividends. Potential constraints on the bank’s earnings distribution will bar them from using the capital conservation buffer during times of adverse financial stress (Gregoriou 2009, p.62). Consequently, most banks will opt for a higher common equity ratio. This will affect the market expectation for common equity, which is probably edging towards the 9 percent mark. In addition, banks may increase their total capital ratio to about 13-15 percent due to potential additional components to Pillar 2 risks and the capital buffer (Gregoriou 2009, p.65). Precisely, increased capital and funding requirements, coupled with the need to restructure according to Basel III requirements, will have a negative financial impact on margins and the operating capacity of banks. Therefore, returns awarded to investors will probably decrease at a time when enhanced investments form investors are important for the building and restoration of buffers (Gregoriou 2009, p.68).
Secondly, proposals on increasing balance sheet funding on a long-term basis will present several implications. Banks will be forced to increase the stability of their available and required stable funding and lower reliance on funding from short-term returns from their investments (Chorafas 2011, p.31). This requirement obliges banks to raise the proportion of wholesale and corporate deposits whose maturity periods extend over periods greater than one year. However, consumer appetite for term debt is very low such that this may need proper strategizing. Another implication of increasing balance sheet funding will be that stronger banks will be able to influence the pricing of assets in the market (Chorafas 2011, p.31). On the other hand, weaker banks will suffer from reduced competitiveness that will possibly decrease the overall competition in the financial market. This may lead to low returns and poor market presence. For example, during times of economic stress, weaker banks will experience more difficulties in raising the required capital amount. Additionally, increased funding requirements will lead to reduced competition and diverse business models (Chorafas 2011, p.33).
Increased quality of capital by Basel III will have the following implications. First, banks will be pushed into adjusting and correcting their balance sheets within the shortest time possible because the BCBS’ proposals are already ignored by markets and do not affect them significantly (Chorafas 2011, p.40). Secondly, banks will raise their capital that will possibly lead to a reduction in issued dividends and retention of profits (Chorafas 2011, p.41). Thirdly, certain banks may be given a go ahead to raise additional capital through the issuance of contingent convertibles, that may offer a competitive advantage at the expense of other banks.
The recommendations may also lead to reduced borrowing by investors because banks will possibly retain or reduce dividends in order to rebuild their capital bases (Labrosse 2011, p.61). Low investor appetite for bank loans will lead to decreased profitability, and certain proposals on non-equity investments will make debt instruments prone to losses upon liquidation for the first time. This will be reflected in changes in interbank lending rates and shifting costs of capital issuance (Labrosse 2011, p.63).
Conclusion
The Basel III framework will have several implications on banks when it is finally implemented. However, it will aid banks in their effort to recover from unfavourable economic situations. The proposals contained in the Basel III framework harbor several implications on banks. These implications include increased quality and quantity of capital, reduction in leverage due to the introduction of backstop leverage ratio, an increase in the balance sheet funding that will be long-term and an increase in short-term liquidity coverage. Most institutions will be constrained in terms of capital and liquidity in the medium term. Basel III has resulted in a rise in minimum capital ratios, a move that will need careful attention from firms. Under Basel III, firms will be able to improve their capital planning by proper alignment of economic capital mechanisms.
References
Chorafas, D 2011, Basel III, the Devil and Global Banking, Palgrave Macmillan, New York.
Eubanks, W 2011, Status of the Basel III capital Adequacy Accord, Diane Publishing, London.
Gregoriou, G 2009, Operational Risk Toward Basel III: Best Practices and Issues in Modelling, Management and Regulation, John Wiley & Sons, New York.
Labrosse, J 2011, Managing Risk in the Financial System, Edward Elgar Publishing, New York.
Wittenbrink, A 2011, Financial Regulation through New Liquidity Standards and Implications for Institutional Banks: Basel III, GRIN Verlag, London.