Basel III in its current form presents challenges to banks on many fronts, making preparation crucial. Most banks are aware of the increased capital requirements, but the Basel Committee also focused on measures to strengthen banks’ liquidity positions. The Committee has proposed two minimum standards to achieve that goal. The Liquidity Coverage Ratio (LCR) is designed to enhance the short-term liquidity position of banks by ensuring they carry sufficient high-quality liquid assets. The second measure, the Net Stable Funding Ratio (NSFR), promotes longer-term liquidity resilience by encouraging banks to obtain more stable funding on an ongoing basis. Our focus in this article is on the LCR.
As it is currently written, Basel III will likely push banks to carry a larger proportion of sovereign debt in their investment portfolios, which tend to be lower yielding assets. Banks may choose to term-out their deposits to reduce potential cash outflows in a 30-day period as an alternative. The LCR requirement could significantly affect the earnings capability of a bank’s investment portfolio and net interest margin.
Banking institutions have time to make adjustments if the implementation of Basel III in the U.S. follows a similar timeline to its predecessor. Many variables remain unknown, including which of the proposed standards U.S. regulators will choose to impose, and to which institutions they will apply. The standards appear to be directed towards large, internationally active banks. These standards may form the basis for future regulation applied to all banking entities, which may have a disproportional effect on smaller banks with limited access to capital markets.
International regulators have recently determined the appropriate extra capital charge for the largest institutions to be 2.5%. The proposed capital surcharge for systematically important financial institutions (SIFI’s) is feared to create costs that exceed the diminishing benefits of higher capital requirements above Basel III minimums.
Baker Tilly insights
Although always a key driver in the regulatory view of a banking organization’s strength, capital has clearly become the most significant lever in managing the growth of individual banks and the industry as in its entirety. It is not yet clear how these new capital guidelines will be applied across the spectrum of banks as it relates to the size of their balance sheets and the relative risks inherent in their businesses. What was once a relatively quantitative measure of bank strength will continue to migrate toward a qualitative analysis determined on a bank-by-bank basis with the potential for measureable variations in capital levels of otherwise very comparable banks. This dynamic could easily shift the competitive landscape as banks look for opportunities to absorb market share and return to profitability.
