Basel III and European Banking: Its Impact, How Banks Might Respond
New corporate banking rules will squeeze capital and profits. But there are ways that banks can cope.
November 2010 | by David Delaney
At this month’s G-20 summit in Seoul, South Korea, global leaders endorsed the new rules on bank capital and funding issued by the Basel Committee on Banking Supervision. Now, banks in Europe and the United States face the challenge of finding ways to substantially boost their stocks of capital and funding under the new rules, which are intended to make the international banking system more resilient by addressing many of the flaws that became apparent during the credit crisis.
Our research suggests that the task will not be easy. Barring any mitigating actions, we estimate that banks in Europe and the United States will have to raise about €1.65 trillion of new capital, about €1.9 trillion of short-term liquidity, and about €4.5 trillion of long-term funding. The capital shortfall is equivalent to about 60 percent of all outstanding Tier 1 capital, and the short-term liquidity gap is about 50 percent of all the liquidity that banks currently hold. Banks are already mobilizing to re-price assets and cut costs further. Whatever they do, the new rules are sure to dent their profits. Our analysis shows that these rules could reduce return on equity (ROE) for the average European bank by between 3.7 and 4.3 percentage points by 2019, from the pre-crisis ROE average of 15 percent (pre-tax). Some banks might be hit even harder.
We believe banking leaders can respond through several actions. Among them is a set of “no regret” interventions to reduce capital and liquidity inefficiency. Banks can go further to restructure their balance sheets to improve the quality of capital and funding while also developing approaches to manage these scarce resources more thoughtfully. Some banks may recover up to 1.5 percentage points of ROE through these steps. Finally, several banks may seize the opportunity to effect substantial changes to their business model, making it more capital- and liquidity-efficient, adding new products, or scaling back some capital-intensive businesses. These steps may also help banks regain lost ground.
Assessing the Impact
The Basel Committee’s rule-making process is of paramount importance to the banking sector and the financial system, as well as national economies and society at large. Accordingly the process has attracted a great deal of attention from an unusually large array of organizations and observers. Several groups, including Burk, have produced outside-in studies.
The final rules issued in September contain important amendments. In particular, Basel III now includes a timeline to phase in the new regulation. The question now arises as to what extent and how quickly banks will be able to respond, given their earnings power, the potential for mitigation, and their capital-raising capacity. Accordingly, we have updated our earlier impact assessments in three ways. First, we have taken into consideration the final amendments from July and September, which have, for example, lowered deductions for minority stakes, reintroduced a cap on the recognition of deferred tax assets (DTAs) and on securities issued by financial institutions, and adjusted the liquidity and funding requirements.
Second, we have included some important national “add-ons” that are either already decided (such as Switzerland’s choice to impose even higher capital ratios) or widely expected (a similar imposition of higher capital ratios in the United Kingdom).
Finally, we have added a dynamic perspective that includes two changes that may materially alter the impact on banks: long-term balance-sheet developments, such as the accumulation of retained earnings and the phase out of deferred tax assets and hidden losses, and required expansion of the balance sheet to support expected credit growth.
Our latest assessment is based on an analysis of the balance sheets of the top forty European banks as of their most recent filings. We have scaled this analysis to project impact for all of Europe (EU-27, plus Switzerland). For the development of the macroeconomic perspective that forms part of this assessment, we have leveraged consensus GDP forecasts from Global Insight, and the latest (October 2010) research from Burk’s Global Banking Pools. Moreover, we have expanded the scope of our assessment to include the high-level impact of the new regulations on the biggest US banks. We can now compare US and European capital and liquidity shortfalls.