Basel III Research Paper

The Implications of Basel III on the Global Banking System: Discerning between

Regulatory Bolstering versus Liquidity Hazard

Emad Khan

Global Money Markets and Institutions

Professor Jim Winder

04/12/2015

Table of Contents

Introduction to Topic………………………………………………………………………………………………………… pg. 3

I. Case Study Commentary………………………………………………………………………………………………… pg. 5

II. Localized and National Basel III Implications…………………………………………………………………. pg. 19

III. Comparative US and Eurozone Effect…………………………………………………………………………… pg. 23

IV Commentary and Conclusion……………………………………………………………………………………….. pg. 35

Bibliography and Cited Works…………………………………………………………………………………………... pg. 42

Footnotes…………………………………………………………………………………………………………………………. pg. 45

Khan, Emad

Professor Jim Winder

4/09/2015

Global Money Markets and Institutions

The Implications of Basel III on the Global Banking System: Discerning between Regulatory

Bolstering versus Liquidity Hazard

In late 2010, the Basel Committee had announced an agreement on their newest

standards for higher liquidity requirements, known today as Basel III. “On 11 November 2010,

during their summit meeting in Seoul, South Korea, the Group of Twenty Finance Ministers and

Central Bank Governors (known as the “G‐20”) formally endorsed the Basel Committee on

Banking Supervision’s proposals for capital and liquidity requirements for banking institutions.

The Basel Committee had announced an agreement on these higher capital standards on 12

September 2010.” [1] Following the aftermath of the collapse and resultant great recession of

2008, it was evidently apparent that the global financial ecosystem (this paper is concerned

particularly with the US) needed a massive overhaul in regulatory procedures. This is where

Basel III comes into play. The ultimate goal here is to reduce the totality of the systemic risk

brought upon “too big to fail” banks, as well as a slew of other financial institutions in

aggregate. Basel’s III’s modus operandi is tackling risk at the forefront through three measures:

1) Developing a Liquidity Coverage Ratio (LCR) to ensure immediate satiation of liquidity needs,

2) hedging against risk coverage by strengthening capital treatment for complex securitizations,

and 3) overhauling global supervisory monitoring through net stable funding ratio (NSFR) to

stabilize long term structural ratio. [2]. Table 1.1 below from the BIS describes the areas of

interest that Basel III looks to address.

Table 1.1

In an ideal world, a fully integrated Basel III should incentivize big banks and institutions

to wade cautiously and intelligently when dealing with transactions, and promote a landscape

where excess capital reserves could buoy the economy in the wake of economic distress.

However, the assertions listed do raise a legitimate concern: Is it worth the proverbial paper

that is written on? Basel III is phenomenal in theory, but often times we’ve seen legislations

sputter when they’ve been extracted from a vacuum and into the real world. Over the course of

next few pages, I will attempt to answer this question. The purpose of this paper is to dissect

the Basel III regulation in detail, and draw out its potential efficacy in a practical landscape. We

will begin with presenting commentary on prominent Basel III case studies by PWC, KPMG and

Accenture. In the second arm of this paper, we will be discussing the implications of the Basel III

application, across both localized and global sectors. Commentary from the Wall Street Journal

and the Mckinsey case studies In the last arm of this paper, I will be injecting my personal

commentary into the discussion, and offer my own assertions on Basel III’s efficacy.

I. Case Study Commentary

PWC:

The major assertions placed in PWC’s case study are that Basel III is a revolutionary regulation

vehicle that is capable of bringing about major changes within the financial system. “Basel III

establishes tougher capital standards through more restrictive capital definitions, higher

risk‐weighted assets (RWA), additional capital buffers, and higher requirements for minimum

capital ratios. The reforms will fundamentally impact profitability and require transformation

of the business models of many banks. These reforms will also require banks to undertake

significant process and system changes to achieve upgrades in the areas of stress testing,

counterparty risk, and capital management infrastructure.” [3] Similarly to it’s predecessor

Basel II, III looks to shore up capital requirements within banks. The three main areas of interest

are the redefining of capital ratios and minimum targets, additional RWA requirements, and

new liquidity standards.

From a capital ratios and targets perspective, preferred stock has been removed and

modifications have been made to bolster the overall quality of capital . Additionally, Basel III

introduces updated countercyclical buffers and leverage ratios to discourage

overcollateralization against the bank’s balance sheet. Finally, Basel III increases the minimum

capital requirement that banks must have on hand at all times. Since one of the synergizers

behind the great recession was a sudden shock resulting from a disappearance of capital within

the financial system, The presence of excess cash on hand could allow for a buffer in the event

of a potential shortfall.

From an RWA (risk weighted adjustment) requirements perspective, PWC’s study shows

that risk management and corporate governance remain a key priority. [4] In my view, this is a

very comprehensive guideline that is bent on incorporating all risk adjustment into the firm,

and applying those adjustments into said capital and liquidity requirements. Intuitively, this

makes sense: More Risk, more Cautiousness. Steps to further consolidate RWA include a charge

penalty for market to market (M2M) losses to compensate for a loss in credit trustworthiness

or credit valuation adjustment (CVA). The idea here is to dissuade big banks and institutions

from taking on unnecessary and hazardous risk at the expense of stability. It then goes on to

address risky financial productions, such as complex securitizations and derivatives.

“Enhancement of risk measures to include missing risk factors and extend coverage in areas

such as counterparty risk and securitizations Considerations of trading book exposures and

securitized products through a set of rules known as Basel II.5 designed to reduce capital

arbitrage between banking and trading books.” [5] Complex Credit swaps, high frequency

derivatives trading, and securitization of MBS’s contributed to a liquidity crisis in an enormous

way because of the lack of general knowledge and oversight associated with these transactions.

To ensure oversight, The IRS’s powers have expanded to oversee the loss of market.

Finally, from a liquidity standards perspective, Basel III introduces new liquidity

standards in the form of the liquidity coverage ratio (LCR), and the net stable funding ratio.

(NSFR). This ties in hand in hand with the capital ratio, with the overall goal of stabilizing risk by

ensuring proper capital flow across the financial markets. From a 30,000 foot view, the LCR

standards are such that the bank is required to hold on (Tier 1) High Quality Liquid Assets that

ensure that it can sustain itself for 30 days in the absence of additional capital. With these

measures in place, the broad objective in this principle is to ensure that the bank does not have

to face insolvency due to an unforeseen liquidity crunch. Table 1.1 and 1.2 from PWC’s Study

below show Basel III’s aggregated objectives. Table 1.3 displays the net effect of the liquidity

coverage ratio and net stable funding ratio on the overall financial landscape. [6]

Table 1.1

Table 1.2

Table 1.3

KPMG:

In reading KPMG’s case study, we can draw multiple parallels to the PWC case study, as was

expected from the outset. KPMG’s assertion here is that the strengthening of capital and

liquidity oversight was a prime goal, and that the global financial crisis provided an opportune

event to accelerate the process with expediency. “The global economic crisis has provided an

opportunity for a fundamental restructuring of the approach to risk and regulation in the

financial sector. the Basel Committee on Banking Supervision (BCBS) has collectively reached an

agreement on reforms to strengthen global capital and liquidity rules with the goal of

promoting a more resilient banking sector, which is referred to as Basel III. Under Basel III, each

area of proposed changes has a separate consultation, debate, and implementation phase. As a

result, compared with the implementation of the previous agreement (Basel II), this enhances

level of dynamism, complexity, and interdependency within the global regulatory landscape will

likely add significant challenge to the implementation of Basel III.”[7]

KPMG breaks down the Basel III proposals into capital reform, liquidity standards, and

systemic risk and interconnectedness. The broad level breakdown was very much in line with

our PWC observations, but there were a few areas of interest that I found intriguing. First,

KPMG has defined Basel III “capital reform” as a steady progression of tier one high quality

liquid assets (HQLA) from the Basel II 2.0% to a more robust 4.5% by the conclusion of it’s

implementation in 2019. [8] Additionally, from a liquidity standards perspective, KPMG drills

down further into “short term” and “long term” liquidity standards. This bears significance

because applying a bottleneck approach would not be as effective in defining what the

appropriate standard of liquidity ought to be. In attempting to personify Basel III’s tiered

liquidity proposition, I liken it to medical therapy for the treatment of periodontal disease.

During treatment, there is a period of “active therapy” where the periodontist carefully

removes layers of dental calculus and biofilm from the oral flora. The end goal of this active

therapy is stabilization. Once stabilization has been reached, periodontal maintenance is

required to ensure long term health of the teeth and gums. Acknowledging this, it becomes

easier to understand the intuition behind KPMG’s liquidity breakout. During the active phase,

the Leverage Coverage Ratio ensures proper liquidity compliance among league tables. KPMG

denotes the active phase as the most arduous, thus the rather long time horizon that allows for

gradual implementation. As we’ll see in the next section on implications, there are uncertainties

and financial roadblocks that make it very difficult to dock down to the LCR. Once the ratio is

met, however, the long term net stable funding ratio is similar to a managed float currency

regime, where liquidity is maintained within a manageable range to ensure a balance between

capital inflow and stable financial liquidity. Table 1.4 extracted from KPMG’s case study shows

the breakout of Basel III’s components. [9]

Table 1.4

Interestingly enough, KPMG depicts systemic risk in a way that integrates the capital and

liquidity ratios together. “The enhanced capital ratios prescribed by the BCBS relate to the ratio

of a firm’s eligible regulatory capital divided by a regulatory prescribed calculation of risk

weighted assets.”[10] Downward pressure on eligible capital in conjunction with upward

pressure on risk weighted assets forces an upward pressure on the capital ratio, which is then

passed on to the firms. Though much of it is indeed firm specific, eligible capital forecasts are

estimated to spiral down 60% on average (resulting from capital deductions in minority

interests, investments in financial institutions and deferred taxes), leading to as much as a 50%

capital shortfall as a result of banks and institutions adjusting to meet the stringent demands of

the Basel III ratios. [11] Table 1.5 shows the percent ranges for increases and mitigations within

Risk Weighted Assets (RWA) as a result of these capital changes. All things being considered,

this formula shows that all three factors are consolidated together to determine the capital

ratio.

Table 1.5

Accenture:

When in the course of presenting case studies, it becomes imperative for the writer to

offer a well diversified message containing both qualitative and quantitative knowledge. This

ensures that the reader can grasp the topic effectively and develop an independent opinion on

the matter. In crafting this section, I chose to begin with the PWC and KPMG studies to relay

the conceptual theory behind Basel III, and what it’s objectives were. Now that we’ve laid out

the foundation for what we are discussing, I’d like to turn the focus to the more nuanced

peripherals of Basel III, which Accenture discusses more in detail. All diagrams have been

derived been from the Accenture Basel III handbook and RWA study. “Introduction of a

leverage ratio as a supplementary measure to the risk‐based framework of Basel II. The

objective is to constrain the build‐up of leverage and avoid destabilizing deleveraging

processes.”

Table 1.6

Table 1.7

This diagram depicts the side by side perspective of the aggregated changes been Basel II/II.5

and Basel III. Some of the major milestones projected by Basel III include an increased CET 1

and additional Tier 1 and 2 capital reserves, the inclusion of a capital conservation buffer to CET

1, a countercyclical buffer, and an SIB buffer.

Table 1.8

Table 1.9

“Basel III strengthens the requirements for the management and capitalization of

counterparty credit risk (CCR). It includes an additional capital charge for possible losses

associated with deterioration in the creditworthiness of counterparties or increased

riskweights on exposures to large financial institutions. The new framework also enhances

incentives for clearing over‐the‐counter (OTC) instruments through central counterparties

(CCP).

The task is monumental, however. Banks face a significant challenge merely to achieve

technical compliance with the new rules and ratios, let alone to reorient the institution for

success. Nor is the implementation challenge made much easier by the long transition

periods prescribed by Basel III, with some rules not being implemented until 2019. In fact,

banks have to begin monitoring certain ratios well before the date of mandatory

compliance—as soon as the end of 2012. More than a few banks have indicated a desire to

meet the requirements even sooner as a way to reassure markets and rating agencies and

give themselves business flexibility.” [12]

II. Localized and National Basel III Implications

The implications of the Basel III regulation are expected to be far reaching and drastically

significant. With ideal implementation, we can realistically see minimum ratio increases across

the board from a minimum capital perspective. Total minimum capital on hand is expected to

rise to 10.5%, up from the current 8‐10% baseline. Tier 1 capital, as was discussed in the case

studies, is expected to rise as much as 4.5% to an 8.5% minimum, up from 4‐6%. The new

conservation buffer, a countercyclical measure introduced in Basel III, is set at 2.5%. Tier 1

common, which does not include the conservation buffer nor the countercyclical buffer, is

increased to 7% from a high of 2‐3%. Finally, Tier 1 Leverage, a new measure introduced in

Basel III, is set at a 3% baseline. [13] This integrates a much stricter definition that incorporates

non weighted assets and off balance sheet items. These ratios in aggregate call for enormous

capital raising for global financial institutions, including the largest banks, in efforts to meet

these rather lofty milestones. Because of the magnitude of these changes in comparison to

Basel I and II, the Basel Committee on banking supervision has structured the transition over

several years, to be fully completed in 2019. The diagram below in figure 2.1 details the exact

transition by year, with corresponding minimum ratio milestones. [14]

Figure 2.1

Now before we delve into the unique impacts within the particular economic zones, I’d

like to point out that these capital standards have a few key similarities, a standardized effect if

you will, in both the US and the Eurozone. Impact from a bank to bank perspective includes the

following: 1) With tighter regulations and heavier scrutiny in weaker economic climates, smaller

banks with few capital reserves will be pushed out as a result of inability to raise the necessary

cash needed to stay afloat. This has a short term impact of bank insolvency with the long term

hit on variable niche business models and potential competitiveness. 2) Basel III regulations will

also place a heavy hit on overall probability and ROE. The excess mandate on capital reserves,

the heavy hit as a result of forced fundraising, and the uncertainty surrounding impending

regulatory reform have the potential to cloud consumer and investor confidence. 3) The

introduction of the new Basel III liquidity ratios (LCR and NSFD) to stabilize the short and long

term liquidity strategies will most likely draw firms out from short term investments to ones

that have a longer duration in nature. This has the ability to impact the bottom line price and

profitability margins associated with these strategies. 4) Increased scrutiny over proprietary

trading, which has been dramatically slashed compared to pre 2008 levels, in conjunction with

greater regulatory oversight on investments in financial institutions and other minority

investments will likely promote spin offs and company reorganization of M&A and internally

held portfolios. [15]

On a macro level, the impact of Basel III on the financial system potentially includes the

following: 1) The heightened capital and liquidity standards, in conjunction with the risk

management measures should help diffuse systemic risk as well as the probability of individual

bank failures. 2) the increased minimum capital requirements could lead to a significant

reduction in bank lending, despite the gradual transition period. 3) Similar to the micro bank

level, there could potentially be a decreased appetite for bank debt and equity due to

decreased dividends as a result of reduced ROE and profitability. These funds are instead

siphoned over to rebuilding the capital base to meet Basel III standards. Though it’s speculative,

we can reasonably expect loss absorbing investor sentiment within the cost of new capital

issuance and the LIBOR. 4) FInally, there is the concern with implementation consistency across

global regions. As was the case with both Basel I and Basel II, Basel III regulations can be

interpreted in different ways. This opens the door to international regulatory arbitrage, which

can potentially threaten the overall instability of the financial system and negate the expected

benefits proposed by Basel III. [16]

Figure 2.2

III. Comparative US and Eurozone Effect

The final part of the implications section discusses the end over end bottom line Basel III

assessments on the US and Eurozone banking systems. “Basel III’s focus is on capital and

funding. It specifies new capital target ratios, defined as a core Tier 1 requirement of 7.0

percent (further specified as a minimum of 4.5 percent of core Tier 1 capital and a required

capital conservation buffer of 2.5 percent). The broader requirement for all Tier 1 capital is set

at 8.5 percent; this includes the core Tier 1 minimum of 7.0 percent and a minimum of

additional (noncore) Tier 1 capital of 1.5 percent. Basel III also sets new standards for

short‐term funding and sketches out requirements for long‐term funding.” [17] Mckinsey’s case

study estimates that Basel III will have “ a significant impact” on the European and US banking

sector. In Europe as of Q2 2010, estimated 2019 shortfalls include €1.1 trillion in additional Tier

1 capital, €1.3 trillion in short‐term liquidity, and about €2.3 trillion in long‐term funding. In the

US, the impact on the smaller financial system will be similar but with perhaps variable impact

drivers. Estimated Tier 1 capital shortfalls are slated at $870 billion (€600 billion), the gap in

short‐term liquidity at $800 billion (€570 billion), and the gap in long‐term funding at $3.2

trillion (€2.2 trillion). [18] With this in mind, as of now, the capital needed to satiate the Basel III

reserve ratio is equivalent to almost 60% of all European and US Tier 1 capital outstanding, and

the liquidity gap needed to satiate the Liquidity Coverage Ratio (LCR) and Net Stable Funding

Ratio (NSFR) is equivalent to almost 50% of outstanding short term liquidity. [19] Figure 3.1

derived from Mckinsey’s case study displays the comparative US and Eurozone Capital

Shortfalls. Based on these shortfalls, at full 2019 implementation, Basel III’s net effect would

lead to a pre tax ROE deduction between 3.7% and 4.3%, with the lower end of the spectrum

excluding the NSFR factor, and upper end incorporating it as presently constructed. [20] Note

that these are aggregated reductions, with gradual reductions of 0.3% in 2013 and 2.1% in

2016. “The ROE reduction comes as a result mainly of capital and funding impact. On the capital

side of the fully implemented (that is, by 2019) effects, capital quality will account for 0.8

percentage points, increased risk weighted assets (RWA) for 1.3 percentage points, and

increased capital ratios for 1.3 percentage points (including 0.3 percentage points for new

minimum ratios, 0.8 percentage points for additional cushion, and 0.2 percentage points for

further national discretions). The leverage ratio will decrease ROE by 0.1 percentage points. On

the funding side, 0.2 percentage points will come from the expense of holding more liquid

assets and 0.6 percentage points from the cost of holding more long‐term funding.” [21]

Figure 3.1

In response to these more stringent regulations, Banks in the US are already underway

with their specific plans to close the capital and liquidity gap. In line with Basel III, minimum

capital requirements have been set in place for all the banks, with specific capital surcharges for

systemically important banks. “Following the global economic recession….banks which are

systemically important on the global scale – the G‐SIBs.” [22] “The solution came in the form of

a minimum capital requirement that should be applicable to all banks, with an additional capital

surcharge for individual banks seen as systemically important globally. In Sept 2010, an accord

about the minimum level of capital requirement was reached at 7%. And the surcharge

applicable was to be one of 5 values: 1%, 1.5%, 2%, 2.5% and 3.5%.” [23] This excerpt from the

trefis article denotes that systemically important banks are incredibly important to the financial

health of the US. I interpret these surcharges as a type of earmark, marked specifically to

particular banks in ascending order so as to dissuade uninhibited growth. The top level mark of

3.5% was designed as a deterrent to extremely large banks from growing further and out of

control. (as an aside, to date no banks have been marked with the 3.5% surcharge.) Additional

buckets that banks are rated on are their inter‐connectedness, size, complexity, global reach,

and susceptibility to take over in the event of failure or insolvency. To ensure that this bucket

concept is clear, let’s assume a hypothetical scenario: If a bank were to fall into the 4th bucket,

like a Citigroup or JPMorgan, the minimum capital percentage held will be the 7% minimum

base percentage, with an additional 2.5% capital surcharge for being in the 4th bucket. This

would mean banks in the 4th bucket have a mandatory capital holding of 9.5%. Additionally,

these assets would need to comply with the strict criterion of asset quality that Basel III

specifically underlies. Figure 3.2 below gives you a better visual idea of the bank bucket

compartmentalization. The diagram displays the banks corresponding to the specific buckets,

with their respective capital surcharges. [24]

Figure 3.2

At present, U.S Banks have made very good progressions toward closing the common capital

and liquidity ratios gap. “U.S. banks have improved their Tier I common capital ratios over the

last seven quarters. While some of them have surpassed requirements comfortably, some have

barely made the mark and are expected to continue to shore up their capital over the next few

quarters” [25] As of Q2 2014, it appears that most of the large US banks have reached or

exceeded their CET1 (Common Equity Tier) capital ratio metric. Morgan Stanley leads the way

with a near 10.7% figure against it’s 8.5% target. Citigroup follows with a near 10.6% metric

against it’s 9% target. Notably, JP Morgan is the only bank that has not significantly exceeded

their target benchmark, only barely hitting the target with a 9.79% cap hit. [26] I posit that the

diametrically opposed values between Morgan Stanley and JP Morgan can be due to variable

business models. Over the duration of this process, Morgan Stanley has internalized it’s cash

instead of returning it to its stockholders. Additionally, it has acquired 100% from Smith Barney

while simultaneously spinning off it’s “capital intensive” fixed income group, which led to a

reduction in its risk weighted assets (RWA) profile and a boost to it’s CET1 figure. These

measures have led to a 220 basis points (2.2%) above it’s target in 7 quarters. [27] JP morgan on

the other hand has remained constant in it’s approach, and has not altered its business model

in any substantial manner. Their objective is to cover the spread using quarterly earnings to fill

the gap. This will eventually lead to gradual increases in Tier 1 Capital, instead of the 130 basis

point (1.3%) average across the spread. Figure 3.3 drawn from the forbes article displays the

quarterly CET figures for Morgan, Citi, JPM and the rest of the banks at large. Note the target

and buffer in comparison to our bucket analysis earlier. [28]

Figure 3.3

Basel III’s impact on the Eurozone is a bit more far reaching in nature than in the United

States. This would agree with our assumption, as the Eurozone is comprised of a larger financial

system spanned across multiple countries. That being said, the drivers that comprise the impact

differ on a few fronts. From a capital perspective, mortgage servicing rights play a bigger role in

the United States than in Europe, where the effect of minority interests are lighter in

magnitude. Additionally, the overall impact of Basel III’s Risk Weighted Asset (RWA) measures

are not equivalent between the two regions. “The impact of Basel III’s RWA‐related measures is

not directly comparable between Europe and the United States, due to the very different

starting position of the two industries. Many US banks have not yet implemented Basel II.

Capital ratios in these banks may be more deeply affected by the simultaneous transitions to

both Basel II and III. That said, it is not possible to predict from the outside‐in the additional

impact this will have on the capital needs of the US banking sector. With respect to funding, the

most significant factors in the United States include the 40 percent limit in the LCR on debt

issued by public‐sector entities, the assumed drawdown rates on corporate and financial credit

and liquidity lines, and the assumed runoff rates of wholesale deposits. “ [29]

Research analysis from Mckinsey’s case study concludes that there are components of

both capital and funding impacts with respect to Basel III implementation. From a capital

perspective, industry need of additional capital will increase 10% from €1.1 trillion to €1.2

trillion. This assumption is an end on end net value that takes into consideration increasing

needs for cash as well as additional basel III deductions. First, some items that Basel III plan on

deducting from capital, such as DTA’s and hidden losses, will be largely irrelevant in 2019. This

reduces capital shortfall by €100 billion. Additionally, Banks can fill in their capital needs using

accumulated retained earnings, as was the case with JP Morgan. The assumption here is a €700

billion increase over 10 years, factoring in 0.6% ROA with a tax rate of 30% and dividend payout

of 50%. [30] Finally, business growth increases the need for excess capital, with an assumption

of about €900 billion. The net result here is a €1.2 trillion shortfall. (100+700‐900= ‐100+ €1.1

trillion ). Key underlying macro level assumptions are that nominal GDP increases at an annual

3.5% rate. Additionally, the effects of deleveraging propose a lowered bank balance sheet

growth rate of 3%. (admittedly, these assumptions do not have explanatory power towards

significant restructurings outside the scope of this model.) From a funding and liquidity

perspective, short term liquidity shortfall would increase from €1.3 trillion to €1.7 trillion, while

long term funding shortfall would increase from €2.3 trillion to €3.4 trillion. (“note that an

increase in long‐term funding would offset a large part of the short‐term liquidity shortfall.”)

[31]

Figure 3.4

The final area of interest that I would like to highlight in my analysis is the nuanced impact

across particular business segments in the Eurozone. As stressed in the Mckinsey study, three

impact types must be considered. 1) Balance Sheet specific impact at the corporate level, 2)

Universal impact across banks and business, and 3) Business specific impact. To assess these 3

impacts on the major business segments (retail, corporate, and investment banking), we can

dislodge the argument into products and analyze the impact by considering changes in capital

costs, liquidity costs, and long term funding costs, and then calculate the change in cost of

making products in each segment on a basis points measurement. Figure 3.5 below shows the

expected changes in product costs under Basel III across the major business segments. [32] (

Note that the upper limit ranges in these assumptions are driven by the long‐term funding

requirement—the net stable funding ratio (NSFR)—as assumptions based on current

construction would be inaccurate due to continuing changes in regulation and deregulation.

“This is particularly important in the following discussion, as the long‐term funding ratio is a key

cost driver for some products, especially corporate products, cash trading activities, and

low‐rated and financial institution bonds.” [33]

Figure 3.5

The retail banking business is affected by Basel III in areas that systematically affect the bank at

large, particularly the higher capital and liquidity requirements. New higher capital ratios will

especially affect retail institutions, as they’ve historically operated under lower capital ratios

than wholesale banks. Liquidity requirements will also be a factor, though not as significant as

the capital requirements. The effect of Basel III’s new product‐specific requirements is less

relevant. The new market‐risk framework does not apply to the retail segment, and funding

agreements in place are acceptable under the july 2010 annex, which “established that deposits

are now largely accepted as long‐term funding and significantly reduced long‐term funding

requirements for mortgages.” [34] Residential mortgages require only 65% long‐term funding,

compared to 100% in earlier versions. Additionally, short‐term retail loans will see an increase

in costs of up to 70 basis points (.7%), as a result of an increase in retail segment targets ratios.

This makes sense intuitively, as higher levels of liquidity in conjunction with long term funding

warrant a higher price. In some cases, banks can diffuse this cost by passing it along to

customers, given the high margins on these products.

Like retail banking, corporate banking will also be affected by the systematic firmwide

effect of increased capital target ratios. “Long Term corporate loans and long‐term asset‐based

finance businesses (commercial real estate, project finance) will face an increased funding cost

of about 10 basis points. Uncommitted credit lines to financial institutions and uncommitted

liquidity lines to both financial institutions and corporates will see a cost increase of 60 basis

points just for higher liquidity requirements, plus some 15 to 25 basis points for higher capital

requirements.” [35] Given the price sensitivity of some lending markets, the segments may be

unable to pass the expense along to customers, leading to a potential decrease in overall

profitability. Riskier products such as specialized lending (including structured finance and trade

finance among other businesses) or unsecured loans are estimated to increase about 60 basis

points (.60%), largely due to new capital target ratios. [36] Trade Finance in particular is

covered by various elements of Basel III. First, risk weights within financial institutions are

increased by a factor of 20‐30%. Second, the new liquidity standards set reserves against off

balance sheet items such as trade guarantees and letters of credit, an essential element of

trade finance within institutions. Finally, trade finance commitments count in full against the

new Basel III leverage threshold, a 500% increase over present capital ratio requirements.

The final business segment under analysis is investment banking. Of the three segments,

investment banking bears the most product groups, with capital markets specifically absorbing

the higher target ratios. “The biggest effects to products come from the new market‐risk and

securitization framework, the changed liquidity of securities through the introduction of the

LCR, and significant amendments to the OTC derivative business.” [37] Trading activities will

face the greatest overhaul and oversight as a result of Basel III. Three particular areas of

interest are OTC derivatives, cash trading, and securitizations.

OTC derivatives will be affected in two ways. First, overhauled Basel III risk management

procedures will require banks to hold more capital to assume more market risk. Second, the

new credit valuation adjustments (CVA’s) under CRD IV will require banks to hold more capital

for counterparty credit risk despite mitigation under the July 2010 Annex. “Our current

estimate is that CVAs will increase RWAs by a factor of 3—on top of the effects of changes in

the market‐risk framework.” Along with increased Basel III liquidity standards and resultant

liquidity costs, bottom line costs on unnetted, uncollateralized positions will increase by a

factor of 85 basis points (.85%). [38] For banks to remain profitable in this area, these costs

would have to be evened out through some combination of “improved collateral and netting

arrangements, more effective central counterparty management, and moving some businesses

and products to central counterparty clearing platforms outside the bank.” [39]

Cash trading overall profitability will be driven down by the higher cost of holding

inventories, particularly the 20 to 40 basis point rise on the matched funding requirements on

lower‐rated assets. Additionally, cash trading will see higher hedge costs from OTC derivatives,

as mentioned above. As these costs cannot be passed along, some market‐making would

potentially be abandoned, reducing overall market depth and liquidity, increasing bid‐ask

spreads, and driving trading activity from banks to exchanges. [40]

Our final analysis in this section is within the area of securitization. An area of interest

that we alluded to at the very beginning of this paper, the securitization business is particularly

noteworthy. All three amendments to the Basel Capital framework—CRD II, CRD III, and CRD

IV—affect securitizations. These changes could increase capital requirements by a factor of up

to ten. [41] CRD II, which serves as an adjunct to Basel III and was implemented in 2010, forces

investors to comply with the “skin in the game” rule—which requires that banks hold at least

5% of all securitizations at all times. Bundled off Mortgage backed securities were a large part

agent to the housing bubble burst and resultant market collapse, so this measure serves as a

hedge against haphazard bundling of securities. “Banks can opt to keep either a first‐loss piece

or a “vertical” slice across the tranches of the securitization. The impact on capital

requirements could be up to 500 percent, in the case of the first‐loss piece, and about 50

percent if they choose to take a vertical slice.” [42] CRD III, which corresponds to Basel II,

introduces market risk capital charges and increased charges for resecuritizations, resulting in a

threefold increase in capital. CRD IV, which corresponds to Basel III, includes an update to a

capital allocation provision highlighted under Basel II. “Under Basel II, securitizations with a low

rating (below BB‐) were typically deducted from capital (50 percent was allowed as Tier 1 and

50 percent as Tier 2). Basel III instead places a risk weighting on such securitizations of 1,250

percent. In combination with the newly increased capital ratio, this translates to significantly

higher capital requirements—some 40 percent to 100 percent higher for capital deduction

items, depending on whether regulatory minimum or industry target ratios are considered.”

[43] Overall, the bottom line here is to move banks as far away from the pre‐2008 securitization

model as possible. These measures make it so that securitization in this new Basel III

environment is a near zero sum game. In fact, in some cases, the required Tier 1 capital would

exceed the actual value of the securitization!

IV Commentary and Conclusion

After reviewing multiple case studies and presenting rigorous analysis, it becomes

apparent that Basel III is indeed a heavy regulation with significant implications across the

financial sector. In this final section, I would like to turn your attention to the very first question

that I asked at the beginning of this paper, “While Basel III is great in theory, is it practical in a

real life financial environment?” Can Basel III accomplish what it sets out to do in the first

place? Will it streamline risk and prevent another systemic failure among too big to fail banks?

Or will it simply be a black hole for liquidity and overall profitability? All very good questions,

and indeed very loaded questions. In truth, after contemplating the issue, my response is a

cautious yes.

To begin, let’s start with the positives of Basel III. First, I appreciated that the Basel III

regulations were given substantial time for gradual implementation. In a regulation with such

drastic overhauls as Basel III, it would be incredibly difficult, if not impossible to address it at

whole within 1 or 2 years. To reference an earlier note, the new Basel III regulations in

aggregate are projected to decrease pre tax ROE between 3.7% and 4.3%. The gradual

implementation softens some of the blow, and allows the banks to come up with additional

resources from tertiary sources such as retained earnings to cover the spread. It also provides

for some leeway to spin off business units on the upper end of the RWA scale to increase their

reserve number as Morgan Stanley had done. In light of the above, I believe this should put to

bed any concerns regarding Basel III eating away at prospective profitability. Admittedly, while

the costs are very front loaded, as is the case with most adaptive regulations, the proper

progressions and exit strategies allow for a seamless transition for the banks and financial

institutions. Figure 4.1 below shows the ease in progression of Basel III from a capital

management perspective. [44]

Figure 4.1

The second objection was that the new liquidity standards would serve as a double

negative in forcing banks to draw up larger reserves, while funnelling money away from

investors and stockholders, further stifling progress. While I do believe that this is a legitimate

concern, I do suspect that the long term positives outweigh the speculative short term

negatives. The objective behind the new liquidity standards was to ensure that banks had the

ability to remain solvent for a satisfactory period of time (30 days) within a tumultuous

economic climate. The discussion over waning investor interest is moot point in the event of

insolvency, which is what we experienced during the great recession. The inability to maintain

substantial liquidity was what led to underwater firms. As is the case with the capital ratios, the

mandated reserve increases are meant so as to stabilize the firms and hedge against future

collapses, and it would appear that Basel III is treading in the right direction on that front. The

beauty of Basel III is that all three facets of the arrangement: Capital, Liquidity, and Risk, are

combined so that the firm can dynamically tackle all fronts in an intelligent manner. In the

process of establishing the proper level of high quality liquid assets (HQLA) in compliance with

Basel III’s liquidity standards, the bank integrates many of the measures required to measure

up to the respective capital ratios as well. Ultimately, this short term standardization paves the

way for the long term consistency provided by the net stable funding ratio (NSFR), which in

practice should keep banks within a sweet zone of measured risk and intelligent compliance.

Because of this, I assess that the liquidity ratios bode very well in the long term for the global

financial ecosystem, despite the elevated initial costs. Indeed, the idea that there is no free

lunch rings true here, but perhaps we can look forward to a grandiose dinner instead.

Finally, the last objection to the Basel III implementation is that it would stifle risk too

heavily, which would have an adverse effect on market liquidity and dissuade involvement due

to the capped upside. Now this is an area with the largest overhaul by far in my opinion due to

the radical increase in oversight surrounding them. Popular measures such as proprietary

trading, securitization, and OTC derivatives have historically been popular routes due to low

barriers of entry as well as the potential for lucrative and substantial profit margins. However,

the objection tends to place a premium on absolute returns, while placing a discount on the

intended risk. Of course, if you or I were to place a trade for our accounts, to eventual

insolvency, we would probably lose a few thousands. Escalate that to a large international bank,

and the results could be catastrophic. The new measures associated with risk weighted assets

(RWA) help to leave a paper trail of responsibility to the respective executors. It brings us back

to this whole idea of “skin in the game”, where the banks and institutions share the

responsibility and risk with the investors. By placing a bigger cap hit on riskier assets, it forces

the bank to pick and choose spots precisely, so as to maximize gain while minimizing losses.

Despite what detractors may say, assuming risk promotes responsibility. By having a legitimate

stake in the products that they sell, banks in the future should operate with a more responsible

and ethically grounded manner.

Figure 4.2 [45]

Over the course of this paper, we’ve discussed the ins and outs of Basel III and its

associated implications. As we finish up our discussion, I would hope that I was able to help you

forge your own opinion on the subject of Basel III. In constructing this paper, I learned that

there are no correct answers when it comes to Basel III. There are various pros and cons, each

with their own valid arguments. Despite my predominantly pro Basel III opinions, I do

acknowledgement there are various areas of deficiency that Basel III needs to address if it is to

avoid repeating the same mistakes as Basel II. THese would include shoring up standardization

across different financial systems globally to shore up any gaps that may open the door for

capital arbitrage. In addition, I believe it is imperative for banks to become more independent

in their stress tests, and to conduct their own safety analyses instead of relying entirely on

credit rating agencies to deliver this task. History has taught us that proactive approaches

trump reactive ones, so it will be interesting to see how that progresses as it unfolds. There are

still 4 year remaining until the conclusion of Basel III’s full implementation, so we will probably

continue speculating until that time. For now, I just wanted to extend a sincere thank you for

reading this paper, and perhaps in four years, can share another perspective on Basel III’s

evolution. Until then, here’s to a great day, and I hope to speak to you very soon.

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Footnotes

[1] http://www.bis.org/bcbs/basel3.htm

[2]http://www.bis.org/publ/bcbs189.htm

[3]http://www.pwc.com/us/en/financial‐services/publications/viewpoints/assets/viewpoint‐Basel‐III.pdf




[7]https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/basell‐III‐issues‐implications.pdf





[12]http://www.accenture.com/sitecollectiondocuments/pdf/accenture‐basel‐iii‐handbook.pdf

http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Basel_III_and_its_Consequences.pdf







http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Basel_III_and_its_Consequences.pdf




http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture-Counterparty-Credit-Risk-Basel-Framework-Successful-Implementation.pdf












http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture-Counterparty-Credit-Risk-Basel-Framework-Successful-Implementation.pdf




[13]http://www.mckinsey.com/insights/financial_services/basel_iii_now_the_hard_part_for_european_banks









[22]http://www.trefis.com/stock/jpm/articles/152796/the‐basel‐iii‐challenge‐for‐banks‐why‐extra‐capital‐requirements/2012‐11‐08



[25]http://www.forbes.com/sites/greatspeculations/2014/03/19/u‐s‐banks‐took‐big‐strides‐towards‐basel‐iii‐compliance‐in‐2013/





















































































