RegTech Intelligence

Concerns are raised over the cost of the Basel reforms

The Global Financial Markets Association (GFMA), a banking lobby, has warned regulators that new rules must be closely examined to assess their impact on the global financial markets. This comes as a result of the proposed changes to capital requirements that the Basel Committee is currently implementing.

These changes to capital requirements could have a huge impact on global financial institutions as the Committee’s members come from countries all around the world, including France, Germany, India, China, the United Kingdom and the United States.

The extent of the financial crisis during 2007 to 2009 had the G20 calling for higher capital and liquidity levels for banks. The Basel Committee began implementing Basel III from January 2013 and that is set to be fully phased by 2019. The Basel III reform is set to improve the banking sector’s ability to absorb financial and economic shocks, improve risk management and governance and strengthen banks’ transparency and disclosures.

Most observers have agreed that capital and liquidity levels do need to increase substantially from pre-crisis levels. However, they have also raised concerns about the costs and unintended consequences associated with the reforms as, since the crisis, there has been a marked increase in banks’ required capital and liquidity levels. Any further tightening of these requirements may “choke the economic recovery”, said the Chief Executive of the International Federation of Accountants, Fayez Choudhury.

Oliver Wyman released a new report commissioned by the GFMA on the interaction, coherence and overall calibration of post-crisis Basel reforms. The report highlights the risks that markets will face because of these reforms. These include a reduction in market liquidity, an increase in direct transaction costs through wider bid-ask spreads, an increase in market volatility and an increase in instability – which could push up liquidity premiums demanded by investors. There is already some evidence of this happening.

The report predicts these impacts and risks are likely to increase substantially over the next few years as the Basel Committee is looking at more stringent parameters for calculating how much capital should be set aside. Many banks have criticised this decision, referring to it as ‘Basel IV’. The report therefore urges the Basel Committee to conduct a further impact analysis before implementing any new rules before it meets next month to work towards the key remaining reforms by the end-of-year deadline.

The report also comments on the impact the Basel Committee will have on capital markets and suggests that there is already evidence of significant changes in market structure driven by the regulators and other factors. This is shown by the fact that banks’ trading balance sheets have contracted by 25-30% since 2010.

The report estimates that funding costs for loans could increase from 60 to 84 basis points, although this depends on the region and on the different types of lending. In addition, loan volumes on banks’ balance sheets are estimated to decline by an average of 2.6% for each 1 percentage point increase in required capital ratios which will lead to a reduction in bank lending.

In light of the report findings, the GFMA has set out several recommendations that they think the Basel Committee should consider. One of these recommendations is a request to identify cases where there may be unnecessary duplication or conflicts between regulatory requirements due to the sheer volume of regulatory changes since the financial crisis. The complexity due to the overlapping of rules can also cause an adverse impact on lending channels and liquidity.

An example of a potential duplication is in the Basel Committee’s proposed guidance on identification and measurement of step-in risk. According to the Basel Committee, step-in risk “refers to the risk that a bank will provide financial support to an entity beyond, or in the absence of, its contractual obligations should the entity experience financial stress.” This could be duplicative of other measures that have already addressed the underlying issue, e.g., prohibition of sponsor support for money market funds.

Another recommendation is to have an observation period for ‘Basel IV’ until the full impact of the not-yet-fully-implemented Basel III becomes clearer. Furthermore, they advise a more rigorous analysis on the impact on capital markets, including assessing the effects on specific instruments, market segments, primary versus secondary markets, emerging markets and the changing dynamics of investment behaviours.

There have been concerns by some observers that the reforms will lead to a further rise in capital requirements, way beyond what the G20 countries originally agreed on.

It should be noted that, while the report addresses the potential costs from the Basel reforms, it does not include the considerable benefits that the reforms may bring – fewer financial crises, smaller crises and smaller effects of these crises on the wider economy creating a more financially stable environment. The Oliver Wyman report has raised many key issues that the Basel Committee should consider when it meets next month and it will be interesting to see how they plan to approach this issue of costs whilst maintaining a fair but stringent implementation on capital and liquidity levels.

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