Regulators recently tightened the capital rules on banking institutions, requiring an extra layer of financial padding and stricter risk controls under a series of reforms commonly referred to as Basel III. Industrywide, banks will now have to hold a greater proportion of capital relative to their risk-weighted assets, but those considered “too big to fail” will be subject to even more-stringent regulations. In fact, about 30 of the world’s biggest financial services companies will have to clear that higher bar, including domestic heavyweights Bank of America (BAC - Free Bank of America Stock Report), Citigroup (C), Goldman Sachs (GS), JPMorgan Chase (JPM - Free JPMorgan Chase Stock Report), Morgan Stanley (MS), and Wells Fargo (WFC).
For its part, the Federal Reserve just announced that it would implement substantially all of Basel III’s recommendations, including the following highlights:
• The quality of the asset base will be raised, with common stock and retained earnings constituting the majority of Tier-1 capital.
• Greater emphasis will be placed on risk coverage, including ways to mitigate market and counterparty credit risk.
• The introduction of leverage ratios to limit the amount of investing financial firms can engage in with borrowed funds.
• The promotion of capital buffers—built up during good economic times—which would allow institutions to weather sudden, substantial losses during a downturn.
In addition, all financial institutions with assets in excess of $50 billion will have to abide by the new rules, not just traditional banks. Of the new regulations, perhaps the most important is the one requiring firms to hold capital equal to 7.0% of their risk-weighted assets, with a sliding scale going up to 9.5% for the largest financial institutions. To put that in perspective, the country’s three biggest banks, Bank of America, Citi, and JPMorgan, together will need to raise about $150 billion in additional capital to meet that requirement. However, the new rules don’t take full effect until 2019, allowing companies ample time to build up reserves through profits while trimming their risk-weighted assets.
The focus then turns to the potential economic impact of the new rules, and the effect they may have on lending. The consensus seems to be that Basel III will have a negligible—albeit slightly negative—effect on economic activity, a consequence of greater risk controls and fewer transactions taking place. On the bright side, the new regs ought to be modestly beneficial to economic stability, owing to the reduced frequency and severity of financial crises that they are prone to engender.
With regard to lending, regulators insist that Basel III should not have a deleterious effect on credit availability, but some market watchers remain skeptical. Critics contend that the greatest impact won’t be on the largest banks, owing to their financial and political might. Instead, smaller, regional players will likely be the ones to suffer, since they don’t have the same access to capital pools as their big-shouldered peers.
By some estimates, the shortfall in Tier-1 capital for the segment comprised of smaller U.S. banks may approach $870 billion, or about 60% of their current capital outstanding. The gap in short-term liquidity is another potential concern, pegged by some at $800 billion, or roughly 50% of their available credit. Surprisingly, Basel III is not expected to have a significant impact on mortgage lending, since long-term capital requirements for that segment have been relaxed in recent years.
However, short-term retail loans—such as auto, home repair, and consumer spending—may suffer. That is because banks, eager to prop up their credit metrics and meet the new requirements, may cut back on retail lending, since that segment has relatively high risk weights and a greater likelihood of default.
Furthermore, corporate banking may also come under pressure, as the cost of commercial real estate loans and project finance is expected to rise as compensation for the added risk involved. Specifically, uncommitted lines of capital, such as the nebulous “credit facility” that is all too common on corporate balance sheets, will almost certainly become far more costly. As a result, companies may use this time to stockpile cash in anticipation of the new rules taking effect, likely to the detriment of investments in R&D, new plant and equipment, and, most important, new hires.
From an investment perspective, big, full-service institutions will probably have an easier time absorbing the impact of Basel III, thanks to their greater access to capital. Indeed, the big fish, namely B of A, Citi, JPMorgan, Goldman, Morgan Stanley, and Wells, are liable to report steadier, more consistent results. Of course, lower risk typically spells a decreased opportunity for outsized returns, and the banking sector as a whole is unlikely to experience the same level of growth that it did in the middle of the previous decade.
At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.