With aftershocks of the recession still reverberating and a very real double-dip threat on the horizon, regulatory officials from more than two dozen countries have come up with a new set of capital standards known as Basel III for the global banking community on Tuesday. The convention is to adopt tougher measures, helping prevent a recurrence of global financial crises and restoring public confidence.
The formal approval of the Basel III proposal is expected on September 12, 2010. The entry point of capital requirements will be different until the introductory period ends in 2018. Will this be perilous to the U.S. banks, or is this what the doctor ordered?
The Basel norms focus on regulatory capital requirements that the banks should maintain. Though the average U.S. banks may fall short of these criteria in the near term with lower capital levels following the recession, they have been raising billions of dollars through the issuance of equity and trying to deploy capital much more cautiously than before. However, major large-cap U.S. banks appear to comfortably maintain the extra capital norms that the Basel Committee advocates.
So what does Basel III mandate? And how comfortable will the U.S. banks be? Here’s a quick look:
Tier 1 Capital Requirements
Banks will have to maintain a minimum Tier 1 capital ratio as high as 12.0%. This will comprise a minimum buffer of 6.0%, a conservation buffer of 3.0% and an additional 3.0% anti-cyclical buffer. The anti-cyclical buffer will help increase the Tier 1 capital requirements to 12% during boom times.
Do U.S. banks comply? As of June 30, 2010, the major banks in the country maintained Tier 1 capital ratios above the proposed minimum level. Bank of America (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo (WFC) and Citigroup (C) had Tier 1 capital ratios of 10.7%, 12.1%, 10.5% and 12.0%, respectively. The capital ratios are expected to somewhat reduce following the repayment of bailout money by some banks. Still, the Tier 1 capital ratios of these banks are not expected to fall below the new minimum capital level requirement.
Tier 1 Common Capital/Core Capital Requirements
The Tier 1 common capital ratio requirement would increase to a minimum of 5.0% along with a conservation buffer of 2.5%. Also, there will be an additional anti-cyclical buffer of 2.5%.
The major U.S. banks swim through these requirements as well. As of June 30, 2010, Bank of America, JPMorgan Chase, Wells Fargo and Citigroup had Tier 1 common capital ratios of 8.0%, 9.6%, 7.6% and 9.7%, respectively. Like Tier 1 capital ratios, the most shock-absorbent Tier 1 common capital ratios are also not expected to decrease below the minimum required level following the repayment of government money by most of the relevant U.S. banks.
Will Dividend Growth be Challenged?
According to the proposals under Basel III, only if a bank operating in a steady economic environment maintains a Tier 1 capital ratio of 12% would it be allowed to pay or increase common dividends. As a result, the pace of dividend increase could be slow as banks will first use earnings to meet the additional capital requirements. However, if the banks can fulfill other regulatory requirements, the dividend increase would follow in due course. Increasing profitability may also help increase dividends.
Though some of the major banks with strong capital ratios would have been able to increase dividends if the proposed capital requirements were immediately implemented, banks with weak capital ratios, including U.S. Bancorp (USB), would have to avoid paying dividends.
Financial Reform Law, the Basel III Harbinger?
The recently passed U.S. financial reform law has already rung in what Basel III is contemplating. Tighter regulations of the recently enacted financial reform law for companies that had threatened the economy are in place. The sweeping financial reform law also imposes stricter capital requirements on banks.
This law would partially restrict the proprietary trading of commercial banks. Also, derivatives trading, used to hedge risks or speculate the future value of assets, would be restricted. Banks will be banned from proprietary trading and will be able to invest only up to 3% of their Tier 1 capital in private equity and hedge funds.
The economic benefits of standards like Basel III are indisputable, as these would somewhat reconstruct the weak capital level that threaten the economy. The norms could ultimately translate to fewer bank failures and less involvement of taxpayers’ money for bailing out troubled financial institutions. However, with the financial reforms already in action, the Basel III would be akin to preaching to the converted. The new standards will probably not be able to add to the nation’s gains.
Regulators and bankers are bound to disagree over the magnitude of positive impact of the new rules as there remain other lingering concerns, including the high unemployment rate, continuation of residential and commercial real estate loan defaults and liquidity challenges. However, over a longer period of time, small U.S. banks, which run with lower capital ratios, will be forced to maintain required capital standards, providing buoyancy to the economy.
On the other hand, the double bind of the Basel III capital standards along with the financial reform law will compel the financial system to go through a massive de-leveraging, and banks in particular will have lower leverage. The implication for banks is that the profitability metrics (like returns on equity and return on assets) will be lower than in recent years.
Above all, the lower leverage due to these restrictions will be a throwback in a sense, leaving banks to perform only their basic functions, including lending and taking deposits. Would Basel III end up curbing the socio-economic functions of banks and de-weave the financial fabric?
By: Kalyan Nandy