PARIS (Standard & Poor's) April 15, 2010--The Basel III proposals on banking
supervision could, in the opinion of Standard & Poor's Ratings Services,
strengthen banks' balance sheets as well as trigger fundamental changes in
their business models and product pricing. However, if adopted as proposed,
the Basel III proposals also run the risk of creating unintended consequences
for parts of the financial system.
In Standard & Poor's view, these unintended consequences could include
constraining banks' lending activities and their ability to trade on
derivative markets, hampering the inter-bank lending market causing
displacements in markets for high-quality liquid securities, and encouraging
banks to shift to short-term lending.
Standard & Poor's credit analyst, Bernard de Longevialle, said: "In our
opinion, the Basel III proposals address many of the weaknesses in Basel II
and should lead to stronger, more stable banks worldwide. However, they are
also likely to affect parts of the financial sector in ways that regulators
may not have envisaged."
Standard & Poor's believes that Basel III will result in some banks having to
make changes to their balance sheet structures or business models. We expect
smaller, deposit-funded retail banks to find it easier to comply with Basel
III's more stringent liquidity and capital requirements than larger
wholesale-funded institutions. We also believe that Basel III will likely
cause more significant changes for wholesale-funded institutions with their
extensive trading operations or large loan books and securities holdings. In
particular, Basel III could have a major effect on the capital requirements of
investment banks, for which counterparty risk already accounts for more than
20% of total regulatory risk-weighted assets.
Our views on the potential effect of Basel III cover five issues:
LIQUIDITY
Basel III's introduction of new liquidity standards could, in Standard &
Poor's view, significantly strengthen banks' liquidity positions and enhance
the supervisory review process. However, an overly restrictive approach to the
definition of liquid assets and requirements for funding certain types of
assets with long-term funds could reduce bank profitability from their lending
and trading activities. Some of Basel III's assumptions could, in our view,
severely hamper the inter-bank lending market and cause displacements in the
high-quality liquid securities markets.
In Standard & Poor's view, if Basel III's structural funding metric, which
introduces minimum requirements for the use of longer-term and more stable
funding sources, is implemented as proposed, banks could respond by shifting
more towards short-term lending. We believe that some level of mismatch
between assets and liabilities is inherent in banking and necessary for banks
to fulfill their role in the economy.
COUNTERPARTY RISK
Although some of Basel III's proposals are consistent with our view that risks
in banks' trading books deserve higher capital charges, we believe that the
proposed regulatory capital charges under Basel III could be far higher than
the counterparty risk losses endured by banks during the recent turmoil. If
implemented in their present form, the proposals could create strong
incentives for banks to move to qualified clearing houses.
Basel III's proposals could, in our view, have significant effects on the
derivatives markets and on financial institutions with large derivatives sales
and trading businesses. We believe that banks with significant trading
activities with hedge funds or other financial intermediary counterparties
would likely be most affected by Basel III's regulatory capital charge
proposals. In particular, the estimated multiplication by four to six times of
counterparty risk compared to the current weighting, could have a major effect
on the capital requirements of investment banks, for which counterparty risk
often already accounts for more than 20% of total regulatory risk-weighted
assets. The proposal could result in increased use of qualified clearing
houses as counterparties for derivatives contracts. If OTC derivatives become
too capital-costly for regulated financial institutions under Basel III, in
our view this business (and its risks) might be driven to unregulated
institutions such as hedge funds.
LEVERAGE
Used as a supplement to risk-adjusted capital measures, both at the industry
and at the specific bank level, we believe Basel III's leverage ratio could be
valuable and could help identify "outlier" banks.
However it remains a raw measure for the purpose of bank capital adequacy
analysis. Assigning too much weight to this measure could, in our view,
incentivize banks to make riskier investment decisions. If Basel III's
leverage ratio proposals are implemented, banks might well move away from
low-risk, low-yielding businesses in favor of higher-risk, higher-return
assets. In our view, the effectiveness of Basel III's leverage ratio proposals
will depend on the definition of "leverage ratio". If defined inaccurately, we
believe it could lead to outcomes that might be seen as undesirable from a
broader perspective, such as for example a reduction in liquidity in the repo
market as banks reduce their portfolios to manage the leverage ratio
calculations.
PROCYCLICALITY
Basel III's proposal to implement countercyclical measures in the form of
regulatory requirements should, in our view, improve the creditworthiness of
the banking industry. The apparent procyclicality of the Basel II ratio was
one of the factors behind our decision to develop our own risk adjusted
capital measure. However, in our view Basel III's proposed discontinuation of
regulatory adjustments for unrealized gains and losses on securities or
properties would likely exacerbate pro-cyclicality.
COMPARABILITY
Basel III's proposals for grandfathering hybrid capital instruments may, in
our view, create a lack of comparability in regulatory capital ratios for an
extended period. Grandfathering could also result in hybrid instruments still
being included in regulatory capital measures despite their demonstrated
ineffectiveness as a form of capital during the recent turmoil.
RELATED RESEARCH
Standard & Poor's Response To The Basel Committee's Proposals On Bank Capital
And Liquidity, Apr. 15, 2010
Basel III Proposal To Increase Capital Requirements For Counterparty Credit
Risk May Significantly Affect Derivatives Trading, April 15, 2010
Basel III Proposals Could Strengthen Banks' Liquidity, But May Have Unintended
Consequences, April 15, 2010
The Basel III Leverage Ratio Is A Raw Measure, But Could Supplement Risk-Based
Capital Metrics, April 15, 2010
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