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February 6, 2014

Easing Basel Rules Boosts Bank Stocks, but Hazards Linger

European banks had not been happy with the proposed rules on leverage and liquidity ratios proposed by the Basel Committee on banking supervision and lobbied hard to have the requirements reduced. Their persistence paid off in mid-January as the committee somewhat relaxed some of its requirements in those two areas.

If that hadn’t happened, banks would have been in for a tough road ahead to satisfy the new regulations. If banks had been required to satisfy the June version of its leverage rules by the end of 2012, 25% of major global institutions would have failed to do so, according to the committee. To satisfy those requirements, they would have had to raise billions more in capital. Such a move would not only have penalized low-risk business, but would also have caused lending to tighten even further, banks had warned. The committee listened, and the changes were seen as a victory for the banks.

News of the modifications sent stocks such as Barclays, Commerzbank, UBS and Deutsche Bank soaring, as fears receded that investment banks would have been on the hook to boost their extra capital by massive margins—according to lobbyists, as much as $100 billion. Still, although some requirements have been loosened, the rules themselves have been rewritten to tighten up potential loopholes, and even the new provisions aren’t yet final, with some going out for a comment period that runs till April.

Basel has proposed that banks be obliged to hold a 3% minimum leverage ratio of capital, but that could still increase. U.S. rules proposed last July called for a leverage ratio of 5% equity to assets for the largest institutions, with their bank subsidiaries being held to a 6% ratio. U.S. rules are more relaxed when it comes to the methods used to calculate assets. However, the higher U.S. capital requirement could not only make U.S. banks subject to a tougher standard but also capture foreign banks that do business in New York.

Changes to the leverage rules put forth by the Basel committee now allow banks to use netting, under specific conditions, to calculate the ratio of equity to assets. They have also eased restrictions on how banks calculate the size of off-balance-sheet business. Other changes reduce the possibility that banks will double-count some derivatives trades.

Modification to the liquidity rule now permits banks to count a specific type of central bank loans against required holdings; the rule, as published in 2013, required banks to have on hand sufficient liquid assets to cover a 30-day credit crunch without relying on such loans. Now, however, those banks may be able to include committed liquidity facilities from central banks in the total of their liquid holdings.

Fitch Ratings said after the rules had been eased that those pertaining to the leverage ratio “are likely to ease capital pressure for global trading banks. The changes, involving reverse repos and derivatives, reduce the assets included in the calculation and make it easier for them to meet leverage ratio requirements, depending on the final rules adopted by national regulators.”

However, that doesn’t mean the ratings agency feels that banks are off the hook for cutting exposure. “We still expect on- and off-balance sheet exposures to reduce as trading banks make progress in meeting leverage ratio requirements, particularly for European institutions, where this is a new regulatory constraint. If banks took on additional risks to take advantage of the revised rules, we would take this into account in our rating analysis.”

Pressure from competitors was likely to push banks into compliance by the deadline of 2018, beginning with holdings that satisfy that minimum 3% requirement, “since public disclosure starts in 2015 and banks will want to keep in line with their peers,” according to Fitch.

However, there is concern at the ratings agency over the difference between Basel Committee rules and those in the U.S., and how it might play out when Basel rules come into full force. “The U.S. supplementary leverage ratio requirement will be double the Basel minimum at 6% for systemically important bank subsidiaries (5% at consolidated holding company level). If the Basel III leverage ratio definitions are not applied consistently across banks globally, this could undermine the comparability and usefulness of this ratio,” according to Fitch.

While the banks may be rejoicing, not everyone was pleased with the more relaxed standards. “For the leverage ratio to be useful to regulators and investors, it should be as simple and inclusive as possible, based on gross exposures rather than net, and including off-balance sheet risks, etc.,” said Greg Ford, a spokesman for Finance Watch, an independently funded, nonprofit public interest advocacy group that works to make finance serve society.

“There are two negative public interest implications from the new Basel framework on leverage ratios: Firstly, it was a missed opportunity to reduce interconnectedness between financial firms, because it allows netting in certain circumstances. A rule based on gross exposures would have further discouraged interconnection between financial firms, which is a key ingredient in the ‘too-big-to-fail’ problem. Secondly, allowing higher leverage weakens banks’ ability to be a reliable provider of credit to the economy. Well-capitalized banks can access cheaper funding which helps them to lend, even in a downturn. When the banking system is under stress, undercapitalized banks are more under pressure to deleverage and cut lending to the real economy, as we saw very clearly after the last financial crisis,” according to Ford.

He concluded, “The concessions are therefore a setback, although the framework is still better than it was two years ago. We now have a common definition from Basel; the next question is how high it will be set. We would argue that 3% is too low and it needs to be raised.”

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