TheMarketForIdeas

A Romanian version of this article was first published on the 18th of December 2017 in “Ziarul Financiar”. 

The Basel III accord was eagerly anticipated and its adoption had a significant positive effect on the banking stocks in late 2017. Of course, there were other considerations behind the positive sentiment, such as the progress recorded by the Brexit talks between the European Union and Great Britain at that time. For analysts, however, the lion’s share of this positive outlook was attributed to the fact that, after almost two years of negotiations with behind-the-scene stratagems and a great deal of lobbying, the leaders of the biggest central banks had succeeded to reach a compromise regarding the new Basel III regulations, which would have an important impact on the activity of the commercial banks. According to the statements of certain officials, this framework was intended to be final.

How did Basel III principles come into being? How «final » can such a convention be in a financial world looking for a new identity and haunted by numerous uncertainties?

The 2007-2008 crisis forced the financial regulators of the biggest economies in the world to come up with new standards for the banks. These standards, established under the aegis of G20 and of the Financial Stability Board, have taken into account the growth of the bank assets, both in the balance sheet and off-balance sheet (including derivative products) in the background of degrading capital ratios and low capacity of many banks to absorb shocks arising from a potential liquidity crisis. Thus, it became clear that banks should maintain adequate capital funding in order to avoid borrowing from the States should a new crisis loom.

Although initially promoted as a tough bureaucratic approach aimed at stabilizing financial markets and decreasing the risk appetite of the banks, the Basel III Regulations seem now less rigid then feared by the commercial bankers.

During prior years, negotiations evolved only to focus more on tighter standards regarding the definition, computation and weighting of the risks associated with bank assets (RWA – Risk Weighted Assets), under all their manifestations, from loans dedicated to the individuals to loans for the SMEs and furthermore structured financing and derivatives products. In this context, one of the key measures of the new framework refers to imposing limits on the principle of internal modeling of the credit risk computation, allowing each bank to continue implementing its own methodology of credit risk assessment instead of adopting the standard solvability computation model. The target is to have a less « mechanical » approach and more of a due diligence method forcing banks to make efforts towards a better knowledge of their own clients. The banks that apply internal risk assessment regulations will be imposed a minimum capital floor of at least 72.5 % of the standard formula. The transition to this capital funding benchmark shall happen progressively (with 50% starting from 2022 and up to 72.5 % by 2027). Operational risks (risks linked to internal processes, frauds, personnel, IT systems, natural disasters…) will be analyzed and assessed based on a primary principle, namely the rise in banks’ incomes corelated with the history of the recorded loss.

Although initially promoted as a tough bureaucratic approach aimed at stabilizing financial markets and decreasing the risk appetite of the banks, the Basel III Regulations seem now less rigid then feared by the commercial bankers. Officials of the large international financial groups correctly expected such rules to become even more flexible with their passage through the European Parliament. On the other hand, the deadline of the measure implementation (year 2027) offers banks sufficient time to adapt to the new background.

But the true reason of the rising share prices of the main financial institutions was the final version of the Basel III Accord that wiped away the fears linked to capital adequacy ratios that banks were supposed to ensure for prudential reasons. Even with the establishment of a specific reserve dedicated to the systemic risk (buffer), the impact of the new regulations on the solvability ratio of the relevant Europeans banks (the financial groups of systemic magnitude) remains limited: under 1%, according to analysts. On the other hand, commercial banks will have ten years time to adopt capital funding increases, which they may easily do by transferring profits to reserves, without afflicting the dividend distribution practices.

I have not seen however in Basel III Accord any references or prudential solutions regarding at least two major phenomena that will, in my opinion, change the shape of the financial – banking industry over the following 5 to 10 years: the situation of the sovereign debt of the Western countries and the transformation of the business model of the banks.

Even with the establishment of a specific reserve dedicated to the systemic risk (buffer), the impact of the new regulations on the solvability ratio of the relevant Europeans banks (the financial groups of systemic magnitude) remains limited: under 1%, according to analysts.

Concerning the sovereign debt, as I have already written (link in Romanian), never have the most powerful Western countries been hit by such high indebtedness – except for times of war - which threatens not only the people of the respective states but also the rest of the world. According to many economists, the debt of the Western developed states will continue mounting. If the rhythm is maintained, it is likely that by 2050 the indebtedness degree of the developed Western countries will exceed 250% of GDP. This level will not be economically sustainable. China will become the leading world creditor, surpassing Japan. Given these tendencies, over the next 5-10 years, markets will no longer trust the capacity of the Western states to manage their sovereign debt and will bet on their ruin, which will result in a rise of the external financing costs, with huge gaps between the Member States of the Eurozone. It is possible for banks to be designated «scapegoats» with some of them ending up nationalized.

On the other hand, the business model of the banks is undergoing deep changes. With shrinking profits of the banking industry and changing client needs, the competition will become even fiercer. This fight will involve all of the players: traditional banks, niche banks, non-banking companies that penetrated the financial services market using high tech business models (FinTech).

The traditional business model banks will find themselves in a very delicate position. They will try to keep their rank and cope with the new trends. Almost all universal banks will lose market share or seek new ways to consolidate, even if this will be achieved by small steps.

Given these tendencies, over the next 5-10 years, markets will no longer trust the capacity of the Western states to manage their sovereign debt and will bet on their ruin, which will result in a rise of the external financing costs, with huge gaps between the Member States of the Eurozone.

In the era of technological developments traditional banks are facing real competition issues. In a few years, the majority of the banks’ clients will be “digital natives”, people who grew up with the internet and with digital technology. This reality will profoundly reshape the financial services sector. The financial services are virtual/symbolic by nature and the Internet is the best channel for the instantaneous personalization models and digital distribution. The modern technologies require business models associated with new forms of the transactions (payments solutions, e-wallets), new forms of brokerage services (financial services aggregators, crowdfunding or peer-to-peer lending) mediated by new trust creation methods (distributed ledger technology). The development of the social networks and of the mobile technologies and equipment also play a major role.

We can assume thus that the biggest threat for the traditional banks comes from non-banking companies that penetrated the financial services market.

On the other hand, the rapid growth of the consumption loans resulted in the creation of the non-banking financial institutions, which are very attractive in the retail sector. This category includes companies coming from non-banking fields (ex. telecommunication companies, retail…), players that benefit from modern technology, flexible management and decision-making models, real integration in remote communication channels and higher capacity to exploit databases in order to deliver customized offers. They will attract significant retail market shares to the detriment of the banks, a tendency that will keep growing. We can assume thus that the biggest threat for the traditional banks comes from non-banking companies that penetrated the financial services market. These players come with technological innovations, offer clients different service models and standards, and enjoy far less regulatory limitations than the traditional banks.

With this in mind, will Basel III regulations become obsolete even before they ever come into force?

Illustration: George Elgar Hicks, Dividend Day at the Bank of England (1859).