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BY JOEY CHAN, CFA, AND STEPHEN HORAN, CFA, CIPM

evere economic crises are usually associated withbanking sector distress. Because banks are highlyleveraged, bank capital can be wiped out quicklywhen asset quality and value deteriorate during a

crisis. A devastated banking sector jeopardizes the paymentsystem (which is crucial to the smooth operation of theeconomy), the provision of liquidity, and the extension ofcredit, all of which can lead to a broader economic reces-sion. Risks from the banking system can spread to sover-eigns as governments increase their debts to rescue theeconomy and the systemically important banks. Therefore,it is imperative for policymakers to improve resilience ofthe banking sector against shocks.

In response to the global financial crisis, the G20 nations and the Basel Committee on Banking Supervision(BCBS) released Basel III, a package of reforms to the exist-ing Basel II regime for banking regulation. Basel III hasthree principal aims: (1) to boost the banking sector’s abili-ty to absorb shocks arising from financial and economicstress, (2) to improve risk management and governance,and (3) to strengthen banks’ transparency and disclosure.

To be effective, these regulations will require all coun-tries to work together to implement the “minimum” stan-dards. Otherwise, institutions are likely to engage in “regu-latory arbitrage.” Under Basel III, similar to Basel I and II,countries can still choose to implement tighter standardstailored to their idiosyncratic national needs. Unlike Basel Iand II, however, Basel III attempts to be more comprehen-sive and consists of reforms addressing risks at the individ-ual financial institutions and risks at the systemic level.

Exhibit 1 presents the core of the Basel III frameworkin broad strokes. Many of these requirements, especiallythose related to capital and liquidity, are tailored to the na-ture of the financial institutions’ assets and liabilities.

From the perspective of investors, the main concern is how new requirements will affect equity markets, bondmarkets, over-the-counter (OTC) derivatives, and trade fi-nance. Unfortunately, implementation of the proposedpackage is likely to come with many potential drawbacks.

Implications for Equity Markets

According to a McKinsey paper in September 2011, banksin Europe and the U.S. will need an additional US$1.5 trillion in equity by 2015 when the requirement of 4.5

The Impact of Basel III on Financial MarketsWill a combination of structural flaws and illogical, mathematically inconsistent rules make matters worse?

S

Strengthened Capital Base

• Increasing minimum Tier 1 capital to 6% of risk-weighted assets (RWA)by 2015.

• Increasing minimum Common EquityTier 1 capital to 4.5% of RWA by 2015.

• Improving the quality of capital (e.g.,tighter definition of Common EquityTier 1 capital to include only commonstocks, retained earnings, and othercomprehensive income).

• Creating capital conservation buffer foruse during a financial crisis and eco-nomic distress. (Starting from 0.625%of RWA in 2016 and increasing to 2.5%of RWA by 2019.)

Liquidity Requirements

• Setting a minimum liquidity coverageratio (LCR) to ensure banks have suffi-cient high-quality liquid assets forexpected net cash outflows over a 30-day period stress scenario.

• Setting a minimum net stable fundratio (NSFR) to ensure that assets atgreater risk of suffering a one-yearstress event are matched with longer-term sources of financing.

Governance & Systemic Risk Mitigation

• Creating firm-wide governance and risk management.

• Requiring sound compensation practices.

• Widening coverage of risks (e.g.,higher capital requirements for securi-tization exposure, counterparty creditrisk, OTC activities, etc.).

• Creating countercyclical capital bufferto mitigate systemic risk during afinancial crisis and economic distress.

• Setting maximum leverage ratios toprevent excess leverage in good timesand reduce the deleveraging dynamicin periods of stress.

• Identifying global systemically impor-tant banks (G-SIBs) for special treat-ment (e.g., greater loss absorbency,more intense supervisory oversight,stronger resolution, reducing their systemic importance over time, etc.).

EXHIBIT 1

Basel III Framework: Highlighting Select Requirements

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Banks are likely to adopt a two-pronged approach ofamassing liquid assets and at the same time scaling downtheir business operations that are more susceptible to liq-uidity risks. For example, they will have an incentive toraise capital through retail deposits, repurchase agree-ments, and stable credit corporate facilities because thesetypes of assets are assigned lower 30-day runoff rates inthe LCR calculation.

To the extent that banks hold less-liquid assets, theywill be required to secure more stable funding and increasethe proportion of longer-term debts in order to reduce the maturity mismatch and maintain the minimum NSFR.This accounts for the popularity of the European CentralBank’s (ECB’s) recent program of offering three-year loansto banks. Banks borrowed €500 billion, enough to refi-nance almost two-thirds of the debt they have maturingover the next year. The banks’ additional demand forlonger-term financing will compete with other borrowersin the bond market, potentially driving up the yields onbank bonds once the central bank’s cheap money isremoved from the market.

To curb funding costs, banks will try to raise moreretail deposits, especially because these are treated favor-ably in the LCR calculation. But such deposits are in lim-ited supply, particularly in jurisdictions where banks haveto compete for retail savings with insurance companiesand pension funds. Accordingly, banks are likely to securefunding through covered bonds or unsecured bonds withlonger maturity.

Bond markets will expand as a result of increasedsupply and the higher yields when the ECB finally stepsback from its role as a primary lender. The improvedmarket liquidity of long-term bonds may make short-terminvestors more willing to consider longer-term invest-ments. To whet investor appetite, banks may have to issuemore collateralized bonds with simpler structures andhigher transparency. Furthermore, unlike mortgage-backedsecurities (MBS), covered bonds are acceptable for LCR,which makes them attractive to banks. For MBS to increasethe chance of gaining LCR recognition, there should be ahighly liquid market coupled with improved transparency.

New regulations giving authorities more latitude tohandle failing institutions might also affect bond yields.Investors may be concerned that they will be required toshare the burden in the event of a failure. Bank bond hold-ers may not be willing to accept the increased politicalrisks without an adequate rise in bond yields.

Higher capital adequacy is likely to increase financialsystem stability and encourage a more stable macro-envi-ronment for bonds. Therefore, more stringent banking regulations are likely to reduce risks for bond investors.

Implications for OTC Derivatives

Derivatives markets have started to factor the impact ofBasel III in transactions and pricing.

Basel III capital requirements are focused on controlling

percent of Common Equity Tier 1 capital kicks in. There -fore, banks are expected to raise more capital through equitymarket issuance. However, since 2005, the average annualequity issuance for eurozone banks has been in the rangeof €20 billion to €50 billion. The corresponding world-wide equity issuance amount is in the range of US$50 bil-lion to US$150 billion. Markets would have a hard timeabsorbing the new issuance before 2015, even though thebanks can reduce external capital requirements by increas-ing retained earnings, which would reduce dividends.

How stock prices of banks will be affected by Basel IIIis more contentious. Although many market observersbelieve that the capital and liquidity requirements are likelyto substantially reduce profitability of banks, some expertsargue that all things being equal, bank stocks may benefitfrom higher capital ratios if the market places a greatervalue on financial stability. The net impact depends onhow the possible profits loss from a small capital basecompares with the marginal reduction in expected costs offinancial distress. It is not easy to determine ex ante.

For the broader equity markets, higher capital reservesincrease costs of capital and reduce available funds forlending. In effect, setting leverage ratios caps the bank’s scaleof business. Limiting leverage and increasing risk weights(see below) discourages prime lending and long-term lend-ing. It may also increase interest rates, making equity financ-ing look relatively more attractive than debt financing forfirms in the product markets. Deleveraged capital structuresin the product markets will reduce the risk and return onequity, and lower earnings per share for both the bankingsector and the broader stock market—assuming that aggre-gate earnings potential remains at about the same level.

Banks may alternatively choose to shrink their loanbase rather than increasing equity, but that will have thesame effect. Either way, Basel III is likely to exert downwardpressure on the broader equity markets in the coming years.

Implications for Bond Markets

Global bonds markets will likely be severely impacted bythe introduction of the new liquidity requirements—theliquidity coverage ratio (LCR), which measures the suffi-ciency of liquid assets to satisfy short-term liquidity needsunder a stress-test, and net stable fund ratio (NSFR),which measures the sufficiency of long-term stable financ-ing sources to fund long-term illiquid assets.

Banks will favor holding assets that satisfy LCR’sliquid-asset criteria and be discouraged from using fund-ing sources with potentially high run-off rates, such asstructured investment vehicles (SIV) and special-purposevehicles (SPV). Because the LCR has a bias towards banksholding government bonds, covered bonds, and high-qual-ity corporate bonds, demand will decrease for less-liquidassets, such as securitized assets and lower-quality corpo-rate bonds. Banks’ preference for holding assets that areconsidered liquid under LCR will shift investors’ return onparticular market segments and affect credit spreads.

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counterparty risk and thus depend on whether bankstrade through a derivatives dealer or a central clearingcounterparty (CCP).

When a bank enters into under-collateralized deriva-tives trades with dealers, it assumes counterparty risk.Basel III creates a liability for such trades and mandates a high capital charge. If a bank trades through a CCP, thecapital charge will be a mere 2 percent, which would beextremely attractive to the banks.

In addition to counterparty risk, Basel III capitalrequirements attempt to distinguish between hedging andspeculative positions. Risk weightings for CCP positionsare applied only to a bank’s “loan equivalent amount” ofderivatives exposure to a counterparty, which is ascer-tained after netting out the derivatives exposures. Allow -ances for netting will encourage central clearing for morebilateral OTC derivatives.

Nevertheless, the “loan equivalent amount” of anexposure after netting must be included in total exposures.Repo and off-balance-sheet commitments must also becounted towards this total and are assigned a 100 percentcredit conversion factor. Off-balance-sheet commitmentsthat are unconditionally cancellable carry only a 10 per-cent credit conversion factor. Whether the end-client is afinancial institution, trading OTC derivatives with a CCPwill be relatively attractive because the capital charge ismuch lower.

Under Basel III, either collateral will have to beposted by end-clients to the CCP or bank fees will haveto increase to compensate for banks locking up their capi-tal to supply liquidity for the non-cleared OTC deriva-tives transactions.

Posting non-cash collateral on a CCP is likely to beless costly. The dilemma is that most clients, such as air-lines, energy companies and insurance firms, do not havesufficient non-cash collaterals for the CCP. These clientswill have to acquire permitted collateral, such as govern-ment bonds, or enter into a collateral-conversion/collat-eral-upgrade trade (which is less cash demanding, thoughnot without its own cost).

Certain assets (such as equities, corporate bonds,warrants, and other tradable products that are not accept-able as collateral by a CCP but otherwise have value inthe market), may be used in a collateral-conversion trade.The asset owner can enter into a securities lending orrepo transaction and receive treasury securities that canbe pledged to the CCP.

The market for collateral conversions has been prolif-erating, mainly with banks as service providers. A CCPcan also provide the same service to reduce complexityand give a one-stop solution to clients who are onlymaking fewer trades. But companies holding large andongoing OTC derivatives positions, such as insurance orenergy companies, may prefer a competitive market thatoffers better pricing. In any event, banks facilitating col-lateral conversion are well positioned to benefit from the

proliferation of collateral-conversion transactions.Similarly, to economize the regulatory costs, banks

try to warehouse their illiquid securities by posting themas collateral assets to the OTC swap transactions withexchange-traded funds (ETFs). This practice explains thegrowing popularity of swap-based synthetic ETFs.

No matter how institutions post collateral, the cost oftrading OTC derivatives will rise. The cost is likely to behigher for dealer trades as opposed to CCP trades. In thelong run, CCPs will evolve to be credit neutral and theleast expensive means for market participants’ hedgingand investing needs. Changes likely will be reflected soonin OTC derivatives agreements.

Implications for Trade Finance

One of the culprits of the recent financial crisis was secu-ritization, a process by which banks move their assets offbalance sheet in order to economize the regulatory capitalcharge. To address this problem, Basel III has increasedthe risk weighting (i.e., credit conversion factor) assignedto off-balance-sheet items by fivefold—from 20 percentto 100 percent.

In the original proposal, Basel III would treat (amongothers) standby letters of credit (LCs) and trade letters of credit similar to off-balance-sheet items. The liquidityand leverage requirements do not consider the risk profileof a loan but simply treat LCs in the same manner as acomplex derivatives transaction. As a result, banks wouldbe required to hold 100 percent capital against a lendingcommitment to finance a trade transaction (a fivefoldincrease over the current 20 percent). Unless the bankscan pass on their increased costs, trade financing will befar less attractive, and they may focus on other businessesand limit their trade credit exposures.

With increased costs of LCs, the trade-financingmarket is likely to deteriorate as exporters find other lessefficient alternatives, such as open account terms, forfeit-ing, or other forms of unsecured financing. Already, banksare pulling back their services in this area. Because LCsare usually used for trading with emerging markets, theseeconomies may be hurt the most if financing means otherthan LCs are used. In addition, companies doing businesswith the developing economies will have to scrutinizemore closely the sovereign, geopolitical, and counterpartyrisks. Similarly, small and medium exporters are likely tobe hurt more than large exporters who can diversify manyof these risks.

These rules have been severely criticized by trade-financing professionals because LCs, unlike other off-bal-ance-sheet items, are traditionally low-risk products forbanks. The rules may actually encourage rather than dis-courage risk taking by treating low-risk trade credit in thesame way as higher-risk transactions that have much higherprofit potential. According to the International Chamberof Commerce, LCs represent approximately 20 percent ofworld trade and are vital to the world economy. LCs are

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an effective means to support the underlying economictransactions and should be recognized and encouragedaccordingly. Otherwise, nonbank financial companies thatdo not fall under the purview of Basel III are likely to fillthe void and expose the financial system to systemic risk.

Despite the rampant criticisms, not until late October2011 did the BCBS adopt two technical changes on thecapital-adequacy framework to address issues with tradefinance. But still, in December 2011, banking associationBAFT–IFSA released a list of recommendations for BCBSwhile a group of 23 banking and trade associations sent a second letter to persuade BCBS to make further changesto the capital requirements for trade finance.

Further Implications for the Banking Sector

Studies abound on Basel III’s implications for the bankingsector. This section summarizes some anticipated trends.

Banks are heavily regulated under Basel III andrespective national laws, such as the Dodd–Frank Act inthe U.S. They are under severe pressure to be more trans-parent and have simpler balance sheets and capital struc-tures. Thus, banks are likely to reduce certain lendingactivities to effectively shrink their balance sheets, limitcapital market exposure, and eschew structured-producttransactions. They will prefer to have their OTC deriva-tives transactions cleared by CCPs. The regulatory favorbestowed on retail deposits will intensify competition forretail deposits and discourage short-term wholesale fund-ing. Similarly, banks will seek to issue covered bonds forlong-term funding because of their treatment in the NSFRcalculation. Standards for mortgage lending have alreadybecome quite stringent and will remain so, and conven-tional products and collateral requirements will be morecommon. Pricing for credit lines, such as home equitycredit and credit cards, is likely to increase. Nonbankinstitutions, outside the ambit of the regulations, will beable to develop cost-effective products that may furtherweaken the position of the banks and circumvent regula-tors’ attempts to control systemic risk. The banking sectorwill undergo a consolidation phase to improve efficiency.

Problems with Basel III

Establishing a minimum leverage ratio, requiring a capitalbuffer, and combating pro-cyclicality through dynamicprovisioning based on expected losses are laudable ele-ments of Basel III. The capital buffer, which is intended toensure that the leverage ratio is not compromised in crisissituations, seems especially important and will require div-idends, share-buyback policies, and executive bonuses tobe restrained in good times so banks can build buffers forbad times. Despite the obvious benefits, Basel III raisesnumerous concerns.

First, Basel III’s liquidity rules are primarily focusingon risks at individual institutions and not risks at the sys-temic level. The International Monetary Fund (IMF)reports that the NSFR would not have signaled problems

in the banks that ultimately failed during the recent finan-cial crisis—despite some of these banks failing from poorliquidity management and overuse of short-term wholesalefunding. More needs to be done to develop effective meas-ures to mitigate systemic liquidity risks.

Basel III has also been criticized for not resolving themost fundamental problem—that banks can use deriva-tives (such as CDS) to transform their risks and thus min-imize capital costs, even shifting them beyond the bankregulators’ jurisdiction—say, to a less-regulated sector,such as insurance, or to a less regulated country.

The shadow banking system continues to compromisethe efforts of the regulators. As financial commitments andexposures are shifted around and treated differently fromsector to sector and from jurisdiction to jurisdiction, onemust question the proper scope of regulatory oversight.Considerations regarding structure of supervision and reg-ulatory process and global coordination among regulatorsfrom different jurisdictions can have far-reaching conse-quences.

Moreover, the process for generating the frameworkmay be hampered by a structural problem. BCBS consistsmainly of heads of central banks of developed economies.It has no representation from the broader community orfrom developing countries that have growing economiesand younger populations. Their perception and assessmentof risk could be very different.

The group categorized risk and risk models intostrategic, market, operational, reputational, credit, and liq-uidity risk. According to fundamental principles of diver-sification, risk is not additive. Combining a 99 percentconfidence-level calculation for one type of risk with a99.9 percent confidence level for another risk type is con-fusing at best and misleading at worst. Risk aggregationrequires consideration of how the individual risks arerelated to each other. The illogical and mathematicallyinconsistent rules—coupled with different implementationand modeling approaches at the banks—can be puzzlingfor the boards of the banks. The new rules may be morefor regulators and compliance officers than guiding busi-ness decisions in the board rooms.

Although some regulations are final, the BaselCommittee has not yet completed its work. Most of theBasel III rules will be revised further as more people criti-cize their suitability. The current timeline is for everythingto phase in by 2019, which provides ample opportunityfor things to change. For example, there were a number of “final” versions before Basel II was refined to the finalJune 2006 version. No one knows how much more BaselIII will change in the coming years. Conceivably, ineffi-ciencies of the framework may lead to the drafting of BaselIV before Basel III is finalized.

Joey Chan, CFA, is director of planning and programme development and Stephen Horan, CFA, CIPM, is head of university relations and private wealth at CFA Institute.