Basel III for DUMMIES!

Warning: This text is developed for persons with experience from banking and corporate treasury.

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Together with my good friend Philippe Roca at the Corporate Funding Association (CFA) we can now publish the first (?) official Basel 3 for Dummies. The purpose is to give you a quick insight into this new regulation targeted to be passed in summer 2012. At its present construct it will severely disrupt bank financing to corporates reallocating banks lending from the private to the public sectors. The Basel III framework has been developed by the Bank of International Settlements in Basel , Switzerland and pushed further by various other regulatory bodies. This text has several and significant shortcomings as do all Dummies since we have had to condense several hundreds of pages. When you read this text please remember it only describes the Basel III framework so do not forget the adverse effects for corporates added from the Tobin tax and the large margin calls required for hedging by the new OTC derivatives regulation. Additionally we have the general crowding out effects from mismanaged sovereigns hovering cash from the investors creating huge misallocations of capital. Basel III is divided in two main areas: 1. Regulatory capital 2. Asset and liability management

AREA 1: Regulatory Capital

Banks shall progressively reach a minimum solvency ratio of 7% as of 2019: Solvency ratio = (Regulatory Capital) / (Risk-Weighted Assets). [RWA = Risk-Weighted Assets] The minimum requirement used to be 2% prior to Basel 3, with many national banking authorities requiring much more leading to that most banks used to have a Tier 1 ratio exceeding 7% According to the Basel III impact study, at the end of 2009, the average solvency ratio (Core Tier One) of large banks was 11.1% So, what is the problem, if banks already exceed the minimum solvency ratio set by Basel III? The devil is in the details and here is where we find the problems caused to the corporate sector: The definitions of the Regulatory Capital and the RWA have changed: Calculated according to the Basel III definitions, the Core Tier One ratio would have been 5.7% instead of 11.1% according to the old definitions The 87 large banks who answered the impact study would have been short of 600bn of equity at the end of 2009. New stress tests are disclosed regularly and the shortcomings differ, but they are still there. This means that banks will either/or have to raise more capital or decrease its present lending, which will create a crowding out of capital in the financial markets either way There are new definitions of core equity leading to that it is reduced with up to 40% for large banks increased the crowding out effects even further. Major changes in the definition: Some financial instruments are not any longer eligible as Regulatory Capital Intangibles and deferred tax assets shall be deducted from the Regulatory Capital There are changes in how RWA is calculated in average increasing it with 23%. Major changes include: Sharp increase of RWA amounts from trading activities (stress tests on value at risk, securitisations) leading to many banks decreasing the trading leading to fewer banks quoting prices. This has already led to reduced liquidity and increased costs and risks for corporates in managing its financial exposure from import and export etc This encourages particularly banks to perform their swaps through clearing houses This may weight on complex derivatives businesses Loan portfolios require being marked-to-market even though it is not required by accounting standards. This increases pro-cyclicality Basel III introduces a Leverage Ratio such that the amounts of assets and commitments should not represent more than 33 times the Regulatory Capital, regardless of the level of their riskweighting and of the credit commitments being drawn down or not The Financial Stability Board recommended in July 2011 that the 29 identified systemically important financial institutions have a Core Tier 1 ratio increased between 1% and 2.5%. Of course these SIFIs are the main large corporates banking counterparts. This provision has been enacted by the G20 in November 2011. The European Commission has added: Minimum solvency ratio shall be 9% for the EU banks (instead of 7%) The EU banks shall comply with this level in June 2012 (instead of 2019)

AREA 2: Assets and liabilities management:

Banks will have to comply with two new ratios: Liquidity Coverage Ratio (LCR) Net Stable Funding Ratio (NSFR) LCR: high-quality highly-liquid assets available must exceed the net cash outflows of the next 30 days: high-quality highly-liquid assets: Recognized at 100%: cash, sovereign debt of countries weighted at 0% (which include the PIIGS as they are part of the Eurozone), deposit at central bank Recognized at 85% and must not represent more than 40% of the assets: sovereign debt weighted at 20% (countries rated below AA-), corporate bonds and covered bonds rated at least AAnet cash outflows = cash outflows - cash inflows cash outflows: o 100% of any repayment in the next 30 days o 5% of retail banking deposits o 75% of deposits from non-financial corporates and public sector entities o 100% of deposits from other financial institutions o between 0% and 15% of secured funding backed with high quality highly-liquid assets o 10% of credit lines to corporates, sovereign and public sector o 100% of liquidity lines (back-up, swing lines) to corporates, sovereign and public sector o 100% of credit lines to other regulated financial institutions cash inflows: o 50% of loan repayments by non-financial counterparties (it is considered that banks, even in difficult times, will have no choice than to renew at least 50% of the maturing loans) o 100% of loan repayments by financial institutions o 100% of bonds repayments (whoever the issuers) NSFR: long-term financial resources must exceed long-term commitments (long term = > 1 year):

Stable funding: o equity and any liability maturing after one year o 90% of retail deposits o 50% of deposits from non-financial corporates and public entities Long-term uses: o 5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting (see comment above for LCR) with a residual maturity above 1 year o 20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year o 50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual maturity above 1 year o 50% of loans to non-financial corporates or public sector o 65% of residential mortgage with a residual maturity above 1 year o 5% of undrawn credit and liquidity facilities

Our conclusions:
Hed is penalized decreasing the liquidity in the markets leading to increase in costs to hedge the operational financial risks of corporations. This is further emphasized by the penalization of the interbank markets through requirement of more capital, and additional constraints on liquidity on interbank transactions. Corporate credit by banks is penalized:

More capital required in general Back-up facilities for commercial paper programs require that banks will have to have 100% of liquid assets in front of 100% of undrawn facility. The cost of carry will obviously be invoiced to the client Restrictions in maturity mismatch (including for repayments) are introduced Other businesses areas threatened:

Trade finance (introduction of the leverage ratio) Consumer finance (leverage ratio) Project finance (NSFR) Public sector finance, except governments (leverage ratio + NSFR) Overall, the main revolution for banks is in the liquidity ratios (LCR and NSFR), whose definitions are very severe for the corporate sector. For example, the average French banks LCR would have been around 58% at the end of 2009 if calculated to the Basel III definitions. Also consider:

Access to central bank liquidity is not considered by Basel III ratios French banks used to push life insurance products vs deposits life insurance, even invested into certificates of deposits, gives no credit at all to liquidity ratios Overall, Basel III aims to sharply deleverage the economy threatening economic growth at the same time as the debt crisis puts a pressure on governments to spend less. There is also some level of naivety in the provisions of the definition of high-quality highly liquid assets, which banks shall hold abundantly in their balance sheets to face their short term liquidity commitments. In fact the banks are pushed to hold huge amounts of sovereign debt Read more on the alternative corporate financial market being built up to mitigate the situation.