Basel III and Banks: Overhaul or Overdraft?

MORNINGSTAR SECTOR REPORT: We look at how the new tougher Basel III rules may impact the largest banks around the world

Jaime Peters, CFA, CPA 10 May, 2011 | 9:50AM
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Basel III is an international accord whose objective is to standardise some banking safety requirements in a worldwide economy. The failure of Lehman Brothers, Northern Rock, and persistent troubles in Greece, Spain, Italy, Ireland and Portugal underscore how shock waves from one nation's problems can reverberate worldwide. Basel III may not be a panacea: It will not necessarily prevent a subsequent global financial crisis, in our opinion, nor will it completely insulate financial institutions from the unsettling effects of one. However, what Basel III will do is require banks to better prepare themselves for the unknown, including requiring them to bolster their balance sheets by holding additional capital.

For Basel III, capital requirements are front and centre. Basel III will implement tougher capital requirements on banks – and both the quality and quantity of capital is being addressed. With regard to quality, banks will need to maintain Tier 1 common capital ratios now – eliminating the sometimes questionable ability of hybrid capital to absorb loan losses. The definition of core capital is also being tightened, and will exclude some items such as deferred tax assets. Second, the quantity of capital needed is going up. Minimum common equity will now need to be 7% of risk weighted asset by 2019, up from the current 2% standard. Tier 1 capital will need to reach 10.5%, up from the current 6% rate. The leverage ratio requirement remains rather modest at 3%, and should not be an issue for any of the US banks. Institutions deemed to be systemically important will have to hold an additional buffer on top of these levels.

Unresolved Issue: Systemically Important Financial Institutions
The definition of Systemically Important Financial Institution, or SIFI, has not yet been announced. SIFIs will have to hold additional yet-to-be-determined capital, so the classification could have a major impact on the individual firm's competitive positioning and need to build additional capital. The leading proposal would be for each nation to determine the additional capital required. But we wonder: Will the Basel III committee look to the worldwide impact of a firm failing, or the countrywide impact? The latter would greatly increase the number of systemically important firms. For instance, Wells Fargo (WFC) may be considered systemically important to the United States, but its failure would be unlikely to compromise the worldwide system.

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About Author

Jaime Peters, CFA, CPA  Jaime Peters, CFA, CPA, is a senior stock analyst with Morningstar.

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