Possible Effects of Basel III

Central Bank leaders from around the world came to a consensus on September 13, 2010 about new banking requirements. Basel III calls for an increase in common equity, which banks use to absorb losses. In addition to that safety net, internationally active banks must hold levels of common equity equal to at least 7% of their assets. The current international standard is 2%, with the US at 4%, Basel III will be a significant increase.

The WSJ reports:

"Some changes will go into effect as soon as 2013, but others won't be in place until the beginning of 2019. Technical changes to the definitions of capital won't be fully in place until 2023.

Banks will be allowed to phase in these new standards over a period of years, so they will have more time to comply. By 2015, banks will have to begin building a 2.5% "buffer" of capital that must be fully in place by Jan. 1, 2019. 

If banks fall below the buffer, regulators could force them to hold onto more of their earnings to augment their capital, which means the companies will have less money on hand to pay dividends or offer large compensation packages. Some analysts believe the new standards could essentially force banks to shrink their loan portfolios or shed other assets in order to improve their capital positions."

Despite the gradual implementation of the conservative requirements, banks claim that the costs will be transferred over to borrowers and employees. This will mean higher lending standards causing a decrease in loans, and higher fees. Employee bonuses, under intense media and shareholder scrutiny will likely decrease; although several analysts expect this to remain steady. Academics argue that according to past data, increased reserve requirements have little to no effect on lending productivity.

Although this is very much needed, there is still the risk of moral hazard. Knowing that there is a safety net, despite it being their own cash, banks might continue risky investments. Surely, if they grow large enough, the state will provide additional funds lacking in common equity reserves - that being the mentality of the crisis. Whatever the case, banks will find themselves scrambling for cash. Inter-bank short term lending might pick up and banks will flock to more liquid investments; those that seem attractive in yield but also pose risk. Banks will find a way to get the cash they need. Government will find it difficult to tackle a new system that grants liquidity, if it poses systemic risk that is.

Another risk is that banks might gradually decrease their stake in government debt. In the US, banks are utilizing bail out cash to purchase Treasuries and other forms of hedging. Since then, the Fed has been active in quantitative easing to try to crowd out the treasury market and encourage banks to transfer their cash to borrowers.

Update: The Fed's latest QE3 program will  provide liquidity to mortgage providers through MBS purchases. However, the underlying disappointment in Wells Fargo's recent earnings report due to lower than expected revenue is concerning. With Basell III approaching, Wells Fargo is in a good position with mortgage banking non-interest income up 53% due to fees associated with the productive mortgage market. However, with low rates providing an incentive to borrower's choosing to refinance, banks like Wells Fargo are seeing interest income plunge. Again, the hope is that QE3 MBS purchases will help compensate for the decreasing returns stemmed from a low rate environment. Currently, Wells Fargo sits on $127bn of MBS, up from $106bn reported in the previous year. There's more to be sold, thus more liquidity to be provided.

In sum, for the US this still means we have more work to do. Basel III is an international standard meant to secure the banking system, but domestic responsibilities of each country still remains. Now that in the long run banks will have to reserve more cash, we need to figure out a way to encourage lending. That starts with a healthy economy of both borrowers and lenders.