Basel III proposals on the banking system could strengthen banks' balance sheets as well as trigger fundamental changes in their business models and product pricing, according to research by Standard & Poor's Ratings Services. However, if adopted as proposed, the Basel III proposals also run the risk of "creating unintended consequences" for parts of the financial system.
These unintended consequences could include: "constraining banks' lending activities and their ability to trade on derivative markets, hampering the inter-bank lending market causing displacements in markets for high-quality liquid securities, and encouraging banks to shift to short-term lending."
Credit analyst, Bernard de Longevialle at S&P, says: "In our opinion, the Basel III proposals address many of the weaknesses in Basel II and should lead to stronger, more stable banks worldwide. However, they are also likely to affect parts of the financial sector in ways that regulators may not have envisaged."
S&P believes that Basel III will result in some banks having to make changes to their balance sheet structures or business models. It expects smaller, deposit-funded retail banks to find it easier to comply with Basel III's "more stringent liquidity and capital requirements than larger wholesale-funded institutions."
Basel III also will likely cause "more significant changes" for wholesale-funded institutions with their extensive trading operations or large loan books and securities holdings.
In particular, S&P notes Basel III could have a "major effect" on the capital requirements of investment banks, for which counterparty risk already accounts for more than 20% of total regulatory risk-weighted assets.
S&P's views on the potential effects of Basel III include five issues:
Basel III's introduction of new liquidity standards "could significantly strengthen banks' liquidity positions and enhance the supervisory review process."
However, an overly restrictive approach to the "definition of liquid assets and requirements for funding certain types of assets with long-term funds" could reduce bank profitability from their lending and trading activities.
"Some of Basel III's assumptions could...severely hamper the inter-bank lending market and cause displacements in the high-quality liquid securities markets," the ratings agency notes.
If Basel III's structural funding metric, which introduces minimum requirements for the use of longer-term and more stable funding sources, is implemented as proposed, S&P says banks could respond by shifting more towards short-term lending.
"We believe that some level of mismatch between assets and liabilities is inherent in banking and necessary for banks to fulfil their role in the economy," it adds.
Although some of Basel III's proposals are consistent with S&P's view that risks in banks' trading books "deserve higher capital charges", the ratings agency believes that the proposed regulatory capital charges under Basel III could be "far higher" than the counterparty risk losses endured by banks during the recent crisis.
"If implemented in their present form, the proposals could create strong incentives for banks to move to qualified clearing houses," says S&P.
Also, Basel III's proposals could have "significant effects" on the derivatives markets and on financial institutions with large derivatives sales and trading businesses.
"We believe that banks with significant trading activities with hedge funds or other financial intermediary counterparties would likely be most affected by Basel III's regulatory capital charge proposals."
In particular, S&P says the estimated multiplication by four to six times of counterparty risk compared to the current weighting, could have a major effect on the capital requirements of investment banks, for which counterparty risk often already accounts for more than 20% of total regulatory risk-weighted assets.
"The proposal could result in increased use of qualified clearing houses as counterparties for derivatives contracts. If OTC derivatives become too capital-costly for regulated financial institutions under Basel III, in our view this business (and its risks) might be driven to unregulated institutions such as hedge funds."
Used as a supplement to risk-adjusted capital measures, both at the industry
and at the specific bank level, S&P believes Basel III's leverage ratio could be valuable and could help identify "outlier" banks.
However it remains a "raw measure" for the purpose of bank capital adequacy analysis.
Assigning too much weight to this measure could, in S&P's view, encourage banks to make riskier investment decisions.
"If Basel III's leverage ratio proposals are implemented, banks might well move away from low-risk, low-yielding businesses in favour of higher-risk, higher-return assets."
However, the "effectiveness" of Basel III's leverage ratio proposals
will depend on the definition of "leverage ratio".
"If defined inaccurately, we believe it could lead to outcomes that might be seen as undesirable from a broader perspective, such as for example a reduction in liquidity in the repo market as banks reduce their portfolios to manage the leverage ratio calculations."
Basel III's proposal to implement countercyclical measures in the form of regulatory requirements "should improve the creditworthiness" of the banking industry, says S&P.
It notes the apparent procyclicality of the Basel II ratio was one of the factors behind its decision to develop a risk-adjusted capital measure.
"However, in our view Basel III's proposed discontinuation of regulatory adjustments for unrealized gains and losses on securities or properties would likely exacerbate pro-cyclicality."
Basel III's proposals for grandfathering hybrid capital instruments may, in S&P's view, create a lack of comparability in regulatory capital ratios for an extended period.
However, it notes grandfathering could also result in "hybrid instruments" still being included in regulatory capital measures "despite their demonstrated ineffectiveness as a form of capital during the recent turmoil."