Banks have feared the impending Basel III reforms for some time now. We have covered the topic in the past, both on the Monitor (the most recent Basel III-related post here) and in Risk Management (our April 2010 issue).
Starting tomorrow, regulators will come together for a two-day meeting of the Basel Committee on Banking Supervision. The purpose of the meeting is to come to an agreement on liquidity and the quality of capital to fill gaps in an overhaul of rules known as Basel III. Earlier this month, the G-20 endorsed the Basel reforms.
To get a bit of insight on the matter and how the reforms will affect insurers, I contacted Adam Girling, principal at the Financial Services Office of Ernst & Young, with a few questions on the topic.
How will the largest global investment banks deal with the impact of Basel reforms?
Adam Girling: One of the most significant impacts of the new Basel reforms is the substantial increase in capital requirements for trading book exposures, which are those positions held on a short-term basis with the intent to trade. The Basel Committee Quantitative Impact Study (QIS) and industry estimates suggest that risk-weighted assets for many trading portfolios will rise under the new requirements by three to four times on average, and potentially more for some portfolios. Particularly hard hit are securitization exposures. The global banking organizations with sizeable trading portfolios are looking at where their capital requirements are increasing most and whether they need to bring capital requirements down by hedging or unwinding positions — although liquidity of positions remains an issue. Coupled with the analysis of changing capital requirements are new Basel III leverage and liquidity coverage standards, as well as industry reforms around over-the-counter (OTC) derivatives and proprietary trading. So institutions are reviewing their business strategies and considering which businesses to exit stay the course or grow given the combined impact of changing market dynamics and new regulatory constraints.
Do you think economic growth will be hampered by Basel III bank capital standards?
AG: This is a profound question and there is certainly a divergence of views. For example, the Institute of International Finance (IIF) analysis suggests a potentially large impact, while the Basel Committee itself projects a quite limited impact. Theoretically, the extended implementation period should provide an opportunity to identify potential unintended consequences and an opportunity to make adjustments as, and if, necessary. The biggest risks are likely in the transition phase. The Basel committee has calculated that with the long transition periods retained earnings can boost capital ratios sufficiently, but the industry may set expectations for banks to meet the new standards sooner. If this is the case, banks will either need to raise extra capital or will need to reduce the risk in their balance sheets — potentially via changing their lending profiles to maintain an acceptable rate of return on equity.
How will the Basel reforms affect insurers?
AG: Basel II applies to banking organizations and Basel III does not propose to change those subject to the risk-based capital standards. In the US, Basel II has, to date, only applied to the largest and most internationally active banking companies on a consolidated basis. And to my knowledge, none of these institutions have a top-tier parent that is an insurance company. If any insurance companies were deemed systemically significant under the Dodd-Frank Wall Street Reform and Consumer Protection Act, it is quite possible that the enhanced capital and liquidity requirements to which they would be subject would incorporate Basel III. In Europe, however, Solvency II is enhancing risk-based capital for insurers using a three pillar framework similar to Basel II.