How is Basel III going to affect you?
by Gavin Madson
One of the major outcomes of the global financial crisis was the crash of Lehman Brothers, ensuring credit crunch and multiple bank bailouts by governments across the globe. This led to a significant increase in the scrutiny of financial institutions and the implementation of more stringent regulations on the sector. This has been undertaken in part to avoid governments having to bailout banks in the future. The effect of this increased scrutiny, currently embodied in the implementation of Basel III regulations, will have a dramatic effect on how banks and the broader markets will interact in coming years.
The changes in regulations for banks will not just affect the banks, but also those who interact with the banks…so everyone. Banking retail clients, SME’s, large industrials; anyone who provides money to banks, borrows money from them or invests in their shares will be affected, whether they know it or not.
The changes which will be brought about as a result of Basel III are wide-reaching and beyond the scope of this article. Today I will keep to some of the broader changes we expect to see. So what are some of the key ways Basel III will affect you?
- The new regulations give preference to ‘sticky money’. That is deposits which are more likely to be held by the banks on an ongoing basis, which is in effect a win for retail investors. Retail term deposits are considered very ‘sticky’, as retail clients tend to roll over TDs at maturity. So you can expect to see a continuation of the strong offers from banks in the TD market. On the downside for retail investors, the ‘at call’ online accounts are generally not viewed as particularly ‘sticky’, so we would expect to see the interest rates on these accounts falling; TDs will be the preferred bank retail offering.
- We would expect SME’s to also be targeted for deposits, ahead of larger corporations for the same reasons
- Again tying into the ‘sticky’ money theme, the longer the deposit, the longer it is stuck on to the bank’s balance sheet, so in turn, we would expect to see banks favouring TDs with longer maturity dates, particularly past one year
- One of the issues highlighted during the credit crunch was banks lending over long periods, whilst borrowing at short dated maturities, leaving considerable refinance risk on the banks. Basel III also seeks to address this and to ultimately move the average tenor of lending closer to that of borrowing. Longer dated funding is more expensive than short dated funding and the banks will need to pass these costs onto customers somewhere. We see this already with mortgage rates not fully reflecting changes in the underlying rate set by the RBA. Business lending and other forms of lending are seeing even less of the pass through. The flip side is for the banks to also avoid lending to longer tenors. This will affect companies which rely on longer dated funding (like the property sector) who will have no choice but to pass on the increased cost of funding via lower profits to shareholders or increases in their prices (where the market permits)
- Companies will also be charged more for undrawn facilities as these will count against bank’s capital position as they are able to be drawn at any time. Again, these costs will either need to be passed on to customers or be reflected in lower profits to shareholders
- Banks will have to hold more capital and a greater proportion of that capital will be common shares, putting pressure on return on equity (ROE) figures (via the denominator). Further, with less leverage and lower risk limits allowed, the outright profits (or numerator from the ROE calculation) will also be impacted
- Banks will also be forced to hold up to 10% of their total assets in very low yielding High Quality Liquid Assets (HQLA), predominately government and semi-government bonds which will also impact profitability
- Banks need to recapitalise by bringing in more in deposits then they are lending. That is deposit growth needs to outstrip loan growth; this will continue to be a drain on bank profits
- The regulatory restraints on capital will continue to limit growth in banks going forward; growth which had previously underpinned the banks share price
- With the Australian banks stepping back from some lending, and longer tenor lending, companies will need to find funding from new sources. For larger companies, they are likely to source funding from overseas markets like the US private placement (USPP) market. We have already seen this with a stream of Australian issues into the USPP market at longer tenors, however due to the size of lending required, this will only be open to larger corporations. Asian banks are likely to be increasingly part of lending syndicates to help fill the bank lending gap. This makes it more difficult for smaller corporations to lend with offshore banks more likely to cherry-pick more familiar names in the sector. Over time we may see an increase in the domestic bond market as issuers look to raise longer term funding
- A proliferation of ‘weaker’ bank hybrids. We have noted in recent weeks that the risk of the new hybrids released in recent months is significantly higher than older bank hybrids, this weakness is driven by specific Basel III changes which require new hybrids to behave more like equity during times of stress. The regulations require hybrids to convert to equity or write-off during stress, have no step-up or incentive to call and the issuer may be prevented from calling by the regulator, APRA, if the intention is to simply call a security and then re-issue a similar security at a higher margin. For these reasons, we have seen a dramatic change in who is buying the new hybrids (compared to who bought the old style hybrids), with professional investors mostly staying clear of the new offerings
The Australian banking sector remains very strong and our banks are already well positioned to meet the requirements of Basel III, (particularly around capital ratios), however the increased regulation will make growth and profits for the banking sector harder to come by, and new lending, and lending costs will also have a dramatic effect on other companies ability to grow (debt funded growth will be a thing of the past) and make profits (as cost of funding will inevitably increase).
Banks will become less risky but less profitable – generally good news for debt investors but not so good for equity investors. This process will continue until the end of the decade and will impact practically all sectors related to banking and the economy in some way.
So whilst these regulations may have been developed in far off Switzerland, they will have very real effects closer to home.
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