Basel III: Implications for China banks and financial system

by Alberto Forchielli e Alberto Pagliarini
The recent changes to bank regulations (so called Basel III) are the second major revision to an original set of rules (now known as Basel I), which was promulgated by the Basel Committee in 1988. An interesting historical fact is that the Basel committee was established in the mid-70s, after the failure of a small German bank (Herstatt) sent shudders through the global financial system as a result of poor coordination between national regulators. As everybody knows, the recent financial crisis had catastrophic effects (just in the US, it led to the failure of 25 banks in 2008 (including Washington Mutual, the largest bank failure in the history of the United States), 140 banks in 2009 and 149 in the first 10 months of 2010: as a comparison, only 11 banks had failed in the 2003-07 period).
 Basel III has emerged in the aftermath of the crisis with the aim of increasing the stability of the global financial system. On 12 September 2010, the Basel Committee defined the last details regarding capital requirement and transition periods. The results have been endorsed at the recently concluded G20 summit in Seoul: with that, Basel III is largely complete.    Major changes are related to the following aspects. Capital Ratios: core Tier 1 ratio (defined as common equity divided by RWAs) will be raised from the current 2% level (before the application of regulatory adjustments) to 4.5% after the application of stricter adjustments). Additionally, Basel III states that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity (after the application of deductions). That takes banks’ minimum regulatory capital to 7%. Broad Tier 1 capital requirement is set at 8.5% and total capital requirement at 10.5%. Leverage Ratios: the financial crisis pointed out the problems with using risk-weighted asset calculations that are intrinsically based on historical experience (for example, during the crisis, the value of many assets fell considerably more sharply and quickly than was suggested by historical evidence, in some cases because good quality data did not exist for very many years). As a response, a leverage ratio (ratio of Tier 1 capital to total assets with no risk-weighting of the assets) should be used as a safety net: the minimum is set at 3%.
Tougher risk weightings for trading assets. A second major problem was that the risk weightings for trading assets were clearly set too low, again reflecting an excessive reliance on favourable recent history. Basel III will require banks to hold more capital for market risks and for counterparty credit risks. New liquidity requirements. The Basel Committee had largely ignored liquidity in the past, leaving national regulators to regulate as they pleased. However, the financial crisis highlighted the fundamental fact that financial institutions depend for their survival on managing liquidity in order to prevent a fatal run on the bank if confidence in their financial strength evaporated.
 As a result, Basel III proposed two tough new liquidity tests that would be standardized globally. First, minimum liquidity levels would be based on a type of stress test which mimicked a freezing of the financial markets for a period of [x] months during which it became extremely difficult to raise new funds. Second, a “net stable funding ratio” test was created. This measured the level of liquid assets to the level of liabilities that matured in a year or less. The intention is to reduce the mismatch between the maturities of assets and liabilities. The impact on the banking sector will be substantial.    A recent report by McKinsey & Co. shows that by 2019 the European banking industry will need approx. EUR1.1trillion of additional Tier 1 capital. The smaller US banking sector will need “only” EUR600billion of additional Tier 1 capital. Closing the gap will have a massive impact on profitability: all other things being equal, applying Basel III standards would reduce return on equity for the average bank by 4% in Europe and 3% in the US.      
As opposed to European and American banks, Hong Kong and Chinese banks will not be much affected for three reasons. Their capital ratios are higher than those of Western banks (for example, average total capital ratio for Hong Kong banks is 15.7% according to the HKMA). Preference shares, hybrids or other forms of non-common equity Tier 1 capital are not commonly found in Hong Kong and Chinese banks: as a result Core Tier 1 and Tier 1 capital ratios are very close (and the increase in Core Tier 1 can be described as the most burdensome requirement of Basel III).
Finally, Basel III requirements include liquidity coverage ratios and net stable funding ratios, aimed at encouraging banks to decrease their reliance on wholesale (interbank) funding that tends to dry up in turbulent times. But the majority of Hong Kong and Chinese banks have extensive retail networks and huge deposit bases, thus they are not likely to be impacted by these requirements. Basel III will further drive the phenomenon of Chinese banks increasingly taking up the role of European and American banks (whose loan growth will be constrained by lack of capital and stable funding sources) in funding capital-intensive projects around the world. Basel III will provide China financial system with new strength that will build up on top of the increasing world role played by Hong Kong, Shanghai and Shenzhen stock markets. The combined global impact of a stronger banking sector and large and liquid stock market will attract multinationals to Asia in search for cheaper and larger capital pools mostly necessary to finance Asia growth. Corporate bond markets will also follow this trend but they will be severely constrained until a truly Chinese rating agency emerges to compete against of oligopoly of S&P, Moody’s and Fitch.