As part of her Master's thesis at the Department of Risk Management of the House of Finance at the Goethe Business School in Frankfurt am Main, author Franziska Mühlenkord carried out a study on the new Basel III capital requirements, the adaptation strategies of banks for them, and the various channels through which the adjustments affected the real sector.
The concept of the thesis was developed in cooperation with leading German banks.
Banks are effectively perceived by the regulatory definition of minimum standards on the market as undercapitalised, and undercapitalised credit institutions raise their lending rates to businesses in a recession.
Basel III Overview
The implementation of the first Basel III reforms has been running since 2013, and on 1 January 2019 - according to the plan - all new requirements will have been implemented in the financial industry
Trigger for stricter rules
The trigger for stricter rules under Basel III was primarily the clear instability in the financial sector during the financial crisis of 2007/08. The chain reaction: 'Bank stress "systemic financial crisis" general economic crisis' could not be prevented by enormous political effort and the use of public funds and had far-reaching negative consequences for the global economy.
New capital and liquidity requirements
The reforms agreed by the G20 of capital and liquidity requirements for all financial institutions have the following objectives, which are addressed at various levels:
- Objective at the level of individual banks: Strengthen resilience of individual banks in stress periods
- Objective at the macro-economic level: Avoid systemic crises
Particular attention is paid to common equity, which represents high-quality equity. A new measure, the "CET1 ratio" (Common Equity Tier 1 ratio) was therefore introduced, whose count generally consists only of the capital stock of the owner. The denominator is the RWA measure, which represents the value of the risk-weighted assets of each institution.
SITUATION & TRENDS IN THE EUROPEAN BANKING MARKET
The current economic situation in Europe and the newly introduced rules for capital regulation, such as in the "Basel III CRD IV package" are currently being implemented in full swing at many banks. This development is reflected in trends in the European banking market:
Limitation of the traditional banking business model
New regulatory liquidity requirements (LCR and NSFR) as well as more stringent requirements for banking supervision make the traditional process of maturity transformation more difficult. The aim of these liquidity rules that enforce an alignment of the term of the financing used on each financial product for the bank is to stabilise the financing bases. Critics fear a disruption in the flow of money that supplies the economy with loans, for example, the craftwork and industry.
Trend 1: Harsh intermediation in the credit market causes difficulties for the real economy
Stricter capital requirements are designed to instruct the banks to start "deleveraging" processes and increase balance sheet equity. The goal here is to avoid new pro-cyclical weakening of the stability of the financial system - in addition to the economy, which in such a case is affected in particular by a downward price spiral for assets and securities on the market. Equity can and should serve as a buffer against the possible outbreak of a renewed financial crisis that protects other banks and the real economy from this negative price spiral. Measures in the financial institutions for this purpose are mainly to improve the models used for risk assessment so that in the future no correlation risks are ignored or underestimated as far as possible as well as the reinvestment and active portfolio management towards less risky assets. However, this results in less attractive profits for risk-affine investors in the banking sector, because the return on equity is reduced.
The result is that that the current situation in the "new markets" outside Europe and North America, with stronger economic growth and without IT contaminated sites in the banking systems, are particularly attractive to international financial investors. New, more efficient systems that are in line with the new regulatory requirements from the outset allow the previously suspended financial sectors medium to long-term access to international financial markets.
Trend 2: Increased transparency enables greater confidence and improved financial stability, and the prevention of further tensions in the financial and capital markets increases confidence in the banking market
Trend 3: At the same time, a loss of market share of international investments threatens European banks
European standard in the "single market"
The introduction of the "single rulebook" based on harmonised European minimum standards allows on the one hand for closing legal regulatory gaps (existing differences between Member States), but on the other hand it is also the lowest common denominator for the European "single market". The Europe-wide compliance with these standards is ensured by the introduction of more appropriate quality checks of the bank management and the prescribed management processes.
Trend 4: Closer inspections of the European minimum standard act as an incentive for increased regulatory arbitrage, i.e. the shift of risky transactions to less regulated subsidiaries
Increased demands on the quantity and quality of common equity leads banks to raise equity through reinvestment and restructure their loan portfolios to less risky assets. This requires an increase in financing costs and a lower return on equity. Banks pass on these costs to their customers through increased lending rates. The result of an estimate for the European payment area amounts to an interest rate of plus 2.7% by 2019/20. The regression model is based on the average values of the aggregated European bank balance.
This behaviour can be positively or negatively influenced by general market conditions, such as the economic cycle and key interest rate, information asymmetries, and the relative dependence of borrowers in the credit market.
ADAPTION STRATEGIES OF FINANCIAL INSTITUTIONS
In addition to a reduction of dividends, an increase in profitability can of course also specifically result in a higher equity ratio. However, the study showed that this strategy was not implemented as successfully.
In terms of portfolio adjustment strategies of financial institutions, a decline in loan volume as a whole was recorded, in particular, fewer loans are approved for relatively high-risk ventures. The context here is that assets that receive a higher risk rating in turn require more equity on the balance sheet to maintain or even improve the capital adequacy ratio. Portfolios with assets that were "expensive" for the banks were thus phased out and a shift in lending towards more secure assets could be seen.