What the new banking rules mean for you

The world's banking regulators have drawn up a new set of rules - 'Basel III'. It is hoped they will help prevent a re-run of the credit crisis that nearly bankrupted the global economy. But will they work? John Stepek explains what the new regulations mean for the banks - and for you.

By John Stepek

published 14 September 2010

in Features

Basel III.

It's a phrase to strike dread into even the most ardent reader of financial news. Banking regulation falls squarely into the "boring, but important" category as far as investors go.

The good news is that you don't need to know the intimate details to understand what Basel III means for the banking sector.

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The market reaction both the stock and bond markets tells you all you need to know.

It's business as usual for the industry that nearly bankrupted the global economy.

What's the point of Basel III?

Basel III is the latest batch of banking regulations from the Basel committee of banking regulators. These rules dictate how much capital banks need to hold in reserve the cushion they need to protect against disasters such as subprime, effectively. The point of the Basel III regulations was well, to stop other disasters such as subprime from happening in the future.

Now let's just take a quick step back here, to get some much-needed perspective on this crisis. Everyone has their own favourite political drum to bang. So they'll blame the financial crisis on anyone from reckless greedy consumers to rapacious American home loan brokers to socially-engineering politicians to corrupt credit ratings agencies to idiot regulators to interfering central bankers (my own personal favourite, I'm sure you'll realise).

And every one of these groups played a role.

However, at the business end which is ultimately what matters the subprime crisis was the result of careless lending by the banks. It might suit them to diffuse the responsibility, but the bottom line is, they're the ones who made the decisions to supply this money for these purposes. And they're the ones who manipulated their balance sheets to allow them to keep supplying the money.

Sure, all of this was done legitimately; but they were bad business decisions. Our system is meant to discourage bad business decisions through the medium of bankruptcy. It may not seem fair that your toy shop has gone bust because last year's big Christmas toy didn't sell as widely as you'd hoped. But that'll teach you to be more careful with your stock management in future.

The trouble is, bankruptcy didn't apply to the banks. We bailed them out.

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So if that's the model we're stuck with, then the only option is to regulate them more closely. It's not very satisfactory, but there you go. So the point of Basel III is to make sure that if banks do mess up in the future, they have a big enough cushion to take the hit without taxpayers having to cough up for them again.

But if you need banks to hold more capital, then by necessity, they can't lend as much money out. And in fact, some of them are in such a bad state, that they may well need to raise more capital to meet any stricter requirements.

Why Basel III has cheered banking sector investors

That's a problem. Politicians are pressing banks to lend more. And the last thing they want particularly in Europe is for banks to be seen to be even weaker than they already are.

As a result, the Basel III regulations have been watered down even more severely than markets had expected. Banks will have to triple their core tier one capital ratios from 2% to 7%. But the new rules won't be fully implemented until 2019.

As James Mackintosh points out in his column in this morning's FT, stock market investors on both sides of the Atlantic were "delighted by the longer-than-expected delay". It means that European banks will be under less pressure to recapitalise rapidly. And US investors are less concerned about the effect on lending.

Meanwhile, bonds investors were also happy with the news. Why? Because, says Mackintosh, the delay makes it clear that governments will continue to prop up the banks. "If the economy is so weak that governments have to delay efforts to force banks to hold more capital, then there is little chance regulators will allow the far more economically painful effects that would follow a big bank failure."

Beware: banks will have time to blow another bubble

So what does it mean? As the FT's Lex column points out, "eight years is a long time in finance. It was enough to encompass the peak of the Nasdaq bubble in 2000, a bear market in equities, a bubble in credit and the implosion of Bear Stearns in 2008."

Do banks have time enough to help blow up another bubble between now and when the regulations come in? I suspect so. As Lex puts it, "the banks are using the profits from exceptionally low rates created for banks by governments to replenish capital month by month." It might not be such a problem if they just cautiously rebuilt their balance sheets in this way.

However, "if the high profitability continues, banks will not feel the need to apply the birch twigs to risky trading desks nor rein in sinful pay packets." And already investors are pressurising the best-capitalised banks to return money to shareholders in the form of dividends and share buybacks.

Meanwhile, you sacrifice interest on your savings to help nurse the sector back to health, so it can make all the same mistakes again. As Mackintosh puts it, "perhaps it is taxpayers who should be throwing their toys out of the pram."

From the investment side, I'd still be reluctant to buy into the banking sector. For one thing, local regulators may (hopefully) be tougher on the banks if they can ignore the lobbyists for long enough. And for another, if we don't deal with the 'too big to fail' problem, then banks might be fine in the short-term, but we'll end up facing another crisis and they'll be at the heart of it again.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.