'Basel III' lets banks off the hook but keeps the rest of us on it

The Basel III regulations have been framed to give banks almost a decade to recover. The problem for the rest of us is that, over that time, we're the ones still on the hook says James Ferguson.

It was always a stretch to expect the Bank for International Settlements' (BIS) Basel Committee on Banking Supervision to come up with draconian new bank regulations. Even so, what we got was a big disappointment. Not to the markets, which rallied enthusiastically on the confirmation that the regulator is asleep at the wheel again and highly geared risk-taking is back on the table. The disappointment was to anyone who wants to see bankers' incentives realigned with the rest of the economy.

Recent events surely convinced everyone that when banks are allowed to gear up excessively, they (perhaps unknowingly) take big risks, pay themselves big bonuses and leave us, as taxpayers, to shoulder the burden when things inevitably blow up.

But the problem right now is that banks across the developed world have hidden losses away on their loan and securities books. They already need to offset these against profits, so it would be a disastrous time for the regulator to insist that they also build up their capital. The BIS, having dropped the ball so resoundingly in the run-up to 2007, really has no choice now but to buy the banks as much time as they need to put their houses back in order. This is what usually happens following a banking crisis it's a bit late to insist on robust capital cushions and less leverage now.

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In that respect, the fact that the new BIS guidelines (unofficially called Basel III) are so benign is a real worry. Why? Because it shows how grim the current picture must be for banks. The BIS has clearly listened to the lobbying banks' concerns, appreciated the harsh reality of their situation, and agreed there was no way they could stand tighter regulations yet. What's scary is that full implementation won't be required until 2019. That implies that many banks are deemed to need almost a decade to get in shape.

Not only that, but the Basel III capital requirements aren't even that onerous. The minimum capital ratio, including a new 2.5% 'capital conservation buffer', will be raised from 2% to 7% by 2019. That sounds aggressive on the face of it until you look more closely at what it actually means. This is not a ratio of capital to a bank's total assets. That would be what is called a leverage ratio. Basel III conspicuously dropped the earlier idea of a 4% minimum leverage ratio (even though that hardly saved the US banking system, which had exactly that requirement going into this crisis). No, the capital ratio Basel III refers to is denominated not by total assets, but by so-called risk-weighted assets (RWA).

RWA are a small, sometimes tiny, fraction of banks' total assets. They reflect the risk that banks' own models or the largely discredited ratings agencies ascribe to banks' holdings. Sometimes these can be hard to justify. In June 2007, two months before Northern Rock blew up, the bank had £97bn of mainly mortgage loans outstanding. Some of these were the famously risky 125% loan-to-value (LTV) mortgages. Yet the RWA measure of this loan book the maximum losses in the event of default, if you like was reported by the bank to be less than £19bn. Even using the very narrow tangible common equity (TCE) definition (more on this in a moment), that meant Northern Rock had a capital ratio in June 2007 of 11.3%, which would comfortably have passed the 2019 BIS requirements of 7%. The ratio of actual loss-absorbing capital to total loans, however, was 2.2% and ripe, in the event of a downturn, for disaster.

The definition of what banks can call 'capital' has been tightened significantly. But then, it really needed to be. When it comes to a crisis (and that's what capital buffers are for), any 'capital' that can't absorb a loss (deferred tax assets, for example) isn't worth the paper it's printed on. The useful stuff is called TCE or common equity Tier 1 (CET1), as the BIS prefers to now call it.

Germany's Commerzbank gives an example of how some banks had padded out their regulatory qualifying 'capital' with non-loss-absorbing items. In the 2009 accounts, Commerzbank claims total capital of more than seven times the more conservatively calculated TCE. This is how a bank with €361bn in outstanding loans last year, €137bn in short-term trading assets such as securities, €111bn in long-term investments and €22bn of assorted other assets such as derivatives a total of e631bn could have supported that whole edifice on just e5.6bn of loss-absorbing TCE. An average loss of 1% across its holdings would leave the bank with no loss-absorbing capital at all.

This also shows why the BIS's hands are tied. Telling such a bank that it must find a decent amount of proper capital now, when it still probably has losses hiding on its books that would further erode what loss-absorbing capital it has anyway, is like telling it to implode. Bank lending is already shrinking from Hungary to Honolulu as it is. No one needs the regulator to make things worse. So the BIS is not only being forced to set the bar extraordinarily low, but to give banks almost a decade to recover. The problem for the rest of us is that over that time, we're the ones still on the hook.

James Ferguson is head of strategy at Arbuthnot Securities and writes the Model Investor newsletter.

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.