Basel III Is Here!

Regular readers will perhaps be surprised that it is not covering the TUC Congress talk today on opposing Conservative cuts.

This blog will oppose the cuts to the Gurkha regiment. It will oppose cuts to playbuilder schemes and to cuts in work-related benefits which are designed to encourage our young people into work.

A less interesting but perhaps more important piece of news is less reported today and are the introduction of the Basel III regulations. These regulations are globally agreed and will force banks to raise hundreds of billions of euros in fresh capital under new regulations designed to prevent the repeat of another financial crisis.

The new rules, known as Basel III, will require banks to hold top-quality capital totalling 7% of their risk-bearing assets, a big increase from 2%, but banks are being given more time than expected to comply with the rules - in some cases until 2019.

The main points

Basel III: Banks will have to increase their core tier-one capital ratio to 4.5% by 2015. In addition, they will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019. Any bank that fails to meet the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet.

Sensible policy. Raising capital requirements under ICAAP will reduce the risk of banks collapsing. It could however impact credit lending in the short term, which has been more than mitigated by the time frame set for 2019. Capital adequacy is a core banking treasury function - the Basel III accords barely mention trading off the capital balance sheet (or prop trading) which is of note. This is important as prop trading, through internal hedge fund activity (Dillon Read Capital Management) was arguably the cause of the problems at UBS.

Financial supervision: The G20 wants closer supervision of systemic risk at local and international levels. We will see the creation of a stronger European Union centred approach to financial regulation - Brussels will take more responsibility.

Brussels, the European Commission and European Union bodies are now the defacto centre for financial policy making with national regulators taking a back-seat lobbying role. This is a concern because the UK has more developed regulatory environment which we need to protect. Government will need to keep a very close eye on developments. The BBA and AFME are strong lobbyists in Europe.

Derivatives: The G20 has called for greater standardisation and central clearing of privately arranged, over-the-counter contracts by the end of 2012.

DTCC and other central clearing entities are likely to onboard more Equity OTC asset classes.

The creation of central counterparties for OTC asset classes has actually been ongoing for the last decade. Most rates / credit OTC trades are already put through exchange. Managing OTC equity asset classes onto exchange will be a key priority. There will always be bespoke structured equity transactions and these will need to be reported and monitored closely.

Hedge funds: US reforms are in line with the G20 pledge that funds above a certain size should be authorised and obliged to report data to supervisors. A draft EU law includes private equity groups and restrictions on non-EU fund managers seeking European investors.

London is the centre for hedge funds and associated prime brokerage functions.

The UK is the centre of prime broker activity in Europe in part due to the regulatory environment being conducive to services for hedge funds. We need to maintain this competitive advantage at all costs... otherwise we can watch the city shrink! This is not in the national interest.

Accounting: The G20 wants common global accounting rules by mid-2011.

Already happening prior to recession. IFRS regulations are already standard in most countries outside of North America, who favour US GAAP. Should be easy to achieve at minimal cost. All accountancy firms are training IFRS as standard.

Credit rating agencies: The G20 wants them registered and supervised by the end of 2009. The EU has adopted a law mandating registration and direct supervision that takes effect this year. US legislation passed this year includes similar provisions.

Eminently sensible. Credit agencies were formerly sponsored by member firms, and therefore bias in favour of constituent clients. The mark-to-market mis-valuation of securitised product classes (MBS / ABS) products led us into the recession. We can not allow this to happen again. Regulators will need to hire, at cost, some very strong valuations specialists and maintain tight control over firm valuations. This is a problem because this type of role is very bespoke.

Pay: The G20 has endorsed principles designed to stop bonus schemes in banks from encouraging too much short-term risk-taking.

The rules on compensation are being discussed at the EU level and our regulator, the FSA, is lobbying hard for a result for January 2011. We should see a change in favour of larger base salaries and longer term deferred stock bonuses contingent upon non-business revenue targets. Revenue and non-revenue bonus pots will be separate. Majority of banks have already adopted what is expected to be the outcome of the EU position.

It will not go far enough and will not stop the bonus cycle.