September 15, 2010

If you, like many in the media, regard the Basel III rules that were issued Sunday as a European yawn fest that doesn't pertain to you, you might want to reconsider that view (unless you're a community banker, in which case you're probably already in compliance). The Dodd-Frank bill authorizes U.S. regulators to enforce Basel III capital guidelines at U.S. banks, according to David Kelly, who as head of global analytics at JPMorgan Chase for five years lived through implementations of previous Basel recommendations; Kelly is currently director, credit product development at financial modeling software maker Quantifi.

Kelly estimates that large banks will spend more than $100 million each over the next ten years to change processes and implement systems to comply with the Basel guidelines. Basel III changes the way banks determine how much capital reserve they need to set aside to recover from losses. It calls for new ways of calculating leverage and liquidity ratios. On the technology side, it will drive banks to integrate data sources and adopt new forms of data modeling, Kelly says.

1. Basel III makes regulatory arbitrage harder. Basels I and II were loose enough to allow banks to play games to set aside as little capital as they could get away with. For example, Basel I has a simple set of risk weights assigned to categories of assets. The weight assigned to Brazilian and U.S. government bonds, for instance, was the same regardless of their actual risk of defaulting. "People loaded up on Brazilian bonds," Kelly recalls. The Basel II rules called for a more risk-sensitive estimate of weightings but mispriced the risk inherent in securitizations; banks reacted by loading up on off-balance-sheet instruments and collateralized debt obligations. "With Basel III, now the committee is saying we know there will be another hole, as hard as we've worked to prevent it, therefore we're going to build in these other provisions," Kelly says. For instance, Basel III adds a leverage ratio: capital has to be at least 3% of total assets even where there is no risk weighting.

2. It requires large banks to modify their risk models. Under the Basel II rules, large, global banks were advised to use their own internal risk rating models to determine the risk weightings for their assets. "The idea was to align regulatory risk calculations with the considerably more sophisticated risk models that were being used by major banks in their own decision-making," according to a paper by the Brookings Institute. "This concept counts on the self-interest of the banks to lead them to use the best possible estimates of risk in their own management of assets." For international banks like JPMorgan Chase, Goldman Sachs and Morgan Stanley, "the additional provisions of Basel III around securitized products adds more complexity to their models," says Kelly. Such banks probably don't need to buy new risk modeling software, but their models will need to be modified.

3. Basel III presents data integration/data management challenges. Basel III requires banks to consolidate positions from all their trading desks and to make their trading book compatible with their banking book; to accomplish this the data must be clean and accurate. This requirement is designed to eliminate regulatory arbitrage in the form of banks transferring assets out of their banking book into the trading book to get better capital treatment, Kelly says. "Basel III picked up on that and said we're going to make you use the same method, especially for securitizations," he says. This will be an implementation challenge, especially for U.S. banks that have not been following the Basel rules.

4. Regional banks may start using their own risk models, like the biggest banks do. Regional banks have had the ability under previous iterations of Basel to run standardized methods for calculating risk-weighted assets, which is easier than coming up with their own risk models. "Their challenge is determining whether that puts them at a competitive disadvantage from a capital perspective," Kelly says. "It could, because banks will find arbitrages and they will optimize their capital." Banks that use advanced, internal models may be able to gain more favorable risk weightings.

5. Basel III discourages loan securitization, which in turn will restrict lending. The packaging and selling of loans is no longer the great way to avoid capital requirements that it once was. "The new rules are punitive toward securitization," Kelly says. "Given the role securitization has played over the last two years in causing large, unexpected losses, the new rules have higher capital charges for these assets, and there's a discouragement of originating securitized products." Because securitization played a large role in providing greater credit access, credit will constrained by lessened securitization activity. However, Kelly disagrees with the common notion that higher capital ratios in and of themselves will constrain lending. "I have yet to see evidence that that's the case," he says. "Right now we have a lot of mid-tier and smaller banks that exceed the capital ratios," he observes. "We want to assign blame [for tight credit markets] to Basel or the capital rules. But I think uncertainty about the environment plays a big role in this, too. I've heard a counter-argument that Basel III rules should remove a lot of uncertainty, free up capital, and encourage lending, because we believe we're going to have a better banking system."

6. Banks will need to find new ways of calculating capital, leverage and liquidity ratios. For banks that already have software making these calculations, these will be substantial projects but not huge overhauls, according to Kelly. "There will be new things for banks to deal with, for example the new leverage ratio involves your balance sheet, so along with running Monte Carlo simulations on your portfolio of transactions, now you need a system that also can calculate a balance sheet leverage ratio." The new liquidity ratio required in Basel III will force banks to perform stress tests on their 30-day cash flows.

7. Banks will have to perform additional data recordkeeping in the way they measure capital. Basel III increases the quality of Tier 1 capital by eliminating some types of capital, such as contingent convertible bonds (bonds that can be converted into shares of stock only if the share price achieves a certain level), that used to be allowed in this category. Now Tier 1 capital is more narrowly defined as common equity, retained earnings and limited other products, Kelly says. The new rules also stipulate that anything banks count as capital must be loss-absorbing. "For any sort of debt-like product to be loss absorbing, it has to be convertible into equity," Kelly says. "What's complicated is, at what point would a debt instrument, say a bond, be convertible to equity?" Software providers like quantitative credit analysis software provider Moody's KMV may come out with products that model the conversion of debt to equity and tie that into the bank's capital ratio, Kelly theorizes.

ABOUT THE AUTHOR