The world’s largest banks need to raise as much as $566 billion of common equity to meet Basel III rules on capital to be implemented by 2019, cutting shareholder returns, according to analysts at Fitch Ratings. The 29 global banks that regulators believe are too big to fail need new capital that equals nearly 23 percent of the lenders’ current $2.5 trillion of aggregate common equity, according to the report. The median lender could meet the requirements with three years of retained earnings, according to Fitch.
Basel III is the latest version of a global regulatory standard on bank adequacy, stress testing and market liquidity risk, requires banks to hold 4.5 percent of common equity, an increase from the two percent under Basel II. The higher standard is an attempt to prevent a repeat of the 2008 financial crisis.
International banking regulators meeting under the sponsorship of the Bank for International Settlements in Basel are seeking to implement rules to prevent taxpayers being forced to rescue failing banks. In addition to boosting capital requirements, they are instituting rules on leverage ratios and funding to ensure lenders can withstand future crises. “There’s a shortfall and we wanted to see what covering that implies,” according to Martin Hansen, a Fitch analyst. The Basel III rules “create incentives to reduce expenses further and to increase pricing pressure on borrowers and customers where feasible,” he said. The banks global systemically important financial institutions must hold a special capital surcharge of between one and 2.5 percent of assets weighted by risk.
The banks are likely to reduce their holdings of more volatile, lower-rated assets, potentially increasing borrowing costs for weaker companies and reducing the availability of credit. The borrowers’ securities would become harder to trade, forcing companies borrow from less regulated lenders such as private equity firms and hedge funds, according to a Fitch report, called “Basel III: Return and Deleveraging Pressures.” “If banks decide to originate risk and then pass it on to outsiders then it adds to the stability of the banking system,” Hansen said. “Risk hasn’t been reduced, though — it’s been moved from one part of the system to another.” The median return on equity of the 29 lenders was 7.3 percent last year and averaged 11 percent between 2005 and 2011. That is expected to decline to 8.5 to nine percent as the banks make up the capital shortfall, according to Hansen.
“Since it is impossible for regulators to perfectly align capital requirements with risk exposure, some banks might seek to increase return on equity through riskier activities that maximize yield on a given unit of Basel III capital, including new forms of regulatory arbitrage,’ Hansen said.
James Moss, another Fitch analyst, said the banks, which have a collective $47 trillion in assets, will have to look at the full spectrum of ways to meet the new capital requirements. “This is a very dynamic time for banking so the strategic side of bank planning is going to get a lot of attention over the coming years,” he said. “Basel III creates a trade-off for financial institutions between declining return on equity, which might reduce their ability to attract capital, versus stronger capitalization and lower risk premiums, which benefits investors.”
“Our overall objective remains to strengthen the resilience of the banking sector in the European Union while ensuring that banks continue to finance economic activity and growth,” said Michel Barnier, EU Internal Markets Commissioner. “The final compromise must contribute to financial stability, the necessary basis for growth and employment.”