By Manos Schizas, senior economic analyst, ACCA
Basel III is the global framework governing the regulation of bank capital, liquidity and leverage, agreed in the aftermath of the global financial crisis of 2008–9. Its provisions will, for the coming years, determine the banks’ cost of capital and therefore the cost and supply of credit to businesses globally. In Europe, it is implemented through the regulatory package known as CRD IV, which sets out the following:
- A new set of minimum capital requirements, much higher than those previously in place, aiming to ensure that financial institutions can remain solvent and able to support the real economy under adverse economic and market conditions.
- A maximum leverage ratio that aims to ensure that fluctuations in asset values cannot easily wipe out financial institutions’ capital.
- A set of liquidity requirements that aim to ensure that financial institutions can service their short-term liabilities even if some of their assets become illiquid or distressed or if access to interbank and wholesale credit markets is constrained.
- A risk-based approach which weighs riskier assets more heavily than safe ones for the purposes of capital requirements and less liquid assets (or less secure sources of funding) more heavily for the purposes of liquidity requirements. Banks can use standard weights developed by regulators or apply their own, as long as they are based on substantial in-house historical data.
- Provisions for a dual capital buffer that aim to rein in the supply of credit in boom times and achieve higher capitalisation under adverse economic conditions.
From the point of view of the accountancy profession, risk-weighted assets (RWA) work in a manner similar to taxable income. In principle, the rules create an obligation for regulated parties roughly proportionate to some systemic ‘footprint.’ More income, more tax liabilities; more risk, more capital requirements.
But in practice such systems always create incentives for regulated parties to swap activities that create a regulatory footprint for activities that, for whatever reason, do not.
In a recent working paper, OECD economist Patrick Slovik showed that, between 1991 and 2008, RWAs fell from 66% to 33% of major systemic banks’ total assets. The fall was very steady, and much of it was down to the falling share of loans. The most extreme example was Deutsche Bank – where loans made up 85% of total assets in 1990, but only 17% in 2005. On paper, banks were safer. In reality – well, we know what happened next.
No place for the little guy?
Who could blame banks for transforming themselves away from SME lending? In 2010, Capgemini calculated that small business loans (which are naturally riskier than loans to large corporates or government bonds), were responsible for 27% of the net income of major European retail banks, but 46% of their risk-weighted assets (and thus the associated capital charges). Indeed, in the more competitive banking sectors, most small business banking is not really profitable.
This is driving a wedge between two things that used to be synonymous – lenders’ appetite for SME loans as a product and investors’ appetite for SME credit as an asset class. While the former is flagging, the latter is still healthy – in surveys, banks seem confident of their ability to sell off portfolios of SME loans and even retail investors are piling into SME credit through peer-to-peer and crowd lending platforms. In the medium term, the best means of bridging this gap may be the mass securitisation of SME loans.
Jumping without looking?
The Basel Committee admitted from the outset that the impact of Basel III on SMEs might be disproportionate. Yet for two years there was no official impact assessment for the sector – so we called for one. To their credit, the European institutions responded with the Commission’s assessment in December 2011 and the European Banking Authority’s (EBA) assessment of SME risk weights in October 2012. Both missed the point.
The Commission assumed that the impact of CRD IV would be felt through higher interest rates or credit rationing, and were reassured when their models pointed to small effects. This ignores the resulting long-term changes to banks’ business models that should worry us more.
Likewise, the EBA assumed that the purpose of capital and liquidity regulation is to manage risk to individual institutions. They were reassured when their calculations showed that SMEs were riskier than large corporates. Yet the purpose of such rules should be to manage systemic risk – the kind that banks expose others to without internalising. By that measure, a AA-rated government bond posted as collateral is riskier than any small business loan will ever be.
It’s too late now for a wholesale review of Basel III or CRD IV. But perhaps the Basel Committee should use the relative quiet of the next six or so years to start preparing a Plan B.
This article was originally featured in Ziarul Financiar banking supplement, June 2013