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How Will Basel III Impact Banks?

August 29th, 2012 |

With Basel III looming, financial institutions are yet again bracing themselves for the changes to come from new regulation. In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measurement, but what will this really mean for a bank? Several bank attorneys think lending will suffer, as many banks will have to focus on increasing capital and taking on less risky loans.

How will the new Basel III capital requirements impact the banking industry in the U.S.?

Luigi-DeGhenghi.jpgBasel III will generally require all U.S. banks, large or small, to hold more capital than under existing rules, especially in the form of common equity. The effect will be to incentivize banks to reduce their risk-weighted assets by reducing their exposures or their level of risk in order to maintain a sufficient return on equity to attract investors. The impact on bank mergers and acquisition activity is unclear. Increased capital requirements will drive banks as sellers, but will temper banks as buyers. But there will likely be a contraction in the supply of credit from banks, which may drive lending into less regulated parts of the financial sector. This seems at odds with the prevailing political push for more lending from banks and more financial regulation.

—Luigi L. De Ghenghi, Partner, Davis Polk

Gregory-Lyons.jpgIf adopted as proposed, the Basel III requirements will have a significant impact on U.S. banks of all sizes.  Community banks were surprised that they were subject to Basel III at all, and the higher substantive and procedural burdens on both residential and commercial lending can reasonably be expected to force many of them to exit the industry.  For the larger banks, much of what is in the U.S. proposals is consistent with what they have been tracking from the Basel Committee since late 2010.  Nonetheless, the higher capital charges likely will continue to force the shrinking of business lines in the short term, and severely inhibit large bank mergers over the longer term.  

—Greg Lyons, Debevoise & Plimpton

Mark-Nuccio.jpgThe impact will be positive in the long term.  Basel III’s higher capital requirements will be phased in over a number of years.  While many are eager for banks to become more generous lenders, Basel III’s capital demands encourage banks to husband their resources.  The new capital regime will be a drag on economic recovery, but it ought to produce greater long-term financial stability. 

—Mark Nuccio, Ropes & Gray

Jonathan-Hightower.jpgThe real impact will be the change on Main Street.  The proposed risk-weighting rules will require banks to tie up more capital with certain asset classes, which will cause banks to increase their pricing of those assets in order to achieve the same return on equity. Therefore, we can expect higher pricing for junior lien mortgage loans, highly leveraged first mortgage loans, and highly leveraged acquisition and development real estate loans.

This change in pricing will affect the demand for these loans, which will in turn limit the number of developers and homebuyers in the market. That contraction will impact both the supply and demand sides of the economic equation. At the end of the day, these changes will lead to a slower recovery of the facets of the economy related to housing and development.

—Jonathan Hightower, Bryan Cave

rob_fleetwood.jpgThe implementation of the Basel III regime will highlight the need for banks to be creative in their capital planning. We have already been assisting numerous community banks in capital raising initiatives to provide support for the development and implementation of lending and other income-producing programs, as well as strategic acquisitions or expansions. We are encouraging our clients, to the extent they have not done so already, to implement comprehensive capital plans that focus on careful management of existing capital resources and proactive research of available sources of future capital.

We have also been discussing with clients the ability to implement new lending programs, other non-interest income sources and deposit products in anticipation of the new requirements. If done correctly, these initiatives may provide additional resources for banks to grow, despite the new requirements. However, as with all new programs, they need to be carefully studied and managed to ensure compliance with all regulatory requirements, not just the new capital rules.

—Rob Fleetwood, Barack Ferrazzano

Peter-Weinstock.jpgBasel III and the changes to risk-based capital regulations provide substantial penalties, in the form of increased capital allocations, for risk taking.  Former chairman of the Federal Deposit Insurance Corp. Bill Isaac, in his book, “Senseless Panic: How Washington Failed America” demonstrated the pro-cyclical nature of mark-to-market accounting.  Yet, the Basel accord now mandates it for the securities portfolio.  The risk-based capital ratios dramatically increase the risk-weighting of several asset classes, including mortgages that are not “plain vanilla” and problem loans.  Because such penalties have a potentially severe impact on capital, prudent bankers will reduce their risk of a capital shortfall either by rejecting loans at the margin or maintaining higher capital cushions.  Either way, the credit crunch for all but the clearly creditworthy is likely to be exacerbated.

—Peter Weinstock, Hunton & Williams

kweaver

Kelsey Weaver is the Publisher for Bank Directoran information resource for directors and officers of financial companies. You can follow her on Twitter at twitter.com/kelsey8762 or get connected on LinkedIn.