Market participants and investors have underestimated the impact that the Basel Capital Framework is having on both the buy-side and the sell-side. The potential impact of the framework will be significant going forward and banks may further cut back on the business lines they participate in.
The Basel Capital Framework evolved from the reporting standards put forth in Basel I, with the goal of creating a completely integrated capital, funding, and liquidity framework. This is being dealt with through the latest version of the Basel requirements – Basel III which includes standards for higher quality and quantity of capital, a leverage ratio constraint and short-term liquidity and longer-term funding rules. Indeed, most jurisdictions are moving toward rules that promote full integration prior to the BCBS phase-in end-date.
Still, even while progress is being made on integration, banks are facing challenges when it comes to meeting requirements and maintaining a profitable business. Basel I first began by placing standardized risk weights for credit and market risk exposures. Then, in Basel II risk based capital calculations for credit, market, operational and counterparty credit risk were introduced. In Basel III, impacted entities will have to focus on the liability side of the balance sheet. Capital buffers, capital quality and quantity, liquidity coverage, and stable funding requirements are now all on the table.
In order to meet these requirements banks are managing assets through a range of capital and leverage ratios outlined in Basel III. The primary ratios are used by both banks and regulatory authorities to monitor the activity and overall health of the banking system. The four ratios are:
- The Common Tier-1 Capital Ratio (CET1)
- Tier-1 Capital Ratio (T1)
- Leverage Ratio (LCR)
- Supplementary Leverage Ratio (SLR)
Both CET1 and T1 focus on risk-based capital, whereas LCR and SLR focus on leverage/non-risk based capital.
Essentially, the Basel framework forces banks to control the quality of their data and to create an infrastructure to aggregate the view of risk in order to assess it on an enterprise-wide basis. This reality will require some heavy lifting on the part of banks to break down silos, gather data assets and render them in a way that is meaningful within the framework. Third party technology providers have emerged as a means of helping banks through the process by re-platforming instead of trying to manage compliance through legacy systems.
Additionally, risk management is being incorporated in everyday processes from end-to-end. Once fully implemented, banks should be able to operate more efficiently and deploy capital more strategically while being less susceptible to event stresses.
In the short run, however, market events are driving up the cost of doing certain types of business while the Basel III process is still ramping up within organizations. So far in 2015, we have seen record issuance on the corporate bond market coupled with asset management concentration and more instances of investor herding. Low-margin capital-intensive businesses are also getting phased out more quickly as the cost of doing those types of transactions continues to rise. There is also a broad-based reduction in dealer risk appetite as capital models now incorporate crisis losses and there has been an expansion in the number and type of risk limits. Finally, technology-driven decision making and trading are growing which comes with a decline in trade sizes.
For banks to manage these realities up against compliance deadlines, they will need a more efficient delivery of information. Risk is more interconnected than ever before through the market, credit and liquidity and will require optimization in processes and information. Calculating credit (CVA), debt (DVA), funding (FVA), liquidity (LVA) and margin (MVA) value adjustments – collectively referred to as XVA – is now essential to risk management. As a result, the all-in price is driving most trade decisions and also reflects the fair value mark-to-market of each trade versus the existing portfolio. These calculations are increasingly technology driven and will define the trading process at most organizations going forward.
The pivot in how banks view their business creates an opportunity set for third party providers who are already informed by the industry process in place at other institutions. Over time, business models inside banks that can develop data enhancements while dealing with issues like risk convergence and notional compression will come out on top. We also expect to see an increase in the use of central clearers, and with that a migration to simpler and price transparent products.