Basel III: core components and implications affecting the payment sector
As reported in January 2011 (see link under 'related articles in previous issues' below), the revised framework, referred to as Basel III, contains important provisions which will affect banks that provide access to payment systems for their clients or other settlement-related facilities. The framework introduces the following new regulatory metrics to sit alongside the existing risk-weighted-asset regime:
- Tighter definition of tier 1 capital: transitional arrangements which require new common equity and tier 1 capital requirements1 to be met by 1 January, 2015. The recommended capital buffers should be fully in place by 2019.
- A framework for counter-cyclical capital buffers.
- The leverage ratio, which is a very blunt comparison of capital to lending.
- Short and medium-term quantitative liquidity ratios: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The impact of these liquidity ratios will be analysed in detail below.
The LCR will require banks to maintain a stock of 'high-quality liquid assets', which can sufficiently cover net cash outflows over a 30-day stress period. This means that a bank will have to maintain a pool of liquid assets that can meet its forecasted net cash outflow over this set timeframe. In comparison to the current rules, banks will be required to hold enough assets to fund normal outflows, which are assessed on a behavioural basis by the banks themselves. The Basel III regime then imposes assumptions about how fast the cash will flow out, leaving the bank to construct its asset pool to match the predictions. For many banks, this will mean an increase of liquid assets by a factor of several times the proportion of its total balance sheet. Additionally, the LCR proposal assigns run-off rates to each source of funding. These are designed to simulate a severe stress scenario. As a result, the treatment of wholesale deposits, for example, will be less favourable from a bank's perspective, which is likely to have an impact on deposit rates.
The NSFR is intended to control the extent to which banks rely on short-term (sub-one-year) funding as a proportion of their overall funding. In effect, it requires banks to fund the illiquid portion of their asset book with assets of more than one year residual maturity. Banks will be under pressure to fund illiquid exposures with capital, long-term debt or non-financial sector deposits.
The impact of Basel III in the payments context will also be felt as regards intra-day liquidity. Banks active in providing payment services typically provide short-term liquidity to their clients, usually in connection with access to clearing and settlement mechanisms (CSMs). For example, a client wanting to participate in a payment system may need to have standby liquidity to cover times between cash outflow and inflow. The bank which provides an agency service, enabling that client to have access to the payment system, may therefore provide an uncommitted credit facility to give the client the liquidity it needs. These facilities are essential to ensure that today's financial system runs smoothly. Basel III has led to regulators, mainly in the US and the UK, to also focus on the identification and management of the intra-day liquidity exposures in the context of payment systems. In the US, uncollateralised intra-day liquidity is charged for by the US Federal Reserve System (informally know as the FED). The UK Financial Services Authority (FSA) and the Bank of England are currently reviewing issues related to intra-day liquidity. In short, intra-day liquidity is fast becoming recognised as a scarce resource, with a real and significant underlying cost, which needs to be carefully managed and controlled.
As a result of the new regulatory focus on intra-day liquidity, individual banks are increasingly likely to bear liquidity efficiency in mind as a factor when deciding how many and which payment systems they wish to participate with, while carefully analysing the make-up of their client base. The result of this analysis may influence the scheduling of their payment flows throughout the day and related liquidity needs.
CSMs and infrastructure providers more generally will be under pressure to make sure that their systems are designed to operate in liquidity efficient ways, deploying the latest liquidity saving techniques and strategies. At the same time they will have to focus even more on minimising and containing systemic risk.
Timelines for implementation of Basel III
According to the recommendations of the Basel Committee on Banking Supervision (BCBS), implementation of Basel III should be completed by 2018. The effects of these new measures will however, have an impact on the payments market long before the deadline, as banks are keen to demonstrate to investors that they are well prepared to meet requirements established with new legal regimes. Some communities, notably the UK, have already begun to implement the liquidity regime element of Basel III. This means that practice is likely to precede the letter of the law this time around - at least in the European Union (EU).
Basel III will be implemented based on a phased approach taking into consideration progress in the economic recovery following the financial crisis. In the , the major provisions of the regime will be implemented with the amended Capital Requirements Directive (CRD) referred to as CRD IV. The European Commission aims to introduce the related legislative proposal in July 2011. It remains open however, as to how and when non- jurisdictions will apply Basel III. The US, for example, has not yet implemented Basel II.
The long-term consequences of Basel III and G20 initiatives now in the pipeline: trends to keep an eye on
Although it is early days to fully predict how Basel III will affect the cost and systemic risk considerations underlying the provision of payment services at a domestic, regional and global level, the assumption shared by most market observers is that the new regime will make the provision of 'wholesale' banking services less attractive. The one thing certain however, is this: Basel III marks only the beginning of increased regulatory scrutiny of the payment market with regard to potential systemic risks. The question as to what role the new European Banking Authority will play in the Basel III environment has yet to be answered.
Finally, it is not clear to what end the tightened requirements introduced within the new regime will impact the expectations voiced in particular by the European Commission to open the euro payments landscape for new market participants. Based on this expectation, the Payment Services Directive (PSD) adopted by EU Member States in November 2009, introduced payment institutions () as a new category of non-bank payment service providers. Non-bank service providers active in payments are not subject to the stringent rules introduced with Basel III thus giving them a competitive advantage over banks.
It is also likely that Basel III will have a significant economic impact: the Institute for International Finance (IIF) and the European Banking Federation (EBF) estimate a negative economic impact of one to two percent for the US economy and four to six percent for the European economy, with an estimated reduction of financial sector profits of two to four percent.
And there is more to come: at its meeting in Seoul in November 2010, the G202 confirmed that additional measures would be imposed on systemically important financial institutions (SIFIS's) and globally important financial institutions (G-SIFIS's). The new regime will trigger a change of the capital structure of many SIFIS's and G-SIFIS's. Several of these have already embarked on core capital-raising exercises that have helped to secure their capital adequacy ratios.
Ruth Wandhöfer is a member of the Plenary. She also chairs the Information Security Support Group.
Basel III document published by the Basel Committee on Banking Supervision on 16 December, 2010:
Related articles in this issue:
Related article in previous issue:
Happy New Year? Post-crisis EU financial sector reform: the impact of Basel III on payments ( Newsletter, Issue 9, January 2011)
1Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. (Wikipedia)
2The G20 was established in 1999, in the wake of the 1997 Asian Financial Crisis, to bring together major advanced and emerging economies to stabilise the global financial market. Since its inception, the G20 has held annual Finance Ministers and Central Bank Governors' Meetings and discuss measures to promote the financial stability of the world and to achieve a sustainable economic growth and development. (http://www.g20.org/index.aspx )
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