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Basel Equity and Its Impact on Banking and Lending

January 22nd, 2013 by 
CameronDaniels

Although this blog regularly deals with personal finance, economics and politics, our interests span a wide array of other areas of life. One of my personal favorite blogs, The Volokh Conspiracy (a legal blog that has a mostly Libertarian bent, I'd say if I was permitted to classify them) recently featured a fascinating article by Nick Rosenkranz on a nuance in constitutional law I had not previously thought about: the power (or lack thereof) of treaties over legislation.  In one opinion, treaties from foreign powers are not directly enforceable by law. The question of whether they are enforcable crops up often in your financial life (often without you even knowing it.)

What (Where) is Basel?

The recent financial crisis has proven to financial regulators the need for greater oversight and stricter regulation of capital holding requirements for banks. After the recession, American regulators including the Federal Reserve were looking elsewhere for help. Enter Basel, Switzerland. Basel is a city in Switzerland that regularly convenes a meeting of financial regulatory bodies across the world in an attempt to promote convergence. It is important to note that the Basel Committee has no direct regulatory or legislative control over American banks. The Federal Reserve, however, has started to push American banks to adopt Basel II recommendations for holding rates.

What does this change?

Consider the balance sheet of some of the banks and holding companies that went bankrupt during the Great Recession. Some estimates have placed the leverage of Bear Stearns and Lehman Brothers at greater than 200-to-1. In the past, there were even more egregious examples of huge leverage - such as Long Term Capital Management, which planned for a leverage of 400-to-1 or greater. Put in other words, for every $1 of equity or capital, the company planned on holding $399 in debt.

In the aftermath of the Great Recession, regulators are looking at leverage ratios as one of the major risks to a bank’s balance sheets. The assets on the balance sheets have volatility in their valuations and capital holding rates is a measure to combat the inherent risk of hard to price assets.

What does this mean for me?

Banks attempt to maintain a certain RoE to ensure that their investors are properly compensated for their risk. Basel requires more capital to be held for those returns. This means that, all else being equal, RoEs should be lower for banks than they were previously under the new standards. This is one of the reasons many analysts now target a P/E for banks of 10-12 as opposed to a "more standard" 15+ for other industries. As an investor, this might mean that you will get lower returns from banks than before, BUT, potentially, banks may perform better with (surprise!) lower P/E. As a borrower, this means that banks will have slightly tighter lending restrictions and also will need to target a higher return to maintain similar RoE (higher APR, more cash $, lower credit limit, etc.).

The silver lining, of course, is that as a taxpayer you directly insure banks through the FDIC (and, the more cynical among you will note, through the general fund through bailouts and the like). This measure will limit the possibility of these bailouts and failures simply because banks will be forced to hold more cash on their books. How exactly the balance is struck and whether it's a positive or negative to the economy would come down to a continued debate. The Basel II accords were published in 2002 and for the most part American banks ignored them. There is a much larger appetite for banks to adopt them now in the wake of the great recession. Just understand: banking as a whole has changed... in the underlying risk, the return on capital and, yes, the ways that banks will lend.

Cheers,

Cameron Daniels

Do you think stricter limits on banking capital is a boon to the economy or a detriment? Have you seen its impact any other way in your day-to-day financial life?

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