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The 2007 market collapse slashed retirement savings, shuttered banks, and left America’s financial corridor in ruin. To diagnose the cause, many pointed to highly-leveraged banks without enough capital in their coffers to handle market panic. A flurry of financial reforms followed to potentially strengthen and safeguard the banking sector. Basel III, which was finally finalized in late 2017, is at the core of those efforts.
Drafting and implementing Basel III
Several global regulatory agencies have taken a crack at fixing the faults in the banking system. The Federal Reserve rolled out the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the Volcker Rule, which prohibits banks from short-term proprietary trading. More recently, Europe also pushed through a Capital Requirements Directive (CRD) aimed at enhancing requirements for the quality and quantity of capital and a new foundation for liquidity and leverage requirements.1
Meanwhile, the Basel Committee was the global regulator tasked to develop uniform capital and liquidity requirements that would patch systematic vulnerabilities and support the global economy through all cycles.2
At a basic level, Basel III increases capital requirements to ensure banks can withstand losses during market panic and adds additional supervision and risk management of the banking sector. Many of Basel III’s intricacies serve the larger goals. It attempts to strengthen the quality capital banks hold in reserve against loans and it adds capital buffers, which banks must hold through common equity or risk losing the right to distribute earnings to shareholders.1
Basel III is also looking to standardize credit risk, requiring banks to expand their due diligence efforts beyond a reliance on credit ratings before giving a loan. These reforms will be implemented during a lengthy transition period, giving banks and legislators time to enact – or some would argue slow down – the changes through 2027.3
What this means for traditional banks
These regulatory requirements may upset the banking system in the short term, but long term, greater solvency and less risk may put bank lending on solid footing.
In the short run, uncertainty brings volatility to the lending marketplace. Many banks still don’t know how to answer, “how much does it cost?”, limiting their ability to lend with conviction. And since Basel is recommending, not directing changes, the sector’s receptiveness is spotty at best. U.S. banks embraced Basel I some three decades ago, but largely ignored Basel II in the mid-2000s, resulting in a collapse that demonstrates ignorance may not in fact be bliss. Without universal adoption, it may be difficult for banks to operate an efficient, sustainable global business.
Long term, if loan growth is to recover from short-term shockwaves, Basel III and future regulatory requirements must balance regulatory cost and financial stability. By building capital and liquidity coverage, banks should improve operational efficiency and lower portfolio risk. However, these benefits do come at a cost to banks, which may pull back on lending or start charging higher interest rates to offset these costs. Finding that equilibrium will determine Basel III’s success within a growing economy in need of capital.
Impact on investing
Regulatory change will also impact today’s fixed-income markets. Limiting systematic risk in the lending markets has in turn added risk to the bond and loan market, making it a significantly more illiquid asset class. This may make active asset selection even more vital moving forward.
And as banks weigh regulatory requirements with profitability, alternative lenders like business development companies (BDCs) and private credit funds have stepped in to fill the lending void. These new channels will provide a unique investment opportunity for the foreseeable future.