Basel III: Endgame
A quick overview of the oddly named but super important proposed banking regulation framework, and why it matters.
A Tough Few Years
The banking sector has had a tough go in recent years, and the usual economic culprits (high interest rates and the always-coming-but-never-quite-here recession) are to blame.
Over the last five years financials XLF 0.00%↑ have significantly underperformed against the S&P 500 SPY 0.00%↑, delivering a total return of 54% against SPY’s 84%.
While the threat of recession is real1 and current interest rates are a problem for most banks’s balance sheets, we can now add a third threat to the list: the oddly named ‘Basel III: Endgame.’
The Basel regulations, broadly, are a series of banking regulation standards adopted long ago and something to which virtually every Western banking system adheres. Basel III, the latest (and supposedly final) set of regulations was announced not long ago, and U.S. banking executives are… well… not thrilled.
In a Basel III world, JPMorgan Chase & Co. would have to stockpile 25% more capital, while Citigroup Inc. would have to rethink its equity investments.
Two of the largest US banks offered more details Friday on what they expect if new capital rules unveiled by regulators in July go into effect without revisions. They’re also stepping up their critiques of the plan and promising a robust push-back from the industry, which is likely to face less capacity for stock buybacks if the rules are passed.
(A quick note: I’ll just be honest when I say that a lot of this stuff probably constitutes the most boring thing on Earth. It’s kind of meant to be that way (you don’t want banking to be reckless and exciting, right? Right?). But it is important!)
Why would banks have to stockpile more capital? Because Basel III would require banks to hold a larger amount of reserves (measured by various capital ratios, such as CET1 and Tier 1 leverage).
Banks today make their money by, in the simplest models, taking in deposits from customers and lending out those deposits. They earn interest on what they lend and they pay the depositors a bit less interest on their deposits. The bank keeps the difference, known as a spread.
Now, banks can’t just go out and lend every dollar on deposit. They need to keep some cash or cash-like instruments in reserve to meet withdrawal requests. A failure to keep adequate reserves would be bad. Like It’s A Wonderful Life or Silicon Valley bank bad.
In other words, the alphabet soup of capital ratios exists so regulators (and the very small portion of the interested public) can ensure that banks aren’t
lending recklessly, and
unable to meet average and above-average withdrawal requests.
You can see, then, the effect that the lowering or raising of reserve requirements by regulators would naturally have. Lowering the ratio would mean that banks would be able to lend more (I.e., fund productive, economic activity). And this is a wholesale statement: it does not benefit bank shareholders to have a management team that arbitrarily keeps capital ratios far higher than required.
Raising reserve requirements, then, would have a decidedly negative impact on bank lending (I.e., less available funding for productive, economic activity).
Bloomberg continues:
“We will continue to engage and forcefully advocate in the comment period and beyond in a great deal of technical detail,” JPMorgan Chief Financial Officer Jeremy Barnum said in a conference call with analysts Friday. “If it goes through as written, there will likely be significant impacts on the pricing and availability of credit for businesses and consumers.”
US regulators’ plans, which are expected to take years to fully implement, would require banks to set aside more capital, tied to an international overhaul that began in the wake of the 2008 financial crisis. JPMorgan Chief Executive Officer Jamie Dimon in September called a key calculation in the new plans “asinine.” The measures will make certain activities such as mortgages and small-business lending harder for banks, he has repeatedly said.
The counterargument, of course, is that banks are greedy and already reckless in many ways with hyper-complex balance sheets that could hide any number of time bombs just waiting to explode under the right economic conditions. Holding higher reserve requirements then seems like the most effective, blunt force way to directly cushion the potential blow to depositors should one of those bombs explode. Memories of the Great Financial Crisis loom large in the minds of regulators, and stopping any repeat of that event is a thing of primary concern.
No matter what side you take on these regulations, however, one thing is clear—banks are fighting a multiple-front war, and things aren’t likely to get better for them (or their shareholders) anytime soon.
Final Thoughts…
Economists think that the Fed will keep rates high until at least July (though it doesn’t seem like traders necessarily agree). The cost of the educational impact from COVID seems to get worse and worse. Google is taking advantage of the turmoil at OpenAI. For no real reason, Bitcoin is now above $44,000. Palantir is falling and just broke through a key technical level.
And while it feels a bit like the boy who cried ‘recession’ at this point, the economy generally tends to turn the way everyone expects only after everyone has been lulled into a nice sense of complacency.