Basel III: Capital requirements and the cost of leverage

John Bakie
13 September 2010

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The Basel III banking regulations took a major step forward over the weekend when central bankers agreed on the latest set of rules to prevent future financial crises. Higher capital requirements for banks have hit the headlines, but what effect will the changes have on banking institutions and those that rely on their services? John Bakie investigates

If the plans run to schedule, from 2013 banks will be required to build up a buffer of capital, termed common equity, worth around 7% of their investments and loans. It is hoped the increased buffer will ensure banks have enough liquid capital to cope with future shocks to the financial system, such as those seen during the US sub-prime mortgage crisis and the collapse of Lehman Brothers.

However, some economists say the new capital rules could lead to a second credit crunch, as banks reel in their lending to meet the tighter regulations. Regulators on the other hand argue that phasing in the regulations over several years will help banks to adapt slowly, preventing the sudden reduction in lending seen in 2008.

For private equity investors, there is a risk that banks may make cuts to the amount of leverage they have available, to ensure they can meet the new capital requirements. They may also look to increase the costs of leverage, which could impact returns and have serious repercussions for those companies which need refinancing.

But the regulations will also introduce measures to discourage the procyclical nature of the existing Basel II rules. Currently, banks are allowed to reduce their capital ratios at times when their profits are high, but must rapidly increase them when economic circumstances are more difficult. This contributed to the financial crisis, causing banks to rapidly scale back their lending. Basel III will instead aim to encourage banks to increase their capital reserves during economic booms, and reduce them during recession which, in theory at least, should result in a far smoother movement in lending trends.

This could prove positive for those who use leverage, by ensuring banks don't suddenly turn off the taps when the economy becomes more difficult. This would allow investors to continue investing, critical when running fixed lifespan funds, and enable portfolio companies to adapt to new economic circumstances without having the leverage prop suddenly wrenched away from them.

The regulations still have a long way to go. G20 leaders are due to agree on the overall format of the rules during a November summit, with full rules to be developed during 2011. This gives the industry plenty of time to consider and prepare for this major, global piece of financial regulation.