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Most outcomes that involve dire consequences result in stringent future parameters which attempt to avoid the repeat of the challenging situation. The Financial Crisis of 2008 and 2009, where the U.S. government was forced to rescue many of the financial sector’s biggest companies will likely be the clearest example of this principle. Due to variety of issues including inadequate regulation in the derivatives markets, declining underwriting standards in the mortgage market, and financial institutions that were too highly leveraged, the Crisis of ’08 & ’09 almost claimed some of finance’s biggest companies. The upcoming formation of Basel III, a global regulatory standard on capital adequacy aims to ensure that financial institutions are not overly leveraged going forward. The final form of Basel III banking standards is a medium term issue that will affect investors in bank stocks.
Basel III regulations, the third iteration of rules from the Basel Committee on Banking Supervision, looks to adjust and strength new sets of capitalization rules first formed after the Financial Crisis. The rules are still evolving, and will be implemented over the next five years. While initial drafts and concept releases of the capital outline have been presented, the rule sets at this point are still a moving target. Major global banks, including UBS (UBS), JP Morgan (JPM), Citigroup (C), and Bank of America (BAC) are attempting to abide by as much that is known by the forthcoming standards as possible.
Basel III will have very specific detail on numerous aspects of a banking institution’s operation, but the baseline part of the forming regulation is that banks will have to have 4.5% in common equity and 6.0% of Tier 1 capital against its risk weighted assets. There will also be a 2.5% buffer requirement as emergency funding to insulate the institution from other potential economic shocks. As an example, if Citigroup has $100 in risky assets (which could include margin loans, securities holdings, mortgages, etc) it then must have $4.50 in common equity against that risky portfolio and $6.00 in Tier 1 capital (which includes common equity plus retained earnings and other equity including preferred equity).
As displayed in the chart above, while rules are not finalized yet, most of the major global banks have positioned their Tier 1 capital to clear the 6.0% requirement and also provide for the 2.5% buffer. UBS, as outlined above, is mostly clear of upcoming capital requirements with 9.8% of its risk weight assets in various forms of equity. Morgan Stanley, Bank of America, and Goldman Sachs are also all over the 9.0% mark currently. Citigroup sits slightly below the rest, with 8.7% in Tier 1 capital, with several of the large European lenders including Barclays, Credit Suisse, and Deutsche Bank all under what would be the Tier 1 threshold of 6.0% and also the risk buffer of 2.5%.
Whilst Basel III regulations are still forming and aim to reduce the chances of another global financial catastrophe, most global banks are already positioning their lending and risk weighted portfolios to meet parameters.
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