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There are changes afoot in the way that banks are capitalized which will result in a tightening of credit conditions. These changes will make it harder for borrowers to gain access to credit, and will also impact banks’ profitability negatively. The regulatory bodies that establish banking rules are still wrestling with the banking crisis of 2008 and its implications, and want to ensure the solvency of “Systemically Important Banks” so that they are no longer considered “too big to fail”.
To understand why these proposed changes are important to the economy and to the stock market, we need to first get familiar with the following two organizations:

The Basel Committee:
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by G-10 central bank governors in 1975. As its name implies, it is based in Basel, Switzerland. Its members include Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The present Chairman of the Committee is Mr. Stefan Ingves, Governor of Sveriges Riksbank, the central bank of Sweden. The Basel Committee makes the rules on banking regulations. They came out with their first regulations for banks in 1975, which is referred to as “Basel I”. After the banking crisis of 2008, we have moved on to “Basel III”, which was created on January 1, 2013, and which will be fully implemented by January 1, 2019.
Once it has decided on a set of regulations for banks, The Basel Committee has never been known to back down from its recommendations, and no member country has, as yet, ever refused them.

The Clearing House:
The Clearing House payments company is a US based group which provides payment system infrastructure to the banking system. It operates an electronic check clearing and settlement system, an automatic clearinghouse, and a funds transfer system known as CHIPS. The Clearing House is the oldest banking Association and Payments Company in the United States. It also serves as a trade body for banks. On June 23 of this year, the president of the Clearing House Association presented to the US Senate committee on banking Housing and Urban affairs. During his testimony, he discussed revisions proposed by the Basel Committee on how credit risk is measured at banks.

Basel III:

After 2008, it was determined that the capital requirements against which banks make loans were woefully inadequate, both with respect to the “quality” of capital and the quantity of capital needed to make a loan against. It was determined that certain banks had too much leverage and that certain banks were “too big to fail”. These banks were called “GSIB’s”, short for “Global Systemically Important Banks”. Basel III attempted to rectify the financial health of banks by defining parameters around what constitutes capital and how much of it is needed to make a loan against it. Many banks before Basel III were using, as their capital, instruments which did not absorb the banks’ losses properly, so it was determined that a bank would need to keep as much as 12% of the value of their loan portfolio in “Tier 1” capital, and another 2% in “Tier 2” capital. Tier 1 capital is defined as either common stock, retained earnings, or paid-in capital. Tier 2 capital is defined as preferred shares and subordinate debt.
So if a large, “systemically important” bank wants to increase its loan portfolio, or “risk weighted assets” (RWA) by $100 million, it needs to have $12 million of additional Tier 1 capital and $2 million more of Tier 2 capital on its books in order to do so.
An implicit goal of Basel III is to reduce RWA at “Global Systemically Important Banks” (GSIB’s) in order to shrink them, basically by regulating that the bigger they are, the higher the capital requirement they need. This is one reason why banks have been so unprofitable since 2008, and why on average they trade with a 40% discount to their book value in Europe, and why certain other large U.S. banks, like Citibank and Bank of America do as well.

Bank regulations use a term called a “Risk Weighted Assets”, or RWA, which is used to apply capital requirements against for a given type of loan. A normal loan from a bank carries an RWA of 100%. A mortgage loan, which is secured by a house might have a RWA of only 50%.
As mentioned earlier, Basel III is still a “work in progress”. There are additional proposals on the table, which are likely to be accepted and implemented between now and January 1, 2019. Two of these proposals, discussed below, will have a major impact on banks, and there will be many more proposed and phased in.

One such change will be to revolving retail credit lines, including but not limited to credit cards, or what banks refer to in jargon as “unconditionally cancellable commitments”. A bank holds the right to cancel any credit card at any time to anybody. Because of this, banks did not have to maintain capital against those loans. According to the new Basel III proposals, they now will. But how much capital? What about those credit lines that don’t get used?
Because not all of these credit lines get drawn down, the Basel Committee proposes treating them as if either 10% or 20% of these lines are being used, they haven’t yet decided. The U.S. now has around $3 trillion of these credit commitments. According to the new rules, 20% of $3 trillion is $600 billion, against which banks will have to raise 14% of Tier 1 and Tier II capital. That amounts to $84 billion.

Another major change will impact revolving wholesale corporate credit lines. These credit lines can be huge, and many large corporations don’t even use them, but keep them in place “just in case”. Sometimes, a large corporation will have a commercial paper program in which they issue very short term debt to investors, and rating agencies like Moody’s will insist that there be a revolving line of credit in place in case demand for the commercial paper dries up.
A CCF is like an assumed drawdown, and stands for “Credit Conversion Factor”.
This is what regulators are changing.
Currently, if these credit lines are less than a year in length, banks need a 20% CCF, and if they are more than a year, banks need a 50% CCF. Under the new rules, a 50% CCF will be necessary for both, and possibly even a 75% CCF for both is under discussion and will be decided upon in the coming months.

The Clearing House recently conducted a study attempting to analyze the impact of the proposed Basel III changes on wholesale and retail revolving credit lines. The study was presented to the US Senate Committee on Banking by Greg Baer, President of the Clearing House Association. They found in the first case that U.S. banks will need $145 billion more CCF against which banks will have to raise 14% more capital. If a CCF of 75% is used, $709 billion more CCF will be needed, against which 14% of new capital must be raised, which amounts to $100 billion.

If banks are obliged to increase Tier I capital, they will either be obliged to do so by:
1) Issuing common stock, which is not only expensive, but will dilute their “return on equity” a ratio that is very important to bank stock investors.
2) Reduce credit by selling their existing loans. Rather than issuing new shares, banks will simply attempt to shrink their balance sheets and buy back shares in order to increase their stock price.
3) Reduce their stock buyback programs, which does not make economic sense.
4) Raise prices on loans, in order to compensate for the additional costs of new capital.

In order to offset these proposals to wholesale and retail revolving credit lines, banks will have to shrink these commitments by anywhere between 2% to 10%, which is contractionary to the U.S. economy.

What about Europe? Well, European banks are much more leveraged than US. Banks. In fact, the European banking system is about three times bigger than the in the U.S., because European corporations cannot access the bond capital market as easily, and need banks more. So every rule change that is imposed by the Basel Committee is worse for European banks than it is for U.S. banks. They end up making less money from less loans, and need even more capital because they are more leveraged.

And China? Basel III attempts to regulate Chinese banks as well. There has been much hand-wringing over the levels of non-performing loans in China, which is unclear because of the opacity of Chinese reporting. It is assumed that if there ever were a run on Chinese banks, the Chinese state would simply step in and guarantee depositors. The problem in China is that the banking system is now too big relative to China’s GDP. The government debt-to GDP ratio is enormous as well, at 260%.
If the Chinese government is ever forced to guarantee deposits, it would probably add an excess of as much as 100% to that figure, (or maybe more) at which time investors will realize that the state has no more room for fiscal policy. Global growth forecasts will then be dramatically impacted. China has a certain “carve-out” agreements from the GSIB rule, but are nonetheless still responsible for adhering to most of it.
Certain bank analysts and experts believe that Chinese bankers may not be up to the task, as they have never experienced a banking crisis before.

Expect to see many other proposed changes to capital requirements phased in between now and Jan 1, 2019. The changes are an admission by regulators that risk is not being measured properly, and when it is measured properly, it is much bigger than it was previously thought to be.

But this raises questions on the pricing of loans. Now that banks will need extra capital, they will need to charge more for each unit of loan. And if these charges are passed on to customers, that is contractionary as well, because loans will become more expensive, and the availability of credit will be reduced. And this will be happening at a time when we are coming to the end of a business cycle.

There have been more than a few signs already that something is greatly amiss with banks. Deutsche Bank is around 45% lower than it was even at its 2008 lows. The CEO of HSBC, Europe’s largest bank, has announced his resignation. Credit Suisse is on its second CEO in as many years, while there have been three CEO’s in as many years at Barclay’s. The European bank stress test, whose results were announced on July 31, produced results that were very disappointing; some major banks such as Unicredito, Deutsche Bank, and Barclays had dangerously low levels of capital after being subjected to stressful hypothetical economic conditions. Monte Paschi di Siena had negative capital after failing the stress test outright; it subsequently announced a third major recapitalization in which it will attempt to raise six times its market value of common stock and sell nearly €10 billion in loans.

Both major U.S. political parties now favor a return to the Glass-Stegall Act separation of commercial and investment bank activities, which would weigh even further on bank shares going forward because it would prevent banks from cross selling between these two activities.

The purpose of this writing is not, however, to discuss the valuation of banks but to examine how regulatory changes may impact global growth resulting from a credit crunch between now and 2019. But what is bad for banks is also bad for business and consumer borrowers who need access to credit. Credit contractions can also often lead to an increase in defaults which can in turn drive higher the cost of credit.

Even though we know that rule changes are coming, there is a certain complacency over the fact that they will, in fact, arrive soon. The manner in which they are implemented could provide a real shock to the market. Banks globally, particularly “systemically important banks” are fighting them tooth and nail at the moment.
But regulators, and vote-dependent politicians, do not like banks.
Once the credit spigot is turned off, the rules will already be in the rulebook, and it will be too late for complaints by either consumers or businesses.

If the reader thinks I exaggerate, I will call his or her attention to the attached letter written by Jeffrey Campbell, the CFO of American Express Corporation to the Basel Committee on Banking Supervision. (Click here). On page 11, please note that he states that the new regulatory changes proposed by the committee would cost Amex as much as $8 billion of core Tier 1 capital if Amex were to maintain its current capital ratio given its credit card exposure. For a company with a $60 billion dollar market capitalization, this would mean having to dilute current shareholders with $8 billion of new common stock. Or, it might mean that a great many cardholders will have their limits curtailed or their cards cancelled.

The second attachment below is a letter from the U.S. Congress to Janet Yellen, Chairwoman of the Federal Reserve. (Click Here). The letter expresses concern that the new Basel III rules will disrupt the availability of credit to the real estate market, increase loan pricing, and increase real estate development costs, which in turn will have consequences on the economy as a whole.

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