Basel 3 will put extra strains on banks

In a study by consultants Bain & Co it was calculated that the net stable funding ratio (NSFR) as required by Basel 3 would cost the five big banks - Absa, First National Bank (FNB) in the FirstRand stable, Nedbank, Standard Bank and Investec - a cumulative R471-billion in new capital.

This new capital could come through increased wholesale lending or greater costs. This preliminary number refers to the present shortfall in the banks' capital resources in order to adhere to Basel 3 rules.

All local banks exceed the present regulatory core tier 1 and core 2 capital requirements, but fall short of the liquidity coverage ratio (LCR) and the NSFR as formulated by the Basel committee. The rules were formulated to prevent a repeat of the financial crisis bedevilling developed economies and banks worldwide.
South African banks have to participate even though they have received no bailout from government. Nonetheless compliance in some form may not be such a bad thing as it is clear local banks do not have much leeway for a capital allocation mistake at any point.

Bain & Co banking partner Fabrice Franzen says it is an open question whether local banks would be able to reach the NSFR target. "The liquidity coverage ratio is not a problem as the Reserve Bank has set up a liquidity facility to support banks."

This facility of R117-billion is based on contributions from banks themselves and would cover any shortfalls up to 40% of a bank's liquidity requirement in the event of a crisis. The scope of the facility is also to support banks in the short term and to give enough time to structurally adhere to the liquid coverage ratio. This ratio requires banks to have an adequate level of liquid assets that can be converted into cash in 30 days.

But the NSFR is a different kettle of fish as much more radical changes in funding would be necessary to meet its criteria. It demands that banks diversify their funding structure to longer-term, more stable retail deposits.

South African banks have a problem because they predominantly use short-term and wholesale funding to fund longer-term products. In essence this means that short-term deposits of less than 24 months are used to fund a mortgage loan of 20 years. This mismatch is a taboo under Basel 3 rules. Another problem is that money market deposits are off-balance sheet products, which fall outside the Basel 3 requirements.

Franzen says this boils down to two options for banks: to obtain more expensive longer-dated wholesale funding on global markets or to increase the ratio of longer-termed retail deposits.

South African banking clients have been bad at depositing money in banks to save, mainly because, in the past, high inflation has made it preferable to invest in equity or money market funds, where higher interest rates can be obtained. Enticing customers to invest in retail deposits will cost banks more as they will have to pay investors higher interest rates.

"It is costly to put more liquidity aside," Franzen emphasises. "It could be questioned whether banks would be able to increase their retail deposits in time."
A positive factor is probably that the NSFR has to be reached only in 2018, which should give banks time to adjust. But the price will be high. Adhering to the present requirements would shave at least 1%-1,5% off banks' present return on equity (RoE) at a time when most have ambitious plans to increase RoE. For example, Absa aims to increase its present RoE of 13,8% to 20% in 2014.

Higher fees and commissions have largely driven RoE growth so far, so it is unlikely that the high pricing structure of banks will level off in the years to come.
Franzen says it makes more sense for banks to build in higher costs in normal lending products. "Somebody has to pay for Basel 3 and charging higher rates on loans is a safer approach than [paying] higher rates on deposits."

Nedbank chief executive Mike Brown has been a vocal critic of the NSFR requirement and has stated it is an inappropriate mechanism for local banks. "In its present format it is unworkable in a developing market, such as South Africa, which also happens to have a developed mortgage market."

He expects the Basel committee to water down some of the requirements eventually. "In fact, it does not worry us much at present because we expect a revision to the ratio."

That is even though banking registrar René van Wyk, a former Nedbank executive, has warned that not meeting the ratios would be a disaster for local banks. But Van Wyk also clearly sees some leeway for changes in the requirements. The final amendments to the liquidity coverage ratio are to be released by the Basel committee, where South Africa is an active participant, in the middle of next year. Final amendments to the NSFR are expected only in mid-2016.
Local banks are in a better position with the LCR ratio than some global banks. For South African banks, the new requirements are reckoned to be only 4,4% of a new deposit dispensation. In contrast, French banks will have to adjust by 31%. Even capital-strong German banks face a 6,7% revision to their deposit structure.

With the NSFR requirement South Africa is, however, relatively behind. The preliminary adjustment percentage is set at 17,4%, compared to 5,5% in the UK and 4,9% in Germany.

Locally, Absa is by far the best capitalised bank. Though it has bad debt and income generation problems its adjustment to Basel 3 rules is expected to be the least disruptive. In contrast, Nedbank and Standard Bank still have a long way to go. Nedbank's long-term funding ratio is only 27% as at the end of June. To adhere to the requirements, long-term funding must increase to 100%.

It is clear local banks will have to tread carefully with capital allocation decisions in the next few years. As Franzen puts it: "It is quite tricky to obtain the right returns and in the process not consume too much capital."

A misstep could have far-reaching consequences, especially for banks that are planning or in the middle of acquisitions. For example, Brown says Nedbank has enough capital at present to convert its loan to Ecobank into equity next year. "But not beyond that," he emphasises.

Source: Financial Mail via I-Net Bridge.