Basel III Research Paper

The Implications of Basel III on the Global
Banking System: Discerning between
Regulatory Bolstering versus Liquidity Hazard

Emad Khan

Global Money Markets and Institutions

Professor Jim Winder

04/12/2015

Table of Contents

Introduction to Topic………………………………………………………………………………………………………… pg. 3
I. Case Study Commentary………………………………………………………………………………………………… pg. 5
II. Localized and National Basel III Implications…………………………………………………………………. pg. 19
III. Comparative US and Eurozone Effect…………………………………………………………………………… pg. 23
IV Commentary and Conclusion……………………………………………………………………………………….. pg. 35
Bibliography and Cited Works…………………………………………………………………………………………... pg. 42
Footnotes…………………………………………………………………………………………………………………………. pg. 45

Khan, Emad
Professor Jim Winder
4/09/2015
Global Money Markets and Institutions

The Implications of Basel III on the Global Banking System: Discerning between Regulatory
Bolstering versus Liquidity Hazard

In late 2010, the Basel Committee had announced an agreement on their newest
standards for higher liquidity requirements, known today as Basel III. “On 11 November 2010,
during their summit meeting in Seoul, South Korea, the Group of Twenty Finance Ministers and
Central Bank Governors (known as the “G‐20”) formally endorsed the Basel Committee on
Banking Supervision’s proposals for capital and liquidity requirements for banking institutions.
The Basel Committee had announced an agreement on these higher capital standards on 12
September 2010.” [1] Following the aftermath of the collapse and resultant great recession of
2008, it was evidently apparent that the global financial ecosystem (this paper is concerned
particularly with the US) needed a massive overhaul in regulatory procedures. This is where
Basel III comes into play. The ultimate goal here is to reduce the totality of the systemic risk
brought upon “too big to fail” banks, as well as a slew of other financial institutions in
aggregate. Basel’s III’s modus operandi is tackling risk at the forefront through three measures:
1) Developing a Liquidity Coverage Ratio (LCR) to ensure immediate satiation of liquidity needs,
2) hedging against risk coverage by strengthening capital treatment for complex securitizations,
and 3) overhauling global supervisory monitoring through net stable funding ratio (NSFR) to

stabilize long term structural ratio. [2]. Table 1.1 below from the BIS describes the areas of
interest that Basel III looks to address.
Table 1.1

In an ideal world, a fully integrated Basel III should incentivize big banks and institutions
to wade cautiously and intelligently when dealing with transactions, and promote a landscape
where excess capital reserves could buoy the economy in the wake of economic distress.
However, the assertions listed do raise a legitimate concern: Is it worth the proverbial paper
that is written on? Basel III is phenomenal in theory, but often times we’ve seen legislations
sputter when they’ve been extracted from a vacuum and into the real world. Over the course of
next few pages, I will attempt to answer this question. The purpose of this paper is to dissect
the Basel III regulation in detail, and draw out its potential efficacy in a practical landscape. We

will begin with presenting commentary on prominent Basel III case studies by PWC, KPMG and
Accenture. In the second arm of this paper, we will be discussing the implications of the Basel III
application, across both localized and global sectors. Commentary from the Wall Street Journal
and the Mckinsey case studies In the last arm of this paper, I will be injecting my personal
commentary into the discussion, and offer my own assertions on Basel III’s efficacy.
I. Case Study Commentary
PWC:
The major assertions placed in PWC’s case study are that Basel III is a revolutionary regulation
vehicle that is capable of bringing about major changes within the financial system. “Basel III
establishes tougher capital standards through more restrictive capital definitions, higher
risk‐weighted assets (RWA), additional capital buffers, and higher requirements for minimum
capital ratios. The reforms will fundamentally impact profitability and require transformation
of the business models of many banks. These reforms will also require banks to undertake
significant process and system changes to achieve upgrades in the areas of stress testing,
counterparty risk, and capital management infrastructure.” [3] Similarly to it’s predecessor
Basel II, III looks to shore up capital requirements within banks. The three main areas of interest
are the redefining of capital ratios and minimum targets, additional RWA requirements, and
new liquidity standards.
From a capital ratios and targets perspective, preferred stock has been removed and
modifications have been made to bolster the overall quality of capital . Additionally, Basel III
introduces updated countercyclical buffers and leverage ratios to discourage

overcollateralization against the bank’s balance sheet. Finally, Basel III increases the minimum
capital requirement that banks must have on hand at all times. Since one of the synergizers
behind the great recession was a sudden shock resulting from a disappearance of capital within
the financial system, The presence of excess cash on hand could allow for a buffer in the event
of a potential shortfall.
From an RWA (risk weighted adjustment) requirements perspective, PWC’s study shows
that risk management and corporate governance remain a key priority. [4] In my view, this is a
very comprehensive guideline that is bent on incorporating all risk adjustment into the firm,
and applying those adjustments into said capital and liquidity requirements. Intuitively, this
makes sense: More Risk, more Cautiousness. Steps to further consolidate RWA include a charge
penalty for market to market (M2M) losses to compensate for a loss in credit trustworthiness
or credit valuation adjustment (CVA). The idea here is to dissuade big banks and institutions
from taking on unnecessary and hazardous risk at the expense of stability. It then goes on to
address risky financial productions, such as complex securitizations and derivatives.
“Enhancement of risk measures to include missing risk factors and extend coverage in areas
such as counterparty risk and securitizations Considerations of trading book exposures and
securitized products through a set of rules known as Basel II.5 designed to reduce capital
arbitrage between banking and trading books.” [5] Complex Credit swaps, high frequency
derivatives trading, and securitization of MBS’s contributed to a liquidity crisis in an enormous
way because of the lack of general knowledge and oversight associated with these transactions.
To ensure oversight, The IRS’s powers have expanded to oversee the loss of market.

Finally, from a liquidity standards perspective, Basel III introduces new liquidity
standards in the form of the liquidity coverage ratio (LCR), and the net stable funding ratio.
(NSFR). This ties in hand in hand with the capital ratio, with the overall goal of stabilizing risk by
ensuring proper capital flow across the financial markets. From a 30,000 foot view, the LCR
standards are such that the bank is required to hold on (Tier 1) High Quality Liquid Assets that
ensure that it can sustain itself for 30 days in the absence of additional capital. With these
measures in place, the broad objective in this principle is to ensure that the bank does not have
to face insolvency due to an unforeseen liquidity crunch. Table 1.1 and 1.2 from PWC’s Study
below show Basel III’s aggregated objectives. Table 1.3 displays the net effect of the liquidity
coverage ratio and net stable funding ratio on the overall financial landscape. [6]
Table 1.1

KPMG:
In reading KPMG’s case study, we can draw multiple parallels to the PWC case study, as was
expected from the outset. KPMG’s assertion here is that the strengthening of capital and
liquidity oversight was a prime goal, and that the global financial crisis provided an opportune
event to accelerate the process with expediency. “The global economic crisis has provided an
opportunity for a fundamental restructuring of the approach to risk and regulation in the
financial sector. the Basel Committee on Banking Supervision (BCBS) has collectively reached an
agreement on reforms to strengthen global capital and liquidity rules with the goal of
promoting a more resilient banking sector, which is referred to as Basel III. Under Basel III, each
area of proposed changes has a separate consultation, debate, and implementation phase. As a
result, compared with the implementation of the previous agreement (Basel II), this enhances
level of dynamism, complexity, and interdependency within the global regulatory landscape will
likely add significant challenge to the implementation of Basel III.”[7]
KPMG breaks down the Basel III proposals into capital reform, liquidity standards, and
systemic risk and interconnectedness. The broad level breakdown was very much in line with
our PWC observations, but there were a few areas of interest that I found intriguing. First,
KPMG has defined Basel III “capital reform” as a steady progression of tier one high quality
liquid assets (HQLA) from the Basel II 2.0% to a more robust 4.5% by the conclusion of it’s
implementation in 2019. [8] Additionally, from a liquidity standards perspective, KPMG drills
down further into “short term” and “long term” liquidity standards. This bears significance
because applying a bottleneck approach would not be as effective in defining what the
appropriate standard of liquidity ought to be. In attempting to personify Basel III’s tiered

liquidity proposition, I liken it to medical therapy for the treatment of periodontal disease.
During treatment, there is a period of “active therapy” where the periodontist carefully
removes layers of dental calculus and biofilm from the oral flora. The end goal of this active
therapy is stabilization. Once stabilization has been reached, periodontal maintenance is
required to ensure long term health of the teeth and gums. Acknowledging this, it becomes
easier to understand the intuition behind KPMG’s liquidity breakout. During the active phase,
the Leverage Coverage Ratio ensures proper liquidity compliance among league tables. KPMG
denotes the active phase as the most arduous, thus the rather long time horizon that allows for
gradual implementation. As we’ll see in the next section on implications, there are uncertainties
and financial roadblocks that make it very difficult to dock down to the LCR. Once the ratio is
met, however, the long term net stable funding ratio is similar to a managed float currency
regime, where liquidity is maintained within a manageable range to ensure a balance between
capital inflow and stable financial liquidity. Table 1.4 extracted from KPMG’s case study shows
the breakout of Basel III’s components. [9]

Table 1.4

Interestingly enough, KPMG depicts systemic risk in a way that integrates the capital and
liquidity ratios together. “The enhanced capital ratios prescribed by the BCBS relate to the ratio
of a firm’s eligible regulatory capital divided by a regulatory prescribed calculation of risk
weighted assets.”[10] Downward pressure on eligible capital in conjunction with upward
pressure on risk weighted assets forces an upward pressure on the capital ratio, which is then
passed on to the firms. Though much of it is indeed firm specific, eligible capital forecasts are
estimated to spiral down 60% on average (resulting from capital deductions in minority
interests, investments in financial institutions and deferred taxes), leading to as much as a 50%

capital shortfall as a result of banks and institutions adjusting to meet the stringent demands of
the Basel III ratios. [11] Table 1.5 shows the percent ranges for increases and mitigations within
Risk Weighted Assets (RWA) as a result of these capital changes. All things being considered,
this formula shows that all three factors are consolidated together to determine the capital
ratio.
Table 1.5

Accenture:
When in the course of presenting case studies, it becomes imperative for the writer to
offer a well diversified message containing both qualitative and quantitative knowledge. This
ensures that the reader can grasp the topic effectively and develop an independent opinion on
the matter. In crafting this section, I chose to begin with the PWC and KPMG studies to relay

the conceptual theory behind Basel III, and what it’s objectives were. Now that we’ve laid out
the foundation for what we are discussing, I’d like to turn the focus to the more nuanced
peripherals of Basel III, which Accenture discusses more in detail. All diagrams have been
derived been from the Accenture Basel III handbook and RWA study. “Introduction of a
leverage ratio as a supplementary measure to the risk‐based framework of Basel II. The
objective is to constrain the build‐up of leverage and avoid destabilizing deleveraging
processes.”

Table 1.7

This diagram depicts the side by side perspective of the aggregated changes been Basel II/II.5
and Basel III. Some of the major milestones projected by Basel III include an increased CET 1

and additional Tier 1 and 2 capital reserves, the inclusion of a capital conservation buffer to CET
1, a countercyclical buffer, and an SIB buffer.

Table 1.8

Table 1.9

“Basel III strengthens the requirements for the management and capitalization of
counterparty credit risk (CCR). It includes an additional capital charge for possible losses

associated with deterioration in the creditworthiness of counterparties or increased
riskweights on exposures to large financial institutions. The new framework also enhances
incentives for clearing over‐the‐counter (OTC) instruments through central counterparties
(CCP).
The task is monumental, however. Banks face a significant challenge merely to achieve
technical compliance with the new rules and ratios, let alone to reorient the institution for
success. Nor is the implementation challenge made much easier by the long transition
periods prescribed by Basel III, with some rules not being implemented until 2019. In fact,
banks have to begin monitoring certain ratios well before the date of mandatory
compliance—as soon as the end of 2012. More than a few banks have indicated a desire to
meet the requirements even sooner as a way to reassure markets and rating agencies and
give themselves business flexibility.” [12]

II. Localized and National Basel III Implications
The implications of the Basel III regulation are expected to be far reaching and drastically
significant. With ideal implementation, we can realistically see minimum ratio increases across
the board from a minimum capital perspective. Total minimum capital on hand is expected to
rise to 10.5%, up from the current 8‐10% baseline. Tier 1 capital, as was discussed in the case
studies, is expected to rise as much as 4.5% to an 8.5% minimum, up from 4‐6%. The new
conservation buffer, a countercyclical measure introduced in Basel III, is set at 2.5%. Tier 1
common, which does not include the conservation buffer nor the countercyclical buffer, is

increased to 7% from a high of 2‐3%. Finally, Tier 1 Leverage, a new measure introduced in
Basel III, is set at a 3% baseline. [13] This integrates a much stricter definition that incorporates
non weighted assets and off balance sheet items. These ratios in aggregate call for enormous
capital raising for global financial institutions, including the largest banks, in efforts to meet
these rather lofty milestones. Because of the magnitude of these changes in comparison to
Basel I and II, the Basel Committee on banking supervision has structured the transition over
several years, to be fully completed in 2019. The diagram below in figure 2.1 details the exact
transition by year, with corresponding minimum ratio milestones. [14]
Figure 2.1

Now before we delve into the unique impacts within the particular economic zones, I’d
like to point out that these capital standards have a few key similarities, a standardized effect if
you will, in both the US and the Eurozone. Impact from a bank to bank perspective includes the
following: 1) With tighter regulations and heavier scrutiny in weaker economic climates, smaller
banks with few capital reserves will be pushed out as a result of inability to raise the necessary
cash needed to stay afloat. This has a short term impact of bank insolvency with the long term
hit on variable niche business models and potential competitiveness. 2) Basel III regulations will
also place a heavy hit on overall probability and ROE. The excess mandate on capital reserves,
the heavy hit as a result of forced fundraising, and the uncertainty surrounding impending
regulatory reform have the potential to cloud consumer and investor confidence. 3) The
introduction of the new Basel III liquidity ratios (LCR and NSFD) to stabilize the short and long
term liquidity strategies will most likely draw firms out from short term investments to ones
that have a longer duration in nature. This has the ability to impact the bottom line price and
profitability margins associated with these strategies. 4) Increased scrutiny over proprietary
trading, which has been dramatically slashed compared to pre 2008 levels, in conjunction with
greater regulatory oversight on investments in financial institutions and other minority
investments will likely promote spin offs and company reorganization of M&A and internally
held portfolios. [15]
On a macro level, the impact of Basel III on the financial system potentially includes the
following: 1) The heightened capital and liquidity standards, in conjunction with the risk
management measures should help diffuse systemic risk as well as the probability of individual
bank failures. 2) the increased minimum capital requirements could lead to a significant

reduction in bank lending, despite the gradual transition period. 3) Similar to the micro bank
level, there could potentially be a decreased appetite for bank debt and equity due to
decreased dividends as a result of reduced ROE and profitability. These funds are instead
siphoned over to rebuilding the capital base to meet Basel III standards. Though it’s speculative,
we can reasonably expect loss absorbing investor sentiment within the cost of new capital
issuance and the LIBOR. 4) FInally, there is the concern with implementation consistency across
global regions. As was the case with both Basel I and Basel II, Basel III regulations can be
interpreted in different ways. This opens the door to international regulatory arbitrage, which
can potentially threaten the overall instability of the financial system and negate the expected
benefits proposed by Basel III. [16]
Figure 2.2

III. Comparative US and Eurozone Effect
The final part of the implications section discusses the end over end bottom line Basel III
assessments on the US and Eurozone banking systems. “Basel III’s focus is on capital and
funding. It specifies new capital target ratios, defined as a core Tier 1 requirement of 7.0
percent (further specified as a minimum of 4.5 percent of core Tier 1 capital and a required
capital conservation buffer of 2.5 percent). The broader requirement for all Tier 1 capital is set
at 8.5 percent; this includes the core Tier 1 minimum of 7.0 percent and a minimum of
additional (noncore) Tier 1 capital of 1.5 percent. Basel III also sets new standards for
short‐term funding and sketches out requirements for long‐term funding.” [17] Mckinsey’s case
study estimates that Basel III will have “ a significant impact” on the European and US banking
sector. In Europe as of Q2 2010, estimated 2019 shortfalls include €1.1 trillion in additional Tier
1 capital, €1.3 trillion in short‐term liquidity, and about €2.3 trillion in long‐term funding. In the
US, the impact on the smaller financial system will be similar but with perhaps variable impact
drivers. Estimated Tier 1 capital shortfalls are slated at $870 billion (€600 billion), the gap in
short‐term liquidity at $800 billion (€570 billion), and the gap in long‐term funding at $3.2
trillion (€2.2 trillion). [18] With this in mind, as of now, the capital needed to satiate the Basel III
reserve ratio is equivalent to almost 60% of all European and US Tier 1 capital outstanding, and
the liquidity gap needed to satiate the Liquidity Coverage Ratio (LCR) and Net Stable Funding
Ratio (NSFR) is equivalent to almost 50% of outstanding short term liquidity. [19] Figure 3.1
derived from Mckinsey’s case study displays the comparative US and Eurozone Capital
Shortfalls. Based on these shortfalls, at full 2019 implementation, Basel III’s net effect would
lead to a pre tax ROE deduction between 3.7% and 4.3%, with the lower end of the spectrum

excluding the NSFR factor, and upper end incorporating it as presently constructed. [20] Note
that these are aggregated reductions, with gradual reductions of 0.3% in 2013 and 2.1% in
2016. “The ROE reduction comes as a result mainly of capital and funding impact. On the capital
side of the fully implemented (that is, by 2019) effects, capital quality will account for 0.8
percentage points, increased risk weighted assets (RWA) for 1.3 percentage points, and
increased capital ratios for 1.3 percentage points (including 0.3 percentage points for new
minimum ratios, 0.8 percentage points for additional cushion, and 0.2 percentage points for
further national discretions). The leverage ratio will decrease ROE by 0.1 percentage points. On
the funding side, 0.2 percentage points will come from the expense of holding more liquid
assets and 0.6 percentage points from the cost of holding more long‐term funding.” [21]
Figure 3.1

In response to these more stringent regulations, Banks in the US are already underway
with their specific plans to close the capital and liquidity gap. In line with Basel III, minimum
capital requirements have been set in place for all the banks, with specific capital surcharges for
systemically important banks. “Following the global economic recession….banks which are
systemically important on the global scale – the G‐SIBs.” [22] “The solution came in the form of
a minimum capital requirement that should be applicable to all banks, with an additional capital
surcharge for individual banks seen as systemically important globally. In Sept 2010, an accord
about the minimum level of capital requirement was reached at 7%. And the surcharge
applicable was to be one of 5 values: 1%, 1.5%, 2%, 2.5% and 3.5%.” [23] This excerpt from the
trefis article denotes that systemically important banks are incredibly important to the financial
health of the US. I interpret these surcharges as a type of earmark, marked specifically to
particular banks in ascending order so as to dissuade uninhibited growth. The top level mark of
3.5% was designed as a deterrent to extremely large banks from growing further and out of
control. (as an aside, to date no banks have been marked with the 3.5% surcharge.) Additional
buckets that banks are rated on are their inter‐connectedness, size, complexity, global reach,
and susceptibility to take over in the event of failure or insolvency. To ensure that this bucket
concept is clear, let’s assume a hypothetical scenario: If a bank were to fall into the 4th bucket,
like a Citigroup or JPMorgan, the minimum capital percentage held will be the 7% minimum
base percentage, with an additional 2.5% capital surcharge for being in the 4th bucket. This
would mean banks in the 4th bucket have a mandatory capital holding of 9.5%. Additionally,
these assets would need to comply with the strict criterion of asset quality that Basel III
specifically underlies. Figure 3.2 below gives you a better visual idea of the bank bucket

compartmentalization. The diagram displays the banks corresponding to the specific buckets,
with their respective capital surcharges. [24]

Figure 3.2

At present, U.S Banks have made very good progressions toward closing the common capital
and liquidity ratios gap. “U.S. banks have improved their Tier I common capital ratios over the
last seven quarters. While some of them have surpassed requirements comfortably, some have
barely made the mark and are expected to continue to shore up their capital over the next few
quarters” [25] As of Q2 2014, it appears that most of the large US banks have reached or

exceeded their CET1 (Common Equity Tier) capital ratio metric. Morgan Stanley leads the way
with a near 10.7% figure against it’s 8.5% target. Citigroup follows with a near 10.6% metric
against it’s 9% target. Notably, JP Morgan is the only bank that has not significantly exceeded
their target benchmark, only barely hitting the target with a 9.79% cap hit. [26] I posit that the
diametrically opposed values between Morgan Stanley and JP Morgan can be due to variable
business models. Over the duration of this process, Morgan Stanley has internalized it’s cash
instead of returning it to its stockholders. Additionally, it has acquired 100% from Smith Barney
while simultaneously spinning off it’s “capital intensive” fixed income group, which led to a
reduction in its risk weighted assets (RWA) profile and a boost to it’s CET1 figure. These
measures have led to a 220 basis points (2.2%) above it’s target in 7 quarters. [27] JP morgan on
the other hand has remained constant in it’s approach, and has not altered its business model
in any substantial manner. Their objective is to cover the spread using quarterly earnings to fill
the gap. This will eventually lead to gradual increases in Tier 1 Capital, instead of the 130 basis
point (1.3%) average across the spread. Figure 3.3 drawn from the forbes article displays the
quarterly CET figures for Morgan, Citi, JPM and the rest of the banks at large. Note the target
and buffer in comparison to our bucket analysis earlier. [28]
Figure 3.3

Basel III’s impact on the Eurozone is a bit more far reaching in nature than in the United
States. This would agree with our assumption, as the Eurozone is comprised of a larger financial
system spanned across multiple countries. That being said, the drivers that comprise the impact
differ on a few fronts. From a capital perspective, mortgage servicing rights play a bigger role in
the United States than in Europe, where the effect of minority interests are lighter in
magnitude. Additionally, the overall impact of Basel III’s Risk Weighted Asset (RWA) measures
are not equivalent between the two regions. “The impact of Basel III’s RWA‐related measures is
not directly comparable between Europe and the United States, due to the very different
starting position of the two industries. Many US banks have not yet implemented Basel II.
Capital ratios in these banks may be more deeply affected by the simultaneous transitions to
both Basel II and III. That said, it is not possible to predict from the outside‐in the additional
impact this will have on the capital needs of the US banking sector. With respect to funding, the
most significant factors in the United States include the 40 percent limit in the LCR on debt
issued by public‐sector entities, the assumed drawdown rates on corporate and financial credit
and liquidity lines, and the assumed runoff rates of wholesale deposits. “ [29]
Research analysis from Mckinsey’s case study concludes that there are components of
both capital and funding impacts with respect to Basel III implementation. From a capital
perspective, industry need of additional capital will increase 10% from €1.1 trillion to €1.2
trillion. This assumption is an end on end net value that takes into consideration increasing
needs for cash as well as additional basel III deductions. First, some items that Basel III plan on
deducting from capital, such as DTA’s and hidden losses, will be largely irrelevant in 2019. This
reduces capital shortfall by €100 billion. Additionally, Banks can fill in their capital needs using

accumulated retained earnings, as was the case with JP Morgan. The assumption here is a €700
billion increase over 10 years, factoring in 0.6% ROA with a tax rate of 30% and dividend payout
of 50%. [30] Finally, business growth increases the need for excess capital, with an assumption
of about €900 billion. The net result here is a €1.2 trillion shortfall. (100+700‐900= ‐100+ €1.1
trillion ). Key underlying macro level assumptions are that nominal GDP increases at an annual
3.5% rate. Additionally, the effects of deleveraging propose a lowered bank balance sheet
growth rate of 3%. (admittedly, these assumptions do not have explanatory power towards
significant restructurings outside the scope of this model.) From a funding and liquidity
perspective, short term liquidity shortfall would increase from €1.3 trillion to €1.7 trillion, while
long term funding shortfall would increase from €2.3 trillion to €3.4 trillion. (“note that an
increase in long‐term funding would offset a large part of the short‐term liquidity shortfall.”)
[31]

Figure 3.4

The final area of interest that I would like to highlight in my analysis is the nuanced impact
across particular business segments in the Eurozone. As stressed in the Mckinsey study, three
impact types must be considered. 1) Balance Sheet specific impact at the corporate level, 2)
Universal impact across banks and business, and 3) Business specific impact. To assess these 3
impacts on the major business segments (retail, corporate, and investment banking), we can
dislodge the argument into products and analyze the impact by considering changes in capital
costs, liquidity costs, and long term funding costs, and then calculate the change in cost of
making products in each segment on a basis points measurement. Figure 3.5 below shows the
expected changes in product costs under Basel III across the major business segments. [32] (

Note that the upper limit ranges in these assumptions are driven by the long‐term funding
requirement—the net stable funding ratio (NSFR)—as assumptions based on current
construction would be inaccurate due to continuing changes in regulation and deregulation.
“This is particularly important in the following discussion, as the long‐term funding ratio is a key
cost driver for some products, especially corporate products, cash trading activities, and
low‐rated and financial institution bonds.” [33]
Figure 3.5

The retail banking business is affected by Basel III in areas that systematically affect the bank at
large, particularly the higher capital and liquidity requirements. New higher capital ratios will
especially affect retail institutions, as they’ve historically operated under lower capital ratios
than wholesale banks. Liquidity requirements will also be a factor, though not as significant as
the capital requirements. The effect of Basel III’s new product‐specific requirements is less
relevant. The new market‐risk framework does not apply to the retail segment, and funding
agreements in place are acceptable under the july 2010 annex, which “established that deposits
are now largely accepted as long‐term funding and significantly reduced long‐term funding
requirements for mortgages.” [34] Residential mortgages require only 65% long‐term funding,
compared to 100% in earlier versions. Additionally, short‐term retail loans will see an increase
in costs of up to 70 basis points (.7%), as a result of an increase in retail segment targets ratios.
This makes sense intuitively, as higher levels of liquidity in conjunction with long term funding
warrant a higher price. In some cases, banks can diffuse this cost by passing it along to
customers, given the high margins on these products.
Like retail banking, corporate banking will also be affected by the systematic firmwide
effect of increased capital target ratios. “Long Term corporate loans and long‐term asset‐based
finance businesses (commercial real estate, project finance) will face an increased funding cost
of about 10 basis points. Uncommitted credit lines to financial institutions and uncommitted
liquidity lines to both financial institutions and corporates will see a cost increase of 60 basis
points just for higher liquidity requirements, plus some 15 to 25 basis points for higher capital
requirements.” [35] Given the price sensitivity of some lending markets, the segments may be
unable to pass the expense along to customers, leading to a potential decrease in overall

profitability. Riskier products such as specialized lending (including structured finance and trade
finance among other businesses) or unsecured loans are estimated to increase about 60 basis
points (.60%), largely due to new capital target ratios. [36] Trade Finance in particular is
covered by various elements of Basel III. First, risk weights within financial institutions are
increased by a factor of 20‐30%. Second, the new liquidity standards set reserves against off
balance sheet items such as trade guarantees and letters of credit, an essential element of
trade finance within institutions. Finally,  trade finance commitments count in full against the
new Basel III leverage threshold, a 500% increase over present capital ratio requirements.
The final business segment under analysis is investment banking. Of the three segments,
investment banking bears the most product groups, with capital markets specifically absorbing
the higher target ratios.  “The biggest effects to products come from the new market‐risk and
securitization framework, the changed liquidity of securities through the introduction of the
LCR, and significant amendments to the OTC derivative business.” [37] Trading activities will
face the greatest overhaul and oversight as a result of Basel III. Three particular areas of
interest are  OTC derivatives, cash trading, and securitizations.
OTC derivatives will be affected in two ways. First, overhauled Basel III risk management
procedures will require banks to hold more capital to assume more market risk.  Second, the
new credit valuation adjustments (CVA’s) under CRD IV will require banks to hold more capital
for counterparty credit risk  despite mitigation under the July 2010 Annex. “Our current
estimate is that CVAs will increase RWAs by a factor of 3—on top of the effects of changes in
the market‐risk framework.” Along with increased Basel III liquidity standards and resultant

liquidity costs, bottom line costs on unnetted, uncollateralized positions will increase by a
factor of 85 basis points (.85%). [38] For banks to remain profitable in this area, these costs
would have to be evened out through some combination of “improved collateral and netting
arrangements, more effective central counterparty management, and moving some businesses
and products to central counterparty clearing platforms outside the bank.” [39]
Cash trading overall profitability will be driven down by the higher cost of holding
inventories, particularly the 20 to 40 basis point rise on the matched funding requirements on
lower‐rated assets. Additionally, cash trading will see higher hedge costs from OTC derivatives,
as mentioned above. As these costs cannot be passed along, some market‐making would
potentially be abandoned, reducing overall market depth and liquidity, increasing bid‐ask
spreads, and driving trading activity from banks to exchanges. [40]
Our final analysis in this section is within the area of securitization. An area of interest
that we alluded to at the very beginning of this paper, the securitization business is particularly
noteworthy. All three amendments to the Basel Capital framework—CRD II, CRD III, and CRD
IV—affect securitizations. These changes could increase capital requirements by a factor of up
to ten. [41] CRD II, which serves as an adjunct to Basel III and was implemented in 2010, forces
investors to comply with the “skin in the game” rule—which requires that banks hold at least
5% of all securitizations at all times. Bundled off Mortgage backed securities were a large part
agent to the housing bubble burst and resultant market collapse, so this measure serves as a
hedge against haphazard bundling of securities. “Banks can opt to keep either a first‐loss piece
or a “vertical” slice across the tranches of the securitization. The impact on capital

requirements could be up to 500 percent, in the case of the first‐loss piece, and about 50
percent if they choose to take a vertical slice.” [42] CRD III, which corresponds to Basel II,
introduces market risk capital charges and increased charges for resecuritizations, resulting in a
threefold increase in capital. CRD IV, which corresponds to Basel III, includes an update to a
capital allocation provision highlighted under Basel II. “Under Basel II, securitizations with a low
rating (below BB‐) were typically deducted from capital (50 percent was allowed as Tier 1 and
50 percent as Tier 2). Basel III instead places a risk weighting on such securitizations of 1,250
percent. In combination with the newly increased capital ratio, this translates to significantly
higher capital requirements—some 40 percent to 100 percent higher for capital deduction
items, depending on whether regulatory minimum or industry target ratios are considered.”
[43] Overall, the bottom line here is to move banks as far away from the pre‐2008 securitization
model as possible. These measures make it so that securitization in this new Basel III
environment is a near zero sum game. In fact, in some cases, the required Tier 1 capital would
exceed the actual value of the securitization!
IV Commentary and Conclusion
After reviewing multiple case studies and presenting rigorous analysis, it becomes
apparent that Basel III is indeed a heavy regulation with significant implications across the
financial sector. In this final section, I would like to turn your attention to the very first question
that I asked at the beginning of this paper, “While Basel III is great in theory, is it practical in a
real life financial environment?” Can Basel III accomplish what it sets out to do in the first
place? Will it streamline risk and prevent another systemic failure among too big to fail banks?

Or will it simply be a black hole for liquidity and overall profitability? All very good questions,
and indeed very loaded questions. In truth, after contemplating the issue, my response is a
cautious yes.
To begin, let’s start with the positives of Basel III. First, I appreciated that the Basel III
regulations were given substantial time for gradual implementation. In a regulation with such
drastic overhauls as Basel III, it would be incredibly difficult, if not impossible to address it at
whole within 1 or 2 years. To reference an earlier note, the new Basel III regulations in
aggregate are projected to decrease pre tax ROE between 3.7% and 4.3%. The gradual
implementation softens some of the blow, and allows the banks to come up with additional
resources from tertiary sources such as retained earnings to cover the spread. It also provides
for some leeway to spin off business units on the upper end of the RWA scale to increase their
reserve number as Morgan Stanley had done. In light of the above, I believe this should put to
bed any concerns regarding Basel III eating away at prospective profitability. Admittedly, while
the costs are very front loaded, as is the case with most adaptive regulations, the proper
progressions and exit strategies allow for a seamless transition for the banks and financial
institutions. Figure 4.1 below shows the ease in progression of Basel III from a capital
management perspective. [44]

Figure 4.1

The second objection was that the new liquidity standards would serve as a double
negative in forcing banks to draw up larger reserves, while funnelling money away from
investors and stockholders, further stifling progress. While I do believe that this is a legitimate
concern, I do suspect that the long term positives outweigh the speculative short term
negatives. The objective behind the new liquidity standards was to ensure that banks had the
ability to remain solvent for a satisfactory period of time (30 days) within a tumultuous
economic climate. The discussion over waning investor interest is moot point in the event of
insolvency, which is what we experienced during the great recession. The inability to maintain
substantial liquidity was what led to underwater firms. As is the case with the capital ratios, the

mandated reserve increases are meant so as to stabilize the firms and hedge against future
collapses, and it would appear that Basel III is treading in the right direction on that front. The
beauty of Basel III is that all three facets of the arrangement: Capital, Liquidity, and Risk, are
combined so that the firm can dynamically tackle all fronts in an intelligent manner. In the
process of establishing the proper level of high quality liquid assets (HQLA) in compliance with
Basel III’s liquidity standards, the bank integrates many of the measures required to measure
up to the respective capital ratios as well. Ultimately, this short term standardization paves the
way for the long term consistency provided by the net stable funding ratio (NSFR), which in
practice should keep banks within a sweet zone of measured risk and intelligent compliance.
Because of this, I assess that the liquidity ratios bode very well in the long term for the global
financial ecosystem, despite the elevated initial costs. Indeed, the idea that there is no free
lunch rings true here, but perhaps we can look forward to a grandiose dinner instead.
Finally, the last objection to the Basel III implementation is that it would stifle risk too
heavily, which would have an adverse effect on market liquidity and dissuade involvement due
to the capped upside. Now this is an area with the largest overhaul by far in my opinion due to
the radical increase in oversight surrounding them. Popular measures such as proprietary
trading, securitization, and OTC derivatives have historically been popular routes due to low
barriers of entry as well as the potential for lucrative and substantial profit margins. However,
the objection tends to place a premium on absolute returns, while placing a discount on the
intended risk. Of course, if you or I were to place a trade for our accounts, to eventual
insolvency, we would probably lose a few thousands. Escalate that to a large international bank,
and the results could be catastrophic. The new measures associated with risk weighted assets

(RWA) help to leave a paper trail of responsibility to the respective executors. It brings us back
to this whole idea of “skin in the game”, where the banks and institutions share the
responsibility and risk with the investors. By placing a bigger cap hit on riskier assets, it forces
the bank to pick and choose spots precisely, so as to maximize gain while minimizing losses.
Despite what detractors may say, assuming risk promotes responsibility. By having a legitimate
stake in the products that they sell, banks in the future should operate with a more responsible
and ethically grounded manner.
Figure 4.2 [45]

Over the course of this paper, we’ve discussed the ins and outs of Basel III and its
associated implications. As we finish up our discussion, I would hope that I was able to help you
forge your own opinion on the subject of Basel III. In constructing this paper, I learned that
there are no correct answers when it comes to Basel III. There are various pros and cons, each
with their own valid arguments. Despite my predominantly pro Basel III opinions, I do
acknowledgement there are various areas of deficiency that Basel III needs to address if it is to
avoid repeating the same mistakes as Basel II. THese would include shoring up standardization
across different financial systems globally to shore up any gaps that may open the door for
capital arbitrage. In addition, I believe it is imperative for banks to become more independent
in their stress tests, and to conduct their own safety analyses instead of relying entirely on
credit rating agencies to deliver this task. History has taught us that proactive approaches
trump reactive ones, so it will be interesting to see how that progresses as it unfolds. There are
still 4 year remaining until the conclusion of Basel III’s full implementation, so we will probably
continue speculating until that time. For now, I just wanted to extend a sincere thank you for
reading this paper, and perhaps in four years, can share another perspective on Basel III’s
evolution. Until then, here’s to a great day, and I hope to speak to you very soon.

Bibliography and Cited Works
http://www.bis.org/bcbs/basel3.htm
http://www.bis.org/publ/bcbs189.htm

http://www.bis.org/publ/bcbs238.htm
https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/basel
l‐III‐issues‐implications.pdf
http://www.accenture.com/sitecollectiondocuments/pdf/accenture‐basel‐iii‐handbook.pdf
http://www.pwc.com/us/en/financial‐services/publications/viewpoints/assets/viewpoint‐Ba
sel‐III.pdf
http://www.mckinsey.com/insights/financial_services/basel_iii_now_the_hard_part_for_eur
opean_banks
http://blogs.wsj.com/moneybeat/2013/06/26/leverage‐ratios‐start‐to‐sting/
http://blogs.wsj.com/moneybeat/2013/11/04/too‐big‐to‐fail‐banks‐go‐ultra‐safe‐for‐now/
http://www.forbes.com/sites/greatspeculations/2014/09/11/how‐do‐the‐largest‐u‐s‐banks‐f
are‐in‐terms‐of‐basel‐iii‐compliance/
http://www.trefis.com/stock/jpm/articles/152796/the‐basel‐iii‐challenge‐for‐banks‐why‐ext
ra‐capital‐requirements/2012‐11‐08
http://www.forbes.com/sites/greatspeculations/2014/03/19/u‐s‐banks‐took‐big‐strides‐tow
ards‐basel‐iii‐compliance‐in‐2013/
http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture‐Basel‐III‐Going‐Beyond
‐Compliance.pdf

http://www.accenture.com/sitecollectiondocuments/pdf/accenture‐basel‐iii‐handbook.pdf
http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Basel_III_and_its_Con
sequences.pdf
http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture‐Counterparty‐Credit‐Ri
sk‐Basel‐Framework‐Successful‐Implementation.pdf
Footnotes
[1] http://www.bis.org/bcbs/basel3.htm
[2]http://www.bis.org/publ/bcbs189.htm
[3]http://www.pwc.com/us/en/financial‐services/publications/viewpoints/assets/viewpoint
‐Basel‐III.pdf
‐Basel‐III.pdf
‐Basel‐III.pdf
‐Basel‐III.pdf
[7]https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/ba
sell‐III‐issues‐implications.pdf
[10]https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/b
asell‐III‐issues‐implications.pdf
[11]https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/b
asell‐III‐issues‐implications.pdf
[12]http://www.accenture.com/sitecollectiondocuments/pdf/accenture‐basel‐iii‐handbook.p
df

[13]http://www.mckinsey.com/insights/financial_services/basel_iii_now_the_hard_part_for
_european_banks
[14]http://www.pwc.com/us/en/financial‐services/publications/viewpoints/assets/viewpoin
t‐Basel‐III.pdf
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
[22]http://www.trefis.com/stock/jpm/articles/152796/the‐basel‐iii‐challenge‐for‐banks‐why
‐extra‐capital‐requirements/2012‐11‐08
[25]http://www.forbes.com/sites/greatspeculations/2014/03/19/u‐s‐banks‐took‐big‐strides‐
towards‐basel‐iii‐compliance‐in‐2013/
_european_banks

_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
_european_banks
t‐Basel‐III.pdf
t‐Basel‐III.pdf

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