By Arush Chopra

The passage of the bill to overhaul the US financial system brought into sharp focus the debate on regulating the day–to–day functions of financial institutions; the regulatory discussion now shifts back to the negotiations on capital levels that will form Basel III, the proposals’ implications and what risk managers will need to brace for. The Bank for International Settlements (BIS) has reviewed banks’ feedback on the proposals and is preparing recommendations for central bank governors and heads of supervision to be discussed in a meeting in late July.

With the new capital rules expected to be put in place by the end of 2012, most institutions are trying to forecast what their capital planning is supposed to look like, and are already thinking about what challenges they may be presented with in two years. “You can already observe the impact of these regulations in the behaviour of banks,” says Nick Minogue, former chief risk officer of Macquarie Bank, citing the fall in commercial and industrial lending in the US, which dropped around 22% to $1.24 trillion at the end of June this year according to the US Federal Reserve.

The changes being proposed are meant to increase the amount of capital required to support any given level of banking assets, to increase the percentage of equity capital within that capital and to increase the level of required holdings of liquid assets relative to banking assets. According to Minogue, this deleveraging will leave the banking system unable to support a level of activity comparable to what it has recently been supporting if the measures are adopted. “If you announced as regulators a series of proposals, which amount to a demand for de-leveraging of the financial sector, this is the sort of result you probably should expect,” he says.

The Asian Banker has calculated in a recent research note that with the eventual redefinition of Tier 1 capital, the heavy use hybrid capital by Asian banks, especially those in Malaysia and Singapore, will be the chief factor in lowering their equity Tier 1 ratios. Also, these measures will have a significant impact on the return on capital that investors should expect if they put money into banks.

In most western jurisdictions the impact of Basel III has been estimated to be at least a 20% reduction in bank return on equity (ROE) and a reduction in bank lending, according to Minogue. However, he feels that the impact on ROE, if a bank follows the Basel Committee’s instructions and holds capital in that way, does not take into account the potential for re-pricing to clients because an increase in the cost of maintaining a certain book will be passed onto them.

Mark Lawrence, senior advisor at McKinsey & Co and the former chief risk officer of ANZ Bank, sees several practical effects of higher capital rules and believes that Australian banks with huge portfolios of low yielding, relatively low risk, residential mortgages will need to adjust the focus of their businesses. “It is quite likely that banks might want to shift their portfolio balance away from these low-yielding assets towards high yielding assets in order to boost the ROE,” he says.

Lawrence also sees overall liquidity heavily impacted by the changes. “Minority interests have to be deducted from core tier one capital and one might ask whether or not this one might have a big impact on the availability of capital into the banking industry and some of the countries in our region. Personally, I think that would be the case.”

Another issue is whether commercial banks will still even be able to provide certain services, such as the loans to small or medium-sized firms that are essential to sustain investment and development in the region.

But the larger question is still whether capital or liquidity is sufficient in preventing another crisis, and practical decisions need to be made by banks about what businesses they should be in, and what they are good at. “Capital is not the entire story. Banks will have to correct the flaws in their business models and capture the risks inherent in them,” says Masamichi Kono, vice commissioner of international affairs at Japan’s Financial Services Agency. “We need more and higher quality capital, more liquidity, and yardsticks to measure the liquidity position of banks so that we do have tools to deal with problems,” he says.

However the BIS has already begun to think about how to deal with banks that don’t have correct business models, through a new proposal for counter-cyclical capital buffers. The proposal, which have just been released for consultation, would encourage banks to set aside capital in good times for an eventual downturn, and could in theory mitigate the need for serious reactive measures such as Basel III in the eventuality of another financial crisis.