What does Basel III mean for re­tail in­vestors?

Finweek English Edition - - INVESTMENT - PRO PICK Pro­fes­sor Evan Gil­bert, head of Mi­tonOp­ti­mal As­set Man­age­ment

Basel III (or the Third Basel Ac­cord) is a global stan­dard for the reg­u­la­tion of banks and fo­cuses on set­ting min­i­mum stan­dards for cap­i­tal ad­e­quacy, stress test­ing and mar­ket liq­uid­ity risk in di­rect re­sponse to the f inan­cial cri­sis of 20072008. Es­sen­tially, it is de­signed to make banks more ro­bust by re­quir­ing them to hold more cap­i­tal against un­ex­pected losses.

A key as­pect of this new stan­dard is the in­creased use of risk-weighted cap­i­tal. The Basel III rule re­quires banks to hold 4.5% of eq­uity (up from 2% in Basel II) and 6% of Tier I cap­i­tal (up from 4% in Basel II) rel­a­tive to the risk-weighted as­sets (RWA) that they hold. Risk-weighted as­sets are the to­tal of all as­sets held by the bank weighted by credit, mar­ket and op­er­a­tional risks. As­sets like cash and cur­rency usu­ally have zero risk weight, while loans have risk charges of up to 100% of their face value.

For ex­am­ple, as­sume a bank with R1 of eq­uity re­ceives a client de­posit of R10 and lends it all out, thus cre­at­ing a R10 book of as­sets (loans) on the bank’s bal­ance sheet. Let’s as­sume that the loan book car­ries a risk weight­ing of 90% ‒ in other words there’s a 90% risk charge due to the credit risk pro­file of the book bor­row­ers (by com­par­i­son, if it was held in cash with the Re­serve Bank, the RWA would be zero). The bank now holds RWA of R9 (R10*90%). Us­ing the orig­i­nal eq­uity cap­i­tal of R1, the bank’s Tier 1 ra­tio is cal­cu­lated to be R1/R9 or 11% ‒ well above the 6% limit. The im­por­tant point here is that as the risk weight­ing of the loan book changes, the bank’s Tier 1 ra­tio changes. The higher the coun­ter­party risk, the lower the ra­tio – and there­fore the more (ex­pen­sive) cap­i­tal the bank must hold against po­ten­tial losses. When com­bined with higher cap­i­tal re­quire­ments of Basel III, the credit weight­ings of the bank’s loan book are go­ing to be­come more and more im­por­tant.

This com­bi­na­tion has clear knock-on ef­fects. Firstly, credit is go­ing to be­come more ex­pen­sive. Banks are go­ing to be charg­ing their cor­po­rate clients higher loan rates to cover the costs of car­ry­ing the ad­di­tional cap­i­tal charges. Se­condly, de­pos­i­tors are also likely to re­ceive lower in­ter­est rates as banks try and im­prove their mar­gins for the same rea­son.

This has sev­eral in­ter­est­ing im­pli­ca­tions for in­vestors. Firms look­ing to bor­row are go­ing to look more ac­tively to the bond mar­kets for (rel­a­tively) cheaper fund­ing. This should lead to a broad­en­ing and deep­en­ing of the cor­po­rate bond, which is very good for fund man­agers who have the man­date to play in this space. How­ever, the higher cost of credit will also f il­ter through to this mar­ket – which will mean higher yields on cor­po­rate debt. Fi­nally, the rel­a­tively lower de­posit rates com­bined with the ex­pected con­tin­u­a­tion of the cur­rent low in­ter­est rate en­vi­ron­ment means that de­posit-based money mar­ket funds are not go­ing to pro­vide very good re­turns in real terms.

In short we ex­pect a rel­a­tive out­per­for­mance of en­hanced fixed-in­ter­est funds rel­a­tive to the more tra­di­tional mon­ey­mar­ket prod­ucts on a risk-ad­justed ba­sis. The higher is­suance of cor­po­rate debt in­stru­ments will pro­vide a huge op­por­tu­nity for fund man­agers in this space to gen­er­ate real re­turn – if they have the man­date and skills to play in this space. Tra­di­tional money-mar­ket funds are sim­ply not go­ing to be able to com­pete against th­ese funds as they don’t have the raw ma­te­ri­als to do so. The im­ple­men­ta­tion of Basel III thus of­fers a sig­nif­i­cant long-term boost for in­vestors look­ing for more di­ver­si­fi­ca­tion and op­por­tu­ni­ties for yield en­hance­ment in the f ixed-in­come space. We be­lieve in­vestors should get ready to ride this longterm wave.

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