What does Basel III mean for retail investors?
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.