Banking regulation moves closer towards peak complexity

Basel III just keeps on giving: The global framework for banking regulation is already extremely complex. Newly presented rules will complicate matters further.

Basel III is the name of the global framework for banking regulation. It is the reaction of regulators around the world to the financial crisis of 2007/08. Even ten years after the crisis, the work on Basel III is still ongoing. Yesterday, a so-called “output floor” was added. The new rules should prevent banking institutions from abusing their internal risk management models to overstate the size of their capital ratios.

Going forward, the risk weights calculated by such internal models can no longer deviate too much from the weights that would result if banks use a standardized approach. In summary, the new “output floor” is supposed to strengthen capital requirements: Banks are now less able to use their internal models to report inflated capital buffers.

Europe in focus

The financial sector in Europe will be particularly affected by the new rule. Some estimate that the reported capital ratio of European banks will decrease by up to 2.5 percentage points. However, we suspect that the effective impact on reported capital ratios will be much lower than this.

Historical experience suggests that banks will successfully "manage" the newest addition to the Basel III framework. Most likely, they will again miminize the impact on their ability to take risks and boost their leveraged returns on equity.

Big banks' lobbying is changing

Nonetheles, the new rules mark a significant change in the regulatory framework. So far, the standardized approach was only relevant for small to medium-sized banks. But now, also large banks are affected by the standardized approach through the new rules.

For the first time, they have strong incentives to water down the standardized approach. If they are successful, they benefit from a relaxed constraint via the "output floor". This way, large banks can keep their reported capital ratios high, and continue to operate on razor-thin equity margins and high leverage.

Hence, we would not bet on banks bolstering their capital ratios due to this new "output floor". Also, the new addition to the Basel III framework continues to increase bureaucracy and complexity.

Numerous rules overlap, sometimes reinforcing, sometimes weakening each other. Banking regulations remains completely opaque to outsiders.

The banking industry will ultimately benefit from this ever increasing complexity, as already very high barriers to entry continue to rise further. Fintech, blockchain and crytpocurrencies may still be buzzwords that excite Twitter users, but for the time being, banks do not have to fear any meaningful competition in their core business.

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