How Basel lll Requirements are Presenting Some Real Challenges – And How Firms Can Meet Them
Since the release of Basel lll, financial firms and regulators are continuing to adapt their systems to the new capital standards – and as the focus of Basel lll is now shifting to implementation, there are some challenges that financial organisations are facing.
Because Basel lll actually narrows the definition of acceptable capital and also calls for more capital than did Basel ll, the newer program will essentially eliminate some of the more hybrid capital and debt instruments that had counted as capital previously.
Basel lll also states what new standards will be applicable to capital quality and ratios, as well as calls for capital buffers, leverage ratios, the capital treatment of counter party credit risk and securitasation exposures, and new large exposure rules.
Certainly, however, although there is still a lack of absolute clarity, those firms that take part in early analysis, as well as in strategic evaluation and planning – while continuing to remain flexible and adaptable to changes along the way – will likely be the ones to find the most success.
One of the key proposals that has been set out for regulatory reform is that financial firms produce recovery and resolution plans. These plans, also referred to as “living wills,” are to set out how a firm’s operations will be resolved in an orderly fashion.
Plans would be divided as follows:
- Recovery – The firms’ recovery plans will outline how these companies would prolong their ability to continue in business.
- Resolution – With resolution plans, firms would need to ensure an orderly workout if the recovery plan failed to save the company.
Preparing such plans would require a great deal of concentration for the firms involved as well as a variety of challenges and questions that could arise – some even forcing a firm’s reappraisal of their operating model, legal entity, business strategy, and even the organisational structure itself.
Capital Implications of these Institutions’ Living Wills
There are a number of issues that banks, insurers, and other financial related entities will likely face in addressing these proposals. One of the primary issues entails that of capital implications that could be faced.
In better preparing for such possibilities, financial organisations must address certain activities in terms of how they will be dealt with. One such implication as it relates to a firm’s capital is that of implementing a plan to de-risk certain of its activities. For example, in this case, does the firm have plans related to its trading book where a large amount of capital charges could exist? And if not, how will plans for the trading book be created and implemented in light of the fluid nature of such positions?
Going further forward, should a crisis arise, do the affected firms have a plan for contacting their potential investors as there is likely to be significant changes in the capital raising environment during times of crisis situations? Likewise, once a recovery plan is in place and ready to be executed, what capital structures may be put into place that can be adapted quickly and seamlessly going forward?
Additional Challenges Ahead
In addition to capital implications, firms could also face other challenges as they move through the living will requirements. For example, many organisations will need to address the issues that they experienced in the recent market crisis – and could also rise again in future distressed market conditions.
Some of these issues could actually even lead to additional financial problems for the companies such as a downgrade of their ratings, requirements for additional collateral, and cross guarantees.
Firms should also consider the potential impact of additional regulations as well. For instance, what will be their ongoing strategy for dealing with issues such as competition regulation and / or state-aid?
Proposed Plans of Action
With regard to an organisation’s recovery plan, firms should be required to set out distinct plans for illustrating exactly how they will deal with severe capital related stress. These plans should cover a number of key issues, including both capital recovery as well as recovery of liquidity.
Some of the proposed movements in going forward with recovery could include the selling of a company’s affiliates or subsidiaries, exiting certain lines of their business, and / or the raising of additional fresh capital.
Coupled with the capital and liquidity requirements, firms should have a clear understanding and plan of implementation in terms of when plans must be activated. In other words, they must clearly state at what indication or measure in the market will they move forward in activating these recovery plans – and, how will these set measures be incorporated?
Going deeper into the issue, company executives should also determine whether their company’s plan of action will be tiered such that certain areas of the firm would be responsible for responding to different levels of capital stress. Within any and all of these potential capital solutions, executives of the affected financial institutions should implement their proposals sooner rather than later.
Some additional overall considerations should also be made in terms of managing capital going forward. Some of these could include:
- Carrying out the planning of various potential scenarios in order to ensure that a successful capital strategy has been developed;
- Defining of consistent and qualified capital objectives that are applied throughout the entire group;
- The identification of what needs to be quickly put into place if necessary in fine-tuning and / or lowering capital requirements;
- The consideration of just exactly how to address any potential pricing implications that could arise due to the changes in capital requirements for various products;
- Preparation of the ability to meet more accelerated implementation time frames if it becomes necessary.
In addition, it should go without saying that executives and firms overall must ensure that they fully understand both their current liquidity position as well as where potential stress points are. Likewise, there should also be a thorough understanding of how business should be properly changed should the capital costs for that particular company be lightened up in the future.
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