A report titled ‘Basel III: tough but realistic' states that while Basel III is necessary to increase the resilience of banks, it's important to find the right balance between greater financial stability and lower economic growth.

According to Nicole Smolders of Rabobank's Economic Research Department regulators must also guard against the possibility that Basel III could lead to greater risk-taking in the financial system.

What does Basel III involve?

Government leaders endorsed the Basel III accords at the G20 summit in Seoul in November 2010. The regulations impose stricter international rules on capital and liquidity for banks, including higher minimum capital requirements and extra buffers.

The accords introduce new regulations for the quality of capital, and will impose extra capital requirements on systemically important banks. For the first time ever, banks will be subject to harmonised international liquidity requirements, based on the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

The LCR requires banks to hold sufficient highly liquid assets in order to absorb a possible outflow of funds for a thirty day period in a severe stress scenario. The NSFR requires banks to finance their assets with additional and more stable long-term funds.

Effects for bank clients

"Higher and stronger buffers contribute to financial stability," says Nicole Smolders. "That is essential for stable economic growth, which benefits clients as well." But this greater stability comes at a price. "Basel III will make borrowing more expensive. Banks will need to pass on the higher costs of capital and funding to maintain the profitability they need to build up capital.

These higher funding costs, coupled to capital and liquidity tightness, will depress lending by banks and hence also economic growth." According to the Rabobank economist this is likely to harm mainly retail banking clients and small businesses, which, unlike large companies, cannot turn to sources like the capital markets to meet their financing needs.

Basel III could increase risk appetite

Some critics claim Basel III might in fact harm the financial stability it is designed to increase. "The need for banks to generate sufficient earnings in order to build up the required buffers might increase their appetite for risk," explains Nicole Smolders. And there are concerns that differences between banks will be magnified if banks aim for early compliance with the new requirements.

The long transition period (2013-2019) designed to help banks adapt to Basel III may prove to exist on paper only. According to Smolders the market already expects large banks to comply with the requirements as from 1 January 2013. "If a rift opens up between strong banks and not-so-strong banks, this will reduce confidence in the sector as whole.

Which is why it's important for regulators to monitor all potential unwelcome effects and act on them, as well as minimise the negative impact of Basel III on lending and the economy."

www.rabobank.com