VideoU.S. banks want to go on a diet, but regulators are telling them they must remain chunky, even as their international competitors get captivatingly thin.
The diet in question is the internationally negotiated rule on bank capital that modernizes how risk is measured on financial institutions' balance sheets. But squabbling between U.S. regulators over how to implement the rule has resulted in a delay that has put U.S. banks two to three years behind banks in Europe, Canada, and Asia. Those countries will begin operating under the new set of capital rules, based on the Basel Committee on Banking Supervision's revised capital framework (and better known as Basel II), this January. In the United States, bankers have been told to expect a three-year phase-in period (the final rules were still not available in early September), meaning that the new capital standards will not be fully implemented until 2011. And the new Basel rules will be mandatory only for U.S. banks with $250 billion in assets or $10 billion in overseas exposure (though other banks will be permitted to opt in).
While their international counterparts will soon begin to shed excess weight, many U.S. banks will have to keep their balance sheets stuffed with regulatory capital — the reserves a bank must have on hand to insure against loan defaults.
That has large implications for U.S. banks.
Basel II, by virtue of being more sensitive to banks' true credit and operational risks, allows financial institutions to free up cash and other liquid assets. Basel II banks can lend and invest this extra capital (and acquire other banks), earning higher returns than they would squirreling away the funds for compliance reasons. Because they have a head start on the United States, banks in nations adopting Basel II this January will also be able to offer lower prices on loans, at least temporarily.
Such regulatory inequality will give U.S. corporations reason to shop at banks based outside the United States — and possibly handicap some U.S. banks trying to capture business overseas. Once Basel II is fully implemented in the States, though, highly rated corporations may be able to borrow more cheaply, since Basel II banks will not have to hold as much capital against their credits. But that advantage will not come for another couple of years. In the meantime, overseas firms will get the chance to exploit it.
"If you're UBS or HSBC, you can't come to the U.S. and get a completely free ride just because your home base is in Europe and your regulatory capital may be lower there; you're still subject to U.S. rules," says Guillermo Kopp, an executive director of TowerGroup, a financial-services research firm. "In the aggregate though, [you] will have a bit of an edge. Depending on the bank's global portfolio, it could be significant."
The numbers bear that out. In a report released in August, The Netherlands–based ING, a $1.75 trillion bank, reported that it expects the capital it needs to hold against credit and other risks to drop by as much as 20 percent by 2009. By comparison, capital levels at banks here will not be allowed to fall more than 5 percent per year.
Why It Matters
For every loan a bank makes, it holds a percentage of the total amount lent in a liquid form — cash, certain securities, Treasury paper — to protect against a borrower defaulting. The amount should reflect the percentage of its loan portfolio that is statistically likely to go into default. But historically, banks have tended to keep in reserve more capital than was strictly necessary, as a cushion against errors in credit-risk modeling.
Basel II uses sophisticated risk-measurement techniques that, ostensibly, will allow banks to safely lower the amount of capital they hold against loans to borrowers with good credit, without compromising safety and soundness. Cutting the capital requirement on a $10 million loan from 8 percent to 5 percent, for example, translates into $300,000 in freed-up cash.
Already, banks in other Basel II–adopting nations are seeing advantages. As long ago as September 2006, says Pamela Martin, the Risk Management Association's director of regulatory relations, lender trade associations like hers were seeing "an increasing willingness of international lenders to price longer-term low-risk deals to reflect lower capital requirements."
"Europeans and Canadians will have a leg up on us for a couple of years," says Kevin Blakely, the former chief risk officer for KeyCorp. who recently took over as president and chief executive officer of the RMA. "It will probably hurt U.S. banks trying to compete in foreign markets. It could also hurt because of large [foreign] banks coming here and trying to compete in the large corporate space."
In the short run, disruptions in the financial markets caused by subprime lending may make competitive imbalances difficult to spot, as lenders of all stripes tighten terms.
"If all returns to normal, the bulk of the hit is on market share," says Karen Shaw Petrou, managing partner of Federal Financial Analytics, a Washington, D.C.-based consulting firm. For U.S. banks, losing overseas business is no small matter. Citigroup, for example, has reported sequential quarterly revenue growth from all of its overseas activities at 4.2 percent for the first half of 2007, compared with a relatively sluggish 0.8 percent domestically.
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