Understanding The Basel III International Regulations

Basel III is a set of international banking regulations developed by the Bank for International Settlements to promote stability in the international financial system. The Basel III regulations are designed to reduce damage the economy by banks that take on excess risk. (Problems with the original accord became evident during the subprime crisis in 2007. Members of the Basel Committee on Banking Supervision agreed on Basel III in November 2010. Regulations were initially be introduced from 2013 until 2015, but there have been several extensions to March 2019 and January 2022. To learn more, see Basel II Accord To Guard Against Financial Shocks.)
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Banks must hold more capital against their assets, thereby decreasing the size of their balance sheets and their ability to leverage themselves. While regulations were under discussion before the financial crisis, the events magnified the need for change.

The Basel III regulations contain several important changes for banks' capital structures. First, the minimum amount of equity, as a percentage of assets, increased from 2% to 4.5%. There is also an additional 2.5% buffer required, bringing the total equity requirement to 7%. This buffer can be used during times of financial stress, but banks doing so will face constraints on their ability to pay dividends and otherwise deploy capital. Banks had until 2019 to implement these changes, giving them plenty of time to prevent a sudden lending freeze as banks scramble to improve their balance sheets.

It is possible that banks will be less profitable in the future due in part to these regulations. The 7% equity requirement is a minimum, and it is likely that many banks will strive to maintain a somewhat higher figure to give themselves a cushion. If financial institutions are perceived as safer, the cost of capital for banks would actually decrease. More stable banks can issue debt at a lower cost. At the same time, the stock market might assign a higher P/E multiple to banks that have a less risky capital structure.

Basel III was not expected to be a panacea. However, in combination with other measures, the regulations have produced a more stable financial system. In turn, greater financial stability has spurred steady economic growth.

While banking regulations may help reduce the possibility of future financial crises, it may also restrain future economic growth. This is because bank lending and the provision of credit are among the primary drivers of economic activity in the modern economy. Therefore, any regulations designed to restrain the provision of credit are likely to hinder economic growth, at least to some degree. Nevertheless, many regulators, financial market participants, and ordinary individuals are willing to accept slightly slower economic growth if it means greater stability and a decreased likelihood of a repeat of the events of 2008 and 2009. (Find out how the Tier 1 capital ratio can be used to tell if your bank is going under. Read Is Your Bank On Its Way Down?)

As with any regulations, the ultimate impact of Basel III will depend upon how it is implemented in the future. Furthermore, the movements of international financial markets are dependent upon a wide variety of factors with financial regulation being a large component. However, it is possible to predict some of the possible impacts of Basel III for investors.

It is likely that increased bank regulation is a positive for bond market investors. That is because higher capital requirements will make bonds issued by banks safer investments. At the same time, greater financial system stability will provide a safer backdrop for bond investors even if the economy grows at a slightly slower pace as a result. The impact on currency markets is less clear, but increased international financial stability will allow participants in these markets to focus on other factors while focusing less on the relative stability of each country's banking system.

Finally, the effect of Basel III on stock markets is uncertain. If investors value enhanced financial stability more than slightly higher growth fueled by credit, stock prices are likely to benefit from Basel III (all else being equal). Furthermore, greater macroeconomic stability will allow investors to focus more on individual company or industry research while worrying less about the economic backdrop or the possibility of broad-based financial collapse.

Basel III should result in a safer financial system while restraining future economic growth to a small degree. For investors, the impact is likely to be diverse, but it should result in safer markets for bond investors and greater stability for stock market investors. An understanding of Basel III regulations will allow investors to understand the financial sector going forward while also assisting them in formulating macroeconomic opinions on the stability of the international financial system and the global economy. (For further reading, refer to How Basel I Affected Banks.)