Banks on both sides of the pond face potential shortfalls when it comes to capital requirements under new Basel III rules. Analysts predict that they will be able to make them up by reducing risk-weighted assets or by increasing capital through retained earnings or equity issuance. However, this will mean a tightening of balance sheets and less money available for lending, which could have a big impact on corporate liquidity.
At the moment the total effect is unclear as different banks are using different risk weightings to determine their capital requirements, which makes it difficult to compare capital needs from bank to bank. Some market watchers have called on the Basel committee to set out clearer guidelines for determining risk weightings.
Nonetheless, US banks could see shortfalls of as much as $100 billion or $150 billion in meeting the 7% minimum equity cushion that banks are required to have under Basel III, according to research by Barclays Capital. In addition, this shortfall will be 90% concentrated in the six largest banks.
European institutions also face big issues in meeting capital requirements, as research by UBS points out. In fact, UBS analysts note that Barclays Capital would not have made an economic profit over the past 10 years if it had been required to meet capital adequacy guidelines under the new Basel rules, said analyst John-Paul Crutchley: “If the proposed Basel rules and likely capital requirements had been in place over the past decade, Barclays Capital would probably not have grown to its current size.”
The upshot of all this is that banks will be looking to reduce their risk-weighted assets, which will result in tighter bank lending conditions. This will affect corporates in both North America and Europe, but may have more of an effect on European markets, as the US corporate bond markets and smaller US banks – which are less affected by the capital requirements under Basel III – can absorb some of the impact.
Companies will likely once again be focused on shoring up liquidity sources and hoarding excess cash. The efficient use of existing internal liquidity will also again be in the spotlight, particularly as this provides a more effective long-term solution to liquidity concerns. The less outside liquidity a company needs, the less of an issue tightened bank lending conditions will be.
As companies do hold onto excess cash, it is important to keep in mind some of the challenges that this represents. In particular, as recent research by academics Nils Backhaus and Luc Soenen – posted on the AFPOnline website – points out, companies that hoard cash are more likely to spend it inefficiently and bring down the time value of that cash, especially for those firms without strong governance or controls in place to manage excess cash usage.
As such, for those firms that are planning to increase their cash base in the face of potential liquidity tightening, it would be wise to review corporate governance and controls to ensure that effective measure are in place to manage that.