Regulatory reforms are still under development globally and in the U.S., with capital adequacy taking center stage under Basel III. Careful planning remains an absolute necessity for banks, however, as earnings could be adversely affected by new regulations, and the implications of requirements for living wills and stress tests will add to the possible consternation among stakeholders.
This changing landscape will require banks and their boards to be more engaged in all aspects of capital and liquidity planning. Specifically, boards will need to review and approve risk-appetite statements and be involved in key decisions about how much capital and liquidity the bank holds, and what are the core products and services of the organization.
Basel III and the Dodd-Frank Act focus on banks operating with a higher quality and quantity of capital, which results in additional regulatory scrutiny of the payment of dividends and other uses of capital such as share repurchases or major acquisitions.
Further, senior banking management and boards of directors should be aware that shareholder dividends would likely wind up on hold if the bank has to draw down its Basel III required capital conservation buffer of 2.5% above the framework's minimums. In addition, shareholder distributions would remain in suspension until the bank re-established the buffer — a potentially daunting provision that could threaten market capitalization and traditional access to capital. It remains to be seen whether that drawdown could threaten market cap, requiring a further drawdown, and eventually pushing a bank into a tailspin.
The consequences are great. American Banker said in a recent "Editor at Large" column ["
What can banks and their boards do now to get ahead of planned changes?
• Evaluate what regulatory reform and in particular Basel III will mean for the bank's line-of-business strategy and capital requirements, potential loss of revenue streams, increases in infrastructure and compliance costs and potential opportunities, and then come up with a plan. Although the specific capital requirements are not clear, banks should try to understand their effects under different scenarios.
• Consider if the bank needs to change business and operating models, and if so, what are the optimum models? With the role of legal entities increasing and higher compliance costs and capital requirements expected to result in lower returns, banks should give thought to how these issues may impact how products are designed, delivered and priced, and many customers will likely see increased costs for credit and other banking services. Another key question — what will the bank's core business activities be?
• Banks and their boards should also monitor and attempt to anticipate the costs of compliance. Direct costs will increase because of added information and processing systems, the increased economic costs of greater capital, more liquid balance sheets and higher execution costs. Boards should make sure regulators can understand the organization's risks and vulnerabilities and the amount and quality of capital and liquidity they are holding.
With continued tight underwriting standards, business uncertainty and the overall economic deleveraging, earnings at regional and community banks will be under pressure, particularly those with large commercial or residential real estate exposure. Such banks could have a difficult time raising the capital required under Basel III and may face more pressures on their business model than would the larger, better-capitalized institutions. Senior management should evaluate strategic plans in concert with their boards of directors, as the likely consequence will be consolidation.
Basel III will have a significant impact on assets and can inflate banks' balance sheets and the amount of capital needed for certain assets. In the old world, on- or off-balance-sheet treatment made a difference. That is no longer the case, as banks will have to hold capital against many off-balance-sheet transactions, such as certain securitizations.
Banks and their boards of directors should be ready now and have a plan for anticipating and planning for the changing regulatory expectations. Banks that engage their boards and make quick decisions will get first-mover advantage and should be best positioned in the market.
