Basel III is a set of international banking regulations developed by the Bank for International Settlements in order to promote stability in the international financial system. The purpose of Basel III is to reduce the ability of banks to damage the economy by taking on excess risk. (Problems with the original accord became evident during the subprime crisis in 2007. To learn more, see Basel II Accord To Guard Against Financial Shocks.)
TUTORIAL: Economics Basics
Basel III and the Banks
With that in mind, banks must hold more capital against their assets, thereby decreasing the size of their balance sheets and their ability to leverage themselves. While these regulations were under discussion prior to the financial crisis, their necessity is magnified as more recent events occur.
The Basel III regulations contain several important changes for banks' capital structures. First of all, the minimum amount of equity, as a percentage of assets, will increase 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 will have until 2019 to implement these changes, giving them plenty of time to do so and preventing 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 in order to give themselves a cushion. If financial institutions are perceived as being safer, the cost of capital to banks would actually decrease. Banks that are more stable will be able to 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 and Financial Stability
Basel III is not a panacea, and will not single-handedly restore stability to the financial system and prevent future financial crisis. However, in combination with other measures, these regulations are likely to help produce a more stable financial system. In turn, greater financial stability will help produce steady economic growth, with less risk for crisis fueled recessions such as that experienced following the global financial crisis of 2008-2009.
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, following the events of the financial crisis, many regulators, financial market participants and ordinary individuals are willing to accept slightly slower economic growth for the possibility of 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?)
Basel III and Investors
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. Nevertheless, it is possible to generalize about some of the possible impacts of Basel III for investors.
It is likely that increased bank regulation will ultimately be a positive for bond market investors. That is because higher capital requirements will ultimately 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 weaker 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 upon other factors while perhaps eventually giving less focus to 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 the possibility of 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 having to worry less about the economic backdrop or the possibility of broad-based financial collapse.
These regulations should result in a somewhat safer financial system, while perhaps restraining future economic growth to a small degree. For investors, the impact is likely to be diverse, but should result in safer markets for bond investors and perhaps greater stability for stock market investors. An understanding of Basel III regulations will allow investors to better analyze 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.)