The implementation of stricter capital rules under Basel III could prompt some banks to increase riskier activities, according to Fitch Ratings.
A study by the ratings agency estimates that the 29 most systemically-important global financial institutions will need to raise about $566 billion in common equity to satisfy new capital rules.
Fitch says banks are likely to use a variety of strategies to raise this capital ahead of Basel III’s implementation at the end of 2018, including retention of future earnings, reduced willingness to carry out share buybacks and cutting back on positions with higher risk weights.
However, the group warns that stricter Basel III capital rules could cause large banks’ median return on equity (ROE) to fall from the 11% or so seen over recent years to between 8% and 9%. Banks attempting to preserve a higher ROE could move towards riskier investments where returns have been imperfectly matched with Basel III risk categories, the study adds.
Martin Hansen, senior director with Fitch Macro Credit Research, says: “Since it is impossible for regulators to perfectly align capital requirements with risk exposure, some banks might seek to increase ROE through riskier activities that maximise yield on a given unit of Basel III capital, including new forms of regulatory arbitrage.” (article continues below)
In addition, Hansen suggests Basel III lead to issues such as increased borrowing costs, a shift to securitisation and capital markets funding, or a migration to less-regulated segments of the financial system such as shadow banking.
Last year, a paper by BNP Paribas argued that Basel III could lead to “a more stable banking system”. However, the bank cast doubt on the claimed macroeconomic benefits of the rules and said the main area of concern is the cost of implementing the regulations.