Understanding the Basel III International Regulations

Basel III is a set of international banking regulations developed by the Bank for International Settlements in Basel, Switzerland, to promote stability in the international financial system. The Basel III regulations are designed to reduce damage to the world economy from banks that take on excessive risk.

Problems with the original accords became evident during the subprime crisis in 2007. Members of the Basel Committee on Banking Supervision agreed on Basel III in Nov. 2010. Regulations were initially introduced from 2013 to 2015, with some extensions being completed later.

How Basel III Works

Basel III and Banks

Basel III regulations contain several important changes for banks' capital structures. First, while banks must still maintain capital reserves equal to at least 8% of their risk-weighted assets, the minimum amount of equity, as a percentage of assets, is increased from 2% to 4.5%.

There is also an additional buffer of up to 2.5% required, bringing the total equity requirement to as much as 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 they scrambled 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 price-to-earnings (P/E) multiple to banks that have a less risky capital structure.

Basel III and Investors

As with any regulation, the ultimate impact of Basel III will depend on 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 on investors.

It is likely that increased bank regulation will be 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. Still, 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.

Basel III and Stock Markets

Finally, the effect of Basel III on stock markets is uncertain. If investors value enhanced financial stability above 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 companies or industry research while worrying less about the economic backdrop or the possibility of broad-based financial collapse.

Basel III: Financial Outcomes

Basel III was not expected to be a panacea; however, in combination with other measures, the regulations have so far produced a more stable financial system with increased bank resilience.

While banking regulations may help reduce the possibility of future financial crises, they may also restrain future economic growth, however. This is because bank lending and the availability 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 2007 to 2009.

The Bottom Line

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 vary, but it should result in safer markets for bond investors and greater stability for stock market investors.