Staying ahead of the Basel curve

The Australian banks aren't stupid. In a broadly accepting acknowledgment of the release of a discussion paper on the implementation of the Basel III liquidity reforms by the Australian Prudential Regulation Authority today, the Australian Bankers' Association inserted a significant proviso.

While agreeing that the Basel III reforms (which will lead to more and higher quality liquidity holdings by banks) would enhance the liquidity profile of the global banking system, ABA chief executive Steven Munchenberg, had this to say:

"It is very important the Basel reforms are adopted globally and that the Australian framework takes into account the application of Basel III in other geographies and any changes to the rules during the observation period.

"This will ensure that global resilience is enhanced and that no country or national banking system is disadvantaged by taking on the more stringent Basel requirements earlier than its trading partners."

Munchenberg may or may not have had his tongue in his cheek when he made those comments. He, and the banks he represents, however, would be very conscious that the global implementation of Basel III on its current timetable is almost inconceivable.

The global liquidity reforms are supposed to be phased in from 2015 and the new tougher capital adequacy regime will be progressively implemented through the latter part of the decade. APRA has adopted the Basel III timetable for liquidity requirements but plans an earlier and more aggressive schedule for its new capital requirements.

The problem for APRA and Basel III, not referred to in the ABA statement, is Europe.

While the European Banking Authority, as part of the response to the eurozone crisis last month, has estimated that the eurozone banking sector will have to raise "only" €106 billion to fill in the holes in their balance sheets created by marking their sovereign debt holdings to market, that was on the basis of their being no further deterioration in the eurozone economies.

Before the ink was dry on that 'rescue' package, which included €100 billion of 'haircuts' for the banks on their sovereign debt exposures, Europe has tumbled even deeper into crisis and the cost of borrowings for the core of the eurozone has shot up.

The economic effects of the crisis and the austerity-driven responses to it will, assuming the region can survive it and emerge reasonably intact, be profound and prolonged.

A year ago McKinsey & Co analysed the impact of the Basel III reforms and concluded that the European banks would need to raise about €1.1 trillion of new tier one capital, €1.3 trillion of short-term liquidity and €2.3 trillion of long-term funding by 2019 "absent any mitigating actions".

Well, there's been not much mitigation (some banks have raised some capital since the report was published) and plenty of exacerbation.

Whether the McKinsey estimates are accepted or not, it is very obvious that the European banking sector's sovereign debt exposures (ironically swollen by the regulators' post-GFC insistence that they hold 'higher quality' liquidity) is interacting with the economic and political crisis in the eurozone in a very destructive way.

The sector is going to have to be massively recapitalised and restructured just to remain solvent under the existing prudential regime. Even without Basel III, it would appear the eurozone banks, particularly those in the most deeply troubled economies, are going to either have to be bailed out by taxpayers or be allowed to fail.

Given the distressed plight of the southern European economies, which are themselves supposed to be bailed out, it is unclear how the banks in Greece, Spain, Portugal and Italy are going to be supported. It is also worth noting that French banks have a €300 billion exposure to Italy alone.

The scale, complexity and sheer political difficulty of the twin and related tasks of 'fixing' both the teetering eurozone economies and the eurozone banking system is daunting, even alarming.

Superimpose the additional capital and liquidity requirements of Basel III on the current timetable and the task would become almost impossible and, indeed, would probably increase and accelerate the destruction of European bank capital bases rather than strengthen them.

That's not necessarily an argument against the Australian system pushing ahead with the new regimes to preserve its status as one of the strongest and best-capitalised systems in the world.

Strengthening the system by pushing aggressively ahead to introduce the Basel III regime ahead of the rest – assuming the external conditions allow that to happen – might well be the best response to the prospect of another global banking crisis emanating from Europe.

A meltdown in the European system, or even successful recapitalisations on the scale required to simply stabilise it, however, would clearly have adverse implications for the Australian banks' own access to capital markets, their cost of debt and equity and the practical degree of difficulty involved in complying with the more onerous and costly requirements.