FWD: Basel III Fundamental Outlook:

Basel III Fundamental Outlook:

Bonds, Derivatives, Equities and Competition

The year is 2013. The first 13 years of the 21^st century has seen a kaleidoscopic collision of events rippling out into the global economy; manifesting into waves of growth and decay. Our most notable example would be the rapid growth and decline preceding and following the 2008 financial crisis. This notorious milestone of our century brought to light inefficiencies in our financial systems that had to be ironed out.

Enter the Basel Committee, in 2010 our financial leaders and intellectuals congregated in the Swiss city, Basel, to update the Basel accord. What they produced was Basel III, which is the latest addition to the Basel accord. This globally regulated standard increases a banks required capital reserves, limits the leverage banks have available and regulates market liquidity.

The global economy’s growth is going to be interdependent on the implementation of Basel III and other peculiarities of the 21^st century, such as: rapid competitive innovation, a growing unemployed youth, an aging population and our limited energy resources. Basel 3 will be introduced from 2013 until 2019, within this period and perhaps beyond I predict two possible fundamental outcomes of our World’s growth.

Basel III will influence financial institutions all over the world, some institutions will adapt well to the new regulation but others will struggle before total adaptation of Basel III is achieved.  Basel III regulates 3 properties of our banking institutions and indirectly regulates financial institutions, such as: pension funds, insurance companies, mutual funds, hedge funds and fund of funds.

The first property is to increase the minimum tier 1 capital requirements of banks to 7%, from the previous 2.5% requirement. Therefore more money will be held in banks and taken out of the markets. The policy strictly requires banks to reserve enough vault cash and liquid assets to survive a crisis for 30 days.

Secondly, Basel 3 consists of a regulated leverage ratio, which limits a banks activity in relation to its own capital. The leverage affect Basel III will have will help prevent over-leveraged banks from failing. This property will prevent a lot of externalities, meaning less volatility in the markets and less credit crunches.

 Finally the last property and perhaps the most important is the Liquidity Coverage Ratio (LCR). This ratio serves as a measurement of the liquid assets a bank has to cover its short term obligations. The Liquidity Coverage Ratio enforces banks to retain an amount of liquid assets that can serve as protection for as much as 30 days of liquidity disruption. Additionally, Basel III allows for a maximum 15% liquidity buffer made up of: corporate debt, equities and securitised mortgage debt.

Bonds

This boils down to banks having to hold a lot more capital per unit currency they borrow; this implies costs to the bank. Banks will have two options: either to increase their prices to offset the additional cost or to humbly be satisfied with less return as the additional cost eats into their returns. The latter is doubtful! That being said, what we are likely to see is a drop in interest on deposits and a rise in interest on borrowed funds.

The new rule makes it clear that banks and investors must return to more traditional financing and investing methods, such as long term bonds and value investing.

Basel III’s LCR requires banks to reserve and maintain a specific amount of liquid assets. This will lead to a massive global insufficiency of available financing to corporations in the foreseeable future. This shortage of financing will be compensated for by an increase in corporate bond issuance. This implies opportunities for growth in the corporate bond market but there is concern that sufficient demand will not exist for the supply that corporations are going to issue to make up for their previous levels of leverage.

A trade-off between government bonds and corporate bonds is expected as the demand for corporate bonds increases. This will most likely be unfavorable for government bonds and hence banks will use their liquidity buffer to hold corporate debt, equities and securitised mortgage debt in times of low earnings.

This is competition at its finest. Capital movement between corporate funds and banks are going to make waves in the years to come, some will sink and some will swim and the rest of us will pray for the best.

Derivatives and the CVA

Basel III also has its sights on disrupting the current derivative and hedging strategies of corporations as they pose additional risks that must be removed from our financial system.

Basel III implements an additional cost on corporations which is the Credit Valuation Adjustment (CVA) risk capital charge. This added cost on a bank’s counterparty is designed to protect against decreases in the market value of the counterparty’s obligations. Market value of long-term derivatives will change as the counterparty’s credit worthiness is tested and adapted to Basel III’s standards.

This all concludes with an increase on the pricing of derivative hedging strategies that corporations employ. Basel III’s effect will be most felt by corporations dealing on an uncollateralized basis with valuable and long term derivatives. There will be organizations that adapt to this change with grace. These organizations will be the ones dealing in collateralized transactions with banks, as collateralized transactions with banks will imply better credit worthiness and therefore protection against Basel III’s effect on hedging processes.

Corporations will be faced with a choice between boosting their credit worthiness by guaranteeing collateral on hedging transactions or give up hedging, no easy task. Once again Basel III is limiting corporation’s activities to their capital reserves to create more stability in the global economy.

Equities and Competition

Concerning equities and all markets in general, Basel III will require investors and corporations who seek additional alpha to adapt with the regulations being implemented. Investors will have to adapt their strategies to be based on the upside an asset’s true value offers rather than their potential to have upside volatility. Investors should also seek stable stocks that offer decent dividends, as the dividends will offset some systematic/market risk.

Volatility will be decreased across the board except in cases of market creation and innovation. These growing industries will most likely also be in line with ensuring a more sustainable future for us. Developments in technology and medicine can revolutionize markets to grow, even in times of stress as manufacturing processes evolve for maximum efficiency in cost structures.

The structuring of finances in publicly traded companies will have to adapt to these capital disruptions of the financial system. Additionally, competitive forces in markets will intensify as corporations fight to stay afloat in the fiscal waves produced by Basel III. Innovation and triumph over competition will result in growth. Lack of innovation will be fatal to a company.

Emerging economies will respond differently to the implementation of Basel III, but the general attitude and the first possible fundamental outcome will be towards a more steady-state economy that is based on a purer perception of value. This steady-state will probably occur in stages. Some corporations and governments of emerging economies will continue to grow while corporations and banks of developed economies will slow down and stabilize as the world finds its new equilibrium.

Alternatively, the world economy will be more heavily regulated towards stability but still innovation within markets will spur on growth by creating new markets and technologies that require less capital intensive investments to produce greater outputs through more efficient processes.

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