Weaker European banks will have to raise hundreds of billions of euros in fresh capital over the next few years and more risky investments like speculative developments or secondary properties will become an even less viable prospect for banks, financially, as a result of new Basel III banking regulation, which has been agreed to and will be given final approval by leaders of the Group of 20 countries (G20) in November.
In response to the financial crisis that pushed several institutions to the verge of collapse (and a handful beyond), new rules have been drawn up by global financial regulators to improve banks’ stability and therefore prevent a re-run of the downturn. Under the conditions of Basel III banks must more than triple the amount of capital they hold in order to be able to survive future shocks to the system without the need for state aid.
The main repercussions of the new regulations on the European property sector will be similar to those generated by Basel II: bank finance will be scarce and the cost of debt will be high, particularly for non income producing assets against which banks must shelve a greater amount of capital. This has fuelled concerns that it could damage the real estate market as well as the wider economy.
“Basel III is certain to affect lending behaviour,” says ULI vice chairman and treasurer, Seth Lieberman, who also works on behalf of private equity fund of funds manager Advanced Capital and was a former UBS real estate banker. “If it’s a good building that’s well leased to a good tenant on good income, the amount of capital required to be reserved against that loan may not change in a material manner. But loans for speculative developments will be a very difficult thing if they’re not pre-let. In other words, buildings that don’t have cash flow are very risky and are being treated so punitively that they’re not going to get the banks’ attention for new lending.”
Basel III stipulates that banks will have to increase their core tier-one capital ratio – a key measure of banks’ financial strength, made up of financial instruments such as equity and retained earnings – to 4.5% by 2015. They will also have to reserve a further “counter-cyclical” capital conservation buffer of 2.5% of assets by 2019. Any bank that falls short of the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet.
Effectively, banks will have to hold 7% of capital in reserve instead of holding capital equivalent to just 2% of their risk-bearing assets, which has, to date, allowed them to hold nearly 50 times more in riskier assets than their core tier-one capital ratio and is the reason some banks were unable to absorb their losses on toxic debts following the onset of the credit crunch in 2007. Institutions deemed “systematically important” will be forced to hold even more, although it has not yet been decided how much this will be. In theory, the new capital reserve rules – to be rolled out in stages between January 1, 2013 and January 1, 2019 – will cushion the banking sector from another downturn like the last.
Supporters of Basel III argue that bigger capital buffers will help banks avoid rights issues, government bailouts or even save them from collapse in times of economic turbulence. The long term nature of the program will also dilute any potentially negative implications associated with Basel III.
But another school of thought questions the logic in forcing banks to tie up more of their capital at a time when there is already a shortage of new loans. Furthermore, the cost of running a bank will become more expensive, with borrowers faced with footing the bill. Whether or not Basel III is well received makes little difference, since its implementation is set to grip the property industry and is, arguably, a much needed dose of what it requires.