SmartRamps Commentary, March 2012
Basel III – What Does It Mean for Core Deposits?
Bank regulation in general and the consistency of bank regulation across countries has
been a concern for at least the past twenty-five years. The original Basel Accords in 1988
established recommended minimum capital requirements. Basel II, published in 1994, was
an extension of the original recommendations, attempting to extend the original Accords to
take into account the growing complexity of financial institutions. Basel II established risk
and capital management requirements based on a financial institution’s specific lending and
investment holdings. A bank adopting a riskier strategy would be required to hold additional
capital to ensure its solvency. Basel II also attempted to reduce differences in regulatory
guidance across countries so international banks could not “game” the system. While Basel
II was intended to protect the financial sector from the collapse of a major institution, the
financial crisis of 2008 suggests that it was not altogether successful in that goal. Thus,
Basel III was born.
The overall approach recommended in Basel III is much more comprehensive than that of
prior accords and can be summarized in five points.
1. Receiving the most publicity, capital standards are both increased and tightened. Tier
1 capital, i.e. common shares and retained earnings, is now emphasized and Tier 3
capital is eliminated.
2. Risk is more closely aligned with the capital framework. For example, banks with
greater derivatives risk or greater pro-cyclicality are held to a higher capital standard.
3. A leverage ratio is introduced to restrict the build-up of excessive leverage at a bank.
4. Capital buffers and stress tests are now required (the U.S. implementation of the rules
has heavily emphasized stress tests).
5. A minimum liquidity standard is introduced.
While Basel III is suggestive only and need not apply to any particular bank in any country,
the U.S. Federal Reserve Bank has made it clear that it takes the recommendations of
Basel III very seriously. Plus, those rules will apply not only to banks in the U.S. but to any
large financial institution, e.g. of more than $50 billion in assets or any institution whose
failure would introduce systemic risk to the financial system.
Two points about the U.S. application of Basel III have been emphasized in the trade press.
First, capital standards have in fact increased. There are concerns that higher capital
mandates potentially reduce economic growth, albeit likely by a small amount. Regulators
appear willing to accept a small reduction in economic activity to avoid financial crises.
Second, in the U.S. the capital standards apply only to a limited set of financial institutions,
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1 only the largest banks as well as large insurance firms and hedge funds, for example. The
vast majority of institutions are not directly covered by the Basel III mandates. Smaller
institutions now may have a slight advantage in one regulatory dimension!
Core deposits (or non-maturity deposits) were not explicitly covered under the prior Basel
Accords. Basel III introduces two features that now cover the role of core deposits, and
these are worth reviewing in detail.
1. The Liquidity Coverage Ratio (LCR) requires that financial institutions hold liquid
assets equal to 100% of short term funding needs over a 30 day stress test period.
That stress test includes 7.5% of core deposits potentially leaving the institution. In
effect, 7.5% of core deposits are required to be matched by high quality liquid assets
such as cash or other liquid assets. Each $1 billion in core deposits would require the
institution to hold $75 million in liquid assets.
LCR is effectively a reserve requirement for core deposits. How does it compare with
existing reserve requirements? Since April 1992, the Federal Reserve’s marginal
required reserve ratio on transaction oriented core deposits has been 10 percent.
Since December 2011 this ratio applies to net deposits exceeding $71 million. That
suggests the existing reserve ratio is higher than required by Basel III’s LCR.
However, the Federal Reserve has set no reserve requirement for nontransaction core
deposits while the LCR applies to those core deposits also. Thus, whether LCR
increases or decreases U.S. reserve requirements depends on the (a) size of the
financial institution and (b) the mix of deposits between transactions and
nontransactions accounts, e.g. between checking and savings accounts. Given the
size of nontransactions accounts at most of the larger financial institutions, it would
appear that LCR will result in an increase in required reserves.
2. Basel III introduced the Net Stable Funding Ratio (NSFR) to measure the amount of
stable funding relative to the risk and liquidity of the assets being funded. The sources
of stable funding are assigned an “availability factor” used to offset the required stable
funding uses that include loans or mortgage backed securities. Tier 1 and 2 capital
instruments, e.g. retained earnings, are assigned an availability factor of 100%. Stable
retail deposits are assigned an availability factor of 85% and less stable deposits are
assigned an availability factor of 70%. Wholesale funding is assigned a 50 percent
availability. Other liabilities are assigned zero availability.
The impact of the NSFR is that each $1 billion in core deposits potentially reduces
capital to fund loans by $850 million. But core deposits are now treated as a source of
stable funding, and NSFR make core deposits more desirable in the long term.
The implications of Basel III for core deposits are ambiguous. The LCR standard suggests
a greater cost associated with core deposits while the NSFR standard suggests a greater
benefit. Some large financial institutions may find greater net benefits of core deposits with
Basel III while others may find greater costs. The outcome will depend on the mix of
2012 McGuire Performance Solutions, Inc.
2 transaction and nontransaction core deposits and the relative costs of raising additional
capital versus generating core deposits and proving their supply stability. In contrast, there
may be a net benefit to small institutions, for two reasons. First, large financial institutions
likely have a greater cost associated with raising stable core deposits. That cost will yield a
potential advantage to smaller institutions in their attraction of stable core deposits. And
second, to the extent that the spirit of Basel III is extended to smaller institutions, the NSFR
standard makes explicit the role that stable core deposits play in funding. Active analysis
and proof of supply stability, as done by MPS Deposit Analysis Service clients for almost 20
years, should lead regulators to a greater appreciation of the value of core deposits.
Final Words: The Current Interest Rate Outlook
A few words are in order on the current interest rate outlook, following up the commentary of
last quarter that interest rates are likely to remain low and stable. From a probabilistic view,
that is still the most likely outcome. But recent favorable economic growth news in the U.S.
suggests that interest rates may begin to increase sooner rather than later.
After years of low short and long term interest rates, and after the Fed’s explicit statement
that Operation Twist was intended to reduce long term interest rates, long rates have begun
to creep back (although short term interest rates have remained fundamentally unchanged).
Is this the start of a long term trend or just the standard volatility of interest rates? Has the
Fed interpreted the economic data as indicating the green shoots of real economic recovery
and is letting long term rates rise? Or have other economic factors begun to push up long
rates even as the Fed continues with relatively expansionary policy?
It is far too soon to read anything significant into the increases in long term interest rate, in
my opinion. Nonetheless, the recent positive economic news coupled with the gains in long
term rates does increase the probability that the economy may be preparing to move into a
new rate environment. So keep a close watch on the curve!
Richard G. Sheehan, Ph.D.
Senior Vice President, Research
2012 McGuire Performance Solutions, Inc.
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