Basel III sounds unnervingly like the latest in a Hollywood pattern of sequels, reminiscent of the Stallone Rocky films. We’re not yet at Basel V, the bankers haven’t yet come to physical blows with the regulators, but bankers look increasingly punch drunk from the multitude of onerous new rules coming from regulators.

To outside observers the whole Basel business is often hard to fathom. When Jamie Dimon says that it is “anti American” (Interview with Financial Times, Sept. 2011) and implies that it is a European attack on US banks, it is clear that discussion has moved into a highly charged atmosphere which makes it difficult to consider the issues with objectivity. In the US, moreover, the controversial Dodd-Frank Act is tightly bound up with Basel III and threatens to pull us into the realm of politics.

Those of us working in the specialist area where banking and insurance overlap have glimpses of what is at stake. We continually strive to understand what is going on and what the impact of Basel III may be on our businesses and on our livelihoods. This article is an attempt to find some perspective on the current confusion and consider how Structured Credit insurance (SCI) may develop in 2012.

It is perhaps worth recalling that SCI is a relatively recent arrival on the insurance scene. It grew out of the private Political Risk Insurance (PRI) market in London in the early 1970’s and started to become a serious proposition after PRI’s defects were revealed by the Argentina crisis in 2002.

Sometimes called “Comprehensive Credit Cover,” SCI denotes the product offered by a segment of the insurance market that is distinct from the short-term trade credit receivables insurers. It is estimated to be a segment with annual premium volume of about 1.5bn USD, whose major clients are banks, commodity traders and large corporations.

Since 2006 the SCI market has been growing steadily, as banks have come to see its value in mitigating credit risk, reducing capital requirements and enhancing returns: thanks to Basel II, banks could substitute the credit rating (or probability of default) of the insurer in place of that of the emerging market borrower. After 2008, the prompt and full claims payments by the SCI insurers finally convinced the banks that they had found a reliable product—just when the securitization, CDS and syndication markets deserted them.

Basel background

“Basel III” is the name given to the latest set of regulations that are being applied internationally to banks. It takes its name from the Basel Committee on Banking Supervision (BCBS) which operates under the auspices of the Bank for International Settlements (BIS), based in Basel, Switzerland. The BCBS was created in 1974 by the then “G10” in the wake of the failure of Bank Herstatt in Germany.

The objective of the Basel process was, and still is, to establish common regulatory standards to be applied globally to banks to ensure that they are solvent, liquid and secure. The Basel process began in earnest in 1988 when the Basel Committee introduced the concept of Risk Weighted Assets (RWAs) and announced minimum capital adequacy requirements of 8% of these (“Basel I”). As the shortcomings of this initial approach became evident, the Committee proposed a more detailed framework that ultimately became “Basel II,” issued in 2004 to 2006, with implementation in Europe starting in 2007. In the US the implementation was delayed until 2011 and is still being rolled out.

Faced with the new rules, the behavior of the banks was unsurprisingly to seek to maximize profit and minimize (expensive) capital. A study by Patrick Slovik (“Systemically Important Banks and Capital Regulation Challenges,” OECD Economics Department Working Paper No 916) shows that since the introduction of Basel I, certain major banks steadily reduced their RWAs and significantly increased their leverage. The following chart (taken from Slovik’s article) provides a graphic illustration. The implication is that banks have been “gaming the system.”

The 2008 Crisis

What can one say about what happened to banks in 2008, particularly in the US and the UK? Why were so many found not to be solvent, liquid and secure? Did Basel II fail to work?

It is hard not to conclude that Basel II failed to do its job properly. The defenses raised by the regulators and bankers have varied from “the new regime hadn’t been fully implemented” to “Basel II did not address key issues such as market risk and liquidity.” Whatever the right answers to those questions are, it is clear that regulators are now responding with a comprehensive set of controls and tools, designed to strengthen banks’ capital and liquidity. The soundtrack to Basel III is filled with the noise of many stable doors being vigorously but tardily closed.

 The Basel III Response

The first reaction of the BCBS was in fact “Basel 2.5,” which was agreed in July 2009 and addressed the risks in the banks’ securitizations and trading books, with implementation set for January 2012.

Basel III was issued in December 2010 by means of two documents, one concerned with liquidity and the other with capital requirements and the regulatory framework. Progressive implementation is to start in 2013 and continue to 2019.

The requirements of Basel III are onerous. They will affect banks in several areas:

            • Firstly, in the area of bank permanent capital:
                • the level of the highest quality capital, Common Equity, is to be increased to 4.5% of Bank RWAs (from 2%);
                • a new Capital Conservation Buffer (CCB) of 2.5% is to be introduced, thus raising the Common Equity requirement to 7%.
                  • Although the original figure of 8% for Minimum Total Tier 1 capital requirement is maintained, the new minimum level including CCB is to rise to 10.5% by 2019. In Europe, banks are being required by the European banking authority to reach a Tier 1 ratio of 9% by June 2012. The burden of these requirements is increased by new, more stringent eligibility criteria for what can count as Tier 1 capital.
              • Secondly, banks are being required to address two other areas that were identified as major problems in the 2008 Lehman crisis:
                • Funding: new ratios to ensure that banks have ready access to short term (30 days) liquidity (Liquidity Funding Ratio) and secure assets to provide longer term funding (Net Stable Funding Ratio).
                • Trading Book/Market exposures: more capital is required for Counterparty Credit Risk (CCR), which in turn is subject to stricter criteria for extreme scenarios.
              • Thirdly, a Leverage Ratio is to be introduced as an overall “blunt instrument” test to be applied to banks’ Total Assets (“TAs”) with no allowance being permitted for mitigants such as guarantees or credit insurances. Common Equity must be at least 3% of TAs.
              • Fourthly, in Trade Finance, an area where many banks have operations that are active buyers of SCI, the pressures continue because the Credit Conversion Factor for Off Balance Sheet items such as Letters of Credit is seen as being excessively penal. There has been some relaxation here by the BCBS in October 2011.

Basel III impact on banks

It is hard to overestimate the severity of the pressures that banks now face. They need to raise more capital and to restructure their balance sheets, at a time when equity markets are unwilling to provide new capital, when traditional bond investors such as insurance companies are being disincentivized by the new Solvency II rules (sometimes described as “Basel II for insurers”) and when politicians are calling for increased lending to promote economic growth.

With distressingly awkward timing, the European Union has thrown itself into turmoil over Greece, and European banks are struggling to find interbank funding from their peers as well as external US Dollar funding.

The likely outcomes are clear. Banks have to delever. In the absence of new equity capital, they have to reduce their lending and their balance sheets. Trade finance—which is predominantly a US dollar business—is severely crimped. Larger corporates may be able to bypass the banks and access the capital markets, but small and medium sized corporates are in for a difficult period.

Basel III is not the cause of this difficult situation, but it is clearly proving to be a major aggravating factor. Moreover, while most current public comment focuses on the regulations and the new requirements, we are in danger of overlooking the increasing amount of internal management time, resources and costs that banks must commit to the new modelling, measuring and reporting requirements.

Basel III impact on insurance markets

The headline issues which the bank users of SCI face are (a) funding and (b) pricing. Insurers, on the underwriting side, are structurally unable provide solutions to (a). As for (b), the struggle is on between supply and demand. Most frequently it takes the form of a vigorously allergic reaction by banks to the “70% of margin” premium rate that has been the default mantra intoned by the SCI underwriters. Since banks will not disclose their funding costs, the debate ranges from basic arm wrestling over premium rates to more subtle hints and suggestions to help guide underwriters. Either way, the brokers’ role is interestingly varied. Banks who have spent time working on their relationship with insurers seem to be best placed to achieve the pricing they need.

Regulators’ views on insurance

Regulators do not opine openly about matters; however, to date it appears that they have been satisfied with the approaches taken by banks over SCI. In the UK, the FSA are known to have taken the view that insurance policies with the “Nuclear” exclusion are not acceptable mitigants for Standardised and Foundation IRB status banks.

There were previous inklings of concern about whether insurance would pay out in a timely manner, but the claims payment performance of the SCI market has been exemplary, prompting some banks to compare insurance favorably against derivative hedges in light of uncertainties over the way CDS will perform for Greek debt.

It is a measure of the success of the SCI market that the issue of claims payment which used to dominate conferences is now merely covered in passing. At a recent Export Credit Conference in London, a leading French bank stated almost casually that it had just collected a claim of close to 100 million USD and was relaxed about the market’s performance.

Concluding perspectives

In the third quarter of 2011, the Eurozone crisis led to an abrupt halt of business from the leading French banks. So far in 2012, their business has not yet fully resumed. However, there has been a significantly increased level of interest from new banks who have not been buyers in the past and from banks that now want to coordinate their use of the product and buy more effectively.

It is likely that any loss of business from European banks will be more than made up by the new players, but it is highly unlikely that the former will be out of the market for long. The perspective on the demand side is therefore likely one of continuing pressure for capacity, especially in those countries such as Russia and Turkey where the market already has major commitments.

A new trend on the demand side is the appearance of non-emerging market credit risks which banks are offering and which many underwriters are willing to consider, particularly those who are able to provide cover that is not tied tightly to underlying trade transactions.

On the supply side, the 2012 reinsurance renewals went well and capacity has continued to grow. New entrants such as XL (the former QBE team) are not merely replacing their previous capacity but making a meaningful addition to the market.

Overall there is a strong feeling among all market participants—banks, insurers, reinsurers and brokers alike—that the rising tide of the Basel requirements will continue to raise all boats and make SCI a desirable product.

The only concern here is that this looks too comfortably predictable—what can go wrong to wrong-foot us all?  ■

David Neckar is a Product Development Director at Willis Financial Solutions.  In this article he brings us up to date on the long-running saga of efforts to craft international regulatory standards for banks, and the role of insurance in responding to those standards.