According to a 2016 report by the Bank for International Settlements (BIS), for every one percentage point increase in capital ratios, banks tend to cut their lending in the long run by 1.4–3.5%.
It is inevitable.
In a post Silicon Valley Bank world, the acceleration of attention to bank liquidity was predictable. Therefore, Basel III, the long-negotiated post-Global Financial Crisis regulation targeting the largest banks and the systemic risk posed by their risk activities, will become only the first step in a journey of tighter capital requirements.
Basel IV, or the Basel III Endgame as it’s often referred to, is meant to take effect in 2025 with a three-year phase-in period. While the details are included in a 316 pages of absurdly small type in the Federal Register, there are some high-level takeaways and potential negative effects on business lending all should be familiar with.
- More Banks Are Affected
Basel has been a headache reserved for the largest of banks, referred to as “higher volume” banks. The original implementation was focused on banks with riskier activities outside of conventional lending, like investment banking, complex wealth management enterprises, etc. But Endgame brings it down to banks with $100 billion or more in assets. Many of these banks already have their hands full with commercial real estate.
- Increased Capital Requirements
Like Basel III, Basel IV is expected to introduce higher capital requirements for banks, particularly for riskier assets. This could lead banks to allocate more capital to lending activities that are considered less risky, such as mortgages or large corporate loans, at the expense of lending to smaller businesses that may be perceived as riskier.
- Tightened Liquidity Standards
Like Basel III, Basel IV mandates banks to maintain a minimum liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) to ensure they have sufficient liquidity buffers to withstand short-term and long-term liquidity stresses. Meeting these requirements may require banks to hold more liquid assets, which could limit their ability to lend to businesses, particularly during periods of economic stress when liquidity needs are higher.
- Complexity and Compliance Costs
Basel IV will introduce more complex and granular risk measurement methodologies, which could increase compliance costs for banks. These costs may be passed on to borrowers in the form of higher interest rates or tighter lending standards, particularly for smaller businesses that may not have access to alternative sources of financing.
- Impact on SME Lending
Small and medium-sized enterprises (SMEs) often rely on bank loans to finance their operations and growth. Basel IV’s stricter capital requirements and risk-weighting methodologies could disproportionately affect smaller banks, which are more likely to lend to SMEs. This could lead to reduced availability of credit or higher borrowing costs for SMEs, constraining their ability to invest, expand and/or innovate.
- Procyclicality
Basel IV’s regulatory requirements could exacerbate procyclical lending behavior, as banks may reduce lending during economic downturns to conserve capital and increase lending during upswings to meet higher demand. This could potentially amplify credit crunches during economic downturns, further constraining businesses’ access to credit when they may need it most.
- Risk Weighted Asset Calculation Changes
Basel IV will bring changes to the calculation of risk-weighted assets (RWAs), which determine the amount of capital banks need to hold against their assets based on their riskiness. These changes may lead banks to assign higher risk weights to certain types of business loans, such as loans to SMEs or loans secured by real estate, making them more capital-intensive. As a result, banks may reduce lending to these sectors or increase interest rates to compensate for the higher capital requirements.
- Impact on Specific Industries:
Basel IV’s changes to risk-weighting methodologies could have different impacts on lending to specific industries. For example, industries perceived as riskier may face higher capital requirements, leading banks to reduce lending to those sectors. This could affect businesses operating in industries such as construction, real estate development and technology.
These impacts are the just the beginning, so Basel IV may not be an endgame.
The recent announcement of forward funding relationships between huge asset managers and regional banks likely will bring a host of benefits for each party, with one of the most obvious the creation of a de-leveraging mechanism in place should the bank have to off-load risk. Could CRE and the looming Basel Endgame accelerate more such announcements? What does this mean for the equipment finance sector, which is already being shaken by bank credit tightening? If you’re not radically rethinking your funding structure right now, should you be?
Control comes at a cost and while Basel IV aims to strengthen the stability and resilience of the banking system, its implementation may lead to unintended consequences, such as reduced business lending, particularly for SMEs, which could potentially impact economic growth and job creation.
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