Basel III – What is Basel III and why is it important for law firms?

16 Oct 2014

Banking reform

The 2008 financial crisis showed regulators that tighter controls were needed over how banks operate, along with safeguards to try to prevent a recession of such magnitude reoccurring.

Basel III is a comprehensive set of banking rules with the main objective of strengthening global capital and liquidity regulations, creating greater resilience, as well as improving the ability to absorb shocks from financial and economic stress within the banking sector. The rules are laid down by the Basel Committee on Banking Supervision.

Wait…what?

The way Basel III reduces risk is through increased capital requirements, reduced leverage and liquidity reforms.

The aim is to improve the quality and quantity of capital. Two new ratios, the liquidity coverage ratio and the net stable funding ratio, have been introduced to ease liquidity problems that caused major issues in the 2008 crisis. The liquidity ratio will ensure a bank can cover its cash outflows with high quality liquid assets over a 30 day stressed period. The Net Stable Funding Ration will look to promote more middle to longer term funding of banks’ activities.

Basel III is fundamentally different to its predecessors.

Simply put, a banks most basic goal is to earn more on its loans than it pays out in interest on its deposit.

Basel I (1992) and Basel II (2004) focused on the loans banks provide, whereas Basel III focuses on the other side of the balance sheet, its deposits.

So what about law firms?

A Bank’s deposits have traditionally been an easy source of low-cost funding for banks. Effectively they borrow at low interest rates from a depositor, such as a law firm depositing money in client account. The banks invest the deposits overnight, aiming to make a quick return.

The idea behind Basel III is to restrict this ability to “play” with deposits and to introduce safeguards to reduce risk, to ensure if a run on the bank occurred and everyone tried to withdraw at the same time, the banks could sustain themselves.

Banks have traditionally tried hard to attract law firms who hold significant clients funds in their accounts.

Over the years banks have benefited from billions of pounds worth of client credit balances at any one time, which they held, invested and made a return on.

What is uncertain is how far the increased capital requirements will dampen banks enthusiasm to deal with law firms.

It is not yet known if client account funds will be treated as Type A capital or Type B capital.

If it is Type A Capital the banks will have to match such deposits 100% with other assets due to the liquidity coverage ratio, and this would greatly reduce the attractiveness of such deposits. If Type B then they must be 40% matched, not as high, but still a fair amount.

Initially what is most likely to come from this is firms will lose out on the interest they had previously shared with banks on returns from their clients deposits. If the bank has to cover these deposits 100% they are much less likely to see these funds as being at all attractive to hold.

Consequently, law firms could find their interest on new loans and overdrafts (borrowing) will increase. This is due to banks currently offering attractive below market rates, as it is known greater returns can be made on deposits. With this no longer the case law firms could begin to see banks becoming more conservative and risk adverse towards them.

When will it happen?

The process has already begun, although it is being phased in, with the necessary percentages on ratios being progressively increased. It was supposed to begin sooner, however the dates were pushed back due to a slower than expected recession recovery.

Liquidity requirements are currently in a sate of supervisory monitoring, but will begin to come into effect 1st January 2015. The liquidity coverage ratio will begin at 60% in 2015, rising 10% each year until 100% in 2019. Basically, Basel III will slowly and steadily begin to be enforced over the next few years. However, banks will not leave it until last minute to reach the minimum standards, they will prepare and ensure they can reach them in ample time. This means that the monetary belt-tightening will being to take very effect soon, if it has not already.

Conclusion

Basel III will change how law firms are viewed by banks. Now a bank must decide upon not just the client but also the type of cash before determining how valuable this is to them. What is still relatively unknown however is how the deposits of law firms will be treated.

Law firms may always be seen as valuable clients to a bank, but, once the reforms come into full force, perhaps not as much as they used to be.

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References:

Billot, S. (2014). Basel III: A double whammy for law firms?. Available: http://www.thelawyer.com/analysis/opinion/basel-iii-a-double-whammy-for-law-firms/3025814.article. Last accessed 14th Oct 2014.

Edwards, J. Vine, P. Gray, K. (2010). An introduction to Basel III – its consequences for lending. Available: http://www.nortonrosefulbright.com/knowledge/publications/31077/an-introduction-to- basel-iii-its-consequences-for-lending. Last accessed 14th Oct 2014.

Manish. (2011). Summary of Basel III – What You Must Know. Available: http://financetrain.com/summary-of-basel-iii-what-you-must-know/. Last accessed 14th Oct 2014.

Anon. (2014). Liquidity Investors and Basel III. Available: http://www.jpmgloballiquidity.com/blobcontent/252/986/1323389800855_WP_GL_Liquidity_Investors_and

_Basel_III.pdf. Last accessed 14th Oct 2014.