Chapter 3: Impact of Regulatory Reforms on Large and Complex Financial Institutions

Aditya Narain, Inci Ötker, and Ceyla Pazarbasioglu
Published Date:
April 2012
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İnci Ötker-Robe and Ceyla Pazarbasioglu Alberto Buffa Di Perrero, Silvia Iorgova, Turgut KiŞinbay, Vanessa Le LeslÉ, Fabiana Melo, Jiri Podpiera, Noel Sacasa and AndrÉ Santos 


The recent crisis revealed the significant risks posed by large, complex, and interconnected institutions and the fault lines in the regulatory and oversight systems. During the past two decades preceding the crisis, banks in advanced countries significantly expanded in size and increased their outreach globally. In many cases, they moved away from the traditional banking model to become globally or regionally active large and complex financial institutions (LCFIs).2 The vast majority of cross-border finance was (and still is) intermediated by a handful of these institutions with growing interconnections within and across borders. Common trends before the recent crisis included a sharp rise in leverage, significant reliance on short-term wholesale funding, significant off-balance-sheet activities, maturity mismatches, and an increased share of revenues from complex products and trading activities. In some systemically important countries, regulatory ratios were not sensitive to the buildup of various risks and capital was inadequate or of insufficient quality to provide a buffer.

Significant reforms are being considered both internationally and domestically to rectify these deficiencies and failures in order to safeguard the stability of the financial system going forward. Their key objective is to promote a less leveraged, less risky (or better cushioned), and thus more resilient financial system that supports strong and sustainable economic growth. The bulk of the proposals have focused on revising the existing regulations applicable to banks and influencing the extent and consequences of their risk taking. These include enhancing the quality and quantity of capital and liquidity buffers, strengthening risk assessment, and enhancing the supervision and governance of financial institutions. Reforms are also being considered to reduce the systemic risk contribution of LCFIs. These initiatives include proposals to impose charges on systemically important LCFIs, to facilitate resolution of cross-border institutions, and to establish measures affecting the structure, organization, or scope of the activities of LCFIs. Work is also underway to design and calibrate specific macroprudential tools that will address procyclicality.

A key challenge for policymakers is to ensure that any changes in banks’ business strategies in response to tighter regulations do not result in a further buildup of systemic risks in the “shadows”; that is, either in unregulated sectors or in locations with less onerous regulatory standards. Important safeguards are therefore needed to mitigate such unintended consequences while also minimizing adverse effects on banks’ capacity to support the economic recovery.

This chapter aims to provide policy recommendations to mitigate these risks and is based on an analysis of a sample of LCFIs. Where data are publicly available, it provides a quantitative analysis of the effects of the proposals on LCFIs, assuming that their business models remain unchanged. It also provides a qualitative analysis of the impact on LCFIs’ business strategies and examines how different banking business models (commercial, investment, and universal) may react to, and be affected by, the regulations. The analysis uses publicly available data and focuses exclusively on implications for LCFIs and their business strategies. It therefore differs from the strictly confidential quantitative impact studies conducted by national authorities (unpublished, based on supervisory data) under the auspices of the Basel Committee on Banking Supervision (BCBS), as well as from other studies that aim to estimate the potential macroeconomic impact of proposed regulatory changes.3

This chapter is organized as follows. The second section, “Regulatory Reform Proposals: Background,” presents a brief overview of vulnerabilities that built up over the last couple of decades and the regulatory reforms that have been proposed to address them. The third section explores the likely effects of regulatory reform proposals on a sample of LCFIs and how different regions and banking business models (commercial, investment, and universal) may be affected by the regulations. The next section then analyzes qualitatively, based on extensive discussions with LCFIs and regulators, the likely impact of regulatory reform proposals on LCFIs’ business lines and the potential consequences of these changes for the financial system and the macroeconomy going forward. The chapter concludes with a discussion of policy implications and safeguards policymakers could put in place to limit unintended consequences for the soundness of the financial system and its ability to support sustainable economic growth.


The recent financial crisis revealed deep structural weaknesses in the global financial system, calling for substantial changes to the regulatory framework. This section presents a brief overview of the vulnerabilities that developed over the last couple of decades and the reforms that have been proposed to address them.

Weaknesses Leading Up to the Crisis

The financial landscape and the business models of financial institutions in advanced economies changed significantly in the run-up to the crisis. Financial institutions across the world, especially in advanced countries, evolved with particular intensity after 2000 in ways that made them more vulnerable to potential adverse shocks.

After 2000, LCFIs became larger, highly complex, and highly leveraged, and they relied increasingly on short-term wholesale funding (Figure 3.1). Lack of transparency and limited disclosure of the types and locations of risks made it difficult to assess the extent of exposures and potential spillovers. To lower costs, institutions switched from deposits to other funding sources, such as money market mutual funds, short-term commercial paper, and repos. The trading book in LCFI assets displaced loans as the most important asset group, reducing the importance of net interest income, and raising the share of trading assets in total assets (from 20 percent in 2000 to above 40 percent in 2008 for U.S., European and U.K. LCFIs). In most countries, regulatory ratios did not capture the buildup of risks, and capital was inadequate or of insufficient quality to provide a buffer.

Figure 3.1.Selected Financial Indicators Leading Up to the Crisis

Sources: Bloomberg LP; and IMF staff estimates.

Note: Financial leverage = the ratio of total assets to total common equity (not adjusted for differences in accounting rules); Tier 1 ratio = the ratio of Tier 1 capital to risk-weighted assets; TCE ratio = the ratio of tangible common equity to tangible assets; wholesale funding ratio = the ratio of nondeposit to total liabilities.

LCFIs also became heavily interconnected, facilitating propagation of the shocks across the system, domestically and globally. Cross-border interlinkages also increased and financial activity concentrated in a small, core set of LCFIs in the years before the crisis (Figure 3.2). In addition to the important links between (bank and nonbank) LCFIs through the funding side, asset-side interlinkages also grew due to increased sophistication and complexity of instruments, and their interconnectedness (IMF, 2010i).

Figure 3.2.Interconnectedness, Complexity, and Concentration of the Financial System

Sources: Bank for International Settlements; Bloomberg LP; Economist Intelligence Unit (EIU); U.S. Flow of Funds Accounts as of 2010:Q1 (Federal Reserve Board); Federal Reserve Board of New York.

1 Shadow banking liabilities include commercial paper, medium-term notes, asset-backed commercial paper, asset-backed securities, repurchase agreements, total return swaps, hybrid and repos/TRS conduits, ABS CDOs, ABS CDO-squareds, bonds, capital notes, and shadow bank “deposits.”

Financial intermediation increasingly shifted to, and became interconnected with, the nonbank (“shadow banking”) sector as a natural consequence of securitization (Figure 3.2). These relatively unregulated financial activities grew in large part to avoid the regulatory requirements affecting banks. This increased the distance between borrowers and the ultimate debt owners and reduced banks’ incentives to monitor and screen borrowers. At the same time, banks and shadow banks have remained interconnected through funding links and activities of bank affiliates in the shadow banking system.

The global financial crisis revealed that financial sector regulation, risk assessment, and resolution authority did not keep up with these changes.4 Regulations did not fully capture the set of risks banks were exposed to, particularly the market, liquidity, and funding risks, and the regulatory oversight framework was not sufficiently wide to capture the buildup of vulnerabilities in the shadow banking system. Many banks lacked adequate governance practices and risk management systems, and the supervisory framework was not effective in identifying and correcting these deficiencies. Efforts to resolve weak banks were hampered by the complexity and interconnectedness of the financial institutions, both domestically and across borders. Radical reforms were therefore needed to strengthen the stability and resilience of the global financial system and prevent the recurrence of a systemic crisis.


In its April 2009 declaration, the G-20 group of countries agreed on a set of reforms to strengthen the financial system (Appendix 3.1). The regulatory reforms have focused so far on improving the resilience of individual institutions and sectors. Regarding the banking sector, in late 2009 the BCBS provided guidelines and recommendations to improve the resilience of banks, some of which were agreed upon by September 2010 (BCBS, 2009a, 2009b, 2009c, 2009e, 2010b, 2010c; and BIS, 2010b, 2010e).

The key components of the BCBS proposals are: (i) higher amounts and better quality of capital (mostly common equity, with better loss absorption features); (ii) better risk recognition for market and counterparty risks; (iii) a non-risk-based leverage ratio as a backstop measure; (iv) tighter liquidity standards, including through a liquid asset buffer for short-term liquidity coverage and a longer-term stable funding requirement to limit maturity mismatches; and (v) capital conservation buffers.

The new capital standards are a substantial improvement in comparison with the precrisis situation. Common equity will represent a higher proportion of capital and thus allow for greater loss absorption. In particular, the required minimum will increase to 4.5 percent from the generally observed 2 percent under existing standards. This minimum will be complemented by an additional 2.5 percent capital conservation buffer, composed of fully loss absorbing capital (i.e., equity), which will restrict distributions in the form of dividends or bonus payments as banks approach the minimum (Table 3.1). The amount of intangible and qualified assets that can be included in capital will be limited to 15 percent (details are provided in Appendix 3.2).5 The implementation period is phased in from 2013, with a gradual introduction of the deductions from 2014, to reach a common equity target at 7 percent by 2019 (including the capital conservation buffer).

Table 3.1.BCBS Capital and Liquidity Standards(In percent; all dates are as of January 1)
Leverage ratioSupervisory

Parallel run 2013-17

Disclosure starts January 1, 2

to Pillar 1
Minimum common equity capital ratio3.
Capital conservation buffer0.6251.251.8752.50
Minimum common equity

plus capital conservation buffer
Phase-in deductions from

CETI (including amounts

exceeding the limit for DTAs,

MSRs, and financials)
Minimum Tier 1 capital4.
Minimum total capital8.
Minimum total capital plus conservation buffer8.
Capital instruments that no

longer qualify as noncore

Tier 1 capital or Tier 2 capital
Phased out over 10-year horizon beginning 2013
Liquidity coverage ratio (LCR)Observation period beginsMinimum standard introduced
Net Stable Funding Ratio

Observation period beginsMinimum


Source: Bank for International Settlements, 2010b.Note: CETI = Common Equity Tier 1 ratio; DTAs = deferred tax assets; MSRs = mortgage servicing rights.
Source: Bank for International Settlements, 2010b.Note: CETI = Common Equity Tier 1 ratio; DTAs = deferred tax assets; MSRs = mortgage servicing rights.

This increase in the level of capital comes on top of an increase in the capital requirements for trading book exposures, counterparty credit risk, and exposures to other financial institutions (BCBS, 2009c). Banks are expected to comply with the revised requirements for better risk recognition and capital coverage by end-2011. These changes are expected to reduce incentives for regulatory arbitrage between banking and trading books.

A leverage ratio of 3 percent will be introduced alongside current regulations on a trial basis starting in 2013, with implementation and migration to Pillar 1 to occur by 2018.6

Global liquidity standards are another key element of the regulatory reform. The Liquidity Coverage Ratio (LCR) aims to ensure that internationally active banks have up to 30 days of high-quality liquid assets to meet short-term institution-specific and systemic stresses and to guard against a run on a bank’s wholesale liabilities, including secured funding.7 It will be implemented in January 2015 after an observation period beginning in 2011. The Net Stable Funding Ratio (NSFR) is designed to promote longer-term funding of assets in times of stress to reduce banks’ dependence on volatile funding sources. It will become a minimum standard by January 2018, after an observation period starting in 2012 and further calibration of the underlying parameters (details are provided in Appendix 3.3).8

However, much less progress has been made overall in developing regulations with a macroprudential approach. These would be needed to dampen the tendency for financial institutions to behave procyclically and to properly account for the systemic risks posed by individual financial institutions, including nonbanks. The BCBS has requested comments on how best to compute countercyclical risk weights and, more generally, how to construct countercyclical capital charges. Table 3.2 lists various proposals under consideration for reducing the contribution of systemically important financial institutions (SIFIs) to systemic risk. Some countries (e.g., Switzerland, the United Kingdom, and the United States) are already implementing policies to address the risks posed by SIFIs.

Table 3.2.Measures to Reduce the Systemic Risk Contribution of SIFIs
Measures to reduce the probability and

impact of failure of SIFIs
• Capital and/or liquidity surcharges based on measure of

systemic importance
• More intense supervision of SIFIs
• Risk-based levies on noncore funding (based on systemic

risk contribution)
Measures to improve the capacity to

resolve SIFIs
• Living wills (resolution plans to map out how to safely

wind down institutions in case of failure)
• Financial stability contribution linked to a credible and

effective resolution scheme
• Special resolution schemes that give power to the

supervisors to break up banks
• Contingent capital and bail-in proposals—as means of

providing further going-concern loss absorbency and

reducing government bailouts
• Cross-border resolution frameworks and burden-sharing

• Subsidiarization/ring-fencing of domestic financial

institutions from cross-border risks (especially if the

previous option proves unviable)
Measures to strengthen the core

financial market infrastructure to reduce

• Requiring OTC derivatives to be traded through central

Structural measures• Narrow banking that would restrict deposit-taking institutions

to investing in a limited set of safe assets
• Other limits or restrictions on the size and/or scope of

banks (e.g., in the United States, the Volcker rule,

restrictions on derivative activities of banks)


This section provides an illustrative analysis of the impact of the new capital and liquidity requirements on a sample of LCFIs.9 The key objective is to explore how banks and their business strategies are affected by the proposed regulations given the structure of their main activities and business lines. The analysis covers the impact of the regulations on capital (definition and market risk) and liquidity requirements (NSFR). The potential implications of the Leverage Ratio and the LCR are not analyzed quantitatively due to a lack of access to detailed data required to estimate these ratios. The sample includes 20 countries with a total of 62 banks from three regions (15 from Asia, 33 from Europe, and 14 from North America), and three business models (34 commercial banks, 19 universal banks, and 9 investment banks).10,11 The sample banks account for more than $24 trillion of risk-weighted assets and more than $2.6 trillion of Tier 1 regulatory capital as of year-end 2009.12 Appendix 3.2 provides sample and definitional details.

Impact of the Capital Requirements

The underlying quality and comparability of the capital structure differ significantly across the sample LCFIs and countries. The total amount of assets with weak going-concern loss-absorbency characteristics is high on average, if compared to banks’ core Tier 1 capital, varying significantly across banks and countries.13 As of end-2009:

  • Such assets represent, on average, about 35 percent of banks’ core Tier 1 capital, ranging from 5 to 60 percent of core capital across countries.
  • European banks have the highest ratio of these assets (38 percent), followed by North American banks (33 percent), and Asian banks (32 percent), though with wide variations within each region.
  • By business models, universal banks with a range of different business lines have the highest average ratio (45 percent of total core Tier 1), followed by investment banks (32 percent), and commercial banks (26 percent).

According to the new standards, banks will be required to deduct most of such assets from the common equity component of capital, which will improve the quality of capital. Assets with low absorption capacity will be limited to 15 percent of core Tier 1 capital. Based on an analysis of the individual LCFIs, about 24 percent of core Tier 1 of the sample LCFIs, on average, will be eliminated from the definition of regulatory capital—a substantial strengthening of the quality of capital (Figure 3.3). The shares vary widely across countries, from less than 5 percent to more than 30 percent, reflecting banks’ business characteristics. For example, some banks have large investments in unconsolidated subsidiaries, reflecting a universal banking model, and others have large minority interests, reflecting sizable operations abroad. Universal banks that carry out a range of different business activities (subject to deductions for minority interests, insurance subsidiaries, and mortgage servicing rights) experience the largest deductions from capital (31 percent), compared with commercial and investment banks (17 percent and 21 percent, respectively).

Figure 3.3Implications of BCBS Proposals on Quality of Capital

Sources: Company reports; Fitch Database; and IMF staff estimates based on data for sample LCFIs.

If applied immediately, the proposed deductions would lower the core Tier 1 capital ratio of the average sample LCFI from 8.6 percent in 2009 to 6.7 percent, and, after incorporating changes in market risk provisions, to 5.8 percent (Figure 3.4). Investment banks are impacted the most by the regulation on market risk weights (given the significant share of trading and securitization in their business mix), followed by universal banks, which also carry out investment-bank-type activities (Figure 3.5). The effect on capital ratios from the two sources (capital definition and market risk) could be partially offset if banks retain the earnings that they can accumulate over the next few years until the start of implementation.

Figure 3.4Breakdown of the Impact of Various Deductions on Core Tier 1 Capital

Source: IMF staff estimates.

Note: RWA = risk-weighted assets.

Figure 3.5Adjusted Core Tier 1 Capital Ratios for Capital Definition and Rise in Risk-Weighted Assets

Sources: Company reports; Fitch Database; and IMF staff estimates based on data for sample LCFIs.

The dispersion of the likely impact of the Basel capital regulations across different regions and business mix suggests the following:

  • The new regulations would have the largest effect on European and North American banks overall, followed by Asian banks. In North America, the drop in core capital would reflect the significant impact of increased market risk-weighted assets, whereas in Europe the most significant impact would come from asset deductions (given the large concentration of universal banks with significant subsidiaries in the region and involvement in bank-insurance businesses).14
  • The proposals would more significantly affect the investment and universal banks, reducing the differences across core capital ratios for different business models (Figure 3.5). For the sample of banks, following the adjustments the core capital ratios of investment, universal, and commercial banks would fall from 9.9 percent, 8.8 percent, and 7.8 percent (respectively) to 7.0 percent, 6.2 percent, and 7.1 percent (respectively). Traditional commercial banks, with their simpler business focus, would be the least affected, whereas banks with significant investment banking activities would experience larger reductions, owing particularly to higher market risk-weighted assets. Universal banks would also be affected by a combination of increased risk weights associated with their trading business and deductions related to minority interests and insurance business.

The phased implementation of the BCBS proposals should allow most banks sufficient time to close the capital gap through earnings retention. BCBS has allowed for a gradual phase-in period to avoid the need for abrupt adjustments to banks’ balance sheets (see Table 3.1).15 During the first years of implementation, the new regulation would therefore have a minimal impact. The number of banks failing to meet the new target (including the 2.5 percent of capital conservation buffer) would reach about 10 by 2019 (Table 3.3). These estimates, however, are based on assumptions of relatively modest earnings growth and do not take into account the possibility that banks that expect to fall short of requirements could raise new capital or increase the proportion of earnings applied to building up capital.

Table 3.3.Impact of the Gradual Phase-In Period(All dates as of January 1 of respective year)
Number of Banks Below Minimum Common Equity Common Ratio (including Capital Conservation Buffer)
Without Retained

With Retained

Thresholds: Capital to Reach

Minimum Common Equity Cap

Ratio + Cap Conservation Buffer
Phase-In Deductions

from CET1
Note: Estimates with earnings at 50 percent of average 2004–07 earnings per bank; and earning retention rate at 60 percent.
Note: Estimates with earnings at 50 percent of average 2004–07 earnings per bank; and earning retention rate at 60 percent.

The capacity of banks to meet the capital requirements will thus depend on their starting level of capitalization and their ability to either rebuild capital through earnings retention or acquire fresh capital. Under a scenario of no earnings retention, the banks in the sample would require about $360 billion in additional capital to comply with the 7 percent core capital ratio. The number of banks failing to meet the 7 percent target would increase to 48 banks by 2019 under this scenario (see Table 3.3 and Figure 3.6).16,17 Universal banks would need the greatest amount of additional capital, whereas banks with significant investment banking activities would benefit from high starting capital levels following the recent rounds of capital raising.

Figure 3.6Banks Falling Below Basel Common Equity Ratio, Various Earnings Assumptions

Source: Company reports; Fitch Database; and IMF staff estimates based on data for sample LCFIs.

A number of messages can be drawn from the analysis:

  • Most banks in the sample should be able to meet the higher target mainly through earnings retention, provided a modest earnings outlook. As some banks have already done, banks can issue additional capital and/or reduce dividend payments to further build their capital buffers. Should banks generate good earnings in the coming years and distribute lower dividends, they could rebuild common equity capital ratios even faster than required under the current phase-in periods. This is important for increasing the banking sector’s resilience and, therefore, enabling it to absorb any potential shocks ahead.
  • An eventual phasing out of the permanent “15 percent allowance” for qualified and intangible assets might be considered to further enhance the quality and comparability of capital; first, however, a careful analysis would be needed of its implications for banks’ earnings and capital generation capacity.
  • These implications should be considered as part of the overall reform package, which includes other aspects of the Basel and other regulatory proposals (e.g., countercyclical buffers, systemic surcharges, and levies), as well as various national reform proposals that would also introduce additional capital requirements on banks.

Impact of the Liquidity proposals

Industry estimates, covering a limited set of U.S. and European banks, suggest that most banks would meet the LCR criteria, and for banks that do not yet meet the criteria, the liquidity gap may be limited and manageable (Table 3.4, panel 1). A comprehensive staff analysis of the impact of the LCR has proven difficult given the lack of publically disclosed information, particularly data on short-term cash flows. Using the ratio of Liquid Assets (cash plus government securities) to Total Assets as a proxy measure of liquidity coverage shows that Asian banks have the best short-term liquidity position, followed by European banks. The favorable position of Asian banks broadly reflects their simpler balance sheet structures, limited amount of complex securities, and stronger funding profile skewed toward deposits. Within these regions there is variation, with some countries having low ratios due to structural shortage of government securities. Across business models, commercial banks tend to have the lowest ratios, likely reflecting the duration of their loan portfolio.

Table 3.4.IMF and Analyst Estimates of the Impact of Liquidity ProposalsEffects of Basel III Regulatory Changes on the Liquidity Coverage Ratio in Large Global Banks
LCRLiquidity Gap (US$ billion)
RegionNumber of BanksDec. 2009 Prop.Jul. 2010 Amend.Dec. 2009 Prop.Jul. 2010 Amend.
JPMorgan February 17 and July 29
United States4148.1%189.5%$140$17
Effects of Basel III Regulatory Changes on the Net Stable Funding Ratio in Large Global Banks
NSFRFunding Gap (US$ billion)
RegionNumber of BanksDec. 2009 Prop.Jul. 2010 Amend.Dec. 2009 Prop.Jul. 2010 Amend.
North America14109.1%127.0%NA$72
JPMorgan February 17 and July 29
United States4133.0%139.6%$0$0
MS January 27
CS May 14
Barclays June 1
HSBC July 27
Sources: Various analysts’ reports; and IMF staff estimates based on sample LCFIs.
Sources: Various analysts’ reports; and IMF staff estimates based on sample LCFIs.

An illustrative analysis of the impact of NSFR on the sample of LCFIs suggests a wide variation in banks’ ability to meet the required 100 percent level (see Figure 3.7 and Appendix 3.3 for a description of the methodology). European banks would be most affected by the NSFR requirement, in part reflecting greater reliance on wholesale funding and high loan-to-deposit ratios (Figure 3.8). Most North American banks and some Asian banks already meet the 100 percent NSFR criterion. The average NSFR is 89 percent for European banks, 112 percent for Asian banks, and 127 percent for North American banks, compared to the 100 percent requirement under the Basel proposals. Compared to other banks in the sample, North American banks, on average, have a high share of securities on the asset side and an above-average share of deposits.

Figure 3.7.Estimates of NSFR across Geographies and Business Models (in percent)

Sources: Bankscope; and IMF staff estimates based on data for sample LCFIs.

Note: The diamonds represent the minimum, median, and maximum values, respectively, for each bar.

Figure 3.8NSFR vs. Loan-to-Deposit Ratio and Share of Wholesale Funding

Sources: Bankscope; and IMF staff estimates based on data for sample LCFIs.

The regional aggregation masks the variation within the regions. In Europe, a majority of the sample banks does not meet the 100 percent criteria, but some banks have much lower ratios than others, for example those with large amounts of long-term lending on the asset side of their balance sheets and high dependence on wholesale funding. A similar structure is observed in some Asian banks that have a high share of wholesale funding to finance long-term assets.

To improve their funding profiles and meet the NSFR requirement, banks could change their funding mix, by issuing term funding and/or raising more customer deposits and/or they could reduce their assets. It is likely that banks will adopt a combination of the three options in meeting the requirements. Changing the maturity structure toward long-term debt will require banks to pay the term premium. Attempts to fill the funding shortfall with deposits would be a challenge given competition in local deposit markets and difficulties associated with building branch networks. Shrinking assets may be costly in terms of foregone market share and profitability. The ultimate choice of the funding mix will likely depend on individual circumstances and ongoing market conditions.

Going forward, some banks may face challenges in meeting the new regulatory requirements as market conditions change.

Increase in Funding Costs

Globally active banks need to roll over a large amount of debt in the coming years. The IMF estimates that nearly $4 trillion of bank debt is due to mature in the next 24 months (IMF, 2010e), which is likely to put upward pressure on borrowing costs for banks, thereby making it costlier to issue term debt. Furthermore, part of the debt maturing in the coming years is government-guaranteed and will likely be refinanced at a higher cost as authorities wind down monetary policy support measures. Finally, banks’ refinancing and balance sheet restructuring efforts could face competition from heavy government and corporate debt issuance.

Structural Shift in Funding Patterns and Higher Cost of Issuance

A more robust regulatory framework coupled with stronger capitalization should lead to a lower risk premium for debt issuance. However, increased burden sharing of losses with bondholders (e.g., due to private-sector involvement in burden sharing via instruments that convert debt to equity) may be associated with a higher cost of debt, as the severity and probability of losses increase (BCBS, 2010e). If senior bondholders are impacted by the final regulation, banks may either have to pay a greater premium to investors or face increased competition for deposits.

Risk Management

Banks, particularly those that are globally active, may face additional funding challenges if tighter liquidity requirements lead to a greater tendency toward decentralized operations and limit their ability to move excess liquidity within banking groups. Also, in jurisdictions where banks manage their liquidity risks by holding liquid assets other than government bonds, their liquidity risk profiles may be affected by the LCR, which treats such assets less favorably than government securities, although some arrangements are being considered for countries where banks face structural constraints in meeting the minimum LCR given low government debt. Finally, increased holdings of government securities to meet the LCR target may raise challenges in an environment of increased sovereign risk.


The new Basel package is not “business model neutral” and, as intended, will have a greater direct impact on investment banking activities. The final proposal, with a long phase-in period for capital and a deferred introduction of the liquidity ratios, should allow for a smoother implementation of the tighter rules, put less pressure on banks’ ability to do maturity transformation, and reduce the calls for substantial deleveraging or passing the associated higher cost of funding on to customers. Meeting the requirements of the Basel package will, therefore, be relatively less difficult for banks that focus on commercial banking activities, providing them with more time to adjust. In contrast, banks’ derivatives, trading, and securitization activities, which will be subject to tighter capital requirements from end-2011, will be more costly under the Basel requirements, as intended, ensuring a better reflection of the associated risks by the liquidity and capital requirements.18

Investment banking activities will also be affected by a host of other regulatory initiatives in addition to the Basel requirements, which will add to the need for higher capital (Figure 3.9):

  • Securitization—The securitization business is affected by the new accounting rules, which require originators to consolidate some securitized transactions onto bank balance sheets, and by reforms that reduce issuer incentives to securitize (e.g., the 5 percent risk retention rule for originators to maintain “skin in the game”). Combined with higher Basel risk weights, these reforms are expected to limit the profitability of and incentives for riskier securitization business.
  • Derivatives—Similarly, the derivatives business will also be more affected by various global proposals (e.g., exchange trading and CCP clearing of OTC derivatives) and national initiatives (e.g., pushing banks’ derivatives business to separately capitalized nonbank subsidiaries, as envisaged in the U.S. Dodd-Frank Act). These regulations will affect the investment and universal banks most active in derivatives business, while attempting to limit adverse effects on legitimate transactions (e.g., hedging) through various exemptions.
  • Trading—Finally, the cost and profitability of the trading business are also affected by higher Basel risk weights for the trading book, as well as by various global and national proposals (including, for example, the Volcker Rule, which limits proprietary trading and investment in, or sponsorship of, private equity and hedge funds [see Box 3.1], and market infrastructure reforms that regulate OTC derivatives trading).

Figure 3.9Various Regulatory Proposals Affecting Investment Banking Activities

The regulatory reforms also affect banks with a universal banking focus; that is, those carrying out an array of activities ranging from retail banking to insurance, leasing, and investment banking. Banking groups undertaking a combination of commercial and investment banking activities will be affected by various other reform measures (e.g., those that propose to break up banks or prohibit certain activities). Although limiting these activities may not be costly from an economic point of view, the reduced ability to benefit from diversification and compensate low-margin activities with investment income could reduce banks’ ability to generate retained earnings and their resilience to adverse economic shocks.

Groups undertaking insurance and banking business under one roof (the bancassurance model in Europe) could also be pressured by the combined impact of the Basel rules and Solvency II,19 which is likely to lower the capital benefits associated with this model—an intended consequence of the reform measures. Partial recognition of insurance participation in common equity may serve to smooth out the real sector implications for banking systems that are heavily reliant on the bancassurance model.

Box 3.1Potential Implications for U.S. Banks of Selected Provisions in the Dodd-Frank Act

The Volcker Rule, an important component of the U.S. Dodd-Frank Act (passed in June 2010), may have implications for the riskier investment banking business. The rule imposes a ban on proprietary trading and a curb on sponsoring or investing in private equity, hedge funds, and other alternative investment funds, subject to certain transition periods and exemptions. It also contains provisions related to derivatives clearing, trading, margins, and infrastructure. The ban on proprietary trading will affect banks with significant investment banking activities, assuming a narrow definition of proprietary trading in the supplementing regulations. The curb on sponsoring or investing in private equity, hedge funds, and other alternative investment funds and the other provisions related to derivatives would also have a strong impact on such banks’ revenues if supplementing regulations are restrictive. However, LCFIs may reorganize their business activities in response (for example by locating businesses in their asset management companies or to hedge funds). Thus it is too early to judge the overall impact of the new rules. The Dodd-Frank Act will affect not only U.S. banking institutions but also foreign banks’ affiliates in the United States that are organized as bank holding companies (or subsidiaries of foreign banks), especially those with investment banking activities.

The impact of the ban on proprietary trading on U.S. and foreign banks’ profitability will depend on the stringency of its implementation. For U.S. banks, as the figure below illustrates, in 2009 total investment banking revenues—comprising trading and investment income revenues—represented 57 percent and 12 percent of gross revenues in investment and universal banks, respectively, while commercial banks relied much less on investment banking revenues, which represented only 7 percent of gross revenues. If 10 percent of total investment banking revenues consists of proprietary trading revenues in all U.S. banks, as estimated by bank analysts, the restriction on proprietary trading would affect mostly investment and universal banks.

The curb on sponsoring or investing in private equity, hedge funds, and other alternative investment funds may have an impact on investment bank revenues by capping bank exposures to such activities. U.S. banks cannot have more than 3 percent of the fund’s equity after its inception. Moreover, U.S. banks cannot hold more than 3 percent of their Tier 1 capital in investments in private equity and hedge funds. The disclosure of U.S. banks’ principal investments in annual reports, shown in the figure below, indicates that investment banks are over the 3 percent aggregate cap of Tier 1 capital by a very large extent, whereas universal and commercial banks are closer, implying that the loss of revenues from alternative investments will be much more pronounced for banks with significant investment banking activities compared with other banks.

Other provisions in the Dodd-Frank Act involving derivatives activities may also add some pressure on investment banking revenues and limit the leverage embedded in derivatives (in particular, provisions requiring mandatory margins for uncleared swaps, mandatory clearing and trading of elegible standardized swaps, registration, and regulation of swap market participants and facilities). At end-2009, revenues from trading in fixed income, exchange rate, commodities, and credit instruments (FICC) amounted to 39 percent of gross revenues in investment banks and a smaller percentage in universal and commercial banks. Because part of FICC revenues corresponds to OTC derivatives trading in swap instruments, the requirements above will initially have a negative impact on investment banking. However, as swap markets become more liquid and bid-ask spreads become tighter, the loss of revenues may be offset by larger trading volumes in swap instruments.

Source: Banks’ annual reports and staff analysis.

Globalized banks with a diversified set of business lines may also be affected by other structural reform initiatives, including stand-alone subsidiarization and living wills.20 By establishing effective firewalls between various parts of a banking group, stand-alone subsidiarization could affect the group’s ability to manage liquidity and capital, reducing its capacity to serve large customers and sustain a diversified corporate structure; this may affect more global banks that follow a centralized business model, compared with banks that follow a retail-oriented business model and are more decentralized (see Chapter 11). While encouraging a more streamlined corporate structure, living wills may limit the diversification benefits of groups with different business lines.

Ultimately, the impact of the reforms on LCFIs will depend on the flexibility of their business models and how they adjust to the changes. Banks with limited flexibility on the asset side of their balance sheets and with less diversified sources of earnings may have a harder time adjusting to the new regulatory environment. By contrast, banks with a major investment banking focus may be able to restructure their activities to reduce the effects of the regulatory reforms, notwithstanding a multitude of regulations affecting their activities. With their flexible balance sheet structures, they can capture the most profitable segments to generate robust cash flows and earnings, buy or sell assets with relative ease, shift their operations rapidly, and manage capital by shrinking assets and repositioning them away from the most capital-intensive activities.

Such adjustments in banks’ business strategies could have unintended consequences that could potentially increase systemic risk. Some activities may move toward the less regulated shadow banking sector21 as the regulatory cost to banks to undertake such activities increases (e.g., certain types of loans, leases, trading, and derivatives).22 However, there is the possibility that the risk to the banking system would remain given the interconnectedness of banks with nonbank entities through the funding relationships and their nonbank subsidiaries. Although supervision could help contain these vulnerabilities, its ability may be limited without a widening of the regulatory perimeter.

Moreover, absent careful global coordination of the implementation of stricter rules, some businesses may be prompted to move to locations with weaker regulatory frameworks. In some countries, the slow progress in reaching international consensus, combined with domestic policy concerns, have resulted in the adoption of national regulatory reform packages (e.g., taxation and compensation regimes in Europe and the U.S. Dodd-Frank Act). Lack of coordination of reform actions may encourage global banks that are active in various jurisdictions to consider moving their activities to minimize regulatory costs, affecting, in turn, the capacity to monitor and manage systemic risks.23


The current BCBS proposals on capital requirements represent a substantial improvement in the quality, quantity, and comparability of bank capital. Illustrative calculations suggest that most banks can meet the more stringent capital requirements through earnings retention, provided a modest earnings outlook. As the global financial system stabilizes and the world economic recovery is firmly entrenched, there may be room to phase out intangible and qualified assets completely and scale back the transition period (both subject to a careful impact analysis of the possible implications). This would further increase the banking sector’s resilience so that it can better absorb any shocks that may lie ahead, while limiting incentives to take excessive risks in the interim. The implications of these reforms, nonetheless, need to be considered as part of the overall package, including other aspects of the Basel proposals (e.g., countercyclical buffers), as well as other ongoing reform proposals that could introduce additional costs to banks. Careful assessments of the cumulative and joint impact of the overall reform package need to be conducted.

Going forward, some banks may face challenges in meeting the liquidity requirements in the current global environment. Although for most banks the adjustment may be manageable, given that implementation will take place over a number of years, a number of factors may put pressure on funding costs, including funding pressures from a large amount of debt coming due in a few years, higher interest rates as authorities wind down monetary policy support measures, and competition from government debt issuance.

A key challenge for policymakers is to ensure that potential adjustments in business strategies to the tighter capital and liquidity requirements do not generate systemic risks. Overall, the new rules are more stringent on the investment banking business. Although this is intended, it is likely that, to create cushions appropriate to the risks taken, banks with a major focus on such activities may shift some activities to the unregulated shadow banking sector or move their businesses to jurisdictions with less onerous regulatory requirements.

These factors argue for a number of safeguards to ensure that recent reforms are consistent with the objective of mitigating systemic risk:

  • There is a continuing need for policymakers to restructure or resolve weak banks. To strengthen the banking system’s resilience to shocks and turn it again into an engine of global growth, policymakers need to ensure that banks are well capitalized, have access to stable funding, and can earn self-sustaining profits on core activities. This will require pursuing orderly and globally consistent regulatory reform; making progress in designing regulations with a macro-prudential focus; and strengthening oversight of the financial system.
  • Supervision needs to be more intensive to prevent a new cycle of leveraging and excessive risk taking. This is particularly important during the period before banks fully build up their liquidity and capital buffers. Supervision needs to be proactive to identify and monitor systemic risks with due attention to understanding the business models and risks assumed by LCFIs.
  • The regulatory perimeter needs to be widened. Such widening should permit effective monitoring of the risks that banks and nonbank institutions may undertake, regulation of all systemically important institutions that conduct banking activities, and close monitoring of markets and instruments used by financial institutions. This will need to be accompanied by a strengthening of the market infrastructure (including through well-managed CCPs) and of the risk management capacity of financial institutions. Also, regulation and oversight need to take into account not just the safety and soundness of individual institutions but the risks they pose to the system as a whole.
  • The need for coordination of policies, as well as of their implementation, is greater than ever. Given the global reach of markets and institutions, effective coordination among national authorities and standard-setting bodies will be critical. This will be needed to maintain level playing fields and contain regulatory arbitrage and to ensure that the cumulative impact of various regulatory initiatives does not stifle financial innovation and growth.
  • Finally, agreement on cross-border resolution regimes should be a top priority. Despite the very positive steps that are being considered to strengthen LCFIs, future failures are inevitable. The BCBS and FSB are developing proposals to address the resolution of “too important to fail” institutions, and an enhanced cross-border coordination framework for resolution has been proposed by the IMF (2010g). Early steps should be taken to make these latter proposals operational among a small set of countries that are home to most cross-border financial institutions. The complexity of reaching agreement on effective frameworks for resolving cross-border institutions means that moving forward on these issues will require political commitment at the highest levels.
Table 3.5.Various Regulatory Initiatives, Objectives, and Instruments to Achieve Them
Reducing Probability of Default of Individual BanksReducing Systemic Loss, Given Default or Loss at Individual BanksReducing Unexpected Systemic Losses through Structural Measures
Microprudential:Objectives• Make all banks more resilient to idiosyncratic risks• To the extent that all banks are more• Make all banks more resilient to
Addressing idiosyncratic risks• Improve incentives for prudent risk management at all banksresilient to idiosyncratic risks, the potential for stress or failure of one bank to cause multiplicative losses toidiosyncratic risks
the rest of the system is reduced
Instruments• Better quality of capital• (Measures in column on the left)• Narrow banks
• Better risk recognition• Limit size/scope of banks
• Higher minimum risk-based CAR(Volcker Rule, Lincoln
• Non-risk-based leverage ratioamendment)
• Robust liquid assets buffer (LCR)• Ring-fencing at national level
• Limits (NSFR)/levies on volatile funding
• Other direct limits on risk exposures
• Intensive, proactive, discretionary supervision (Pillar 2)
Macroprudential:Objectives‘ Recognize, earlier in the cycle, expected losses and risks building• Limit the buildup of systemic• Limit banks’scope for
Addressing timeup in good timesvulnerabilities and contagioncontributing to financial system
dimension of• Limit effective leveragechannels (e.g., leverage, complexity,procyclicality
systemic risk• Dampen swings in leverage and maturity mismatch over the cycleinterconnectedness) in upswings
(procyclicality)• Reduce incentives for exuberant lending and excessive
maturity mismatch in upswings
Instruments• Microprudential measures (see above)• Measures in column on the left that• Narrow banks
• Forward-looking provisions on loans, valuation reserves onlimit the buildup of effective leverage• Limit size/scope of banks
marked-to-market assetsand/or maturity mismatches in(Volcker rule, Lincoln
• Limits on LTV, minimum haircuts on collateralupswingsamendment)
• Reduced procyclicality of Basel II capital requirements• Intensive, proactive, discretionary super-• Ring-fencing at national level
• Capital conservation rulesvision (Pillar 2)• Intensive, proactive, discretionary
• Countercyclical capital bufferssupervision (Pillar 2)
• Limits (NSFR)/levies on volatile funding
• Intensive, proactive, discretionary supervision (Pillar 2)
Reducing Systemic Loss, Given DefaultReducing Unexpected Systemic Losses
Reducing Probability of Default of Individual Banksor Loss at Individual Banksthrough Structural Measures
Macroprudential:Objectives• Make SIFIs more resilient to idiosyncratic risk• Limit contagion channels across the• Limit banks’scope for becoming
Addressing• Internalize externalities created by SIFIs (reduce implicit subsidy)system: complexity, interconnectednesstoo big, too complex, or too
cross-sectional• Improve incentives for prudent risk management at SIFIs and• Improve the resolvability of SIFIs.interconnected to fail
dimension ofto lower spillover effects• Lower the probability of key providers• Limit banks’scope for generating
systemic riskof interbankfunds hoarding liquiditynegative spillovers
[network risk)• Provide incentives to lower spillover effects and for more robust funding networks
Instruments• Capital/liquidity surcharges based on systemic riskiness/• Limits (NSFR)/levies on volatile funding• Force OTC derivatives to be
nonresolvability• Other measures (in column on the left)traded through central
• More intensive supervision of SIFIsthat limit the buildup of leveragecounterparties
• Contingent capital requirements• Living wills• Limit size/scope of banks (Volcker
• Going-concern bail-in of creditors• Adequate resolution powers (includingRule, Lincoln amendment)
• Intensive, proactive, discretionary supervision (Pillar 2)to break up SIFIs during resolution)

• Power to break up SIFIs in normal times

• Cross-border resolution frameworks

• Burden-sharing arrangements

• Subsidiarization

Intensive, proactive, discretionary supervision (Pillar 2)
• Ring-fencing at national level

Intensive, proactive, discretionary supervision (Pillar 2)

Scope and Limitations of the Analysis

The scope of the analysis is to explore the overall impact of the new BCBS capital standards for a representative group of LCFIs. The analysis is based on an array of assumptions that seek to address the lack of sufficiently detailed publicly available data on the various components of banks’ capital bases, and attempts to be as realistic as possible, basing most of the assumptions on market evidence and taking into consideration regulatory specificities. However, given the lack of access to granular country-specific data on a consistent basis, a standard set of assumptions common to all banks is used where needed. Because the exercise focuses only on a limited number of banks for each country, the results should not be taken as representative of a country’s banking system.

Furthermore, due to a lack of publicly available data, the analysis does not take into consideration the full array of the new elements introduced by the BCBS regulatory standards. Notably, defined pension assets and other minor items could not be deducted from capital, given the lack of sufficient data. Likewise, the increase in risk-weighted assets from future counterparty credit risk requirements could not be simulated.


The analysis covers a sample of 62 banks, with appropriate representation by business model and by geography. As of year-end 2009, these banks held more than $2,400 billion in total risk-weighted assets, and more than $2.6 billion in Tier 1 equity. Banks have been clustered as follows:

  • By geography: 15 Asian banks, 33 European banks, and 14 North American banks. Mapping has been based on banking groups’ country of residency: Asia (Australia, China, India, Japan, and Korea); Europe (Austria, Belgium, France, Germany, Greece, Italy, Nordics [Sweden, Denmark, Norway], Portugal, Spain, Switzerland, United Kingdom); and North America (United States and Canada).
  • By business model: 34 commercial banks, 19 universal banks, and 9 investment banks. Mapping has been based on banking groups’ principal activity (for commercial banks: lending activity; for universal banks: an array of lending, insurance, and other services; for investment banks: trading activity/advisory/asset management services) (see Figure 3.10, which confirms such categorization).

Figure 3.10Composition of LCFI Revenues

(in percent)

Sources: Bloomberg LP; and IMF staff calculations.

For each bank, a “Basel III Core Ratio” is estimated following the proposed new BCBS rules on capital deductions and on market risk framework (BCBS, 2009c, 2009d). As a starting point, as a best approximation to the BCBS’ concept of “Common Equity Capital Ratio,” banks’ published “Core Tier 1 Ratio” was taken (Box 3.2).

As far as market risk-weighted assets are concerned, the analysis follows the BCBS indication that “market risk capital requirements will increase by an estimated average of three to four times for large internationally active banks,” and increases them by three times, bank by bank.

As far as capital deductions are concerned, the new BCBS rules are applied by deducting, from each bank’s core Tier 1 ratio (data as of end-200924), the following items: minority interests, net deferred tax assets, investments in unconsolidated subsidiaries (including the insurance business), mortgage servicing assets (for U.S. banks), and residual intangibles. We try to take into account the cases where such items are already deducted from capital based on common regulatory practices—whether from Tier 1 capital or from a combination of Tier 2 and Tier 1 capital.25 Also, partial recognition is allowed into core capital of certain items, in line with the BCBS amendments published July 2010 (see Box 3.3). The phase-in timetable announced by BCBS in September 2010 has been used to compute the new ratios (Table 3.6).

Box 3.2Methodology in a Snapshot: From Current Core Tier 1 Ratio to Revised Basel Core Ratio

For each year of the phase-in period, the expected retained earnings are included in each banks’ core capital ratio. To this end, given the average of what banks earned in the four years prior to the crisis (2004-07), different percentages have been used in terms of earnings performance (e.g., if banks earn on average 30 percent of what they earned in the 2004–07 period). Earnings retention is assumed to be at 60 percent of net income.

Box 3.3Definition of Items Subject to Change in July 2010 Revisions

Under the new Basel requirements, the definition of capital will contain only a limited number of certain intangibles and qualified assets. The assets and the corresponding equity components with a low absorption capacity include goodwill (representing the amount a bank has paid or would pay over book value to acquire another bank); minority interests (representing partial ownership of a part of the banking group by outside parties); investments in unconsolidated subsidiaries (including other financial institutions); the value of deferred tax assets (DTAs) arising from time differences or loss carry-forwards; mortgage servicing rights (MSRs, representing income related to servicing mortgages that banks have originated and sold to third parties); and other intangible assets. The following items are subject to partial recognition:

Minority Interests—The book value of third-party shareholdings in consolidated subsidiaries within a group. As specified in the July 2010 announcement, banks are required to deduct the subsidiary’s capital that is in excess of the required minimum, taking into account the respective minority shares of each subsidiary.

Deferred Tax Assets (DTAs)—DTAs represent the difference between current tax charges or credits recognized by tax authorities and total taxes recorded in financial statements.

DTAs usually relate only to timing differences between financial reporting and tax recognition of specific assets or liabilities, often related to unrealized gains and losses that may not crystallize in a stress scenario. DTAs can also relate to annual losses carried forward to offset against future taxable income of the bank or its subsidiaries to reduce the tax charge. DTAs relating to losses carried forward are dependent on the bank or its subsidiaries making future annual profits, so may not be available to absorb losses in stressed conditions. Under the July 2010 proposals, banks could recognize up to 10 percent of DTAs arising from timing differences as core capital (also capped at 15 percent for the aggregate of DTAs, MSRs, and significant investments in common shares of unconsolidated financial institutions). The deductions are limited only to tax losses that are carried forward, while excluding DTAs that arise from timing differences up to a limit.

Mortgage servicing rights (MSRs)—MSRs refer to income related to the servicing of mortgages that banks have originated and sold to third parties. Historically, MSRs tended to make relatively good quality capital given that MSRs’ value is tightly linked to the present value of the expected net future cash flows of servicing assets, and that there is an active market for trading MSRs. However, high concentrations of MSRs in the capital base of some banks prompted their deduction from core capital. Under the July 2010 amendment, banks could recognize up to 10 percent of MSRs, capped at 15 percent for the aggregate of DTAs, MSRs, and significant investments in common shares of unconsolidated financial institutions.

Significant investments in common shares of unconsolidated financial institutions—Such investments, similar to the MSRs, are also subject to deduction, aimed at limiting a group from having both a bank and an insurance company under one corporate roof. Such ownerships have been motivated by assumed capital benefits of banks’ owning insurers based on presumed risk diversification benefits, whereas the crisis has shown that risks to which banks and insurers are exposed were highly correlated. Under the July specifications, in line with treatment for MSRs, banks can also count up to 10 percent of significant investments in common shares of unconsolidated financial institutions.

Table 3.6Basel III Capital Phase-in Arrangements—as Proposed by BCBs (All dates as of January 1, of respective year, percent)
Leverage RatioMinimum

Common Equity

Cap Ratio


Minimum Common Equity

Cap Ratio + Capital

Conservation Buffer


from CET1
2013Supervisory Monitoring3.503.500
Parallel Run
2015(Jan 1, 2013-Jan 1, 2017)4.504.5040
2016Disclosure starts4.500.6255.12560
Jan 1, 2015
2019Migration to Pillar 14.502.507.00100

The net stable funding ratio (NSFR) is a ratio of available to required stable funding. The available stable funding (ASF) is a weighted sum of funding sources according to their stability features. Similarly, the required stable funding (RSF) is a weighted sum of uses of funding sources according to their liquidity. To calculate the required amount of stable funding, specific RSF factors would be applied to the assets and off-balance-sheet activity (or potential liquidity exposure). The RSF factor represents the proportion of the exposure that should be backed by stable funding: the more liquid the asset, the lower the RSF factor. The table below provides a summary of definitions and coefficients defined by the Basel proposal and those used in calculating the NSFR.

Basel ProposalDecember 2009July 2010Used in NDFR CalculationsDecember 2009July 2010
Available Stable FundingAvailability FactorAvailable Stable FundingAvailability Factor
Tier I100%Equity100%
Tier II100%Subordinated debt and hybrid capital100%
Stable deposits of retail and small business customers (residual maturity <1 year)85%90%Demand deposits77.5%85%
Less stable deposits of retail and small business customers (residual maturity <1 year)70%80%
Wholesale funding by non-financials (residual maturity < 1 year)50%Bank deposits50%
Other preferred shares, capital instruments in excess of Tier II and other liabilities with maturity >1 year100%Saving deposits100%
All other liabilities and equity not included above0%Residual funding40%
Required Stable FundingRequired FactorRequired Stable FundingRequired Factor
Securities and non-renewable loans to financials with remaining maturity <1 year; short-term actively traded instruments0%
Debt issued or guaranteed by sovereign and IFIs5%Government securities5%
Unencumbered nonfinancial senior unsecured corporate bonds rated at least AA, maturity ≥1 year20%Investment securities20%
Unencumbered listed equity securities or nonfinancial senior unsecured corporate bonds rated at least A—, maturity ≥1 year; loans to nonfinancial corporate clients, maturity < 1 year; gold50%Equity investment50%
Retail loans, maturity <1 year85%Customer loans, maturity < 1 year85%
All other assets100%Customer loans, maturity < 1 year100%75%
Residual assets180%
Off-balance-sheet exposures10%5%Contingent liabilities10%5%
Sources: Basel Committee on Banking Supervision, 2009b, 2010c; and IMF staff assumptions.
Sources: Basel Committee on Banking Supervision, 2009b, 2010c; and IMF staff assumptions.
Table 3.7.The Potential Impact of Regulatory Initiatives on Business Models: Industry Views
MeasureBusiness Model Impact
Basel Measures
Capital Definition• In general, tighter capital definition is expected to lead to a scaling down or
shift out of the activities that are more capital intensive (hence expensive).
• Deduction of minority interests: could reduce involvement of foreign global
banks in emerging markets.
• Deduction of investment in insurance subsidiaries: would affect the integrated
bancassurance model and could induce banks to separate their insurance
business from the banking group, possibly reducing synergies.
• Deduction of participations in other financial institutions: may discourage
holding stakes in other financial institutions, market making, and underwriting.
• Deduction of mortgage servicing rights: may affect mortgage lenders, raise
mortgage rates, and discourage securitization.
• Deduction of pension liabilities: would penalize banks with large pension
• Higher capital needs resulting from tighter regulations: could induce banks to
pass on the cost to customers (raising lending/product rates), and reduce
balance sheet size (including through cut back in lending). Banks attempt to
shift focus from highly capital-intensive activities toward less capital-intensive
business that is attractive from risk-return point of view.
Leverage Ratio• If leverage ratio is binding, it may cause further deleveraging and lead to
further cuts in lending as banks shrink their balance sheet size.
• May encourage banks to shift to more risky activities to compensate for
lower profitability from shrinking asset size, given the lack of risk sensitivity
of the measure. Banks may also only keep high quality assets and very risky
assets to boost returns, and nothing in between.
Liquidity Coverage• May induce banks to reduce lending so as to hold more liquid assets eligible
Ratio (LCR)for LCR (mainly government securities).
• Like capital, would push banks to hold more liquid assets whose returns are
lower and affect profitability.
• May lead to greater tendency toward decentralized operations in local jurisdictions that trap pools of liquidity and limit global banks’ ability to move excess
liquidity across borders within a banking group—switch from more integrated
centralized business models toward decentralized stand-alone banking models.
Net Stable Funding• Limit banks’ ability to do maturity transformation—a core function of
Ratio (NSFR)banks—hence a major shift in their business models, with corporate sector or
other nonbank actors doing maturity transformation outside the banking
• May hurt retail banking, reducing capacity to lend to the private sector
(for households and firms) to meet the longer-term funding requirements.
• Increased competition for customer deposits may reduce the stability of
deposits as depositors could be tempted to “shop around” to get the best rates.
Counterparty risk• Reduce banks’ interactions with each other and market-making.
regulations• If not calibrated appropriately, may adversely affect derivative business and
Higher risk weights for• Reduce business in certain trading activities with complex structures toward
trading and formore traditional banking activities.
securitized products• Potential reduction in ability of large trading firms to facilitate deep, liquid
(July 2009)markets and provide hedging tools.
• Possible delay in rehabilitation of securitization markets.
•Structural Reform Initiatives
Measures on the size• Impact banks that have large trading (and proprietary trading) activities, and
and scope of banksponsorship/investment in hedge and equity funds.
activities• Risk of shifting trading activity to unregulated nonbanks.
(Volcker Rule of the• Shrink banks’ proprietary trading books and their stakes in hedge funds and
Dodd-Frank Act)private equity.
Derivatives spin off to• Affect the business models of investment and global banks most active in
separately capitalizedderivatives business (including on European banks operating under a BHC
subsidiariesstructure in the United States); while the final bill is less onerous than initially,
(Lincoln Amendmentit may drive the activity into less regulated nonbank institutions or foreign
of Dodd-Frank Act)peers (level playing field concerns with respect to foreign peers and nonbank
financial institutions).
• U.S. LCFIs would become less competitive vis-à-vis European banks because
the latter will continue to have the economies of scale (i.e., OTC netting with
other parts of their franchise) and continue with under-collateralization in
OTC products.
• Derivatives business would become more costly for banks (if it results in banks
having to “spin off” clients’ OTC books to a sub, and keep a book for their own
OTC trades, this would create firewalls between the two books, raising
collateral costs sizably).
• May introduce implementation hurdles (intragroup transfers, unwinding of
existing contracts, capitalization of subs), though in its final form existing
swaps are grandfathered over a two-year phase-in period.
• Would hinder hedging/risk management activities by banks and their customers.
OTC derivatives to• Impact investment and global banks with the largest share in derivatives business.
CCPs• High capital impact for collateral (initial and variation margin) and higher
charges for nonstandard derivatives contracts would increase the cost of
derivatives business, potentially causing banks to shrink such business and
nonbank institutions to pick it up.
• May create competitiveness considerations in the derivatives market.
Systemic surcharge• Possible for the market to interpret it as an indicator of TBTF and reinforce
implicit state support.
• May discourage business models that seek to take advantage of efficiencies
of scale or scope.
Levy on noncore• Discourage noncore funding models and create disincentives for being a SIFI.
funding based on• International consistency and level playing field considerations (may be
contribution toimportant when there is no coordination among national regulators).
systemic risk• Risk of double taxation in different jurisdictions (when there is no coordination).
• Could result in efficiency losses associated with economies of scale.
Living wills• May ease winding down by creating simple bank structures but risk losing
diversification benefits.
MeasureBusiness Model Impact
Stand-alone• Implications for global banking group structure and universal model and the
subsidiarizationsingle passport regime in Europe.
• Would reduce ability to manage risk with liquidity/capital trapped locally—
a significant change for global integrated centralized business model.
• Constraints on the ability to move capital and liquidity limit ability to serve
large customers, affecting the business models of large global banks.
• Greater cost for global banks with substantial operations in regions with
structurally higher wholesale funding requirements; if a greater proportion of
capital has to be raised at the local subsidiary level, overall funding costs are
likely to be higher as investors assume more risk.
Source: Discussions with key representatives of U.S. and European LCFIs, rating agencies, and analysts’ reports.
Source: Discussions with key representatives of U.S. and European LCFIs, rating agencies, and analysts’ reports.
1The authors thank Jonathan Fiechter and José Viñals for their comments and guidance, and Pierluigi Bologna, Gregorio Impavido, Mohamed Norat, Scott Roger, Manmohan Singh, Jay Surti, and other IMF colleagues for their helpful input and comments. Morgane de Tollenaere, Ivan Guerra, and Moses Kitonga provided able research assistance. This chapter was also issued as an IMF Staff Position Note, SPN/10/16 (November 3, 2010).
2LCFIs could be defined as diversified cross-border financial firms with complex organizational and management structures whose large-scale activities cross national borders and sectoral boundaries. The group of LCFIs covered in this chapter includes a broader range of institutions that may be either globally or regionally systemic and is not based on the IMF view of global systemically important financial institutions (G-SIFIs).
3The recent studies include the macroeconomic impact assessments of the Institute of International Finance (IIF), Financial Stability Board (FSB), and BCBS (see IIF, 2011; FSB and BCBS, 2010; and BCBS, 2010a).
4See, for example, Claessens and others (2010); and Chapter 2 in this volume.
5These include deferred tax assets (DTAs), mortgage servicing rights (MSRs), significant investments in common shares of financial institutions, including insurance subsidiaries, and other intangible assets.
6In several countries, such as Canada, Switzerland, and the United States, the leverage ratio is part of the regulatory requirements.
7As announced by BCBS in July 2010, eligible liquid assets include Level 1 assets (cash, central bank reserves, and high-quality sovereign debt) and Level 2 assets (high-quality corporate and covered bonds and nonzero risk-weighted sovereign debt subject to haircuts and a cap). The BCBS also announced that a carve-out should be granted to countries where banks face structural constraints in meeting the minimum LCR because of low government debt. The rules provide for some flexibility, while limiting country specific exemptions and minimizing regulatory arbitrage opportunities.
8LCR, defined as the ratio of Stock of High Quality Liquid Assets to Net Cash Outflows over a 30-day horizon, is required to be at least 100 percent. The NSFR, defined as the ratio of Available Stable Funding to Required Stable Funding, is also required to be at least 100 percent (see Appendix 3.3 for details).
9Given limited publicly available data on a consistent basis, especially on components of bank capital, a standard set of assumptions common to all banks was used where needed. Further details on the methodology are provided in Appendix 3.2.
10Geographies are mapped based on each banking group’s country of residency: Asia (Australia, China, India, Japan, Korea); Europe (Austria, Belgium, France, Germany, Greece, Italy, Nordics, Portugal, Spain, Switzerland, United Kingdom); and North America (United States and Canada).
11Business models are based on banking groups’ principal source of income (commercial banks: lending activity; universal banks: lending, insurance, and other services; and investment banks: trading/advisory/asset management activity).
12End-March 2010 in the case of Japanese banks (which have a different reporting cycle).
13These assets include goodwill, minority interests, investments in unconsolidated subsidiaries, and the value of DTAs, MSRs, and other intangible assets (see Appendix 3.2).
14The low impact of the deductions across Asian banks is not homogeneous, with Japanese banks affected more than other Asian banks, given the large deductions related to minority interests and net DTAs.
15Banks could issue new capital, reduce balance sheet size through further deleveraging, increase product pricing, rebuild capital through earning retention and limited dividend distribution, or use a combination of these different options to meet the higher requirements. During 2009—10, several of the large banks in the sample, both in Europe and in the United States, issued additional capital to raise their capital ratios and continued to deleverage.
16Bloomberg market consensus estimates suggest that by 2012, the LCFIs in the sample would generate earnings in excess of the 2004—07 average.
17For the purposes of this analysis, risk-weighted assets are kept constant over the phase-in period.
18See Appendix 3.4, Table 3.7 for industry views on the potential impact of various regulatory proposals on banks’ business models.
19Solvency II, the updated set of regulatory requirements for insurance firms that operate in the European Union, is scheduled to come into effect in late 2012 and is likely to increase insurance capital needs and reduce the fungibility of insurance capital.
20Living wills are recovery and resolution plans for large banks that map out how to safely wind down institutions in case of failure, encouraging, in effect, simpler and more streamlined corporate structures. Stand-alone subsidiarization requires banking groups to be organized as constellations of self-sufficient national subsidiaries, with effective firewalls between the parent and the affiliates, each holding sufficient capital/liquidity to survive alone. The key objective of the two proposals is to facilitate easier and less costly resolutions of large banking groups by compartmentalizing risks and making individual group parts more resilient to shocks, respectively.
21Shadow banks are intermediaries between investors and borrowers, profiting either from fees or differences in interest rates between those paid to the investor and received from the borrower; for example, securities broker-dealers, hedge funds, special purpose vehicles (SPVs), conduits, money market funds, monolines, and other nonbank financial institutions that do not accept deposits and are not subject to the same regulations as depository banks (Adrian and Shin, 2009). Shadow banks have high levels of leverage and maturity mismatches and are subject to similar market, credit, and liquidity risks as banks, but with no direct or indirect access to a lender of last resort. They could fail if they are unable to refinance their short-term liabilities.
22There are press reports that suggest, for example, that a number of LCFIs have been closing and/or transferring their proprietary trading activities to asset management arms or to hedge funds.
23There are some press reports that some global universal banks may move their operations out of jurisdictions that introduced tougher measures to others that do not have such regulations.
24End-March 2010 in the case of Japanese banks.
25Current regulatory rules for deductions may vary on a country-by-country basis. We assumed them to be normalized based on the common practices.

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