Bank Capital Requirement Rules Hits Lending, Shares in Scramble to Raise Cash

European banks are fighting hard to shore up their balance sheets in time for regulatory changes that force them to hold a certain level of cash, in case of another major market crisis, just as they're being battered for not lending as much as governments would like.

The Swiss National Bank's (SNB) warning to Credit Suisse and UBS provided a stark reminder that the battle to make sure their capital requirements are compliant under international Basel III rules, is certainly not over.

The SNB said that while both have a bigger cash cushion than its European counterparts, the banks still fall behind in capital requirements under international Basel III rules, which are coming into force in 2019.

With other global regulations coming into force over the next few years, the costly exercise will become even more expensive when UK banks are forced to shore up even more capital if the UK's Treasury "White Paper" is voted in by lawmakers.

On Thursday, UK Chancellor George Osborne backed-up recommendations by the Independent Commission on Banking (ICB) report in September last year - dubbed the "Vickers Report" - by telling British banks to split their retail and investment divisions in order to give savers more protection and to hold more capital against bad bets as part of a far-reaching overhaul of the country's financial system.

"The government has got itself into a terrible muddle over this crucial policy area," says Professor Philip Booth of Cass Business School. "On the one hand, it is imposing huge liquidity and capital requirements on banks to reduce the potential cost to the taxpayer of bank failure. The FSA is also increasingly regulating financial product markets to reduce the flow of funds to borrowers. On the other hand, the government is bringing in a series of schemes to subsidise and guarantee lending through the same commercial banks whose lending is being restricted. Emergency measures to deal with liquidity crises are one thing. However, with regard to the fundamental policy issue, the left hand of the Treasury does not seem to know what the right hand is doing."

Scrambling for cash

Enforced and impending global regulatory changes have been designed to prevent another banking industry collapse.

At the centre of these changes are capital requirements and due to the substantial amount of cash that banks are legally required to hold, banks have been staggering towards the future enforcement date.

In Europe, Basel III commitment rules that the minimum requirement for banks' tier-one capital ratio (ratio of equity capital to risk-weighted assets [RWA]) has been raised from 2 percent to 4.5 percent and is effective as of 2019.

Lenders will also need to add a "conservation buffer" of 2.5 percent, meaning banks must hold a total core capital equal to 7 percent of their RWA.

Furthermore, European Banking Authority (EBA) published its formal Recommendation in December last year, and the final figures, related to banks' recapitalisation needs, which revealed that European banks must raise €114.7bn of additional capital buffers by June this year, which is 8 percent more than its initial estimate of €106bn.

Critics said that asking banks to keep capital requirements at such a level, on top of other regulatory pressures, will hurt lending. However, the EBA hit back and said that "as a result of the crisis, the deterioration of credit quality and the difficulties in attracting new funding, banks already started to reduce lending activities."

However the EBA warned that "a comprehensive policy response is needed to avoid an excessive deleveraging and therefore a credit crunch and to ensure continued lending to the real economy including to SMEs."

But it doesn't stop there.

In the UK, plans are ramping up to enforce the recommendations under the Vickers Report after the Osborne released the treasury's "White Paper" - a step which is usually followed by draft legislation that will be voted on by lawmakers.

The White Paper, which takes most of Vickers' recommendations, calls for a 17 percent capital buffer - the sternest of any country in the world apart from Switzerland.

Government estimates suggest the rules will cost the industry as much as £7bn a year. Banks with larger international operations that don't put Britain's financial system at risk, such as HSBC, will be exempt from portions of the new capital rules.

Banks will likely need an extra £19bn to meet compliance, the government said, and it the legislation will be in place by 2015.

The costs to prepare and implement this comes on top of the various other regulatory changes out there. According to Thomson Reuters research, regulators around the world have announced 14,215 changes in the 12 months to November 2011, which was up from 12,179 changes for the same period a year earlier.

What is causing concern is that the costs may be too much for banks to bear, but it is also hurting lending.

"There are as always many practical challenges for both the local regulators and the banks themselves," says Richard Squire, Managing Partner at Crossbridge. "Simply getting all the legislation drafted and approved is no easy process, but also each jurisdiction may have different local laws and languages. This can cause subtleties in interpretation, which often leads to a different pace of implementation."

"We have also seen, in the experience of implementing Basel 2.5, that practical guidelines from the EBA have only been formally issued after the event and can see that different regulators and banks may have subtly different assumptions or interpretations. The true impacts only really come to light close to the actual implementation, once the full magnitude of the charges becomes apparent. In some cases some undesirable side effects can occur, which may require further clarification with the regulator, since the intention of the regulation may end up having some unexpected results."

Will banks have any money left to lend?

In the UK, banks are continually being criticised for not lending money to SMEs and to each other but the banks are crying out that they are and are sparing as much as possible.

Osborne's announced the £100bn package is set to support banks by increasing lending levels and tackle this. Apparently, the "funding for lending" scheme will cut banks' funding costs in exchange for lending commitments, which could see up to £80bn of new loans.

But will increased lending happen, despite this package deal and in the face of increased capital requirement costs?

RBS' CEO Stephen Hester proclaims that the group are lending well above its marketshare of Project Merlin - an agreement between Britain's four largest banks, HSBC, Barclays, Royal Bank of Scotland and Lloyds Banking Group, which covers lending, bonuses and transparency.

However, RBS' lending contracted by nearly £2bn to SMEs in 2011, despite the claims by Hester.

The four banks were meant to commit to providing £190bn worth of credit to smaller businesses in 2011, however in February this year, the Bank of England (BoE) revealed that lending to SMEs fell £1.1bn short of the target.

Lending conditions are set to tighten as capital requirements, imbedded in wider regulatory changes will only make it harder for the banks to release any cash.