Assessing the impact of Basel III The Basel III framework was developed in response to the issues revealed by the 2008 financial crisis, now Professor Andreas Dietrich together with Professor Gabrielle Wanzenried and other researchers at the Lucerne University of Applied Sciences and Arts aim to assess the impact of these new rules and guidelines on the Swiss banking sector. The crisis of 2008 revealed significant deficiencies in the way the financial sector was regulated as banks across the world experienced severe liquidity problems, to which many governments responded by bailing out major institutions. New rules around liquidity and funding structures have since been agreed in the Basel III regulatory framework, now Professor Andreas Dietrich and his research team aim to assess their impact on Swiss retail banks in a new research project. “Our belief is that these liquidity rules are the ones that really matter for banks. We want to assess the impact of these new liquidity rules on the banks, on their overall profitability and performance. How have they reacted to these new rules and guidelines?” he outlines. Prior to 2008, liquidity rules often weren’t discussed at a strategic level, but the impact of the crisis prompted a major re-think. “After the financial crisis, it was realised that liquidity risk is actually very important,” says Professor Dietrich.
Market liquidity This relates both to a bank’s ability to raise capital from selling assets, and also the extent of its cash reserves. Professor Dietrich and his colleagues are essentially
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addressing two aspects of liquidity in their research. “One is short-term liquidity, which can be thought of as a fairly basic form of liquidity. So if liquidity flows out during a stress scenario, then the banks still need to have enough liquidity to cover short-term demands from customers,” he outlines. Many banks found themselves unable to do this in 2008, as they were over-leveraged and had extended excessive amounts of
example provides mortgages that are funded by deposits over a more extended period. The Basel III framework set out the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) to promote more sustainable funding structures. “These funding ratios are the focus of our project,” says Professor Dietrich. These ratios set out the amount a bank should hold in cash and assets in relation to its cash outflows
We want to assess
the impact of these new liquidity rules on the banks, on their overall profitability and performance. How have they reacted to these new rules and guidelines?
credit, leaving them badly exposed when the crisis hit. “Liquidity risk can be thought of as the danger that a bank will not be able to fulfill all its liquidity requirements. So people remove money from their accounts, because they are afraid that the bank might not have sufficient liquidity any more,” explains Professor Dietrich. A second part of the project’s research centres on long-term liquidity, which relates to a bank’s ability to maintain liquidity in the long run, where an institution for
Dietrich has written a number of papers exploring the impact of these ratios on the banking sector. One part of his research involved looking at data from a sample of over 900 banks over the period between 1996-2010, with researchers using a regression framework to analyse the effects of these liquidity rules. “We can get pretty close to the NSFR by looking at historical data from banks’ balance sheets. How would it have looked if banks had already had to implement these ratios previously?” asks Professor Dietrich. Research shows that those banks which expanded rapidly have generally maintained lower NSFRs. “A lot of banks were trying to essentially optimise their return on equity, that was the main target,” explains Professor Dietrich. It is more difficult to establish a longterm perspective on the LCR, as there is a lack of consistent data on the same kind of level as the NSFR. However, since 2015 banks have been required to report it, while researchers also have access to data from
a representative set of Swiss retail banks, which provides a basis for Professor Dietrich and his colleagues to investigate it in greater depth. “How will banks operate in future? What will happen if the interest rate goes up in Switzerland? What will that mean for the LCR?” he continues.
Market entrants The impact of the LCR will vary to a degree according to the size of the bank and the nature of its operations, so Professor Dietrich and his colleagues are looking at data on a wide range of institutions in their research, from small banks to large institutions. While many major institutions are able to ensure that they comply with the ratios, it can be more of a problem for smaller banks, who may not be able to commit the same level of resources.“Fulfilling regulatory requirements is often a major task for smaller banks, as they may not have a separate team for the job,” explains Professor Dietrich. This is a prominent concern for regulators, who may want to
ensure a degree of diversity and ensure that the market is open to potential new entrants. “We can see that new banks coming into the market face a lot of challenges. In Switzerland and the UK for example, there are different kinds of regulations for these challenger banks,” says Professor Dietrich. A number of new banks have entered the UK market over recent years, in part because of relatively enlightened regulation from the authorities which has encouraged new entrants. The Financial Conduct Authority (FCA) in the UK adjusted its regulations for new banks, which Professor Dietrich says has helped introduce more diversity into the market. “There is space to allow these new kinds of challengers,” he outlines. The Swiss financial regulator, FINMA, also has a rigorous regulatory framework, where larger banks are subject to a more intense degree of scrutiny, with the wider aim of maintaining stability in the final system. “FINMA has five categories of banks, where the largest banks are in category 1, while the smallest
under certain scenarios, with the ultimate goal for regulators of helping the market run effectively, while still giving banks scope to lend money and take on risk at an appropriate level. “These two new ratios were included in the Basel framework and as a result I believe the liquidity risk is now lower than it was before the financial crisis,” continues Professor Dietrich. As head of the institute of financial services at Lucerne University of Applied Sciences and Arts in Switzerland, Professor
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ones are in category 5,” continues Professor Dietrich. “We saw that introducing LCR was more expensive in overall cash terms for the larger banks.” The smaller banks were nevertheless hit harder by these new regulations, as the costs of introduction were significantly higher in relation to their overall profits. For a large bank, introductory costs of a billion Swiss francs may be relatively negligible in terms of their overall profits, whereas a smaller bank would be hit much harder. “Introductory costs of 500,000 Swiss francs in relation to the profits of a smaller bank could be a higher burden than a billion for the larger banks, who often make enormous profits,” points out Professor Dietrich. This may raise concern for regulators in terms of market competition, so Professor Dietrich’s research holds wider relevance for the authorities. “I was recently invited to FINMA to talk about our results,” he says. “During the course of our research, we realised that there are some elements of our work that can be fed back to regulators, to help them optimise some aspects of the regulatory regime.” A relatively small bank that lends primarily to companies and businesses in its local area is of course very different to a
major international institution with a global reach and an investment portfolio that spans the world. However, regulations are often developed with the bigger institutions in mind, which can create problems for smaller banks. “A smaller bank may argue that it would cost a lot of money to comply with a specific regulation, and the problem it seeks to address isn’t relevant to them,” explains Professor Dietrich. This is an issue that FINMA is addressing through the small banks regime. “The regulator is looking at how it can kind of make changes for smaller banks, so that they have to deal with less regulation than larger banks,” continues Professor Dietrich. “A one-size-fits all approach is not the best way to regulate the banking sector.” The major banks operate internationally, so it could be argued that a global regulatory framework is required to provide a level playing field and ensure fair competition. However, smaller banks don’t operate on the same kind of scale, and Professor Dietrich says regulations under the small banks regime have been modified to reflect this, subject to the bank meeting certain criteria in terms of liquidity and capitalisation. “Under the small banks regime, banks don’t need to report as regularly, and they also have some other
freedoms,” he outlines. One major area of divergence is that these smaller banks do not need to calculate and comply with the NSFR. “This is one way in which small banks are released from this big regulatory burden that was constructed more for the bigger banks,” explains Professor Dietrich. Researchers at Professor Dietrich’s institute are working to assess the impact of these new rules on the Swiss retail banking sector, work which holds important implications for the banks themselves and their evolution. Banks are of course keen to maximise profits while also preparing for the future and considering how the market will evolve; Professor Dietrich’s research could lead to some important insights in this respect. “We are very close to industry and a common question from bankers is, how should we plan for the future?” he outlines. Regulatory frameworks can in a sense be seen as quite reactive, as they are often developed in response to the issues that led to an earlier crisis, so it is difficult to forecast how the banking sector will evolve. However, Professor Dietrich maintains close contacts with industry, and says the project has generated some interesting results. “I have been advising banks on what they might do in some areas in future,” he outlines.
The specific economic context in which banks are currently operating is an important consideration in this respect. At the moment interest rates remain extremely low, and they have even strayed into negative territory at some points over the last few years, yet this cannot persist indefinitely, and when rates do rise the impact is likely to be significant. “I think we can only say whether liquidity rules work and assess their impact on the
Evidence suggest that the Basel III rules are proving effective in terms of helping banks maintain adequate liquidity, but are also affecting the efficiency of their operations. At the moment there is enough liquidity in the Swiss market, as many people are putting their money into savings accounts rather than investing in shares, yet circumstances may change in future. “A bank looking to invest in high-quality liquid assets would normally invest in assets like bonds for
We can get pretty
close to the NSFR by looking at historical data from banks’ balance sheets. How would it have looked if banks had already had to implement these ratios previously? economy when interest rates go back to normal levels,” says Professor Dietrich. When interest rates do go back to a more historically normal level, of say 2-3 percent, then banks will need to invest more in highquality liquid assets like bonds, which can be converted quickly into cash without losing their value. “This will be much more expensive for banks than what they are doing now,” continues Professor Dietrich.
example. However, bonds aren’t a particularly attractive asset class at the moment. So, what banks can do is put money in a certain type of account, where the costs are lower than if they were to spend that money investing in high-quality liquid assets,” outlines Professor Dietrich. “We don’t know how people will react if interest rates rise in future, but the cost of fulfilling the LCR will be much more expensive for banks than it is today.
Impacts of new Basel III Impacts of new Basel III liquidity rules on retail banks in Switzerland Project Objectives
As a reaction to the latest financial crisis, the Swiss banking sector is confronted with a large variety of new rules and guidelines. The research project investigated the impacts of the new Basel III liquidity rules on retail banks in Switzerland, i.e. it analyzed the determinants of the liquidity coverage ratio (LCR)1 and the net stable funding ratio (NSFR) and their impacts on Swiss retail banks’ performance as well as range of products.
Project Funding
The project was funded by the Swiss National Science Foundation SNF
Contact Details
Professor Andreas Dietrich Institute of Financial Services Zug IFZ , School of Business Lucerne University of Applied Sciences and Arts T: +41 41 757 67 46 E: andreas.dietrich@hslu.ch
Professor Gabrielle Wanzenried Professor Andreas Dietrich
Professor Gabrielle Wanzenried is professor of finance at the School of Management and Engineering in Yverdon, part of the University of Applied Sciences and Arts of Western Switzerland, a position she has held since September 2019. Prior to joining (HEIG-VD) she was professor of corporate finance at the Institute of Financial Services Institute of the Lucerne Unviersity of Applied Sciences and Art. Her research and teaching topics are Corporate Finance, Banking Corporate Governance, Diversity and Real Estate. Professor Andreas Dietrich heads the Institute of Financial Services Zug IFZ, where he has worked since 2008. He obtained his doctorate at the University of St. Gallen (HSG), where he also worked as a research associate. He also sits on the board of directors of the Lucerne Cantonal Bank.
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