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LONDON (Reuters) - Strict new capital rules and regulation will make banks less risky and reduce the need for taxpayer bailouts, but this will come at a heavy cost to the banks and possibly the economic recovery in developed nations.
As a result of regulatory reforms by the Basel Committee on Banking Supervision, some banks will have to raise billions of dollars in new capital and liquidity, hive off stakes in firms they don't fully own -- or buy them outright -- and think twice about financial market trading and paying bumper dividends.
Credit Suisse bank estimates the reforms will create an additional capital requirement of 139 billion euros ($197 billion) in Europe compared with current Basel rules.
When the rules take effect at the end of 2012, the amount of extra capital needed is likely to be much lower, around 50 billion euros, since regulators are already pressing banks to top up capital in anticipation of the new rules.
Investors are worried, however. Shares in Barclays, for example, came under pressure last week after Credit Suisse analysts estimated the Basel reforms might force the British bank to raise 17 billion pounds of capital, expanding its current capital base by about a third.
The Basel Committee, composed of central bankers and financial supervisors from nearly 30 leading countries, is now consulting with the banking industry on the reforms; final details are to be published by the end of 2010.
Although the implementation date is end-2012, there may be a grace period for some provisions. But the industry seems resigned to the likelihood of major change to its operations.
"I have no doubt business models will change," said Simon Hills, a director at the British Bankers' Association and chair of a global industry working group on the Basel reforms.
Public anger over banks' role in the financial crisis is so great that opposing most major elements of the package appears futile. Instead, banks are focusing their lobbying firepower on implementation.
"We will be pushing back on the degree of calibration and transition periods," Hills said.
The package radically alters Basel II, a global set of rules which the committee introduced during the late 1990s and which policymakers say failed to ensure banks held enough capital to ride out the worst financial crisis since the Great Depression. The United States has not even implemented Basel II in full.
Under Basel II, banks hold Tier 1 capital equivalent to 4 percent of their assets, half of which is deemed to be core capital in the form of common equity and reserves.
Many analysts, bankers and regulatory officials expect Tier 1 under "Basel III" to remain around 4 percent in numerical terms, but the range of instruments eligible as Tier 1 capital, and deductions from the calculation of Tier 1, would be tightened considerably so that it is predominantly top quality.
The aim is to ensure banks have plenty of high-quality capital to absorb losses without government help, and to halt use of lower-quality capital such as debt-like hybrid capital.
Other provisions also promise to have a major impact. Banks would have to build up an extra capital cushion in good times which they could tap during downturns; this cushion could end up being equivalent in size and quality to the new Tier 1, analysts and regulatory officials say.
Bank capital would also have to remain above a buffer zone resting on top of the minimum requirements; if capital fell into the zone, a bank could lose its freedom to decide the size of its dividends, bonuses to staff and share buybacks.
The net result could be to weaken banks' ability to provide as much credit as corporations and consumers need as their demand increases during economic upswings.
Also, markets' perception of banks would shift; from being relatively high-risk, high-return investments, banks would offer lower returns with less risk.
Meanwhile, banks could play less of a role in financial markets because of the Basel committee's plan to introduce a cap on bank leverage, the ratio of a bank's equity to its assets. The United States has a required ratio of about 4 percent; Basel might maintain such a number but would use a much more inclusive definition of assets, including those held off balance sheet.
Separate regulatory proposals made by U.S. President Barack Obama last week, which would place specific limits on banks' size and restrict their proprietary trading, may strengthen these shifts, although those proposals are not expected to be adopted widely outside the United States.
Taken together, the Basel reforms look set to limit banks' ability to maximise earnings; and as banks lose some dominance in the markets, other companies may challenge them in some business areas.
"It has huge revenue implications. This combination of reforms will significantly impact return on equity, and will therefore make it harder for existing banks to raise new equity capital," said Simon Gleeson, a lawyer at Clifford Chance.
"Conversely we may see a lot of new non-banking entities doing financial business, and possibly an increase in financial business done by conglomerates."
Liquidity rules in the new Basel package will put pressure on banks to turn overseas branches into subsidiaries to please local regulators, who are anxious to avoid a repeat of Britain's experience with defaulting Icelandic banks.
A branch's capital requirements can be handled at group level but a subsidiary must hold more capital locally, which tends to be more costly and less efficient for multinational.
"It can dismantle many of the drivers behind international banking. There will be subsidiarisation no doubt or, for those who don't, there will be a lot more transparency," said Patrick Fell, a director at PricewaterhouseCoopers, a consultancy.
Banks will try to skirt some of the rules.
"We may see assets being moved to unregulated special investment vehicles within banking groups to solve liquidity problems," Gleeson said.
But before the Basel committee makes its final decision on the package, analysts expect parts of it to be watered down at the behest of banks and some national regulators, who are keen to protect national banking champions.
One example is a proposal for banks' minority shareholdings in other firms to be excluded from the common equity part of their capital, which could pressure banks to sell off strategic stakes in emerging markets such as China.
"We believe the rules will change materially, to the benefit of the banks, before they are implemented," said research company Keefe, Bruyette & Woods.
(Editing by Andrew Torchia)