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The approaching regulatory capital and liquidity 'cliff'

The financial sector has in recent months been preoccupied with the U.S. “fiscal cliff”. A less debated, but nevertheless important, risk for (and from) the financial economy is the prospect of the approaching regulatory capital and liquidity “cliff”, in the form of the impending date for the implementation of Basel III. Thankfully, like its U.S. fiscal equivalent, this cliff has been deferred: following the over-optimistic undertaking by Michel Barnier to implement Basel III faithfully by the end of 2012, European capital and liquidity reform have been delayed (until 2013) as CRD IV becomes caught up with the broader banking union, resolution and deposit compensation proposals. The U.S. authorities have cast doubt on whether it will be implemented at all in the U.S.

Although the slow pace of regulatory reform attracts censure from the political classes, it is welcome in this case. Basel III’s triple cocktail of requirements to increase capital, hoard liquidity and reduce leverage has the potential to drain liquidity and reduce the flow of credit. There is still a worrying absence of any meaningful analysis of how it will affect banks’ behaviour. In particular, little seems to have been done to assess properly its quantitative impact – and in particular how far it would stifle growth in the real economy.

We are now beginning to detect a dawning realisation among regulators that, perhaps because of this, deferral of reform might not be such a bad idea – and indeed that the loosening of existing standards could be useful to support economic recovery. For example, we have recently seen the FSA temporarily waive its capital requirements in respect of certain classes of lending (arguably such lending as might be politically expedient). One can also detect the first signs of a certain amount of back-pedalling on Basel III in the recent announcement watering down the substance, and timing, associated with the introduction of the Liquidity Coverage Ratio.

Although the continuing uncertainty makes business planning and pricing transactions difficult (particularly with structural reform proposals in the pipeline), and adds frictional costs to financial business, it is perhaps better than the lemming approach to the regulatory cliff.

Near-term, regulatory attention in Europe will be moving towards implementation of the European Market Infrastructure Regulation and Alternative Investment Fund Managers Directive – both of which are due for implementation in 2013. Market participants have been awaiting secondary legislation in order to commence implementation. This has arrived very late, where it has arrived at all. There will be a scramble to implement many aspects of these over the coming months: we expect a capacity squeeze on compliance and derivatives resources (both in banks and in services firms) in particular. This is an unfortunate, but depressingly predictable, output of the uncoordinated and unwieldy European legislative process – expect several repeats of this rather frustrating process over the coming years.


Basel III's triple cocktail of requirements to increase capital, hoard liquidity and reduce leverage has the potential to drain liquidity and reduce the flow of credit.

Legal and Regulatory Risk Note
United Kingdom