After a year of some of the largest banking failures in U.S. history, new regulatory reform like Basel III Endgame aims to strengthen the banking sector by mandating higher capital requirements against bank assets. Such requirements could reduce available liquidity for consumers unless banks can transfer risk on loans to (re)insurers.
Capital requirements are legal percentages of equity that must be held alongside assets. This equity helps pay off debts and avoid defaults on loans. The collapse of Silicon Valley Bank was caused by a sudden mass withdrawal of bank depositors that depleted available capital, causing the bank to default as they lacked funds to payout all depositors. Higher capital requirements can, therefore, ensure a larger buffer for banks during future mass withdrawals.
The issue is that funds being held as a capital requirement can’t be lent as credit for consumers. A simple supply-demand curve demonstrates that as supply for credit goes down, the price will increase and can ultimately price out many borrowers. Increased capital requirements could also exacerbate recessionary trends, as one component of a recession is the tightening of available credit as the economy slows down. This is not to say that increasing capital requirements presents no positive value, but the adverse effects could be offset through reform to Basel III, which enables (re)insurer credit risk transfers (CRT).
CRTs are a form of risk securitization, in which the primary holder of the loan pays a (re)insurer regular fees so that if loans result in losses over a certain threshold, the creditor receives loss reimbursement. The guarantee of loss reimbursement effectively “transfers risk” from the initial creditor to the (re)insurer. The effects of securitizing risk through CRTs are that creditors can offer more capital to borrowers and maintain more reliable streams of credit. This is because the risk is a loan mitigator, and the ability to transfer risk to (re)insurers for regular fees removes that mitigating factor.
Basel III has the potential to alleviate this regulatory uncertainty and provide needed relief to credit borrowers. However, under the current language of Basel III, it is not clear that (re)insurers would be considered an “eligible guarantor” in mitigating the risks on bank credit. Banks may be unable to utilize CRTs as a tool for capital relief. Without reform, available credit could shrink, leaving consumers with fewer loan options at higher costs.
It is not too late to make amendments to Basel III that would clarify (re)insurers as qualifying eligible guarantors. However, the longer legislators and regulators wait, the less credit businesses may have at their disposal. Citi Research believes recessions will loom heavy in the first half of 2024, making reform to Basel III urgent businesses upon the start of the 118th Congress.
