This paper examines how the capital requirements introduced under Basel III affect retail banking in Europe. While much regulatory attention has focused on capital-markets and wholesale banking businesses, the paper argues that retail banking faces significant — if underappreciated — challenges. It analyzes projected declines in return on equity (ROE) across four major European markets (the United Kingdom, France, Germany, and Italy), identifies the specific Basel III provisions most relevant to retail institutions, and outlines four strategic levers banks may use to rebuild profitability. The paper concludes that although retail banking's starting position differs from wholesale banking, the cumulative impact of Basel III alongside other national and regional regulations presents a serious structural challenge.
After almost four years of turmoil in the financial markets, a comprehensive reform of banking regulation finally arrived in Europe. Many observers — both inside and outside the market — believed that these new rules were coming at a critical moment, as the industry was already facing renewed pressures. Regulation needed to keep pace with the problems emerging in the sector. At the same time, this appeared to be a once-in-a-generation opportunity to place the industry on a firm regulatory foundation, restoring its capacity to play a vital role in the broader financial system (Blundell-Wignall, 2011).
Under the new regulations, Basel III imposed its most intensive treatment on capital-markets businesses. Many universal banks consequently concentrated their investment and attention on managing the effects of these new rules on those particular business lines (Blundell-Wignall and Atkinson, 2008).
Retail banking, by contrast, received far less attention. On the surface, the impact of the regulations on retail banks appeared moderate. Basel II and Basel III dramatically increased the risk weightings for wholesale-banking products in some cases, while the risk weights for retail products were largely left unaffected. The retail-banking capital requirements were affected by Basel III primarily through the higher capital ratios applied to all businesses. At first glance, retail banking even appeared to benefit from the funding rules under Basel III, given that retail deposits are regarded as critical to the future funding stability of universal banks (Blundell-Wignall and Atkinson, 2010).
On closer examination, it becomes clear that European retail banking faces a severe set of challenges. Four distinct factors explain why the regulatory burden on this sector is greater than it initially appears.
First, while the impact of Basel III on retail banking is less pronounced than its impact on wholesale banking, it is by no means negligible.
Second, numerous other regulatory initiatives are being pursued at both the national and European levels. Individually, these may appear manageable; however, their cumulative impact is very significant.
Third, unlike return on equity (ROE) in capital-markets businesses, retail banking ROE starts from a considerably lower base. As a result, even a modest regulatory impact may push ROE below the cost of equity.
Fourth, mitigating the regulatory impact in retail banking is particularly difficult. Adjusting business models in retail banking takes considerably longer than in capital-markets businesses, where it is far easier to shift trading desks and reposition portfolios (Blundell-Wignall and Atkinson, 2011).
Research estimates suggest that the return on equity for retail banking across Europe's four largest markets will fall from an average of 10% to 6% — a decline of 41%. This fall is projected to result from new national, regional, and global regulations in the absence of any mitigating action by banks or material changes in competitive and economic conditions. This analysis is based on fiscal year 2010 data, with the assumption that the full cumulative regulatory impact — which will unfold over many years — is treated as if realised immediately (Uslenghi, 2011).
The projected ROE drops by market are as follows (Uslenghi, 2011):
Italy: from 5% to 3% (a decline of 40%)
France: from 14% to 10% (a decline of 29%)
United Kingdom: from 14% to 7% (a decline of 48%)
Germany: from 7% to 4% (a decline of 47%)
A further decline in ROE is expected for banks that qualify as global systemically important financial institutions (G-SIFIs), with an additional reduction of between 0.4 and 1.2 percentage points projected for their retail-banking activities (EBA, 2012b).
Although Basel III is the most significant driver of these impacts, other factors also contribute to the cumulative ROE decline. Mortgage products have been particularly hard hit among asset-based products. In liability products, debit cards and investment products suffered the greatest impact, especially in the United Kingdom (EBA, 2012b).
"Specific capital, liquidity, and product rules relevant to retail"
"Four bank-level strategies to recover pre-reform ROE"
It seems likely that revenues, profits, and margins will be substantially affected as Europe's retail banks enter this prolonged period of regulatory reform. The time-honoured ways in which these institutions conduct their business are also set to change. These effects have been estimated in a number of research studies (Packer, Stever and Upper, 2007).
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