The global financial crisis of 2008 thrust into the spotlight the undercapitalization of many foreign banks. Financial institutions became insolvent and were either dissolved or received taxpayer-funded bailouts. International regulators criticized globally issued forms of Tier 1 capital — that is, other than common shares — for not effectively absorbing losses before taxpayers. It was clear that the global financial system needed an overhaul. Enter Basel III, the more aggressive, younger sibling of Basel I and Basel II.

In December 2010, the Basel Committee responded to the worldwide economic collapse by unveiling this new framework aimed at more strictly regulating banks and strengthening the global banking system. The Committee wanted to create a system that is better equipped to weather financial and economic pressure and a financial future with fewer (unpleasant) surprises. The regulatory rules set out in Basel III include higher minimum capital requirements, new capital conservation and counter cyclical buffers, revised risk-based capital measures, a new leverage ratio and two liquidity standards.

On Feb. 1, 2011, Canada’s Office of the Superintendent of Financial Institutions issued its own action plan for the Canadian implementation of Basel III. As Canadian banks are among the most well capitalized, well managed and well regulated in the world (all coupled with a more conservative and risk-averse Canadian business culture), they are well positioned to absorb these regulatory imperatives — particularly when compared with most foreign financial institutions. Accordingly, OSFI expects banks in Canada to be fully compliant with Basel III requirements by Jan. 1, 2014.

There is no question that Basel III reforms will affect Canadian banks’ strategies and business operations and possibly profitability by increasing the quantity, quality and transparency of capital and negatively impacting return on equity. The potential for a growing divide between economic capital and regulatory capital could fuel discord between banks and their regulators. The diminished emphasis on total capital and increased emphasis on Common Equity Tier 1, commonly referred to as CET1, could cause Canadian banks to focus on assets that are capital and liquidity friendly. Accordingly, the landscape of Canadian banking could shift dramatically.

In March 2013, OSFI designated all six of Canada’s largest domestic banks — Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada, and Toronto-Dominion Bank — as domestic systemically important banks, or D-SIBs. Basel III has finalized 12 principles to assess and create higher loss absorbency for D-SIBs. It is not anticipated, however, that these Canadian banks will be designated as global systemically important banks.

Aimed at limiting the likelihood of failure, D-SIBs will be subject to a 1% risk-weighted capital surcharge starting Jan. 1, 2016, in addition to the CET1 ratio of 7% they already have to hold as protection against financial instability, which increases their relative cost of doing business and puts even more pressure on ROE. The Big Six will also have to comply with continued supervisory intensity and enhanced disclosure requirements.

THESE ENHANCED DISCLOSURE requirements are the equivalent of a Distant Early Warning Line for Canada’s banking sector, a radar system of sorts, to provide initial warning to banks and regulators of looming financial and economic stress. In addition, an increased emphasis on timely and accurate disclosure will result in greater transparency, with a focus on Tier 1 capital and, less so than is currently the case, on Tier 2 capital.

While this regulatory DEW Line benefits the greater economy by reducing the risk of spillover from the financial sector in the event of a disruption, it results in a hefty impact for banks in Canada. D-SIB designation, together with the adoption of Basel III and its resulting capital, leverage and liquidity implications, could have significant consequences for banks’ ROE, dividends and share repurchases, operations, merger and acquisition activity, costs, overall margins and profitability generally.

As Canadian banks revisit their business models, a bigger focus on return on capital and liquidity and an emphasis on capital re-allocation based on revised risk weighting and risk assessment concerns will shift their acquisitions and divestitures activities. In short, they are likely to divest themselves from more capital-intensive, less liquid and/or less profitable business lines.

Canadian banks will not necessarily be simply sellers, however. As a result of capital, liquidity and leverage requirements, non-Canadian global banks (such as those in Europe) will be required to scrap certain activities, giving Canadian banks some attractive takeover opportunities.

Basel III imposes new liquidity requirements for banks in the form of two new ratios: liquidity coverage ratio and net stable funding ratio. Banks are also required to maintain high quality liquid assets to cover 100% of net cash outflows that could be encountered under certain stress scenarios — LCR — and maintain a minimum amount of secure medium- and long-term funding based on the liquidity characteristics of their assets over one year — NSFR. From a Canadian regulatory perspective, it is this new emphasis on liquidity which is truly novel.

In this new regulatory reality, Canadian banks will likely jump at the chance to expand and acquire divesting businesses, but their focus will likely be on pursuing assets that are core (rather than peripheral or ancillary) to their banking business. The future may also see some banks in Canada divest themselves of noncore banking assets or those that are too capital intensive, which will create buying opportunities for strategic buyers and private equity investors. The pressure will also only increase on banks (and therefore regulators) to use innovative outsourcing techniques such as cloud computing.

THE EMPHASIS ON RETAIL banking and the necessary incentivizing of longer-term deposits will help banks fulfill their liquidity requirements and long-term funding issues. However, Canadian banks may find it more challenging to manage liquidity risk over capital, and they will be significantly affected by non-Basel III considerations, including Dodd-Frank and the Volcker Rule in the United States. To stay ahead of the game, banks will have to simplify or, in some cases, collapse legal structures and consider branch alternatives to ease capital strain. Canadian banks will also have to measure their exposure to foreign regulatory conditions.

Basel III’s increased complexity combined with a lack of regulatory consistency across countries will require significant investment in tools and personnel necessary to effectively manage change. As Canadian banks work toward realigning their operational priorities, the push to enhance liquidity models and stress testing will require a significant investment in newer and more sophisticated tools necessary for better modeling, measuring and liquidity risk management. Better data administration, new and improved systems and highly trained personnel will become critical components of a bank’s operations. Banks will have to streamline reporting both up and across institutions. Board and senior management time will be increasingly consumed with capital and liquidity concerns. There will be a greater premium on risk management and appropriate governance and the regulatory importance of the chief risk officer’s role will increase.

The global financial crisis was amplified by huge flaws and oversights in the banking sector, resulting in the failure or taxpayer rescue of a number of non-Canadian distressed banks. Basel III’s global framework aims to improve the resilience of banks and banking systems in the event of financial and economic stress, before taxpayers are stuck footing another enormous bill.

Banks in Canada are in a good position to adopt Basel III; they are strongly capitalized and have existing and sophisticated liquidity and leverage models, excellent risk management capabilities, advanced and robust compliance and well-developed recovery plans. Canadian banks will find it easier to deal with the new liquidity requirements thanks to their historical emphasis on retail banking.

Basel III, its requirements involving capital, liquidity, leverage and governance and its implications, both intended and unintended, represents one of the most significant regulatory developments affecting the banking industry in recent memory. It will dramatically change the ways in which banks in Canada are managed and do business. It should be an interesting ride.