Canada’s banks may not have had the sort of near-death experiences that some of the world’s biggest banks did during the global financial crisis, but Canada’s banks are nevertheless going to have to take the same medicine (from both regulators and markets) as those that had almost expired. As a result, all banks are sure to find themselves in a tougher operating environment in the years ahead.

In mid-September, the Basel Committee on Banking Supervision announced its planned changes to the capital requirements for global banks, which will both significantly boost the amount of capital banks must hold and introduce a countercyclical component to combat the effects of the credit cycle, among other things. Mercifully, from the banks’ point of view, the committee proposes a very long implementation period for the new standards to give banks time to adjust to the new capital demands.

In general, the Canadian banks pronounced themselves pleased with the planned changes and have suggested that they already have enough capital on hand to meet the beefed-up requirements. Canada’s federal banking regulator, the Office of the Superintendent of Financial Institutions, has echoed this stance by declaring that in light of the proposed changes, it won’t be so strict with banks looking to use up their excess capital (by hiking their dividends, for example, or making significant acquisitions).

Indeed, the question of how to utilize capital in a post-crisis environment is emerging as one of the big questions facing banks generally.

A recent research report from Toronto-based Stonecap Securities Inc. predicts: “Capital-related issues — including how it is generated and deployed, what it earns and what it costs, among others — will become key differentiators [among] domestic banks over the medium term.”

ENOUGH FOR INVESTORS?

But, in the banking business, it’s not as simple as merely chinning yourself up to the regulatory minimum and then returning any excess capital to shareholders or devoting it to growth initiatives. Banking is partly about trust — and that trust has been shaken in the past couple of years. So, merely meeting minimum capital requirements probably isn’t going to be enough for many investors — or banks.

Notwithstanding the very achievable new standards set by the Basel Committee, it may be that certain regulators, or the banks themselves, will decide that it makes sense to hold much more capital than the Basel guidelines require — both to inspire confidence in the safety and solvency of the banking system and to attract a lower cost of capital as a result.

One of the reasons the Canadian banking industry has been basking in its status as one of the safest in the world since the financial crisis is that Canadian regulators had pushed the domestic banks to hold more capital than the minimums required by the Basel Committee. Now, policy-makers in other countries seem to be learning that lesson.@page_break@For example, in early October, Switzerland’s government-appointed “commission of experts” studying the problem of banks that are deemed “too big to fail” recommended that the two banks in that country deemed to be systemically important (UBS AG and Credit Suisse) be required to hold much more capital than the new Basel requirements imply.

The Swiss commission calls for UBS and Credit Suisse to maintain capital equivalent to 19% of their risk-weighted assets, and that more than half of this (10%) be in common equity, while up to 3% could be made up of contingent capital (bonds that would convert to equity if the bank’s common equity ratio slips below a certain level).

The Swiss commission estimates that its proposals would require those banks to hold about 80% more capital and 40% more common equity than required under the Basel guidelines’ minimums.

This bigger capital allocation is necessary, the Swiss commission says, because systemically important banks enjoy an implicit government guarantee that distorts competition and could imperil government finances.

Indeed, that is proving to be the case in Ireland right now, where the government has seen its credit ratings downgraded after the cost of a bank bailout there has swelled to twice its original size, pressuring the country’s balance sheet.

CAPITAL REQUIREMENTS

If Switzerland’s government adopts the commission’s recommendations for much higher capital requirements for the big banks in that country, the effects are likely be felt throughout the ranks of the global banks. Indeed, if Switzerland or some other country sets a much tougher standard than the Basel Committee, that tougher standard may become a sort of de facto minimum that the market demands for large, global banks.

The Stonecap report suggests that if the capital requirements being recommended in Switzerland were imposed on Canada’s big banks, the levels would be achievable. The report estimates that the banks would need an additional $5 billion in common equity capital and up to $55 billion in contingent capital.

However, the Stonecap report also cautions that if the market demands meaningfully higher capital requirements than what the Basel Committee envisions, Canada’s big banks may have a tougher time delivering the sort of earnings performance and dividend growth that they have enjoyed historically.

And, it would also affect their strategies, adds the report: “Pre-vailing views of domestic banks as being in significant ‘excess’ capital positions would, however, need to be rethought, which, in our view, will make planned growth by acquisition strategies somewhat less appealing.”

Beyond the bottom-line implications for Canada’s banks, the emergence of alternative capital requirements — if they stick — would also deal a blow to efforts to move toward harmonized international regulatory standards.

Banks may get some more clarity on this situation — namely, whether governments and banking regulators hew to the levels being proposed by the Basel Committee or push on with imposing much higher capital requirements — when the G20 representatives meet again in November. IE