Opportunity knocks

The Capital Require-ments Directive (CRD) is likely to have negative and positive effects on Europe’s savings banks. But overall, the results are expected to prove marginally positive.

On the negative side, it is thought that the CRD – and the Basel accord generally in the rest of the world – could distort competition between banks of different sizes. The concern is that smaller banks could find the costs of compliance proportionately higher than larger banks, and may, initially, lack the scale and sophistication to be able to use the more advanced approaches to calculate their capital requirements for their credit and operational risk.

On the positive side, smaller banks with significant retail portfolios should be able to take advantage of the lower risk weightings for retail lending; larger banks with corporate portfolios will have to set aside more capital for their higher risk-weighted corporate lending.

Nicolas Jeanmart, banking supervision adviser at the European Savings Banks Group (ESBG), says the group’s members are, on the whole, “satisfied with the final version of Basel II, and with the specific aspects of the CRD”.

He adds: “Despite the challenges of compliance, they consider it an opportunity. Though some ESBG members plan to start with the standardised approaches first, most are preparing ultimately to use foundation internal ratings-based [IRB] or advanced IRB approaches.”

Banks opting for the standardised approaches to credit risk, and the basic indicator or standardised approach to operational risk, must do so from January 2007. Those opting for the IRB approaches to credit risk, and the advanced measurement approach to operational risk, must do so from January 2008.

Basel only applies to ‘internationally active banks’, so in the US only about 20 of the country’s 7000 banks will be affected. But the CRD applies to all credit institutions in Europe. “The ESBG has, from the start, defended the idea of a universal implementation of Basel II, made possible by the inclusion of a menu of approaches and by the application of the principle of proportionality,” says Mr Jeanmart.

“We believe this is the best way to avoid competitive distortions between banks of different sizes and levels of sophistication.” He believes that, on balance, banks will benefit from the new accord and therefore a level playing field is necessary.

Font of knowledge

The ESBG has been disseminating advice about the CRD beyond its own membership. Last year, its consultancy services division sponsored a series of conferences organised by the European Commission in 30 countries to explain to small and medium-sized enterprises (SMEs) how it could affect their borrowing.

Some internationally active banks have argued that the CRD means radical changes are needed to the prudential supervision framework in Europe, as it is not capable of addressing fully the needs of international banks. Their argument goes that supervision should be much more aligned on their organisation, characterised by business lines and risk functions managed centrally.

The ESBG, however, believes that such a move would be premature. “It is the ESBG’s view that the future EU supervisory architecture merits its own and intensive debate and consultation” separate from the CRD, it says in its annual report.

“The ESBG feels that an evolutionary approach is more likely to bring about true benefits than a revamp of the current system introduced with great haste and without due deliberation.”

German view

Peter Konesny of the German Savings Banks Association (DSGV), a member of the ESBG, says: “The last quantitative impact study [QIS 5] conducted by the Basel Committee showed a slight capital reduction in the requirements for retail banks in general. We expect this even for the standardised approaches.”

Mr Konesny expects most German savings banks to use the standardised approaches when the CRD goes live in 2007, but believes that a few of the bigger banks will remain on Basel I and adopt the more advanced approaches in 2008. Some of the smaller banks later may then move from the standardised approach to credit risk to foundation IRB a few years later, though probably not to advanced IRB.

“Our association has developed all the necessary instruments and ratings tools to allow our members to use the foundation IRB approach,” he says. “But there is still more work to be done from a supervisory perspective, so the vast majority will start with the standardised approach.

“The bigger commercial banks in Germany are likely to go straight to advanced IRB in 2008. The advantage this will give them over the savings banks will not be significant, because even with the standardised approach the risk weightings for retail business are quite low. I think it will be a level playing field for both types of banks.

“In general, German savings banks welcome the Basel II framework and the CRD. This is not just because we expect some capital relief – some members will actually have some capital add-ons – but because we believe a more risk-oriented approach to setting capital against risk and the business makes sense.”

Spanish view

Andrés Martin Pintor, head of global risk at the Spanish savings banks confederation (CECA), also a member of ESBG, says: “Most of the cajas [savings banks] are going to be opting for the standardised approach to credit risk. Only the larger ones will opt for an IRB approach.”

In both cases this will lead to an “important” decrease in capital held in their retail portfolios, he believes. Some of the decrease will be offset by an increase in the operational risk capital charge, but not all of it.

However, further increases in the capital charge are likely to be required under Pillar 2 of the CRD, which sets out how supervisors will monitor banks’ capital adequacy relative to all their risks (not just those in Pillar 1, which deals with just credit, operational and market risk) and this will further erode any capital decreases achieved under Pillar 1.

Dr Peter Kavalamthara, a risk specialist for consultant BearingPoint, says: “Most savings banks in Europe will face more competition in retail lending from the larger commercial banks that adopt the more advanced risk management approaches, as they will be able to measure and price risk using more robust methodologies. The advanced methods will typically not only lead to lower regulatory capital, but allow banks to differentiate between different asset classes and chose the assets that deliver more return to shareholders.

“If savings banks do not prepare for these changes there is a risk that their asset quality will materially worsen. They will tend to pick up the poorer credits. Margins for blue-chip and large clients are lower, so larger banks are focusing more on small businesses and mid-corporates, which is an important market for savings banks.”

One way of combating this competition could be consolidation among savings banks, which will make it financially viable for them to adopt the advanced approaches, he believes.

“They are already consolidating for competitive and cost reasons,” says Dr Kavalamthara. “Implementing advanced Basel II methods is not cheap, so we could see more consolidation.”

What options are there other than consolidating and using the advanced approach? “There is much that medium-sized retail banks could do under Pillar 2. They should revamp their internal risk management systems, policies, capital planning and internal governance. Most of them have unsophisticated frameworks for all of these things, so this is the time to look at them.

“It would mean major cultural change, so senior managers in these banks should engage in changing the credit culture and implementing a more forward-looking approach to portfolio management,” he says.

Merger pressures

Bernard De Longevialle, credit analyst at Standard & Poor’s, says: “Small savings banks that don’t have the capacity to move to the more advanced approaches won’t generate as much capital relief. This could put pressure on them to merge, because if they were part of a larger bank using the advanced approaches they could benefit from higher capital relief – and if you need less capital for the same amount of business, it enhances profitability and adds value.”

Mr De Longevialle makes the point that ratings agencies may not, however, accept all of this capital relief, as it is regulatory capital (as defined in Pillar 1), not economic capital (as defined in Pillar 2).

An agency might downgrade a bank’s rating if it were to fully reduce its asset base based on regulatory capital calculations, a threat that would prevent most savings banks from maximising their regulatory capital relief.