Spiro Pappas of ABN AMRO and Charles Lucas of ABN AMRO Rothschild talk to Jules Stewart about the future of capital management post-Basel II and how preparation for the Accord’s implementation has changed the thinking of financial institutions.
Basel II may be just round the corner or it may be three years down the road, depending which commentators you listen to. Nevertheless, the final draft is on the table and financial institutions worldwide are being forced to think in a different way.
The third consultative paper on capital adequacy is part of the process to replace the 1988 Basel Accord, the first global attempt to set minimum levels of capital that banks need to hold. Under the new rules, the focus for determining capital adequacy will shift to a more sophisticated measurement of credit risk. It will take into account some financial disasters that have taken place since the original proposals were drawn up, such as the collapse of Long Term Capital Management (LTCM) – the world’s largest hedge fund. There is little doubt that with the implementation of Basel II and the new International Accounting Standards (IAS), capital management will become more dynamic. The greater emphasis on marking financial instruments to market on both sides of the balance sheet and the increased calibration of credit risk for risk weighting purposes will entail greater volatility in reported earnings and capital.
Bank treasurers and CFOs will be looking for tools to manage this volatility. In so doing, they will make use of a range of financial markets products including securitisation, covered bonds, hybrid capital in all its forms and equity linked financings.
“We find that in capital management discussions with banks, and in particular in relation to Basel II, that treasuries are looking at using the existing range of capital management tools in a different way,” says Spiro Pappas, global head of financial institutions and public sector debt capital markets at ABN AMRO. “For the more granular types of assets that a bank has on its balance sheet, such as residential mortgage, that will typically have lower risk weightings, financial institutions will increasingly be looking to fund those on-balance sheet.” Mr Pappas states, “Covered bonds will become the originator’s funding product of choice with volume originators providing the scale for efficient and regular market access. The two effects are self-reinforcing. Basel II will reward such clearly linked asset and liability balance sheet management.”
Product choice
If such rewards are on offer, what products can financial institutions choose from to achieve such active funding and capital management?
The conventional products in the fixed income toolbox include:
- senior and unsecured debt funding,
- subordinated debt,
- hybrid capital
- covered bonds
- securitisation of different asset classes
- credit derivatives
In addition there are equity-like Tier 1 instruments and straight equity capital markets products.
Refined response
Looking at the equity market first, how are products changing and how are banks responding to client concerns about Basel II? “Our Basel II discussions with clients have helped us to evolve and refine some of the products we can offer clients,” says Charles Lucas, global head of financial institutions at ABN AMRO Rothschild, the equity capital markets joint venture created in 1996 by the two banks. Mr Lucas believes that the impact of Basel II will be more subtle than some commentators have suggested. “Banks are already tending to allocate their capital internally in a more economically rational way,” he says. “Basel II will provide the regulatory overlay to something that is already happening so there shouldn’t be a shattering change in what banks do. Big banks with cross-border issues at stake will feel the greatest incentive to get a grip on these issues and they will be blazing the trail.
“Inevitably Basel II is a compromise,” says Mr Lucas, “and bear in mind that the big thing Basel II does is change the way you measure your risk assets, it doesn’t change the banks themselves. Therefore it wouldn’t make sense that before Basel II a bank should be regarded as well capitalised, and the moment Basel II is enacted it should suddenly be poorly capitalised. I think the regulators will take care to ensure that there are no step changes and so Basel II will stimulate more evolution than revolution. On the equity side, most banks worldwide are currently effective generators of capital to support their new business. So we will continue to see them using the equity capital markets more for active balance sheet management rather than for reconstruction unlike the insurers.”
Industrial holdings let go
Mr Lucas is confident there will be continued secondary offerings of listed companies and the unpicking of the web of industrial holdings by banks. “The banks are concluding that they don’t need to have these industrial holdings, and that they’re very capital inefficient to hold,” he says. “There will be continued cash sales, and also sales of exchangeables and convertibles and derivative products to unwind this web of cross-holdings.” Banks will continue to imaginatively create new subordinated instruments with which to leverage their balance sheets and protect their senior obligations. “In the past there was a clear division between debt and equity capital products,” he says. “Now it’s getting harder to distinguish between some debt and equity products, so investors are going to have to figure out how to categorise them. That process has been accelerated by the hedge funds, which aren’t too bothered if it is in the debt or equity compartment and are active investors in these cross-over instruments.”
Other options
Obviously equity is the purest form of capital and is the vital foundation of Tier 1 capital, however it is – by its very nature – the most dilutive form of capital. Mr Pappas sees many banks issuing across the range of capital markets products to maximise efficiency and leverage relative to their equity. In Mr Pappas’ view, “Given the relatively high core Tier 1 buffers of larger international banks, the capital management decision-making process will focus on other aspects. For such banks, the discussion has shifted to the cheapest and most appropriate funding, diversification of funding sources, and efficient risk transfer.” Mr Pappas believes that, in this regard changes arising from Basel II will oblige the banking industry, at least in the developed markets, to think carefully about which asset classes and associated risks they wish to retain on and off-balance sheet. Hence, he sees flexibility as the cornerstone of future capital management.
Capital constraints
According to Mr Pappas there is an interplay of forces that constrains management in terms of capital allocation, risk management and funding (see pie chart). “Playing at the edges allows a better alignment of risk, price, funding sources and capital.” In Mr Pappas’ view, ABN AMRO has been a leading player through its utilisation of risk transfer techniques, such as securitisation technology and credit derivatives, to actively manage this complex interplay.
Mr Pappas says that ABN AMRO’s financial institution clients are growing increasingly sophisticated in terms of how they manage and deploy their capital and how they manage risk in all its guises. “We have to respond to that and the Financial Markets Advisory group (FMA) was created to look at bundled solutions for complicated client needs,” he says. Mr Lucas agrees, saying: “Put simply, its bigger and better ideas for more demanding clients.” Mr Pappas continues: “Clients want to be able to manage their risk and sell it down to the most efficient taker. ABN AMRO’s job is to facilitate that process. The major challenge for us is to become a partner with our clients in their decision making for both strategic capital and risk management. We believe we can leverage our own experience as a globally active bank (with all the risks and portfolio management challenges that this entails) to the benefit of our clients.”
