New regulations and resolution and recovery regimes are forcing banks across the world to change their models and strategies. While much is still uncertain, it is clear that how they manage their capital levels and funding will be crucial to determining what business lines they can go into. 

In the pre-crisis days, investment bankers would not have been caught dead talking about cash management, trade finance or letters of credit. For them, those were boring, unprofitable businesses that were to be dealt with by mere commercial bankers.

Yet the allure of racier types of banking such as fixed-income trading is no longer what it was. Many of the world’s biggest lenders have cut back these activities and ramped up more vanilla ones.

This is a result, in large part, of the new regulatory environment banks now face. A multiple of recovery and resolution regimes have been created over the past two years or are in the process of being established. Many of them will force banks to increase their capital levels and their liquidity. While the full consequences may not be known for a while, they are almost certainly going to push banks’ costs up.

“I don’t think we’re that much closer to knowing the combined impact of new regulations on banks,” says Emil Petrov, head of capital solutions at Nomura. “But I think we all agree that the cost of doing business is going up.”

Mixed reception

The main basis for banks’ capital requirements will be the Basel III framework, whose various provisions are scheduled to be implemented between 2013 and 2018. Yet it became clear over the course of 2012 that the final capital requirements banks will have to meet will depend less on Basel III than on the wishes of their home regulators. In Europe, so-called ‘national finishes’ have cropped up in several countries, with some authorities insisting that their lenders hold buffers of capital above Basel III’s core requirements and, as in the case in the UK, ring-fence their retail banking arms.

While such measures are designed to make banks that much safer, and make the prospect of taxpayers having to bail them out that much more remote, they are far from universally popular with bankers, many of whom believe they will lead to a motley collection of regimes. “In certain countries regulators are saying: ‘We understand Basel III, but we want to do a bit more than just that',” says Julian van Kan, head of the financial institutions group for Europe at BNP Paribas. “So, we now have these national finishes that are complicating things. This is going to create unevenness in the market. Nationalistic buffers will cause problems.”

Others add that the process of regulators regularly coming up with new rules is frustrating for banks. “Just as banks get to grips with new requirements, they are hit by yet more regulatory initiatives, new capital buffers to be built on top of the existing ones,” says Mr Petrov. “And this is only one part of the equation. You also have to consider the cost of structural reforms, resolution, bail-in regimes, etc,” he adds.

Buffers on top of buffers

The extra buffers have come about thanks to governments wanting their banks to hold more loss-absorbing capital. Depending on the size of the institution and whether it is deemed systemically important, most big lenders will probably target core Tier 1 ratios of at least 10% and total capital levels equivalent to about 20% of their risk-weighted assets.

In the UK, a large proportion of the extra layer of non-core capital will likely be made up by contingent capital notes (so-called ‘cocos’) in the form of Tier 2 hybrid bonds. These will act as quasi-equity instruments and be written down or converted to equity if the issuer’s common equity ratio falls below a certain level. Although the UK's Financial Services Authority (FSA) has not yet officially given credit to such trigger-based instruments, Barclays sold a $3bn, 10-year coco in November 2012 that will be written off entirely should its core Tier 1 ratio drop below 7%. This has led bankers to believe that UK regulators will support such instruments, with many saying that they will become an important funding tool in the next five years for banks across Europe.

Investors have raised concerns about cocos, with some fixed-income funds fearing that their mandates do not allow them to hold such bonds because their features are too equity-like. Yet Thomas Huertas, a partner in Ernst & Young’s financial services risk management team and a former executive committee member at the FSA, says that investors will not dismiss cocos simply because of their loss-absorbing features. That the Barclays deal attracted an order book of $17bn backs up his point. “People have asked if there is enough money out there from investors who know they’ll run the risk of being bailed in,” he says. “For me, it’s a matter of price. In today’s low-rate environment, something that pays a good yield is going to attract investors.”

Tough on emerging markets

There are some, however, that argue that all unsecured bank bonds, including senior ones, will be viewed in the future as forming part of a borrower’s loss-absorbing capital, which should make investors less wary of cocos. “Some investors have taken the view that in the future all bank unsecured debt will be in some way contingent,” says Adam Bothamley, head of debt syndicate for Europe, the Middle East and Africa at HSBC. “For them, where they are positive on a particular credit, it makes sense to buy the instruments with explicit contingent provisions and get paid the premium for that.”

As well as capital requirements, the other new regulatory features that will have a major effect on banks’ strategies will be rules regarding liquidity. These form part of Basel III, with banks having to meet a liquidity coverage ratio – which will make them hold enough saleable assets to survive a month-long funding squeeze – and a net stable funding ratio (NSFR), which will force them to match the tenor of their liabilities and assets more closely.

Reaching the NSFR targets will be especially onerous for emerging market banks, according to analysts. Some fear that their mortgage and infrastructure arms – both of which require providing clients with long-term loans – will have to be slimmed down because of their inability to source long-term liabilities from their local bond markets. Jacko Maree, head of South Africa’s Standard Bank, Africa’s biggest lender, has such concerns. “With Basel III coming in, mortgage lending will become harder,” he says. “It’s all very well to talk about matching assets and liabilities if you’re operating in a country with deep bond markets. In South Africa, the situation is not so simple.”

Clarification to come

The final terms of many other aspects of new regulations, recovery and resolution regimes will not be known for years. There is particular uncertainty when it comes to global banks with operations in many jurisdictions. The UK authorities hinted in December that they would 'trust' their American counterparts to execute a resolution of a failed US bank with subsidiaries in the UK and would thus be unlikely to grab any assets from them. While no other national regulator has stated the same thing, analysts say the US seems determined to provide support to the foreign operations of its banks anywhere in the world, potentially meaning those arms will not have to be self-funding. European officials are yet to articulate whether they will do the same.

“The US is sending strong signals that it will take a global approach to resolution and that it will provide ongoing support to the operating subsidiaries of any failed US-headquartered bank,” says Mr Huertas. “So, if you’re a liability holder of an operating subsidiary, you should be in reasonably good shape.

“We haven’t had as strong a signal from any European jurisdictions that they intend to take the same global approach. Europe is simply not as far along in the process as the US is.”

Banking union

A banking union in the eurozone will also potentially force banks to change their strategies. Should one emerge in the next 18 months, it would likely cause banks to have to raise capital levels more quickly than they might have done otherwise. Mr Petrov of Nomura believes that a proper banking union would entail an overall regulator harmonising calculations of risk-weightings, which vary widely from country to country.

Some countries – analysts often point to Germany as being one of them – have a seemingly more relaxed stance about risk-weightings than the rest of the bloc. Deutsche Bank, for example, had a risk-weighted-to-total asset ratio of just 18% at the end of 2011, which was largely why it was able to have far less Tier 1 capital than many of its continental peers despite having more assets than any of them.

“Net-net, the result will probably be that eurozone banks need more capital,” says Mr Petrov. “Many banks in some core eurozone countries have pretty low risk-weighted-to-total asset ratios. Therefore, it is not inconceivable that the process of harmonising the denominator of the capital ratio – risk-weighted assets – will push them to raise more capital.”

Banks are already facing higher funding costs thanks to new regulations, even when those have yet to be implemented or even articulated in detail by financial watchdogs. “I think that current bank spreads already reflect many of the risks and uncertainties that the financial sector faces,” says Nik Dhanani, head of capital solutions at HSBC.

For banks, this will result in a fundamental shift in their practices. While strategies will differ from institution to institution, it is clear that the management of capital and funding will be of far greater importance than in the pre-crisis era. “What you’ll find increasingly is that banks, in addition to meeting their client needs, will have to adapt their business models to match what they can realistically fund that business with,” says BNP Paribas’s Mr van Kan.

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