Managing the transition to a new global framework for bank capital

The first phase of Basel III came into effect for EU member states this month through the Capital Requirements Directive (CRD) IV, and other countries around the world have also started to implement it. Banks have until 2019 to meet all the requirements, and the signs are that the vast majority will have little trouble in doing so, but they are having to make big changes to their business strategies and operating models, especially because of the tougher rules on capital adequacy.

Basel III’s broad objectives, drawn up by the Basel Committee on Banking Supervision, are well known. They are to improve the banking sector’s ability to absorb shocks arising from financial and economic stress by applying stricter capital and liquidity requirements; to improve risk management and governance; and to strengthen banks' transparency and disclosures.

Capital requirements

This article is concerned only with the capital requirements of Basel III. In that respect, the goal is to improve the quantity, quality, consistency and reliability of bank capital ratios around the world. Under the new framework, the minimum capital requirement remains at 8% of risk-weighted assets (RWA) – as it was under Basel II – but 4.5% of that must now be common equity Tier 1 (CET1), the highest quality capital, compared with only 2% under Basel II.

But 8% is not really the minimum any more, as there are several capital add-ons:

• A capital conservation buffer, which must be CET1, of 2.5%. This brings the minimum to 10.5%.
• A surcharge for global systemically important banks (G-SIBs), which must also be CET1, ranging from 1% to 3.5%, depending on a bank’s systemic importance. This will increase the minimum for G-SIBs to 11.5% to 14%.
• A countercyclical buffer, which again must be CET1, ranging from 0% to 2.5%. This is to be applied when the authorities decide that credit growth is creating an unacceptable build up of systematic risk. At the highest rate, it would increase the minimum to 13% for most banks, and 16.5% for banks subject to the higher G-SIB surcharge.

In addition to these add-ons, which will be phased in between now and 2019, there are two other key capital requirements:

• Capital loss absorption at the point of non-viability: in other words, capital instruments must include a clause that allows regulators to write them off, or convert them to common shares, if the bank is judged non-viable.
• A minimum 3% leverage ratio on all of a bank’s assets (including off-balance-sheet items), without any risk weighting. This serves as a backstop to the risk-based capital requirements.

These rules are not binding on countries – it is up to the regulatory authorities in each country to implement them within their jurisdiction – but there is expected to be little deviation.

Be better, not richer

In his just-published book Heads or Tails: Financial Disaster, Risk Management and Survival Strategy in the World of Extreme Risk, Evgueni Ivantsov of Lloyds Banking Group argues that the Basel Committee missed the point by focusing on capital. They should have dealt with weaknesses in risk management.

“Normally, financial institutions fail not because they have insufficient capital, but because they suffer unbearable losses,” writes Mr Ivantsov. “They face losses because they cannot manage extreme risk properly by opting for reckless business strategies, flawed business models or by making unforgivable mistakes. I don’t dispute the idea of sufficiency of capital, but loss absorbency is no more than an ‘airbag’ and ‘seat belt’ for the banking industry’s passengers. Yet regulators keep on referring to the same mantra: more capital, more capital, more capital.”

That 'crash protection' comes at a huge cost. Recent estimates suggest US and European banks will need about €1700bn of additional Tier 1 capital, €1900bn of short-term liquidity and about €4500bn of long-term funding to meet Basel III rules.

In an interview with The Banker, Mr Ivantsov, who is head of portfolio management and strategy at Lloyds Banking Group, and chairman of the European Risk Management Council, explains how banks have been able to meet the new capital rules, despite the cost. “They have done it in two ways,” he says. “First, they have reduced their risk-weighted assets, the denominator in the capital ratio, by exiting many of their businesses, often non-core ones. They have also taken a more pragmatic approach, shifting their lending activity from capital-hungry assets to assets with lower risk weightings. I would estimate that European banks have reduced their risk-weighted assets by circa 10% since 2011.

“Second, banks have accumulated more capital, the numerator in the ratio. They have done this mainly by retaining more of their earnings – by paying out lower or no dividends. In addition, some banks have raised more equity capital via rights issues.

Meeting the capital requirements is only half the story. The other half is trying to run a profitable business when so much capital is tied up. “Before the crisis, the average return on equity [ROE] for banks in developed countries was about 15%,” says Mr Ivantsov. “Immediately after, it was in the region of 0.5%. By the end of 2012 it had risen to 6%. Now, most banks are working on ROE targets for the near future of 8% to 10%.”

Re-evaluating business models

The need for banks to change their business models as a result of Basel III was a theme in the fourth annual study of risk management in banking and insurance, carried out in 2013 by EY in conjunction with the Institute of International Finance. Seventy-six firms from 36 countries took part.

“Our survey showed that banks are under a lot of pressure to mitigate falls in ROE following the capital increases,” says Patricia Jackson, head of financial regulatory advice at EY. “As a result, 81% of respondents said they are evaluating portfolios, and 44% said they are exiting lines of business, up from 29% on 2012.”

The survey showed that capital management is being rethought. With regulatory capital now much higher than economic capital, 55% of respondents said they are aligning capital allocation with regulatory capital. “It’s an enormous re-evaluation of business models,” says Ms Jackson.

The retreat by banks from many activities – such as infrastructure lending, project finance and energy finance – is creating a gap that is increasingly being filled by the shadow banking sector. Ms Jackson has written a chapter on shadow banking in a book – 50 Years of Money and Finance – just published by Suerf, the European Money and Finance Forum. “The Basel III capital and liquidity buffers and wider uncertainty regarding future regulatory change have led to deleveraging and this in turn is leading shadow banking again to grow,” she writes.

Although Basel III has created scope for regulatory arbitrage between financial sectors – banking and shadow banking – there is unlikely to be similar arbitrage between countries, because Basel III is being implemented consistently by the world’s major economic powers. “You hear talk about banks being able to exploit differences in regulatory requirements between countries, but I think it is a chimera,” Ms Jackson tells The Banker. “All jurisdictions of any size are tough.”

Peter Davis, head of of financial risk management services in North America at EY, says that US banks are following the global trend to move out of capital-intensive and highly leveraged businesses. For US banks with leverage constraints, repos will be one of the businesses most affected.

“In the US we expect a rule to come out soon that will require banks to hold some long-term debt at the group level to act as an additional cushion against failure,” says Mr Davis. “Over time, banks will shift to where their competitive advantage is and re-price certain products to get acceptable returns. There will be a shift to businesses that use less capital, are more fee based and attract lower risk weights."

Basel IV looming

Many people believe that a Basel IV is a strong likelihood. That is certainly the view of Paul Tucker, former deputy governor of financial stability at the Bank of England, and now a senior fellow and member of the finance unit at Harvard Business School. In a speech given just before he left the Bank of England in October, he raised the prospect of a revision to the Basel capital framework to distinguish between capital that can absorb losses when a bank is a going concern – namely equity – and capital that can smoothly absorb losses when the bank is a “gone concern” and goes into liquidation.

“The recent G20 leaders' summit called on the Financial Stability Board to produce plans over the coming year for the level and location of gone-concern loss-absorbing capacity in global banks and dealers,” said Mr Tucker, who while at the Bank of England was also a member of the Financial Stability Board's steering committee. “In a nutshell, this will be a policy for the amount of term-bonded debt issued by banks, and where in the group structure it is issued from.

“I believe that in time, the Basel Capital Accord could usefully be recast so that it has distinct components for going-concern and gone-concern requirements. That would replace what to my mind is the fuzzy distinction between what are termed ‘common equity Tier 1’, ‘additional Tier 1’ and ‘Tier 2’ capital – not all of which is capital in the ordinary sense of the term that it can absorb losses outside of liquidation.”

If Mr Tucker is right, those who had hoped that Basel III would be the end of the matter will have their hopes dashed.