Counting the costs of more bank capital

Posted by Tracy Alloway on Dec 11 09:14.

Another blow to bankers this week came on Wednesday when the FSA released its third consultation paper on strengthening banks’ capital requirements.
The document is a staggering 360-pages long, exploring the implementation of amendments to the EU’s Capital Requirements Directive (CRD) in detail, but there are a few main points to be picked out.
For instance, under the proposed changes, hybrid capital will require enhanced loss absorbency features to be counted as Tier 1. That’s not surprising given European regulators recent war on hybrids, but it does have an impact on things like contingent convertible capital — which are debt instruments that convert into equity once a certain trigger is breached.
Under the proposals, CoCos will be able to count for up to 50 per cent of Tier 1.
There are new rules for securitisations and re-securitisations, requiring originators to hold up to 5 per cent of any credit risk — along the lines of the `skin in the game‘ proposals by other regulators.
There are also higher capital requirements for banks’ trading books and a requirement to use a stressed VaR – a supposedly more rigorous version (more tail events included etc.) of the Value at Risk models banks currently use to forecast expected portfolio losses over a certain period and probability.
More interestingly, the consultation also deals with the issue of large exposures, that is relatively big exposures to a single debtor, by limiting them to 25 per cent of a firm’s capital base.
Really, though, all you need to know is in the below table, showing the FSA’s estimated capital and non-capital costs banks for the various proposals:
So the FSA expects the new capital requirements to jump by about £33bn, most of that increase being required from 2011. Of course, these costs could well turn out to be lower if banks decide to do things like decrease the size of their trading book, or move certain operations to less capital-stringent jurisdictions.
Jonathan Pierce at Credit Suisse gives some more perspective on the numbers:
We are still digesting the document, but the standout figures are that the FSA expects the industry’s capital requirements to increase by £33bn versus the previous CRD, and its annual costs to increase by around £6bn. These numbers appear very high, but we make two points.
First, we believe only around a half of the capital increase relates to Barclays, Lloyds Banking Group and RBS (the rest being the Asian banks and subsidaries of e.g. US investment banks). This equates to an additional £175bn of RWA across the three domestic banks, on our numbers, which is actually broadly in line with our expectations.
Second, around £3.5bn of the annual cost increase relates to the additional cost of holding capital, which wouldn’t be relevant if equity were raised to cover the shortfall (i.e. we shouldn’t double count).
However, the other £2.5bn costs are noteworthy and relate in particular to potential changes in “large exposure” rules. This is not something we have explicitly focused on before – but does relate to our concern on funding costs in the new regulatory regime. It is also worth noting that changes to the definition of hybrid tier 1 capital will leave many types of existing tier 1 capital (e.g. preference shares) as tier 2. Indeed, tier 1 will in future be largely equity and quasi-equity, increasing the WACC of the tier 1 capital base and again impact margins.
Of course, many of the above estimates and impacts are subject to change. Indeed, the FSA believes its analysis likely provides an upper-end set of estimates with any eventual impact likely lower, particularly given the potential for banks to change their balance sheet structure, or group structure, ahead of the changes. Nonetheless, it is a timely reminder that the sector faces many headwinds.
Clearly then, having higher capital requirements, which are meant to help protect banks in events like financial crises, is not without costs.
Indeed, one of the theories about why lending by UK banks has yet to pick up — despite the Bank of England’s QEasing efforts — is that banks have been preparing for higher capital rules just like the ones above. That rather implies there are, perhaps less expected, costs for consumers as well.
As the FSA notes in the consultation:As noted in Table 1, costs for firms will rise substantially as a result of these measures and these costs will be passed on, at least in part, to consumers. This increase may manifest itself as lower deposit returns and higher borrowing interest rates. The extent to which this occurs depends on a number of factors, including the extent to which firms may already be able to charge above competitive prices for some products.
Another key impact is a likely reduction in growth in lending to consumers. As discussed in paragraphs 6.70–6.73, financial market firms respond to higher capital requirements by both raising capital and slowing the pace of lending. Consequently, there is likely to be a reduction in the volume of loans extended to consumers as a result of these changes.
http://ftalphaville.ft.com/blog/2009/12/11/88476/counting-the-costs-of-more-bank-capital/
Related links: Banks face £6bn bill after cheap loans end – FT
European banks to face capital demands – FT