Digesting the Basel reforms

Posted by Paul Murphy on Dec 17 18:17.

The latest Basel proposals for the banking sector were released on Thursday, and they are not going down well.

Here’s a snap summary from the banks team at Credit Suisse:

The Basel Committee has published its latest thoughts on capital and liquidity. We are still digesting the main implications of this, but at first read it looks pretty punitive on the sector. In particular, the new definitions of common equity tier 1 appear to take a very hardline with the majority of deferred tax assets, insurance equity capital, excess expected losses, unrealised debt losses, minority interests and pension fund liabilities being deducted. Other supervisory deductions will get a 1250% risk weight on these proposals. The calculation of counterparty credit risk also seems to be changing markedly. The liquidity document seems less surprising with the broad thrust being an increase in Government bond holdings and a reduction in short-term wholesale funding which we have written about extensively before.

Overall, we believe this is negative for the European banks sector. Timeline for implementation isn’t until 2012, with grandfathering arrangements thereafter, but the market is likely to look through this and penalise banks which rely heavily on DTA, pension fund add backs, and financial subsidiary capital in our view.

For individual banks, we need to do more work, but our first read is that UK banks, in particular LBG and RBS look substantially exposed (see our research pre-empting this two weeks ago). But this will affect most European banks as well. For example, the French banks have 6-22% of equity tier 1 capital from minorities. Consider also that Credit Agricole and Natixis are potentially exposed due to the listed entity owning 20-25% of their own retail networks with the associated deduction 50% from tier 1 and tier 2 – the rules might not apply here but could create uncertainties until decisions are made in 2010. Another example is Dexia with an equity tier one ratio at 10.8% but below 5% if the €8.8bn of unrealised negative AFS currently not deducted is applied to tier 1. Other regions, like Scandinavia and Italy are arguably less exposed given tier 1 definitions are already prudently struck.

Of course, these are still proposals and there’s a lot of detail still to emerge. There might also be national discretions, although the aim of this in part seems to be to remove those. One need only look at the Australian banks, several of which would report equity tier 1 ratios 200bps higher were they to adopt UK FSA standards. But generally speaking, the definitions are tightening up for all. Of course, the BIS might apply relatively low equity tier 1 minima, in line with tighter definitions. The question then is whether the market would accept lower headline numbers, or still push for relatively high (e.g. 8-10%) ratios on the new definitions. At the very least, the BIS’ starting point seems to be a relatively hardline approach to new capital and liquidity definitions – and hence we would view this negatively for the sector as a whole.

The real sticking point here seems to be changes to the definition of Tier 1 equity. Minority interests no longer apply, unrealised losses (and gains) must be taken into account, the use of deferred tax assets is largely ruled out and there are stringent new rules proposed for the related treatment of pension fund deficits. In short, banks’ core equity is going to have to get a lot purer.

Also, at the Tier 2 level, it looks like banks will be kissing goodbye to the upper and lower divisions.

There are some very complex changes to the treatment of counterparty risk, including the charming concept of “wrong way” risk, and also alterations to calculations like the probability of default, which in future will include the important caveat: in a downturn.

Meanwhile, on the liquidity front, the proposed framework here is broadly as expected, with banks being required to hold significantly more government bonds on their books.

Here’s some more from Credit Suisse:

1. Liquidity coverage ratio. This new regulatory ratio aims to ensure adequate liquidity in the event of another market disclocation. It is meant to require a bank to maintain an adequate level of “unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30 day time horizon under an acute liquidity stress scenario”. The ratio is defined as:

· (stock of high quality liquid assets) / (net cash outflows over a 30 day time period), with a minimum of 100%.

With high quality liquid assets including Government bonds and covered bonds. This isn’t a major surprise and is effectively a similar definition to central bank eligible collateral pre-crisis. More surprising though is the regulator’s assessment of an extreme stress scenario:

· 7.5% of “stable” retail and small business deposits go in the first 30 days;
· 15% of “less stable”deposits, high net worth (uninsured) deposits and internet deposits;
· 25% of wholesale funding with a maturity of less than 30 days supplied by large corporate customers as part of an operational payments services float;
· 75% of wholesale funding < 30 days from large corporate customers other than as part of payment systems float;
· 100% of interbank funding with a maturity of less than 30 days.

2. Net stable funding ratio. This new regulatory ratio aims to “promote more medium and long-term funding of the assets and activities of banking organisations”. It is defined as:

· (available amount of stable funding) / (required amount of stable funding) with a minimum of 100%

The numerator of this ratio is roughly equivalent to “core funding”, as defined in the Reserve Bank of New Zealand regulations and in our recent note “More important than Tier One?”, 27 November. It is calculated using a weighting schedule as below:

· 100% of total tier 1 and tier 2 capital and preferred stock
· 100% of liabilities with a contractual maturity >1yr
· 85% of “stable” retail and small business deposits with maturity <1yr
· 70% of “less stable” retail and small business with maturity <1yr
· 50% of large corporate deposits with maturity <1>

plus

· 10% of all undrawn committed credit lines and overdraft facilities
· And a percentage of guarantees, uncommitted credit lines, letters of credit, potential money market mutual fund repurchase obligations etc, at local regulator’s discretion.

The denominator is calculated as a weighted sum of the asset side of the balance sheet:

· 0% weighting – cash, securities with a remaining maturity <1yr, interbank loans with a maturity <1 yr, securities held with an offsetting reverse repo
· 5% weighting – unpledged high-quality liquid securities (similar definition to central bank eligible collateral)
· 20% weighting – corporate bonds and covered bonds with a proven record of liquidity (ie, no major increases in repo haircut in the last 10 years)
· 50% weighting – other corporate bonds, gold, equities, loans to corporates with a maturity less than one year
· 85% weighting – retail loans with a maturity less than one year
· 100% weighting – all loans with maturity > one year, all other assets

All in all, the view seems to be that this is a tad more aggressive than forecast. According to back of an envelope calculations by Credit Suisse, the European banking sector as a whole will have an aggregate funding requirement of €1,100bn.

Credit Suisse says that is broadly as expected, but it still sounds like an awfully large amount of money.

Related links:
Bank capital rules face overhaul – FT
Strengthening the resilience of the banking sector – BIS
International framework for liquidity risk measurement, standards and monitoring – BIS