The Basel Committee on Banking Supervision has released the detail of capital ratios required in the ‘New World’ of Basel 3. This follows on from some modest watering down of the detail of the calculation of Core Tier 1 capital (which incorporated more generous treatment of minority interests, plus some limited inclusion of deferred tax assets and investments in financial institutions) back in late July. ..
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What are the new rules?
Under the new regime (popularly referred to as Basel 3), banks will be required to hold a minimum ratio of 4.5% common equity (‘Core Tier 1’) to risk weighted assets. This compares with 2% under Basel 2. Below this level, a bank will be deemed insolvent.
In addition, a ‘capital conservation buffer’ of 2.5% must be held, giving a total Core Tier 1 minimum of 7%. The capital conservation requirement is effectively buffer capital, which can be drawn on in times of stress. Banks in the capital conservation zone (i.e. between 4.5% and 7% Core Tier 1) face constraints on their ability to distribute capital or pay bonuses.
A further Core Tier 1 requirement of 0-2.5% may also be added at the discretion of local regulators (referred to in regulatory parlance as the ‘countercyclical buffer’). This has the aim of constraining the enthusiasm of banks during periods of ‘excess credit growth’ – a phenomenon that is unlikely to recur in Europe for many years.
The above rules are towards the lower end of where market expectations would have been a few weeks ago. However, the real surprise is in the generous phase-in arrangements.
The minimum common equity requirement starts at just 3.5% in 2013 and does not rise to 4.5% until 2015. The capital conservation buffer does not kick in until 2016, and then only in 0.625% increments over the four years to 2019. In addition, stricter rules on the definition of Core Tier 1 capital (principally limiting the inclusion of deferred tax assets and significant financial investments to 10% of Core Tier 1 each, or 15% in aggregate) are phased in smoothly over 2014-2018.
Finally, banks have until 1st January 2018 to repay government capital injections.
In addition, a ‘capital conservation buffer’ of 2.5% must be held, giving a total Core Tier 1 minimum of 7%. The capital conservation requirement is effectively buffer capital, which can be drawn on in times of stress. Banks in the capital conservation zone (i.e. between 4.5% and 7% Core Tier 1) face constraints on their ability to distribute capital or pay bonuses.
A further Core Tier 1 requirement of 0-2.5% may also be added at the discretion of local regulators (referred to in regulatory parlance as the ‘countercyclical buffer’). This has the aim of constraining the enthusiasm of banks during periods of ‘excess credit growth’ – a phenomenon that is unlikely to recur in Europe for many years.
The above rules are towards the lower end of where market expectations would have been a few weeks ago. However, the real surprise is in the generous phase-in arrangements.
The minimum common equity requirement starts at just 3.5% in 2013 and does not rise to 4.5% until 2015. The capital conservation buffer does not kick in until 2016, and then only in 0.625% increments over the four years to 2019. In addition, stricter rules on the definition of Core Tier 1 capital (principally limiting the inclusion of deferred tax assets and significant financial investments to 10% of Core Tier 1 each, or 15% in aggregate) are phased in smoothly over 2014-2018.
Finally, banks have until 1st January 2018 to repay government capital injections.
What does it mean for bank shares?
In a nutshell, it is now clear that new Basel rules will not force another round of mass capital raisings in the banking sector. In aggregate, we would expect that the pan-European banking sector will have a Core Tier 1 ratio of over 9% – under current rules – by the end of 2010.
As a broad approximation, higher risk weightings for investment banking activities (expected in 2011 and 2012), together with limits on the inclusion of deferred tax assets and significant financial investments would knock this aggregate down to 7%, with likely growth of at least 50bps per annum (assuming that a modest economic recovery continues).
In a nutshell, it is now clear that new Basel rules will not force another round of mass capital raisings in the banking sector. In aggregate, we would expect that the pan-European banking sector will have a Core Tier 1 ratio of over 9% – under current rules – by the end of 2010.
As a broad approximation, higher risk weightings for investment banking activities (expected in 2011 and 2012), together with limits on the inclusion of deferred tax assets and significant financial investments would knock this aggregate down to 7%, with likely growth of at least 50bps per annum (assuming that a modest economic recovery continues).
A minimum; not a target
By these rules, some banks – notably Nordic banks, the Swiss and even the UK names – would already appear overcapitalised. However, this does not mean that we are rushing to the spreadsheets to factor in share buybacks within the sector. Required capital levels are just that – a minimum requirement; not a target. Local regulators and bank management teams will want to ensure that banks (especially those deemed systemically important) remain comfortably in excess of regulatory minima through all ‘tail risk’ outcomes, bar the extreme. We would also expect equity and credit markets to impose their own form of ‘super-equivalence’ (additional buffer requirements) on the banks.
Nevertheless, it is now clear that regulatory reform will not inhibit the ability of the bulk of the sector to earn a midteens return on equity – in which case the sector still looks to be on the cheap side given an average price to book of 1.3x at the end of 2010. Of course, banks remain a leveraged play on economic prospects in an environment where double-dip risks remain, funding markets are still disrupted and credit spreads remain elevated for many European sovereigns.
Nevertheless, it is now clear that regulatory reform will not inhibit the ability of the bulk of the sector to earn a midteens return on equity – in which case the sector still looks to be on the cheap side given an average price to book of 1.3x at the end of 2010. Of course, banks remain a leveraged play on economic prospects in an environment where double-dip risks remain, funding markets are still disrupted and credit spreads remain elevated for many European sovereigns.
A sensible balance
All in all, European bank capital requirements have been significantly increased as a result of these proposals – 7% is the new 2% and, with a stricter definition of capital and risk weighted assets, it is fair to say that the sector’s regulatory capital needs have increased more than four-fold compared with pre-crisis levels. This strikes me as a sensible balance between the need to bolster the resilience of the sector and the need to ensure that banks can help sustain economic recovery.
In addition, it is worth remembering that higher capital requirements are just part of a package of measures to reduce the likelihood that the crisis of 2007-9 can recur. Stricter liquidity rules are also to be introduced (in the form of the ‘Liquidity Coverage Ratio’ and the ‘Net Stable Funding Ratio’ to be introduced in 2015 and 2018 respectively), new rules are to be drafted to force the burden of bailouts on bondholders rather than governments, and the International Accounting Standards Board (IASB) continues to work on expected credit loss provisioning.
All in all, European bank capital requirements have been significantly increased as a result of these proposals – 7% is the new 2% and, with a stricter definition of capital and risk weighted assets, it is fair to say that the sector’s regulatory capital needs have increased more than four-fold compared with pre-crisis levels. This strikes me as a sensible balance between the need to bolster the resilience of the sector and the need to ensure that banks can help sustain economic recovery.
In addition, it is worth remembering that higher capital requirements are just part of a package of measures to reduce the likelihood that the crisis of 2007-9 can recur. Stricter liquidity rules are also to be introduced (in the form of the ‘Liquidity Coverage Ratio’ and the ‘Net Stable Funding Ratio’ to be introduced in 2015 and 2018 respectively), new rules are to be drafted to force the burden of bailouts on bondholders rather than governments, and the International Accounting Standards Board (IASB) continues to work on expected credit loss provisioning.
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Source: ETFWorld – Schroders (Justin Bisseker – European banks analyst)
