ALMForum - Finance Trainer€¦ · 6 ALMForum May 2015 | Fully loaded Equity - the challenge in the total bank management With the prospective that regulators may at any time require

Fully loaded Equity –

the challenge in the total bank management

May 2015 | No. 11

ALMForum

2

ALMForum May 2015 | Fully loaded Equity - the challenge in the total bank management

Contents

Executive Summary ........................................................................................................3

1 Equity „fully loaded“ - The challenge in the total bank management ......................4

2 Summary of capital regulations for credit institutions ...............................................7

3 Definitions and bibliography ......................................................................................13

Available online at http://www.financetrainer.com/en/knowledge/almforum/

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Executive Summary

If a bank aims to pay dividends it has – according to the requirements of the ECB of January 2015 – to fulfill already today the currently valid equity requirements (“fully loaded”) neglecting the transitional arrangements. (1)

In our article we show an overview and the sources of the currently valid requirements. We estimate that the equity requirement will increase by 50% to 300% assuming an unchanged balance sheet. (2) Additionally Basel 4 is in development leading to an additional increase (see part 1).

Additionally to the quantitative increase in equity a qualitative improvement is required. The dominating part of the required equity has to be in core capital. To build up this is getting harder and harder for banks: the bail-in rules of the recovery and resolution regulation of the European Union (3) as well as expectation of low to zero dividends is discouraging for private investors. The low interest policy of the ECB and the resulting pressure on the banks’ deposit margins additionally makes it difficult for banks to increase their equity ratio with higher net interest incomes.

Currently we identify 2 options for the banks: Reducing the risk weighted assets (politically not wanted but necessary in an economic view) and a finetuning of the interest risk manage-ment in order to compensate the effects of the low interest environment (see part 2).

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1. Equity „fully loaded“ - The challenge in the total bank management

Our first graph shows that the minimum requirement is bank individual and furthermore is depending on a risk view of the bank management (board of managers and governors). Should the equity for buffers (systemic buffer and countercyclical buffer (4) already now be reserved or can it be used for new business? Does the bank need additional equity for future stress tests (not only for systemically important banks) (5&6), for the required SREP Ratio (7)? Does the bank have enough equity in order to fulfil the leverage ratio? Does the expected MREL Ratio (8) lead to an equity gap? What is the additional equity requirement of Basel 4?

Out of all these reflections each bank has to define its individual equity target. This target should be between 14.5 % and 22% plus the additional equity for the “cloud” shown in graph 1. 14.5% in case not being classified as systematically important and no equity is required for the coun-ter-cyclical buffer and the systemic risk buffer. This however seems quite risky as by this mean one or more “cloud” requirements may be triggered. As a consequence we expect a minimum requirement of 16% for non-systematically important institutions and up to 25% for globally systematic important banks.

Equity target to be fixed by the management: a range of 16% to 25%.

Equity requirement „fully loaded“

MREL RatioEBA Stress Test

SREP RatioLeverage RatioBasel 4 effects

22,0%

Simple components Total Equity requirement

Tier 1 Core Capital

Systematically important banks

- Global- Other

Systematic risk buffer

Countercyclical buffer

Pillar 2 risks

Capital conservation buffer

Additional Tier 1

Tier 2

4,5%

1,5%

2,0%

2,5%

0-2%

2,5%

1-5%

4,5%

6,0%

8,0%

10,5%

13,0%

18,0%

Bank individual buffer

1-2%20,0%

Graph 1: Basic: EC; FAQ in CRD IV; 21.03.2013: http://europa.eu/rapid/press-release_MEMO-13-272_en.htm

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Often the equity requirement of banks is argued as a percent of risk weighted assets (RWA). This is an incomplete view as the equity requirement for risks in the trading book and for operational risks is missing. As a consequence banks may have differing equity requirements even if their risk weighted assets are the same (9). The total absolute equity requirement of banks was increased by a change of the parameters in the RWA calculation and a substantial increase of the required equity for trading positions. As a consequence 8% of the equity requirement before 2009 is not comparable to 8% equity requirement in 2015. In our view this effect increases the equity basis already by 10% to 50 % and is basically due to the following changes in the regulation

» Increase of the equity requirements for credit risk » Standardised approach: increased requirement for bank due to the obligatory risk

weighting according to the issuer rating (country option no longer possible) (10) » IRB approaches: “Through the Cycle” view for the estimation of the PD, „Down Turn“

view for the LGD estimation (11)

» Internal models for market risks (CRD III; „Basel 2.5“): The Value at Risk PLUS the Stress Value at Risk as a risk measure and increased equity requirements for complex securitisa-tion products (12)

» Replacement risk derivatives: additional CVA requirements for OTC derivatives (13)

With Basel 4 the parameters for standardised approaches (credit risk, market risk and operati-onal risks) are getting more risk sensitive and will serve as a floor for the outcome of the more complex approaches (14). This will probably increase the “parameter effect” of the required equity by additional 30% compared to 2009. The parameters of the standardised approaches in Basel 4 tend towards the current IRB approaches, the old spirit that the one with the more precise risk measurement techniques needs less equity was already given up with Basel 3 and is now backed in with the floor. Details for this new regulations and concrete examples are shown in our Workshop*ALM-Update (A). We are persuaded that for the equity budgeting and equity targets it is essential to take into account these “parameter effects”. 16% equity instead of 8% does not mean that the equity requirements doubles but (after Basel 4) the requirements will be 2,5 to 3,75 times the old requirement.

(A) The current and planned regulations and a simulation of their effects are presented in our Workshop*ALM-Update (17th to 18th of September 2015 in Vienna in English)

from 8% (2009) to 16 % (2015) is equivalent to a multiplicator of 2,5 to 3,75 in absolute values (EUR)

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With the prospective that regulators may at any time require a fully loaded equity but with the certitude that the capital markets assume a “fully loaded” bank in case of issues, equity management is the challenge of all ALM departments. In our Basel 3 workshop in 2012 our prognostic of a minimum of 13 % lead to sceptical amazement – nowadays an equity target of 16% leads to no surprised reactions anymore.

What the ECB president Mario Draghi subsumed by his dictum “whatever it takes” (15) and what are the consequences on the banks’ results and by that mean their possibilities to plough back earnings, is the most recent surprise. The perspective that interest rate will not recover for years and that interest transfer prices may even be negative, forces all banks to review their plannings and business models. The prospective of negative margins for the deposits, an interest risk contribution that tends towards zero due to the missing curvature of the yield curve, a reduced leeway in private banking, make it difficult to reach the new equity target by retained earnings.

Parts of the reduced interest income can only be earned back with the concepts that were already successful in equity management. What happened in equity management by impro-ving the data basis, the precise attribution of collaterals, the prompt reaction to rating migra-tions and to negative risk/return relations has to be done also in the management of the total interest income: more precise and daily up to date position data, use of all available instruments, immediate reaction to changed markets and market views, precise calculation of the results.

8% RWA

+ Operational risk

+ Risk trading book

Systematically important banks

- Global- Other

Systematic risk buffer

Countery cyclical buffer

Pillar 2 risks

Capital conservation buffer

+ Δ RWA+ CVA

+Market risk

Basel 2

Parameter „tightening“ through Basel 3

Base

l 3 /

CRD

IV

100

110

144

144

144

158

150

197

244

338

412

2,5%

0-2%

0-2,5%

0-5%

1-2% Bank individual buffer 144 375

Minimum Maximum

„Basel 4“1-3%

174 468

What happend since 2009 out of 100 equity requirement

Source: FT Research

Ploughing back equity: the interest gap contribution has to be “rescued”

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Equity

Core Capital

(Going Concern)

Tier 2

(Gone Concern)

Tier 1 Core Capital

Additional

tier 1

2. Summary of capital regulations for credit institutions

Content:

1. Tightened criteria for capital quality

2. Minimum capital requirements and capital composition

3. Variable additional capital buffer

3.1 Capital conservation buffer

3.2 Counter-cyclical buffer

3.3 Buffer for systematically important banks

3.3.1 Systematic risk buffer

3.3.2 G-SII (Global systemically important institutions)

3.3.3 O-SII (Other systemically important institutions)

4. REP / ICAAP requirements

1. Tightened criteria for capital quality

Under Basel 2 different quality levels of Tier 1 to Tier 3 were eligible as capital. With Basel 3, on the one hand the Tier 3 category as eligible capital completely disappears, while on the other hand precise criteria for the eligibility of Tier 1 and Tier 2 are defined. The system distinguishes between so-called going-concern capital with the feature to offset losses incurred and assure the continuing existence of the institute. The going-concern capital is further divided into com-mon equity Tier 1 (core Tier 1 / CET1) and so-called additional core capital (additional Tier 1). In the CRR (Articles 26 to 31) it includes only the ordinary shares issued by the bank, share premium, retained earnings, disclosed reserves and funds for general bank risks. Furthermore, 14 criteria are defined that have to be met without exception if additional equity qualities shall be created. These include: temporally unlimited provision and subordination in the event of bankruptcy.

Graph 3

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In addition to common equity also additional core capital may be eligible as part of the core capital. 14 criteria were defined by the CRR (CRR Articles 51 to 55), amongst these the subor-dination, the indefinite duration and the restrictions on dividend payments are particularly worth emphasizing.

The gone concern capital (supplementary capital / Tier 2) has the purpose of compensating losses in case of bankruptcy. Again CRR defines 14 criteria for the eligibility of supplementary capital, including a minimum term of 5 years, the subordination to not-ranking creditors and the independence of dividend payments from the issuer‘s creditworthiness. The importance of supplementary capital is significantly reduced, because its ability to protect creditors in case of insolvency is limited and its function to the protection of creditors in case of insolvency limited.

Tier 3 capital which was eligible under Basel 2 in order to cover market risk is completely eliminated in the new capital structure.

In addition to higher quality standards, the deductions were revised. Compared to Basel 2, deductions almost always have to be made from common equity.

2. Minimum capital requirement and capital composition

In principle, in the CRR a minimum capital requirement of 8% remains, the requirements for the composition, however, were considerably tightened.

While under Basel 2 only 2% common equity was required, under Basel 3 at least 4.5% common equity must be available from 2015 onwards. In addition, the elimination of Tier 3 capital which could be used under Basel 2 to cover market price risks should be noted.

Tier 1 Core Capital (2,0%)

Additional Tier 1 (2,0%)

Tier 2 1. class (2,0%)

Tier 2 2.class (2,0%)

Tier 3 capital

Basel 2

Tier 1 Core Capital (4,5%)

Additional Tier 1 (1,5%)

Tier 2 (2,0%)

Basel 3

Graph 4

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3. Variable additional capital buffer

In addition to the minimum capital requirements, the CRR /CRD regulations provide for capi-tal buffer requirements which should be built especially in periods of excess credit growth and can be reduced in times of crisis. The additionally required various capital buffers have to be of CET 1 quality. The following buffers have to be available, whereas with regard to the level, transition periods are provided until the full extension in 2019:

3.1 Capital conservation buffer: 2.5 % mandatory for all instituts, step-by-step introduction as from 1.1.2016, full rate as from 1.1.2019. (Art. 129 CRD IV)

The fixed buffer should consist of common equity and aims to build capital in good times. In principle, this buffer can be used in times of stress. However, the closer a bank comes to the 8% minimum capital ratio, the less dividends can be distributed.

According to the recommendation of the European Central Bank of 28 January 2015 („Recom-mendation of the European Central Bank regarding the policy on the distribution of divi-dends“) (1) the following restrictions apply with respect to dividend policy for the year 2014:

Category 1: Banks that both meet the 8% total capital ratio, all of the buffers, the require-ments of Pillar 2 as well as the fully transposed (“fully loaded”) capital ratios already now, should only distribute its net profit in the form of dividends in a conservative way.

Category 2: Banks which can satisfy the capital ratios that are applicable according to transi-tional provisions, though have a gap to the full transposition of capital ratios should arrange their dividends in a way that a linear path is secured to the full transposition of ratios.

Graph 5, Source: German Central bank (Deutsche Bundesbank) Monthly Report June 2013

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Category 3: Banks which do not entirety meet the applicable ratios according to transitional provisions should basically not distribute any dividends.

As seen from these recommendations of the ECB, the statutory minimum requirements after the transitional provisions („fully loaded“) are already relevant for banks today.

3.2 Counter-cyclical buffers: 2.5%, step-by-step introduction as from 1.1.2016 (CRD IV Article 130, 135-140)

In addition to the capital conservation buffer, a further counter-cyclical capital buffer of up to 2.5% of risk-weighted assets is introduced. This buffer will be defined by the national supervisory authorities of the respective countries as from 2016 onwards. As a basic idea, bank lending should be slowed down due to this additional capital in times of economic recovery and rising gross domestic products in order to prevent speculative bubbles. In times of economic hardship, the national supervisor can reduce the requirements regarding the counter-cyclical buffer in order to release pressure from lending not to let shrink bank lending too much. In case of macroeconomic indicators arriving at warning levels the build-up of the countercyclical buffer in the institutes must be made no later than 12 months after the interjection of building up by the national supervisors.

3.3.1. Buffer for systemic risks: Systemic risk buffer as from 1.1.2014 possible (CRD IV Article 133 and 134)

The capital buffer for systemic risk can be used flexibly. It can be set, for example, for all or certain types or groups of institutions and for loans in the domestic territory, in other Member States or in third countries – also at different levels.

The capital buffer for systemic risk can be prescribed by the regulatory authorities of the Member States if long-term, non-cyclical systemic or macro-prudential risks arise at the nati-onal level. The capital buffer for systemic risk is at least 1% of risk-weighted assets. Up to a buffer of 3%, only the higher-level supervisory authorities must be informed.

3.3.2. Capital buffer for global systemically important institutions (G-SII): 1–3.5 %, step-by-step introduction as from 1.1.2016. (Article 131 and 132 CRD IV)

Global systemically important institutions have to hold up a mandatory additional capital buffer on a consolidated basis as of 2016. It is - depending on the systemic importance of the group - 1% to 3.5%. G-SII are determined annually in accordance with the internationally agreed identification procedure (16) taking into account the criteria size, interconnectedness with the financial system, substitutability, complexity and cross-border activity. In a ranking system the institutions concerned are assigned with risk buffers.

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3.3.3. Capital buffer for other systemically important institutions: 0-2.0 %, possible as from 1.1.2016; no looping-in necessary (Article 133 and 134 CRD IV)

For other systemically important institutions (O-SII), the national supervisory authorities can require an additional capital buffer as from 2016. The risk buffer for O-SII is determined with similar but less rigid indicators and can be up to a maximum of 2% of risk-weighted assets. The buffer for O-SII can be charged both on all levels of consolidation as well as at individual institution level.

The capital buffers for G-SII and O-SII are generally not designed to be added up, because they are used to cover the same risk. In this respect the following applies: If an institution is subject to both a capital buffer for G-SII as well as a capital buffer for O-SII, only the higher buffer is applicable. If an institution is subject to both a capital buffer for G-SII or O-SII as well as a capital buffer for systemic risk, only the highest requirement is applicable higher of the buffer applicable, unless the capital buffer for systemic risk only applies to loans in the Member State.

3.4. Supervisory review and evaluation process (SREP) (Article 22 and 123 as well as the annexes V and XI of Directive 2006/48/EG)

Credit institutions are required to ensure by the use of appropriate procedures and systems an adequate capital under consideration of all significant risks. The Supervisory Review and Evaluation Process (SREP) together with the Internal Capital Adequacy Assessment Process (ICAAP) is part of the broader Supervisory Review Process (SRP). The ICAAP is geared to the nature, scale and complexity of the banking transactions and thus has to be shaped individu-ally by the financial institution.

According to CRD IV which forms the basis for the SRP and the implementation of Pillar 2 in the member countries, the following risks have to be taken particularly into account (17):

1. credit Risk

2. concentration risk

3. the types of risk in the trading book

4. commodities risk and foreign currency risk, including the risk arising from gold positions

5. operational risk

6. the securitization risk

7. liquidity risk

8. the interest rate risk in respect of all transactions that are not in the trading book

9. the residual risk from credit risk mitigation techniques

10. the risks arising from the macroeconomic environment.

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Due to the fact that risks which are not included in pillar 1 have to be reported in the ICAAP (18), measuring risk in the ICAAP results in an additional capital requirement which is essen-tially composed of the

1. interest rate risks in the banking book

2. liquidity risks

3. macroeconomic risks

4. concentration risks.

Under the additional consideration that in the current version of the risk measurement the ICAAP has to be based generally on the stress scenario, we assume that in a conservative estimate – taking into account the additional ICAAP risks, depending on the risk policy – an additional burden between 1-4 % arises.

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3. Definitions and bibliography

(1) Single Supervisory Mechanism (SSM) – ECB recommendation of the European Central Bank of 28 January 2015 on dividend distribution policies (ECB/2015/2), ABl. C 51 of 13 February 2015, S. 1; date of publication 29 January 2015

(2) Announced or in consultation are currently the following changes regarding the Stan-dardised Approaches by the Basel Committee (BCBS). Should then also be implemented as floor (minimum capital requirement) for internal models (new floor regime). Furthermore, a consultation on the revision of the IRB Approach should follow mid-2015.

(3) Bank Recovery and Resolution Directive (BRRD) of 15 May 2014, date of publication 12 June 2014, Article 45

(4) EU Directive 2013/36/EU of 26 June 2013 and national provisions in order to implement Art. 103, 129, 130 and 131 CRD; country specific add-ons

(5) Methodological note EU wide Stress Test 2014 of 29 April 2014

(6) Results of 2014 EU-wide stress test of 26 October 2014

(7) Capital Requirements Directive (CRD IV) Art. 97: CRD and ECB as consolidating supervi-sory authority; SREP ratios (for the individual institute or within the IPS), date of publication 27 June 2013

(8) Definition MREL according to BRRD = minimum requirement for own funds and eligible liabilities. The Member States shall ensure that the institutions adhere at all times to a mini-mum requirement for own funds and eligible liabilities. The minimum requirement is calcu-lated as a percentage share of own funds and eligible liabilities in the sum of total liabilities and own funds of the institute (Article 45 BRRD). „Eligible liabilities“ means the liabilities and other capital instruments then Common Equity, Additional Tier 1 or Tier 2 of an institu-tion [...] that are not excluded from the scope of the bail-in instrument (Article 2 (1) point 71 BRRD). Eligible Liabilities consist in accordance with Article 45 (2) of subordinated debt and senior unsecured debt securities with a residual maturity of at least 12 months that are subject to bail-in powers. Examples: Cocos, participation capital, preference shares

(9) Capital Requirements Regulation (CRR), EU Regulation 575/2013 of 26 June 2013, Art. 92 CRR, date of publication 27 June 2013

(10) CRR Article 119, 120, 121, 138, 139

(11) CRR Article 177, 179, 180, 181

(12) Revisions to the Basel II market risk framework, BCBS, July 2009; Enhancements to the Basel II Framework, BCBS, July 2009; CRD III (Directive 2010/76/EU) of 24 November 2010, date of publication 14 December 2010

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(13) European Market Infrastructure Regulation (EMIR), Regulation 648/2012/EU of 04 July 2012, date of publication 27 July 2012

(14) Basel Committee on Banking Supervision (BCBS), Consultative Document, Revisions to the Standardised Approach for credit risk, Issued for comment by 27 March 2015; The stan-dardised approach for measuring counterparty credit risk exposures, 03/2014 (rev. 04/2014)

(15) Speech of Mario Draghi, President of the European Central Bank at the Global Invest-ment Conference in London, 26 July 2012

(16) Financial Stability Board (FSB) 2014 update of list of global systemically important banks, 06 November 2014

17) Capital Requirements Directive (CRD IV) Article 107 in conjunction with Article 97 and 76 to 87; § 25a Abs. 1 KWG; § 39 Abs. 2b BWG

(18) German Federal Financial Supervisory Authority (Deutsche Bundesanstalt für Finanz-dienstleistungsaufsicht, BaFin), Prudential assessment of banks‘ internal risk-bearing capa-city concepts, 07 December 2011; German Central Bank (Deutsche Bundesbank), „Range of Practice“ to ensure the risk-bearing capacity at German banks, 11 November 2010; Austrian National Bank (Österreichische Nationalbank, OeNB), Supplementary remarks on the ICAAP Guide, December 2012; OeNB / Financial Market Authority (Finanzmarktaufsicht, FMA), Guideline for overall risk management – ICAAP, January 2006; Implementation of Pillar 2 in Austria, 02 December 2008; German Bundesbank Monthly Report March 2013 p. 31 ff; Minimum Requirements for Risk Management - MaRisk circular 10/2012, 14 December 2012; CEBS (Committee of European Banking Supervisors) Guidelines on the management of con-centration risk under the supervisory review process, 02 September 2010; CEBS guidelines on stress testing, 29 August 2010

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ALMForum - Finance Trainer€¦ · 6 ALMForum May 2015 | Fully loaded Equity - the challenge in the total bank management With the prospective that regulators may at any time require