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Efficient capital management under Basel III Challenges and perspectives

Chris Matten
28 May 2011

Agenda
Perspectives on Basel III The financing challenge Importance of capital planning and stress testing

PwC

Key Basel III components

Areas Capital ratios and targets

Main Basel III components

1 Capital definition 2 Countercyclical buffers 3 Leverage ratio 4 Minimum capital standards 5 Systemic risk

RWA requirements Liquidity standards

6 Counterparty risk 7 Trading book and securitisation (also known as Basel II.5) 8 Liquidity coverage ratio 9 Net stable funding ratio

PwC

Evolution of Basel I to Basel III

1 Tighter capital definition Capital Ratios and Targets 2 Capital buffers 3 Leverage ratio 4 Higher minimum ratios 5 Systemic add-on
Pillar-3 Disclosure

RWA Requirements
Pillar-1 Market risk Pillar-1 Credit risk

Pillar-2 ICAAP Pillar-1 Operational risk Incremental risk

6 Counterparty risk

7 Trading book revisions

New Pillar-1 Credit risk Securitisation revision

8 Coverage ratio Liquidity Standards

Tier 1 and 2 definition

9 Net stable funding ratio

Basel I

Basel II

Basel II.5

Basel III

PwC

Capital buffers: procyclicality and capital conservation

Issues
Procyclical amplification of financial shocks in banking system, financial markets and wider economy. Amplified through: Basel II risk sensitivity Accounting standards for both mark-tomarket assets and held-to-maturity loans Build up and release of leverage among FIs, firms, and consumers

Basel III proposals

Measures to dampen cyclicality in IRB minimum capital requirements Forward-looking provisioning Capital conservation buffer Discretionary countercyclical buffer Stress buffer range

PwC view
On-going analyses needed to determine extent procyclicality of minimum capital requirements Role of Pillar 2 internationally remains unclear Essential to identify appropriate indicators to take timely action/release buffers Consider alternative methods such as tightening underwriting standards and reducing credit supply

PwC

Leverage ratio

Issues
Pre-crisis build up of excessive leverage in the banking system Crisis market pressure to reduce leverage, amplified downward pressure on asset prices Capture Off-Balance Sheet (OBS) items

Basel III proposals

Constrain build-up of leverage in the banking sector Mitigate destabilising deleveraging which damages financial system and economy Reinforce risk-based requirements with a simple, non-risk-based backstop measure based on gross exposure Limiting excessive credit growth

PwC view
Better as a backstop measure in Pillar 2 not a hard Pillar 1 measure Range of ratios needed for different types of firm and business units within groups Rate of change likely to be a key indicator

PwC

The approach to buffers is complex and can 11.Volatility buffer double-count 10. Impact of future accounting changes
9. Management buffer 8. Market buffer 7.Economic growth buffer 6. Systemic buffer (tbc) 5. Countercyclical buffer (0.0% - 2.5%) 4.Conservation buffer (2.5%) 3. Definition change

Target CT1 ratio

Basel III
2. Basel III RWAs 1.TTC adjustments.

Basel III minimum (4.5%) Basel II minimum (2.0%)

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Basel III and other regulatory changes

Additional considerations in setting target CT1 ratio

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Liquidity and Net Stable Funding Ratio (NSFR)

Issues
Banks struggled to maintain adequate liquidity
Lack of focus on liquidity risk Inaccurate and ineffective management of liquidity risk Unprecedented levels of liquidity support were required from central banks Liquidity concentration risk

Basel III proposals

Improve liquidity risk management and buffers
30-day stress buffer Reduce maturity mismatch through NSFR Ensure that inventories, OBS exposures and securitisation pipelines are funded with a minimum amount of stable liabilities

PwC view
Implications for availability, costs and maturity transformation Trade-off between size and quality of buffer NSFR should be used as a Pillar 2 backstop measure Need for more harmonisation of liquidity risk regulatory / supervisory frameworks

PwC

Systemic effects
Issues
Interconnectedness of financial institutions transmitted negative shocks across the financial system and economy Systemic impacts are beyond the control of a single FI or supervisor

Basel III proposals

Develop practical approaches to assist supervisors to measure importance of banks to financial stability and economic growth Review policy options to reduce the probability and impact of failure of systemically important banks Evaluate pros and cons of a capital surcharge for systemically important banks Consider liquidity surcharge and other supervisory tools

PwC view
Focus macro-supervision first on oversight of market-wide macroeconomic indicators Focus on the overall impact of failure, not the risk Capital is usually not the answer: raise capital levels as a final option, not the first Be aware of market distortions caused by excessive regulation
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Much still to be done: regulatory agenda

Clarify - Definitional changes - Buffer approach: countercyclical/ in aggregate - Role of Pillar 2 Develop recovery and resolution approach - Legal framework - Contingent capital Decide how to address SIFIs Strengthen supervision Implement consistently across countries

PwC

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Much still to be done: bank agenda

Manage/communicate expectations - Peers more important than formal timetable Plan and manage capital - 10 year view - Capital/liquidity management processes - Stress testing Complement capital and liquidity defences (partial solution) - Strengthen risk governance and management - FTP - Change risk culture Business planning - Adapt business models

PwC

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Basel II in India: Key challenges in adoption by Indian banks

Re-structuring: - Asset quality and NPL levels? - M&A? Bias towards banks with better risk management: - Cost efficiencies and economies of scale? IRB models - Data? Implementation cost - According to estimates, Indian banks, especially those with a sizeable branch network, may need to spend over $ 50-70 mn. Need to enhance levels of risk management expertise

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Basel III in the Indian context (1)

Regulators are now focusing on financial stability of the system as a whole rather than just micro regulation of any individual bank. Existing stringent capital requirement in India may help the banks to transition to Basel III The capital requirement as suggested by the proposed Basel III guidelines would necessitate Indian banks raising Rs. 600,000 crore in external capital over next 8-9 years, out of which 70%-75% would be required for the Public sector banks and rest for the private sector banks Lowering of leveraging capacity impacting RoEs Each one percentage point rise in bank's actual ratio of tangible common equity to risk-weighted assets (CAR) could lead to a 0.20 per cent drop in GDP

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Basel III in the Indian context (2)

Key challenges Indian banks on average have Tier 1 capital ratios of around 7.5% to 8%, which prima facie meet the proposed Basel III requirements BUT: beware of definitional changes Transition to Basel III may not impact earnings much, but the upside potential associated with higher leveraging would decline. Further, as the countercyclical buffer has to be set periodically by the RBI, this could introduce an element of variation in lending rates and/or the ROE of banks Implementation of the liquidity coverage ratio (LCR) from 2015 may necessitate banks to maintain additional liquidity; also some assumptions on the rollover rates and the required liquidity for committed lines may be more stringent. However, considering the period of one month and the fact that most Indian banks have upgraded their technology platforms, the transition to LCR may not be a very difficult one While the proposal to make deductions only if such deductibles exceed 15% of core capital would provide some relief to Indian banks , the stricter definition of significant interest and the suggested 100% deduction from the core capital (instead of 50% from Tier I and 50% from Tier II) could have a negative impact on the core capital of some banks.
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Agenda
Perspectives on Basel III The financing challenge Importance of capital planning and stress testing

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Going Concern Vs Gone Concern

Probability

Loss distribution (not to scale)

Profit = zero

Expected Loss

Tier 1 = x%; regulatory insolvency triggered

Surplus core

Earnings

Accounting insolvency equity Tier 1 Tier 2

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Going concern

Gone concern

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Basel III putting the squeeze on capital

Capital ratio % Available total capital (illustrative)
T1 and T2 instruments phase out 2013 2022 New deductions phase in 2014 2019

New total capital Available Core Tier 1 (illustrative)

Non-core T1 instruments phase out 2013 - 2022 New deductions phase in 2014 - 2019

10.5% including Conservation Buffer 1/1/19 New available CT1 7% (including Conservation Buffer) 1/1/19 4.5% minimum -- 1/1/15

Minimum Total Capital

8%
6.375% 5.75% 5.125% 4.5% 4% Minimum Core Tier 1 (common equity) 2% 3.5%

2010
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2011

2012

2013

2014

2015

2016

2017

2018

2019
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Bringing it all together the overarching capital challenge

Banks: cost of equity vs return on equity
25 20 15

Percentage

10 5 0 1998 -5 -10 -15 -20 Source: Capital IQ; PwC analysis UK banks

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

RoE Time CoE

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Bringing it all together the overarching capital challenge

Banks: cost of equity vs return on equity
25 20 15

Percentage

10 5 0 1998 -5 -10 -15 -20 Source: Capital IQ; PwC analysis UK banks

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

RoE Time CoE

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Issues with financing

Size of the problem Timing market supply vs bank demand Basel III transition periods CoCos Growth especially for PSU banks Impact on RoE

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Capital re-financing is going to be a major issue

The BCBS own quantitative impact survey (QIS), the results of which were published in Dec 2010, shows that for 94 Group 1 banks (Tier 1 capital > 3 billion, welldiversified and internationally active), gross CET1 ratios (before deductions) today of an average of 11.1% will fall to net CET1 ratios of 5.7% - equivalent to a shortfall of 165 billion to meet a CET1 ratio of 4.5% and 577 billion to meet a CET1 ratio of 7.0%. Tier 1 ratios for the same banks would fall from 10.5% to 6.3%. From this we can deduce that each additional 1%-point in CET1 is equivalent to 165 billion for these banks alone the global impact is likely to be much larger. The fall is driven largely by the changes in the way deductions in capital will made in the future, as these come entirely from CET1 (no longer from total capital). The changes to RWAs are expected to give rise to an increase in RWAs for the Group 1 banks of 7.3%. However, the subsequent announcement in January 2011 that all non-core Tier 1 and all Tier 2 instruments will have to have a contingent convertible feature means that, on our estimates, some USD 600-800 billion of hybrid Tier 1 and approx. USD 1,500 billion of Tier 2 will have to be refinanced. Although the transition period runs from 1 January 2013 for 10 years, the addition of a 10% haircut, increasing by the same amount each year, is a strong incentive to get the refinancing done as soon as possible, ideally by 31 December 2012. These numbers were not reflected in the QIS.
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Agenda
Perspectives on Basel III The financing challenge Importance of capital planning and stress testing

PwC

22

Capital Base Transitional arrangements

From 1 January: 2011
Min Common Equity Ratio Capital conservation buffer Min common equity + cap conservation buffer Phase in of deductions from Common Equity Minimum Tier 1 Minimum Total Capital Min Total Capital + cap conservation buffer Capital instruments that no longer qualify as Tier 1 or Tier 2 4.0% 8.0% 8.0% 4.0% 8.0% 8.0% 4.5% 8.0% 8.0% 3.5% 4.0% 20% 5.5% 8.0% 8.0% 4.5% 40% 6.0% 8.0% 8.0%

2012

2013
3.5%

2014
4.0%

2015
4.5%

2016
4.5% 0.625% 5.125% 60% 6.0% 8.0% 8.625%

2017
4.5% 1.25% 5.75% 80% 6.0% 8.0% 9.25%

2018
4.5% 1.875% 6.375% 100% 6.0% 8.0% 9.875%

2019
4.5% 2.5% 7.0% 100% 6.0% 8.0% 10.5%

Phased out over 10 year period starting 2013

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Capital planning
Was always required under Basel II Pillar 2 But is now much more important Need to map supply and demand against the transition timetable Be wary of comparing ratios under Basel II with Basel III (definitional changes) Look at internal capital structure for efficiencies (esp changes in deductions)

PwC

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Capital stress tests illustrated (1)

Capital ratios Bank will need to show how it intends to ensure that this gap is eliminated, usually by adding this amount to the initial ICA as a buffer or by raising additional capital in the plan

Base case forecast Net stress test Gross stress test

Minimum

Time horizon of forecast and stress test

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Capital stress tests illustrated (2)

Additional capital raised Capital ratios Base case forecast Net stress test Gross stress test

Minimum

Time horizon of forecast and stress test

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Some concluding thoughts

Transition calibration, sequencing and timing of Basel III is critical Basel III - part of an eye-wateringly complex set of change Capital and liquidity defences are only part of the solution Strengthened risk management and governance Strengthened supervision is key New business and operating models likely to follow Need to do detailed capital planning and stress testing An internal capital clean up may be required

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Thank you

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