No surprise the reaction across Wall Street is strong to quite strong on the latest regulatory farice out of Europe, especially since our initial read of a 20x leverage cap was in fact low: the 3.5% minimum common equity ratio by 2013 means leverage will be just under 30x, or enough for every bank in the world to pull a Lehman, which blew itself up at roughly the same leverage. All who think European banks will survive through 2019 with this type of leverage should look into investing in these great companies: New Century Financial, Countrywide, and IndyMac.
In the meantime, here is Bank of America, which loves it across the board...
Basel 3 looks bullish for spreads
Yesterday, the Basel Committee on Banking Supervision finally revealed the actual level of minimum capital that banks will be required to adhere to. We think the numbers are in line with prior market expectations and the implementation period long enough and therefore not at all alarming. In fact, our initial read of the impact on banks is positive. Credit investors should look forward to a number of capital raisings from European banks, as looks like is already happening. This should be very bullish for bank spreads, in our view.
7% common equity ratio the norm
The level of common equity rises to 4.5% (from 2%); however, there is an additional ‘capital conservation buffer’ of 2.5% meaning that the minimum level of capital is in effect 7%. The 4.5% level must be achieved by 2015. However, the additional buffer level need be in placed by as late as 1st January 2019, via a transition period which begins in 2016. Perhaps less importantly, the Tier 1 ratio stays – the minimum rises from 4%-6% and can include ‘other qualifying instruments based on stricter criteria’ though of course these are not defined. Therefore, there will be room for non-dilutive T1 instruments in the total capital of the bank. They may account for 25% of total Tier 1. The Committee believes that large banks will require ‘a significant amount of additional capital to meet these new requirements’. Oddly, they think that smaller banks already meet them. We’d not be sure that this is true, at least in Europe. However, it’s clear that the aim here is the larger systemically important banks.
Grandfathering – ends 2013 but amortises
Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital will be progressively phased out over a 10-year horizon beginning 2013. Their recognition is capped at 90% of their nominal amount as of 1st Jan 2013. Instruments ‘with an incentive to be redeemed will be phased out at their effective maturity date’. Whilst we are not 100% clear what this could mean for perpetuals, it does reinforce the idea that existing T1s, should a new format be decided which is radically different from the one we have now, should become obsolete and therefore should disappear. This looks quite bullish for us for calls of Tier 1s, especially those after 2013. In the meantime, note that we have no concrete agreement on the new format of new bank capital instruments.
This could mean that there is still extension risk in the short term (e.g. for bonds like the ISPIM8.126%) which could affect valuations. It definitely looks bullish though for T1s with calls after (say) 2013, or when there is final agreement on a format of ‘new’ T1 that investors will actually buy.
Note too that Government capital injections, even if they don’t meet the new format, are to be grandfathered to 2018, giving banks plenty of time to adjust. We will publish later our updated valuations of T1s in the light of these potential changes.
The idea of the ‘capital conservation buffer’ appears to be that it can be run down in times of stress but we doubt there would be any bank who would want to manage their business that way. If the total core capital ratio dips below the 7%, then banks are potentially subject to limitations on their distributions (e.g. bonuses and dividends). In practice, therefore, we’d be expecting banks to raise levels of core capital a few percentage points above the 7% level (which most banks would probably meet). Buffer capital, according to the release, must also be common equity. It’s not immediately clear to us that contingent capital instruments would necessarily qualify as this buffer capital.
There’s also a ‘countercyclical buffer’ of 0-2.5% which is even sketchier. The countercyclical buffer would kick in where there has been pronounced asset growth – it would have kicked in in Spain, Ireland and the UK by 2007 for example. We had thought that some kind of countercyclical buffer would have been built into provisioning (like in Spain) but it looks like its just being done via higher equity.
Note too that major systemically important banks will have even higher capital demands than those outlined here but these have yet to be defined. The Committee talks about a combination of ‘capital surcharges, contingent capital and bail-in debt.
Loss absorbency of non-common T1 and T2
Not much new on this: it merely says the Governors and Heads of Supervision ‘endorse the aim of strengthen the loss absorbency of non-common Tier 1 and Tier 2 capital’. We’ll see how far this aim gets, given widespread investor objection to these suggested new formats.
Total capital still at 8%
No change to the overall level of capital, but it’s hard to see anything other than a major de-emphasising of anything that isn’t common – as we were expecting. According to the release: The difference between the total capital requirement of 8% and the Tier 1 requirement can be met with Tier 2 and higher forms of capital. Existing hybrids could potentially easily fill that role then.
Deductions by 2018
Deferred tax assets (for example) will have to be fully deducted from Tier 1 by 2018 and there will be a progressive phasing in of the deductions from 2014.
Credit Sights, which highlights that it is impossible to actually do any practical bank-by-bank analysis due to "the long lead-in period, lack
of disclosure, and the remaining uncertainties over changes to certain risk weightings and allowable capital instruments, while new criteria are still being finalised"
The Basel Committee's oversight body has pronounced on the new minimum capital ratios under "Basel 3"
The numbers had been partially leaked, so there are no great surprises, and the final rules are not harsher than recent expectations have led us to anticipate
Nevertheless, the Committee says that "large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements"
Existing hybrid Tier 1 instruments, issued before the announcement, will be grandfathered until 2013 but phased out over 10 years from then
Working out the exact impact on individual banks is difficult, because of other pending changes to risk weightings and capital components, along with an extended phase-in period until January 2019
But the latest ratios are at least a starting point: our updated spreadsheet gives a breakdown of major European banks' capital structures and ratios at 30 June 2010, with comparisons against 31 December 2009
Capital ratios are largely unchanged since end-2009, with an average Core Tier 1 and Tier 1 ratio of 8.7% and 10.7% respectively
But this masks some movement in the ratios of a few individual banks, with Deutsche Bank and Allied Irish well below their year-end levels
And last but not least, here is Goldman's exhaustive reaction to Basel III, as well as individual commentary by Dirk Schumacher:
Basel Committee agrees on new rules - long implementation phase implies small macro risks. The Basle committee agreed on new capital requirements for banks this Sunday. As our banking team notes the new rules - which still need to be approved by the G20 summit - are broadly in line with expectations. Banks will be required to hold common equity of 7%, with a 4.5% minimum requirement and 2.5% conservation buffer. On top of this, banks will have to hold a counter-cyclical buffer of up to 2.5%.
There are two crucial questions when trying to assess the macro-economic implications of the new regulatory environment for banks. 1) by how much will banks have to raise their capital on the back of these changes. 2) Will lending become more costly/rationed and what are the growth implications of this. Our banks team estimates that only 4 banks among the 47 European banks covered have a core tier 1 ratio of below 7% by 2012. While this looks reassuring, it is less straightforward, however, to assess what the figure for the whole banking sector - including the non-public parts of the banking sector - looks like. The head of the Dutch central bank Wellink is cited this morning as saying that banks would need "hundreds of billions" to meet new capital requirements, though the economy, according to Wellink, will not be impacted by this. It is not clear where these numbers are coming from and other ECB board members have not mentioned any figures when commenting on the new capital rules.
With respect to the growth implications the BIS found in an impact study that a "1 percentage point increase in the target ratio of tangible common equity to risk-weighted assets is estimated to lead to a decline in the level of GDP by a maximum of about 0.19% after four and a half years". Assuming that the banking sector as a whole would currently show a 4% ratio, as required under the old Basle II regime, the overall growth impact looks manageable.
To be sure there are significant uncertainties involved in estimating the growth impact of the new capital rules. The Basle committee was certainly aware of this and this is reflected in the rather long transition period granted. Implementation will start in 2013 and will have to be finished by 2018. This should give banks sufficient time to adjust, arguing for an overall small macro impact of the new capital regime