ALMForum
Fully loaded Equity –
the challenge in the total bank management
May 2015 | No. 11
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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May 2015 | Fully loaded Equity the challenge in the total bank management
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 management in order to compensate the effects of the low interest environment (see part 2).
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May 2015 | Fully loaded Equity the challenge in the total bank management
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 counter-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“
Simple components
MREL Ratio
EBA Stress Test
SREP Ratio
Leverage Ratio
Basel 4 effects
1-2%
Bank individual
buffer
0-2%
Pillar 2 risks
1-5%
Systematically
important banks
- Global
- Other
Systematic risk buffer
2,5%
2,5%
Countercyclical
buffer
Capital
conservation buffer
2,0%
Tier 2
1,5%
Additional Tier 1
4,5%
Tier 1 Core Capital
Total Equity requirement
22,0%
20,0%
18,0%
13,0%
10,5%
8,0%
6,0%
4,5%
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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May 2015 | Fully loaded Equity the challenge in the total bank management
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
from 8% (2009) to 16 % (2015) is equivalent to a multiplicator of
2,5 to 3,75 in absolute values (EUR)
»» 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 securitisation 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 operational 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)
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What happend since 2009 out of 100 equity requirement
Basel 3 / CRD IV
Minimum
1-3%
„Basel 4“
1-2%
Bank individual
buffer
0-2%
Pillar 2 risks
0-5%
Systematically
important banks
- Global
- Other
Systematic risk buffer
0-2,5%
2,5%
Parameter
„tightening“
through Basel 3
Basel 2
Countery cyclical
buffer
Capital conservation
buffer
+ Δ RWA
+ CVA
+Market risk
Maximum
174
468
158
412
144
375
144
338
144
244
144
197
110
150
100
8% RWA
+ Operational risk
+ Risk trading book
Source: FT Research
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.
Ploughing back equity: the interest gap contribution has to be “rescued”
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 improving the data basis, the precise attribution of collaterals, the prompt reaction to rating migrations 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.
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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
Equity
Tier 1 Core
Capital
Core Capital
Tier 2
(Going Concern)
(Gone Concern)
Additional
tier 1
Graph 3
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 common 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.
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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 subordination, 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.
Tier 3 capital
Tier 2 2.class (2,0%)
Tier 2 1. class (2,0%)
Tier 2 (2,0%)
Additional Tier 1 (1,5%)
Additional Tier 1 (2,0%)
Tier 1 Core Capital (4,5%)
Tier 1 Core Capital (2,0%)
Basel 2
Basel 3
Graph 4
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.
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3. Variable additional capital buffer
In addition to the minimum capital requirements, the CRR /CRD regulations provide for capital 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:
Graph 5, Source: German Central bank (Deutsche Bundesbank) Monthly Report June 2013
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 („Recommendation of the European Central Bank regarding the policy on the distribution of dividends“) (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 requirements 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 transitional 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.
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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 Article133 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 national 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 individually 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 essentially 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 Standardised 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 supervisory 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 minimum requirement for own funds and eligible liabilities. The minimum requirement is calculated 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 institution [...] 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 standardised 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 Investment 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 Finanzdienstleistungsaufsicht, BaFin), Prudential assessment of banks‘ internal risk-bearing capacity 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 concentration risk under the supervisory review process, 02 September 2010; CEBS guidelines on
stress testing, 29 August 2010
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