Risk Minds
June 2012
Making Sense of Increased Capital
Requirements
By J.V. Rizzi
The opinions expressed herein are those of the author.
They do not reflect the views of CapGen Financial.
Table of Contents
 Change
 Reaction
 Reality
 Impact
 Response
 Conclusion
2
Change
3
The Change
(BIS III and Dodd Frank)
(Capital goes where it is welcome…
 Message: more capital, more liquidity and less risk
 Specifics
4
- tightened capital definition
- increased RWA weights
- more liquidity
limit illiquid assets
restrict unstable funding
- increased capital requirements
BIS III
Dodd Frank (well capitalized)
CE
2  4.5
[5+]
T1
46
>6
TC
88
> 10
Buffer
0  2.5
-Lev
03
>5
 Why
- Banking as an industry failed
- Clear that prior capital rules were insufficient
…and stays where it is treated well)
Reaction
5
The Nonsense
(Do you want to believe what you see…
 Higher Capital Requirements
 Put aside more reserves
 Curtail lending
 Impede growth
 Decrease ROE
 Increased Funding Cost
 Un-American
…or what I am telling you?)
6
Reality
7
The Reality
(Facts ignored…

Set aside
 Confuses liquidity reserves with funding mix

Increased funding cost
 Limited given proportion of equity in capital structure
 Ignores cost of forced capital raise at distressed price

Reduced ROE
 Cost of equity is not fixed
 Key is the spread between ROE and cost of equity

Un-American
 “The policy goal should be a healthier banking system, rather than high returns for banks’ shareholders
and managers with taxpayers picking up the losses and economies suffering the fallout.”

Bankers resistance of higher capital requirements: capital shifts risk from taxpayer to capital
provider
 Vested interest in subsidies and compensation– especially for banks with weak franchise value and
 Debt overhang: benefits to debtholders
…do not cease to exist.)
8
Impact
9
Impact
(You cannot lever up a sow’s ear into a silk purse…
 Business Model
 Balance sheet mix
 Capital generation and growth
 Shareholder distributions
 Restructuring
 Shrink
 Break-up
 Merge
 Capital structure
…you may think you can during the good times, but…)
10
CAPITAL STRUCTURE
11
Stakeholder Views of Capital Differ
(Is the glass half full or half empty…
Rating Agencies
 Capital focus is primarily on tangible equity
capital and capital replenishment capabilities.
Regulators
 Concern on through the cycle capital and
Shareholders
 Are focused on capital discipline and
buffers
allocation
Management
 Capital Returns and bonuses
… it depends on whether you are pouring or drinking)
12
Introduction
Volatility
(Once set…
Strategic Capital
Budgeting (CEO)
Liquidity
Capital Structure
CFO
Capabilities
Risk Appetite
Return
Risk
Management
(CRO)
Opportunities
Correlations
Performance
External Stakeholders
Shareholders
Risk/Return
Regulators
Governance
Rating Agencies
13
…Capital structure is continuously monitored and revised)
Overview
(Capital structure is important not because it creates value…
 Set capital structure independent of regulation
 Except for banks with limited franchise value and suffering from debt overhang
 Enough capital to pursue strategy and weather cash flow shortfall
 Positive relationship between value and equity thru the cycle
 Long term decline from insufficient capital going into crisis outweighs short term leverage benefit
 Major determinant of capital is the market and rating agencies
 Most banks hold more than regulatory minimum
 Framework
 Estimate financing surplus or deficit through the cycle


Surplus- shareholder distributions
Deficit- raise additional capital
 Ratings requirements


Agencies
CAMELS
 Peers
… but because getting it wrong destroys value.)
14
Capital Structure – Integration of Capital
and Risk Management
(Risk never disappears….
Mix of securities (Capital Structure) and Risk Management Products

Capital structure optimization is the purpose of risk management – 2 sides of same
coin
 Risk management is capital structure in disguise
 Risk management as synthetic or substitute equity
 Risk transfer transfer (Cause)
 Risk Finance (Effect)
 Integration of corporate finance and risk management
 Cost/Benefit analysis regarding use of risk management or risk finance
 Issue is whether it is more efficient to (self insure) hold capital or to use risk
management to eliminate the risk cause
15
…someone is always on the other side of the trade)
Capital Guidelines
(How much is enough?…
S&P: RAC
Very strong
>15%
Strong
15/≤ X <10%
Adequate
10 ≤ X < 7%
Moderate
7% ≤ X < 5%
Weak
5% ≤ X < 3%
Very Weak
>3%
CAMELS – “C” and “A”:Classified Assets/T1 + ALL
1 - O ≤ X ≤ 25%
2 – 26%< X ≤ 40%
3 - 41% < X ≤ 80%
4 - 81% ≤ X ≤ 100%
5 - > 100
16
…it depends
Scenarios: To Assess Possible Strategies
Against Capital Structure Robustness
(Can I survive and tolerate…..


17
The upside (U) and
base (B) cases
generate excess capital
which points toward
shareholder
distributions
The downturn (D)
scenario suggests
possible changes in
risk appetite and the
development of
appropriate
contingency plans to
maintain ratios, sell
assets and raise
capital.
Forward looking Core Tier 1 development under alternative scenarios
(Stress testing)
Core Tier 1 Ratio
Financial policy
implications:
U
------------------------B
-------------------------
Return
Capital
Raise/release
Capital
Probably
Unlikely
May be
May be
Unlikely
Probably
D
T
…the worst plausible outcome?)
In a ‘sustained severe recession’ scenario, contingency measures may be
required to meet target capital ratios
Sust. Sev.
Recession
(EUR bln)
YE
YE
YE
YE
YE
Capital
Ratios
Net profit
x
x
x
x
x
RWA
x
x
x
x
x
Core Tier 1
x
x
x
x
x
Gearing
x
x
x
x
x
Tier 1
x
x
x
x
x
Total BIS
x
x
x
x
x
x
x
Assumptions
x
x
x
Excess CT1
Capital
18

Downturn scenario is based on a net profit decrease of
EUR __ bln relative to the reference case to EUR __ bln in
__, a drop of __bln to __bln in __ and recovery thereafter.

Decrease in RWA of EUR __ bln in __, __ bln in __ and a
__% growth through __ and __ due to lower credit
demand and reduction due to FX devaluation.

Divestitures __ according to plan (reference case)

Dividend payout of __ for __, __ thereafter

Share buyback as announced for __ and ongoing
neutralisation of stock dividend, but no additional
buybacks.
Time
Observations

The ratios as presented would trigger a regulatory response
as the Tier Total ratio is < __%. Additionally, ratings would
be pressured resulting in possible downgrade.

The scenario would lead to a significant shortfall from the
6.0% Core Tier 1 ratio target.

Compared to the mild recession, additional contingency
measure to replenish the capital meet target ratios would be
required, e.g.

Suspend or reduce dividend

Suspend stock dividend neutralisation

Increase divestment programme
Elements of Strategy Based Capital Structure Management
(Risk and capital as inputs into strategic planning….)
Choice of Markets with Attractive economics in
which the organization enjoys a competitive advantage
Strategy
Risk Appetite
Risk the organization is willing and able to accept in
pursuit of its strategy
Risk Assessment
Risks underwritten and retained
Capital relative to Ratings Agencies, Regulators and peers
Actual Capital
Return capital to shareholders when actual capital exceeds
need, or raise capital when exceeds actual capital
Allocation to business units based on an economic
capital determination
19
Capital Need and
Capital Assessment
Capital Plan
Capital Allocation
(…and not just consequences)
How Much?
(Better to be approximately right…
REITS
(29%)
LNYC PreDepression
Banks
(20%)
Asset Value
Losses/Cushion
(7% / 7%)
15-20%
Depending on risk of Business Model
High CRE
Derivatives/ Trading
20
…than precisely wrong.)
Conclusion
21
Conclusion
(Capital structure as a Process…
 Need to incorporate capital structure and risk considerations
as an input versus consequence of strategy
 Capital as cost of risk
 Return as cost of capital
 Risk as cost of return
 Capital structure links strategy, risk and return–represents
total risk exposure an organization is capable of accepting
and retain in pursuit of its strategy
 Market factors have a larger impact on bank capital structure
than regulation
… Not a Number)
22