Risk & Capital Management under Basel III€¦ · Risk & Capital Management under Basel III London,...

Risk & Capital Managementunder Basel III

London, 15 February 2011

www.pwc.com

Draft

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Agenda

• Impact of Basel III changes on banks and the economy

• What are banks doing to address the challenge?

• Some quantitative examples:

- Return on Equity

- Pricing

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Risk & Capital Management under Basel III

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Transitional impact on the macro-economy:

Capital:

1% increase in required capital ratio = c. 0.19% decline in GDP after 4½ years.

Liquidity:

25% increase in holding of liquid assets + extension of the maturity of banks’wholesale liabilities = c. 0.14% increase in lending spreads + fall in lendingvolumes of 3.2% after 4½ years + a decline of c. 0.08% in GDP.

BCBS Interim Report August 2010 – Assessing the macroeconomic impact ofthe transition to stronger capital and liquidity requirements.

What is the impact of the changes on the economy?What the Basel Committee says ...

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Overall impact on risk based capital requirements for:

Group 1 banks - Gross CET1 ratio falls from 11.1% to 5.7%. Capital shortfall: €165bn (4.5% CET1 target) €577bn (7.0% CET1 target)

2009 ∑PTP = €209bn

Group 2 banks - Gross CET1 ratio falls from 10.7% to 7.8%. Capital shortfall: €8bn (4.5% CET1 target) €25bn (7.0% CET1 target)

2009 ∑PTP = €20bn

LCR: shortfall of €1.73 trillion

NSFR: shortfall of €2.89 trillion

BCBS December 2010 – Results of the comprehensive quantitative impact study.

What is the impact on banks?


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What is the world saying about banks?

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“The new rules will force banks to set aside more capitalfor their fixed-income operations, and would havereduced the average returns on equity by 5.7 percentagepoints from 14% to 8.3% in 2010, while the return fromequities would have fallen by 2.6 percentage points from19.1% to 16.5 %, they said.”

Huw van Steenis, 17 January 2010

Morgan Stanley

“The new rules will force banks to set aside more capitalfor their fixed-income operations, and would havereduced the average returns on equity by 5.7 percentagepoints from 14% to 8.3% in 2010, while the return fromequities would have fallen by 2.6 percentage points from19.1% to 16.5 %, they said.”

Huw van Steenis, 17 January 2010

Morgan Stanley


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What is the world saying about the banks?

“We expect dividend contributions to be curtailed untilcapital bases are restored to required levels, in 2015, forthe sector.”

Philip Richards and Gert van Rooyen, 4 February 2011

Société Générale

“We expect dividend contributions to be curtailed untilcapital bases are restored to required levels, in 2015, forthe sector.”

Philip Richards and Gert van Rooyen, 4 February 2011



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“Never again” – the response of regulatorsBut will requirements keep rising?

Bank of England Discussion Paper No. 31 - Optimal bank capital:

We conclude that:

even proportionally large increases in bank capital are likely to result in a smalllong-run impact on the borrowing costs faced by bank customers.

even if the amount of bank capital doubles our estimates suggest that the averagecost of bank funding will increase by only around 10-40bps

substantially higher capital requirements could create very large benefits byreducing the probability of systematic banking crises.

We use data from shocks to incomes from a wide range of countries over a period of 200years to assess the resilience of a banking system to these shocks and how equity capitalprotects against them.

In the light of the estimates of costs and benefits we conclude that the amount of equityfunding that is likely to be desirable for banks to use is very much larger than banks havehad in recent years and higher than targets agreed under the Basel III framework.

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It’s more than compliance - the rules challenge bankson capital, funding & profitability (1/2)

Event Impact Resulting in ...

Increased competition fordeposits.

• Need to look for alternative(more expensive) funding.

• Potential for reduced NIImargin.

Cost of funding ↑NII / P&L ↓

Changes to repo marketdynamics.

Higher haircuts and moreencumbered assets.

Cost of funding ↑Availability of liquidassets ↓

More competition for funds inthe bond markets - frominsurers; corporates

Need to look for alternative (moreexpensive) funding – especially ifbank credit ratings fall.

Cost of funding ↑Availability offunding↓

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It’s more than compliance - the rules challenge us oncapital, funding & profitability (2/2)

Event Impact Resulting in ...

CCR requirements forcetrading books to become thepreserve of hedge funds.

Another potential source ofincome is challenged.

P&L ↓

Need to maintain a portfolioof high quality liquid assets.

Lower returns on larger portfolioof high quality assets (potentiallywith more limited availability todrive returns down further).

NII / P&L ↓+ Opportunity cost

Changes to the definition ofcapital.

Capital growth limited andbecoming scarcer and moreexpensive.

Cost of capital ↑Availability ofcapital↓

Contingent convertibles andbail in bonds

Need to find buyers for riskiercapital instruments. Huge volumeof capital to be replaced

Cost of capital ↑Availability ofcapital↓

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In summary - what are the rules telling us to do?How to respond: invest to comply?

• Capital and liquidity management:

- RWA optimization and mitigation

- Monitoring available liquidity and liquid assets

- Funding and transfer pricing

• Collateral management

• Stress testing: risk management tool or regulatory requirement

• Trading book:

- Monitoring and managing counterparty credit risk

- Embedding stressed VaR limits

• Contingency plans – recovery in times of stress; resolution on death

• Rebuild the structure and booking models

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Agenda




- Return on Equity

- Pricing

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What are the banks saying?

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“UBS may have to change its structure and move somecapital- intensive investment banking businesses,such as securitization, into subsidiaries in otherjurisdictions with lower capital requirements. The bankcurrently operates through branches in other countriesand holds almost all capital in Switzerland while booking80 percent of assets elsewhere.”

Oswald Gruebel, 8 February 2011

Chief Executive Officer, UBS

“UBS may have to change its structure and move somecapital- intensive investment banking businesses,such as securitization, into subsidiaries in otherjurisdictions with lower capital requirements. The bankcurrently operates through branches in other countriesand holds almost all capital in Switzerland while booking80 percent of assets elsewhere.”

Oswald Gruebel, 8 February 2011

Chief Executive Officer, UBS


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What are the banks saying?

13

“I think we’re going to have to move to a regime ofbooking more business in fully capitalizedsubsidiaries, especially in the U.K., which is ourEuropean Union hub, and the U.S.”

John Cryan, 8 February 2011

Chief Financial Officer, UBS

“I think we’re going to have to move to a regime ofbooking more business in fully capitalizedsubsidiaries, especially in the U.K., which is ourEuropean Union hub, and the U.S.”




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What is the world saying?

14

“We have to be a little more selective both in relation to thepotential profitability of those business lines but also in relationto the capital they use,”

“We will de-emphasize some businesses that look as though wecan’t make them profitable or they use too much capital for theprofit potential.”



“We have to be a little more selective both in relation to thepotential profitability of those business lines but also in relationto the capital they use,”

“We will de-emphasize some businesses that look as though wecan’t make them profitable or they use too much capital for theprofit potential.”




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How to respond: invest to comply ... or refreshwhat I do?

• Banks are transitioning from a ‘post-crisis’ focus to preparing for the newworld of stringent regulation. Can they successfully change their playingfield, or will others do it better?

- Low capital/liquidity businesses become more valuable

- Move trading books out into hedge funds

- Reshape deposit base to longer maturities

- Review maturity transformation - longer term lending (property?)

- Consider balance between banking and insurance – Basel III vs. SolvencyII?

- Review options in shadow banking – private equity, money market,property and other funds

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What is the world saying about the banks?... and the effect is?

“Banks are already adapting business models to offset theexpected impact, and extra pricing power should enhancesector profitability.”

Philip Richards and Gert van Rooyen , 4 January 2011


“Banks are already adapting business models to offset theexpected impact, and extra pricing power should enhancesector profitability.”

Philip Richards and Gert van Rooyen , 4 January 2011



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Agenda




- Return on Equity

- Pricing

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Possible effects on bank profitability : presentrules (1/2)

• A simplified Balance Sheet and a capital structure consistent with the present minimum regulatoryrequirement is assumed as a starting point.

• The minimum equity value is equal to 1,44.

Capital structure

Tier 1 - in % RWA 4,0% 2,88

Tier 2 - in % RWA 4,0% 2,88Minimumrequirement 5,76

- o/w

Equity - in % RWA 2,0% 1,44

Equity - CCB 0,0% 0,00

Total assets RWA % RWA Liabilities

Cash 10 0% 0 Current and deposit accounts 47,12

Government bonds 10 0% 0 Bonds 47,12

Loans to banks 10 20% 2 Tier 2 instruments 2,88

Loans to customers 60 100% 60 Other tier 1 instruments 1,44

Other assets 10 100% 10 Equity 1,44

Total assets 100 72 100

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Possible effects on bank profitability : presentrules (2/2)

• Considering the data of the table on the right, the RoE is equal to 15,9%.

Profit & loss

Interest received 4,60

Interest paid -2,64

Interest margin 1,96

General expenses -0,98

Risk cost (EL) -0,60

Gross profit 0,38

Net profit (@ 40%) 0,23

RoE 15,90%

Interest ratesGovernment bonds 3,0%Loans to banks 1,0%

Loans to customers 7,0%Current and deposit accounts 1,0%Bonds 4,0%Tier 2 instruments 6,0%

Other tier 1 instruments 7,5%Risk cost (EL) 1,0%General expenses(as a % of revenues) 50,0%


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Possible effects on bank profitability: incomingrules (1/2)

• According to the new rules the minimum equity is equal to 5,04.

Total assets RWA % RWA LiabilitiesCash 10 0% 0 Current and deposit accounts 46,22

Government bonds 10 0% 0 Bonds 46,22Loans to banks 10 20% 2 Tier 2 instruments 1,44Loans to customers 60 100% 60 Other tier 1 instruments 1,08Other assets 10 100% 10 Equity 5,04

Total assets 100 72 100

Capital structureTier 1 - in % RWA 6,0% 4,32Tier 2 - in % RWA 2,0% 1,44Minimu requirement 5,76

- o/wEquity - in % RWA 4,5% 3,24Equity - CCB 2,5% 1,80


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Possible effects on bank profitability: incomingrules (2/2)

• Considering the same conditions as in our initial example, the RoE decreases to 5,49%

Interest rates

Government bonds 3,0%

Loans to bank 1,0%

Loans to customers 7,0%

Current and deposit accounts 1,0%

Bonds 4,0%

Tier 2 instruments 6,0%

Other tier 1 instruments 7,5%

Risk cost (EL) 1,0%General expenses(as a % of revenues) 50,0%

Profit & loss


Interest paid -2,48




Gross profit 0,46

Net profit (@ 40%) 0,28

RoE 5,49%


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Agenda




- Return on Equity

- Pricing

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Possible effects on pricing: present and futuresituation

• A simple one-year bullet loan is assumed. Interest is paid in arrears.

• The interest rate to be paid to achieve break-even will increase from 5,12% to 6,12%.

Pricing (present situation)

Amount financed 100,00

Interest rate 5,12%


Cost of funding -2,64




Gross profit 0,24

Net profit (@ 40%) 0,14

Cost of equity(@10%) -0,14

Value 0,00

Pricing (Basel III)

Amount financed 100,00

Interest rate 6,12%


Cost of funding -2,48




Gross profit 0,82

Net profit (@ 40%) 0,49

Cost of equity(@10%) -0,50

Value -0,01


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Conclusions

• The aim of the Committee’s proposals is to create a more stablefinancial system

• The Basel Committee’s proposals tend to enhance some areas ofBasel 2 framework

• The parameter calibrations and the transition periods are twoimportant factors that will determine the impact of the new proposalson the banking system. But as we all know “the devil is in thedetail…”.

• The new measures should be implemented consistently as part of aglobal framework. To this end, most of the specific parameters usedin the new metrics should be harmonised internationally

• Most of the proposals will have relevant impact on bank profitabilityand pricing


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