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Competitive Effects of Basel II on U.S. Bank
Credit Card LendingWilliam W. Lang
Loretta J. Mester
Todd A. Vermilyea
Federal Reserve Bank of Philadelphia
2006 FDIC/JFSR ConferenceArlington, VirginiaSeptember 13 ,2006
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Purpose
Basel II creates a more risk sensitive capital requirementto reduce market distortions created by capitalregulations
However, different banks will operate under differentregulatory capital rules
Different regulatory requirements could create
competitive inequities
Analyze this issue for credit card portfolios
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Outline of presentation
Structure of U.S. credit card (CC) market
Conceptual Framework
Are Basel I requirements binding?
Basel II affect on regulatory capital
Will Basel II Changes Matter?
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Summary of findings and main implications
CC markets are highly concentrated; only a few bankssignificantly affected by CC rules
Community banks and most regional banks not affected
Basel I capital requirements on CCs are not binding
Basel II substantially raises requirements for CC lending
Most of the increase is in tier 2 capital
Capital requirements for CC may be extremely procyclical
Basel II increases incentives to securitize CCs
CC lenders not subject to Basel II may receive a modestcompetitive advantage
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Credit Card Market is Highly Concentrated
40
50
60
70
80
90
100
1997 1998 1999 2000 2001 2002 2003 2004 2005
Top 5 issuers Top 10 issuers
% of total industryoutstandings
Source: The Nilson Report, 1998-2005.
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Other Structural Elements of the U.S.
Credit Card Market Credit Card Specialty Banks (CCSB)
Monolines
Credit Card operations of large banks oftenplaced in a separate charter
Nonbanks issue CCs through bank subsidiaries
CCs largely funded through wholesale market
60% funded through securitization
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Capital concepts
Economic capital: capital that banks wouldchoose if there is no regulatory minimum
Regulatory capital: refers to pillar 1 capitalrequirements
Binding regulatory capital:
bank capital > economic capital
can occur even if:bank capital > regulatory capital
economic capital > regulatory capital
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ActualCapital
Regulatory Capital
45
EconomicCapital
kb
kb is point of binding capital requirement
Buffer Capital
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Capital Levels at Credit Card Banks Are FarHigher Than Regulatory Requirements
Ratio
CreditCard S ecialty
Banks
Non-CreditCard
S ecialty Banks
EquityCapitaltoRisk-
Weighted Assets 17.84% 12.17%
Tier1CapitaltoRisk-
Weighted Assets 15.04% 10.46%
TotalCapitaltoRisk-Weighted
Assets 18.47% 12.06%
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Securitization Rates and Capital Demand atCredit Card Banks
Securitization rate for CC loans has risen over time
Higher securitization rate lowers regulatory capitalrequirements relative to managed assets
Capital to assets ratio has risen in response, while capital
to managed assets ratio has been stable
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Capital levels and securitizationrates over time
5
7
9
11
13
15
17
19
92 93 94 95 96 97 98 99 00 01 02 03 04
0
10
20
30
40
50
60
70
Equity Capital/Assets(left axis)
Securitization Rate(bars, right axis)
Equity Capital/Managed Assets (left axis)
Percent Percent
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Regression Analysis of Capital Demand at CreditCard Banks
Regression models:
Dependent variables: different bank capital ratios
Controls for growth and risk
Sample of banks with: Over $1 billion in assets
Managed loans to managed assets 60 percent
Equity to assets 25 percent
Contrast managed assets to balance sheet assets
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Equity capital ratio regressions
*** Significantly different from zero at the 99% level ** significantly different from zero at the 95%, level
* significantly different from zero at the 90% level
Model 1 Model 2 Model 3
Dependent Variables
Equity Capital
to Total
Assets
Equity Capital
to Managed
Assets
Equity Capital to
Risk-Weighted
Assets
Independent Variables
Intercept 0.09041*** 0.09021*** 0.1196***Coefficient of Variation in ROE 0.00373*** 0.00366*** 0.00506***
Total Assets -0.000252** -0.000231* -0.000382**
Total Assets Squared 0.000000667 0.000000586 0.00000105*
Growth in Total Assets 0.00295306*** 0.00295*** 0.00268*
Growth in Total Assets Squared -0.0000131*** -0.0000131*** -0.0000114*Credit Card Bank Indicator 0.09623*** 0.00917 0.06209***
Adjusted R2 0.3944 0.1057 0.1741
Number of Observations 275 275 275
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Are Basel I requirements binding for bankcredit card activities? No.
CCSBs high capital buffers cannot be explained by growthor risk
CCSBs demand for capital is more in line with their
managed portfolio rather than their on-balance-sheetcredit card assets
Model indicates that CCSBs demand for capital is similar to peerbanks when CCSB assets are measured as managed assets ratherthan on-balance-sheet assets
Conclusion supported by prior research and views ofcredit rating agencies
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Basel I vs Basel II: Risk Weighted Assets
On Balance Sheet CC Loans
Basel I 100% risk weight
Basel II risk sensitive risk-weight for loans andunused lines
Depends on PD, LGD, EAD
Regulators set asset value correlation to 8%
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Basel I vs Basel II: Risk Weighted Assets
Securitized CC: normal times
Approximately the same for total capital withslightly higher effective tier 1 requirements
Securitized CC Loans: stressed times
Much higher regulatory capital requirements
under Basel II
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Basel I vs Basel II: Definition of Capital
Total Capital
Basel I: reserves are a component of capital
Basel II: reserves minus EL a component of capital
(UL only)
Tier 1 Capital
Basel II: deduction if EL > reserves (typically truefor CC lenders)
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Formula for Basel II total capital requirement
T D EL = 0.08 RWA
RWA = RWAON + (CCFSEC x RWASEC)
=>
T = 0.08 x [RWAON + (CCFSEC x RWASEC)]+ EL + D
Gross totalregulatory
capital
Deductions Expectedlosses
Risk-weightedassets
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Estimated impact of Basel II on typical CCbanks required capital in normal times
No Adjustment for Eligible Reserves Adjustment for Eligible Reserves(Monoline CC Bank Assumption)
Average 44.3% 23.6%
Min 19.1% 6.7%
Max 67.0% 32.2%
Percentage Change in Required Tier 1 Capital
(Assuming Securitized Assets Are Healthy)
No adjustment for shortfall of reserves from
expected losses
(Diversified Bank Assumption)
Deduction of half of shortfall of reserves from
expected losses
(Monoline CC Bank Assumption)
Average 2.2% 13.2%
Min -5.4% -1.7%
Max 14.8% 25.8%
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Estimated impact of Basel II on typicalCC banks capital ratios in Normal and
Stressed Times
Total Capital to Risk-Weighted Assets
No Adjustment for Eligible Reserves(Diversified Bank Assumption)
Adjustment for Eligible Reserves(Monoline CC Bank Assumption)
Basel I 18.5% 18.5%
Basel II, healthy portfolio 12.8% 14.9%
Basel II, stressed portfolio 10.4% 12.1%
Tier 1 Capital to Risk-Weighted Assets
No adjustment for shortfall of
reserves from expected losses
(Diversified Bank Assumption)
Deduction of half of shortfall of
reserves from expected losses
(Monoline CC Bank Assumption)
Basel I 15.0% 15.0%
Basel II, healthy portfolio 14.7% 13.3%
Basel II, stressed portfolio 11.9% 10.8%
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Summary of estimates for typical large CClender in normal times
Substantial rise in total capital requirements for CCactivities; total capital requirements might becomebinding
Modest rise in tier 1 requirements; unlikely to feelsignificant impacts on actual tier 1 capital
However, some CCSBs may see a substantial tier 1impact.
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Summary of estimates for typical large CClender in stress periods
If stress is sufficient to trigger a 15% CCF forsecuritized CCs, then increase in capital requirementsignificant for total and tier 1 capital
If stress is sufficient to trigger a 50% CCF forsecuritized CCs, then severe capital pressures
Note that Basel I banks might also face substantial pressurefrom supervisors and the market to increase capital underthese circumstances
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Implications of our findings
There may be a cost advantage for large CC lenders that are
not subject to the Basel II capital requirements
Disincentives for independent monoline CC banks to adoptBasel II
Any cost advantage would likely be modest since Basel IIbanks may be able to meet additional capital needs throughadditional tier 2 capital (rather than more expensive tier 1capital)
There will be no substantial competitive effect on communitybanks and most regional banks, as credit cards are not amajor product line
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Implications of our findings (contd)
Basel II could generate extremely large increases in required
capital for CCs during stress periods
This might result in CC lenders holding higher capital even innormal times
Differential in pillar 1 capital requirements may overstatethe effects of Basel II since Basel I banks in financial distresswill face increased supervisory and market demands forhigher capital Basel II likely raises incentives to securitizecredit cards and possibly mitigate the increase in requiredcapital for on-balance sheet exposures
Basel II likely raises incentives to securitize credit cards andpossibly mitigate the increase in required capital for on-balancesheet exposures
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