How will regulation reshape the banking system? Yasmine de Bray 11/05/2012.

How will regulation reshape the banking system?

Yasmine de Bray 11/05/2012

How will new regulation reshape the banking system? - 18/04/23 -

page 2

Summary

01 New regulation is putting pressure on the size of the banking system…

02 …but the risk of an abrupt shrinkage has more to do with the current sovereign crisis

03 Regulation should be instrumental in avoiding future liquidity crisis but should not overshoot


page 3

1/ New regulation is putting pressure on the size of the banking system

Regulators require banks to hold more capital

– The switch from Basel 2 to Basel 3 is reducing the average common equity ratio of the top 100 global banks by 3% points from 10.2% at June-end 2012 to 7.1% as per the latest QIS published by the Basel Committee on April 12th.

– In practice, European regulators are requesting their domestic banks to hold common equity ratios of at least 9%.

More than €500bn has been raised so far in Europe: 55% of which has been provided by governments and 45% by private investors. European banks’ core tier 1 ratios have improved from 6.5% in 2008 to 10% in 2011.

Source of capital Form of capital raising

Private State Total Ords / MCN Other Total

Austria 2,3 5,9 8,2 3,9 4,3 8,2Benelux 0,0 15,4 15,4 6,0 9,4 15,4France 26,7 16,5 43,2 24,2 19,0 43,2Germany 24,1 38,2 62,4 44,4 17,9 62,4Greece / Cyprus 7,1 3,8 10,9 6,8 4,2 10,9Italy 25,5 4,1 29,6 21,7 7,9 29,6Ireland 1,8 71,1 72,8 69,8 3,0 72,8Spain 31,7 27,5 59,2 54,5 4,7 59,2

Portugal 3,8 13,0 16,8 4,8 12,0 16,8

Nordics 10,4 4,2 14,6 11,1 3,5 14,6Switzerland 25,6 3,9 29,5 26,0 3,6 29,5

UK 76,8 82,3 159,2 149,4 9,8 159,2

Eurozone 123 195 318 236 82 318

as % 39% 61% 100% 74% 26% 100%

Non-Eurozone 113 90 203 186 17 203

as % 56% 44% 100% 92% 8% 100%

Total 236 286 522 423 99 522

as % 45% 55% 100% 80% 20% 100%

Country (€ bn)

Ability to raise further capital is limited given governments’ over-indebtedness and the lack of investors’ appetite for bank stocks due to poor risk-adjusted returns (cf Unicredit’s difficult capital increase in early January which required a 40% discount to TERP).

The other way for banks to release capital is to reduce their balance sheets…

Source: Goldman Sachs


page 4

1/ New regulation is putting pressure on the size of the banking system

Regulation is to structurally reduce the size of the senior debt market:

– The European commission recently issued a consultation paper suggesting that regulators should be able to impose losses on bank creditors before the bank become insolvent potentially based on a trigger mechanism. The key is whether it will be a low or high trigger.

– Term senior unsecured debt would become more “capital” than “funding” in nature, and would become more expensive. This could lead to a structural reduction in banks’ unsecured debt funding reliance, only partially offset by growing covered bond issuance.

Regulation is likely to reduce the velocity of money– Growing scrutiny on re-hypothecation.– Higher risk weights for credit exposure to large regulated banks

(>100bn asset).

We estimate the total deleveraging effort to be close to €1.3 trillion of assets (5.7% of total assets) over the next 3 years for European listed banks, which could release €50bn of capital.

– Under the IMF base-case scenario for a sample of 58 large EU banks, the reduction of bank assets would be €1.6bn over the next two years, €2.5bn under their worst-case scenario.

This should help close an estimated capital shortfall of around €80bn in Europe and help manage down the stock of senior debt funding (€730bn maturities in 2012-2014).

Assets/loans

Legacy assetsCIB/

markets Lending CEEGreece / Ireland

Total deleverage

% of total assets

Lending as a % of deleveraging

plan

UCG 19 000 61 500 7 000 87 500 9% 78%

ISP 15 700 5 000 20 700 3% 100%Medio 3 600 3 600 6% 100%

BMPS 16 000 16 000 7% 100%

BP 18 894 18 894 14% 100%

UBI 7 000 7 000 5% 100%

PMI 500 500 1% 100%

Other 40 000 40 000 2% 100%Italy 19 000 - 163 194 12 000 - 194 194 5% 90%Soc Gen 2000 0 34 300 2 053 250 38 603 3% 94%BNP 22800 0 47 000 406 70 206 4% 68%CASA 11524 7 000 10 000 60 5 460 34 044 2% 30%Natixis 19300 8 400 27 700 6% 0%France 55 624 15 400 91 300 2 520 5 710 170 554 3% 55%KBC 6 300 7 545 5 400 9 800 29 045 10% 45%INGBenelux 6 300 - 7 545 5 400 9 800 29 045 4% 45%SAN 19 962 19 962 2% 100%BBVA 14 678 14 678 3% 100%Caixa 5 256 5 256 2% 100%Pop 6 810 6 810 5% 100%BTO 7 069 7 069 7% 100%SAB 3 177 3 177 3% 100%BKT 5 678 5 678 9% 100%BCIV 4 180 4 180 6% 100%Other 60 000 60 000 6% 100%Spain - - 126 809 - - 126 809 5% 100%CBK 15 164 216 624 25 981 257 769 37% 94%Deutsche 24 333 24 333 1% 0%Germany 15 164 24 333 216 624 25 981 - 282 102 9% 86%UBS 22 648 32 520 55 168 5% 0%CS 5 405 48 103 53 508 6% 0%Switz 28 053 80 623 - - - 108 676 5% 0%RBS 12 195 85 366 48 171 5 488 151 220 8% 32%Lloy 28 049 70 976 9 146 108 171 9% 66%Barc 20 122 20 122 1% 0%HSBC 60 000 3 846 63 846 3% 0%UK 120 366 85 366 119 146 - 18 480 343 358 5% 35%BOI 36 000 36 000 23% 100%AIB 3 360 13 440 16 800 13% 80%Ireland - 3 360 49 440 - - 52 800 19% 94%Erste 1 385 7 140 8 524 4% 84%RI 12 800 6 717 19 517 14% 34%Austria 14 185 - - 13 857 - 28 041 8% 49%Total 258 691 209 082 774 059 59 757 33 990 1 335 580 5,7% 62%

% of Total 19% 16% 58% 4% 3% 100%

0bp

0bp

0bp

1bp

1bp

1bp

1bp

1

0

0,2

0,4

0,6

0,8

1

1,2

1

0 0,5 1 1,5

1

Source: Amundi, Morgan Stanley


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2/ New regulation is putting pressure on the size of CIB activities

The deleveraging effort is focusing on corporate and investment banking– European banks announced risk-weighted asset reduction plans of €700bn since 2009 in their CIB business, 37% of

which has been completed so far.– 35% of the remaining deleveraging efforts will focus on CIB activities.– CIB activities can be downsized faster.– CIB is very competitive and will become less profitable under Basel 3 (CVA, greater capital requirement for market risks

etc..).– Example of explicit regulatory/political pressure: RBS requested to specifically downsize its investment bank.

Regulation will lead to a polarisation in the investment banking industry– Scale will be a competitive advantage given the sector’s high operational leverage (elevated fixed cost base) – Heavy technological investments will be required, with the FICC business likely to move to electronic platform trading

business.

EUR bnRWA Reduction

done so far% Target

RWA Reduction Target

UBS 14 18% 78CS 38 48% 80Deutsche Bank 30 25% 120CASA 36 120% 30BNP 26 58% 45Soc Gen 16 40% 40Natixis 3 30% 10RBS 94 32% 292TOTAL 257 37% 694


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3/ New regulation is putting pressure on cross-border lending

Regulators are increasingly requesting liquidity to be ring-fenced– The UK independent commission for banking (“ICB”) is requesting the UK ring-fenced entity to be subject to minimum

liquidity ratios on its own– The Austrian regulator recommended that Austrian banks’ foreign subsidiaries do not issue new loans in excess of 110%

of available local funding.– Hungary, Romania and Bulgaria particularly at risk.

Foreign subsidiaries’ compliance with the Basel 3 NSFR will also put pressure on intra-group funding and lending growth given the yet limited size of local debt capital markets.

Basel 3 creates a capital shortage: banks will seek to better optimize capital utilization by favouring multiproduct relationships over lending-only relationships, which tend to favour domestic clients.

– Banks will however not stop funding their core clients’ off-shore projects.

0%

50%

100%

150%

200%

UK

R

SL

O

SR

B

HU

RO

BG PL

RU

TR

SA

SL

K

CZ

0%

25%

50%

75%

100%

Sector loan-to-deposits (LHS) Assets controlled by European banks (RHS)

CEE countries will be most impacted…

Reduction in credit supply by European banks under the three IMF deleveraging scenarios (in % of total bank credit)


page 7

Banks will favour short-term lending over long-term lending to meet Basel 3 liquidity ratio.

Banks will seek to gain large corporate (investment-grade) exposures through corporate bonds rather than lending.

AssetAsset weighting as per first draft

New weighting

LiabilityLiability weighting as per first draft

New weighting

Cash 0% All other liabilities 0%Short-term unsecured <1Y 0% Wholesale funding 1Y- 50%Repos 0% Retail and SME deposits 70-85% 80-90%Sovereign 5% Wholesale funding 1Y+ 100%Corporate bonds AA+, >1Y 20% Tier 1 & Tier 2 capital 100%Corporate bonds A- 50%Corporate lending <1Y 50%Retail loans <1Y 85%Mortgages 100% 65%All other assets 100%Credit facilities 10% 5%

4/ Basel 3 will reduce the amount of stable funding to the economy

Corporate balance sheets might be weakened (reduced availability of long-term funding for SMEs and greater reliance on volatile market funding for large corporates).

This is already visible in the ECB banking surveys: “Some further tightening is expected to affect large firms (8%) rather than SMEs (2%), as well as primarily long-term loans”, April 2012.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

US Corporates US AllIncorporations

UK Eurozone Europe

Borrowed frombanks

Obtaineddirectly from thebond market

Sources of corporate debt


page 8

60%

70%

80%

90%

100%

110%

120%

EUROPE LatAm Europe- witha US sizedcorporate

bond market

Africa US Asia ex J apan

J apan

LDR

201

1

Europe Other regions

Smaller investment banking and international, activities, together with growing disintermediation for corporate funding will help reduce the size of the European banking system…

Domestic credit will also be impacted

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

Irel

and

UK

Sw

itzer

land

Den

mar

k

Fra

nce

Net

herla

nds

Spa

in

Aus

tria

Ger

man

y

Bel

gium

Sw

eden Ita

ly

Aus

tral

ia US

Nor

way

Can

ada

Sou

th A

fric

a

With a European sized corporate

bond marketAdding

Mortgages held in GSEs

Banking system assets as a % of GDP Loan to deposit ratios by region

Source: Barclays


page 9

But closing the customer gap will still be needed through:

1. Re-intermediation of off-balance sheet assets, although this could be partially crowed out by State borrowing

– Italian banks selling their own retail bonds and term deposits instead of third-party bonds. Introduction of a more favorable fiscal regime for government bonds vs. other savings products.

– French banks trying to repatriate savings on balance-sheets:

2. And real lending deleveraging efforts :– Key risk to growth is tightening conditions for investment loans.


0

10

20

30

40

50

60

Net inflows (life insurance) Net inflows (on-balance sheet savingsproducts)

2009

2010

2011

€bn

Source: OEE

Dotted lines show the IMF’s three deleveraging scenarios


page 10

2. And real lending deleveraging efforts :– Key risk to growth is tightening conditions for investment loans.


Source: IMF

Dotted lines show the IMF’s three deleveraging scenarios


page 11

Summary





page 12

The current risk of credit crunch has more to do with the current crisis.

But what is at stake is the risk of an abrupt credit crunch

Net % of banks contributing to tightening their credit standards, ECBCredit standards have tightened in H1 2012 with the worsening of the sovereign crisis. Recent relief in Q1 is due the easing of banks and governments’ funding access in the wake of the two LTROs (Dec and Feb).


page 13

Credit tightening has more to do with sovereign-related liquidity and capital issues rather than regulations.

– Credit conditions for corporates: a net 87.5% of Italian banks reported tighter standards in Q4 vs 35% of European banks in the Q4 2011 ECB survey (25% vs. 9% respectively in the Q1 2012 survey)

– Credit conditions for households: a net 87.5% of Italian banks reported tighter standards in Q4 vs 29% of European banks in the Q4 2011 ECB survey (37.5% vs. 17% respectively in the Q1 2012 survey)

But what is at stake is the risk of an abrupt credit crunch

5 YR CDS spreads

0

100

200

300

400

500

600

700

800

Bankin

ter

Sabad

ell

BBVASan BP

MPS

UCIIS

P

SOGN

CASABNP

CMZ

DBKSwed

DNB

Nordea

Handels

banke

n

ITALY FRANCE GERMANY NORDICSSPAIN Country split of EBA's €106bn european banks capital shortfall

GREECE29%

SPAIN25%

ITALY14%

FRANCE8%

PORTUGAL7%

DENMARK0%

SLOVENIA0%

NORWAY1%

BELGIUM4%

CYPRUS3%

AUSTRIA3%

SWEDEN1%

GERMANY5%

Source: EBA

Difficult wholesale funding access based on sovereign risk Capital shortfall driven by net unrealized losses on bonds

As at end of April 2012


page 14

0

500

1 000

1 500

2 000

2 500

3 000

3 500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012YTD

$tr

…driven by market forces and a previous lack of regulation

Eurozone banking assets / GDP (x)

2,42,4

2,62,6

2,7 2,72,8

2,9

3,1

3,2

3,5

3,7 3,7 3,7

2,0

2,2

2,4

2,6

2,8

3,0

3,2

3,4

3,6

3,8

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

0

100

200

300

400

500

600

700

02/0

1/20

04

02/0

4/20

04

02/0

7/20

04

02/1

0/20

04

02/0

1/20

05

02/0

4/20

05

02/0

7/20

05

02/1

0/20

05

02/0

1/20

06

02/0

4/20

06

02/0

7/20

06

02/1

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06

02/0

1/20

07

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4/20

07

02/0

7/20

07

02/1

0/20

07

02/0

1/20

08

02/0

4/20

08

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7/20

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02/1

0/20

08

02/0

1/20

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02/0

4/20

09

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7/20

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02/1

0/20

09

02/0

1/20

10

02/0

4/20

10

02/0

7/20

10

02/1

0/20

10

02/0

1/20

11

02/0

4/20

11

02/0

7/20

11

02/1

0/20

11

EU BANKS SECTORCDS INDEX 5Y - CDSPREM. MID

US BANKS SECTORCDS INDEX 5Y - CDSPREM. MID

Banks’ market funding costs were extrememly low…

120%

125%

130%

135%

140%

145%

150%

Jan-1999 Jan-2001 Jan-2003 Jan-2005 Jan-2007 Jan-2009 Jan-2011

L/D Ratio European System

Total market funding issued by European banks p.a.

… creating a strong incentive for banks to leverage their balance sheets.

Source: ECB


page 15

Authorities are seeking to avoid a severe credit crunch:– In Dec 2011 and Feb 2012 the ECB provided €530bn of net additional funding to European banks (LTROs

take up less MRO transfers), equivalent to the amount of senior and covered bonds maturing over the next 12 months.

– Spanish and Italian banks have covered their 2012 maturities and invested in short-term government bonds.

Monetary authorities are trying to smooth the process

ECB Lending, Since End-Nov 11SPAIN ITALYSource Use Source UseECB New Loans 210 526 2012 debt maturities 99 734 ECB New Loans 116 813 2012 debt maturities 45 764 LT debt issued in 1Q12 7 000 Sov Acqn 87 748 LT debt issued in 1Q12 5 931 Sov Acqn 80 630

Balance 30 043 Balance 3 650- 217 526 217 526 122 744 122 744

ECB new loans as a % of total assets 6% ECB new loans as a % of total assets 3%

0

200

400

600

800

1 000

1 200

janv

07

juil

07

janv

08

juil

08

janv

09

juil

09

janv

10

juil

10

janv

11

juil

11

janv

12

€bn

ECB lending to commercial banks


page 16

Summary





page 17

A survey of the Basel Committee on Banking Supervision (BSBC) estimates that the net present value costs to output from financial crises range between 19% and 163% of annual GDP (with a median estimate of 63%). The same survey estimates that financial crises occur approximately every twenty to twenty-five years. So financial crisis would cost 3% of GDP per year.

According to a BIS paper published in 2010, the probability of systemic banking crisis is substantially reduced for systems’ core tier 1 in excess of 9%.

The relationship between bank lending growth and GDP growth, although intuitively positive, is not straightforward

– 1980s: the introduction of credit cards did not lead to stellar GDP growth– Past periods of deleveraging show varying outcome for underlying economic growth.– Credit crunch induced by banking crises negatively impact investments.

The cost of financial crises might outweigh that of regulation

0%

1%

2%

3%

4%

5%

6%

7%

8%

6% 7% 8% 9% 10% 11% 12% 13% 14% 15%

Core Tier 1 ratio

Cri

sis

Pro

bab

ility


page 18

Shadow banking is defined as “the system of credit intermediation that involves entities and activities outside the regular banking system“ as per the FSB): insurance companies, asset managers, hedge funds, pension funds, non-regulated credit institutions…”

– Non-rated private securitization placements (with more flexible collateral eligibility criteria)– Loans

Liquidity and credit risks are being transferred to “unregulated” institutions. When regulated, regulation plays against this transfer (cf Insurance).

Non-regulated shadow banking entities could pose systemic risk if connected to the banking system (ex: banking affiliates):

– Risk of moral hazard, – Remember that US subprime loans were primarily originated by non banking institutions.

Banking is a confidence business no matter what: regulators need to be pragmatic when deciding upon the final calibrations of the NSFR and LCR ratios (40% cap on level 2 assets, calibration of corporate deposit outflows).

Too much regulation kills regulation? The shadow banking system

The shadow banking system is particularly big in the US. Globally, shadow banking account for 25-30% of the financial system.

Source: Morgan Stanley/Oliver Wyman

Excess return/capital requirement (%) of different asset classes under the draft solvency 2 rules


page 19

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How will regulation reshape the banking system? Yasmine de Bray 11/05/2012.

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