Basel III: Return and

Deleveraging Pressures
Macro Credit Research May 17, 2012
www.ftchratings.com
Analysts
Martin Hansen
+1 212 908-9190
martin.hansen@fitchratings.com
James Moss
+1 312 368-5455
james.moss@fitchratings.com
Robert Grossman
+1 212 908-0535
robert.grossman@fitchratings.com
Andrew Murray
+44 20 3530-1073
andrew.murray@fitchratings.com
Meeting Basel III Targets: Fitch Ratings estimates that, as of end-December 2011, the 29
global systemically important financial institutions (G-SIFI), which as a group represent
$47 trillion in total assets, might need to raise roughly $566 billion in common equity in
order to satisfy new Basel III capital rules, which represents a 23% increase relative to these
institutions aggregate common equity of $2.5 trillion. Although Basel III will not be fully
implemented until end-2018, banks face both market and supervisory pressures to meet these
targets earlier. Banks will likely pursue a mix of strategies to address these shortfalls, including
retention of future earnings, equity issuance, and reducing risk-weighted assets (RWA) (see the
text box on page 3). Absent additional equity issuance, the median G-SIFI would be able to
meet this shortfall with three years of retained earnings, which might constrain dividend payouts
and share buybacks.
Falling ROE Pressures: This potential capital increase would imply an estimated reduction of
more than 20% in these banks median return on equity (ROE) from about 11% (over the past
several years) to approximately 8%9% under the new regime. Basel III thus creates a tradeoff
for financial institutions between declining ROE, which might reduce their ability to attract
capital, versus stronger capitalization and lower risk premiums, which benefits investors. For
banks that continue to pursue mid-teen ROE targets (e.g. 12%15%), Basel III creates potential
incentives to reduce expenses further and to increase pricing on borrowers and customers where
feasible. Additionally, since it is impossible for regulators to perfectly align capital requirements
with risk exposure, banks may seek to increase ROE by favoring riskier activities that maximize
yield on a given unit of Basel III capital, including new forms of regulatory arbitrage.
Potential G-SIFI Response: G-SIFIs face a trade-off, with higher capital requirements
potentially offset by competitive advantages stemming from their official status as systemically
important institutions. Some investors and counterparties might perceive these institutions
as more likely to receive government support in a distress scenario. This perception, coupled
with the G-SIFIs higher capital standards, could in turn reduce funding costs and stimulate
business flow from more risk-averse customers. Conversely, institutions that deem G-SIFI
status as a regulatory burden might seek to reduce or limit their size and complexity in order
to avoid this designation.
Study Background:
29 global systemically important
financial institutions (G-SIFI).
Conducted as of end-December
2011.
Fitch core capital as proxy for
Basel III Tier 1 common equity
(e.g. harmonizes deductions).
Assumes Basel III Tier 1 common
equity ratio of 10%, composing:
4.5% minimum.
2.5% capital conservation
buffer.
2% G-SIFI surcharge (ranges
from 1.0% to 2.5%).
1% additional discretionary
buffer.
Basel III: Higher Capital Requirements to Pressure ROE
No. of
Banks
Total
Assets
($ Tril.)
Average
Risk-
Weight
Increase
(Basel III)
(%)
Projected
Basel III
Capital
Shortfall
($ Bil.)
% Projected
Increase
in Common
Equity
(Median)
ROE
(Pre-
Basel III)
(%)
ROE
(Basel
III)
(%)
All G-SIFI 29 46.8 26 566 23 10.8 8.5
29 G-SIFI banks (with $47 trillion in total assets) subject to higher Basel III capital ratios.
Potential equity capital increase of about $566 billion to meet Basel III standards.
ROE decline (median) to 8.5% from 10.8%.
Source: Fitch Ratings, BIS, company nancial statements, and investors presentations.
Fitch Core Capital: The Primary Measure
of Bank Capitalization (Jan. 19, 2012)
Basel II Capital Ratios A Field Guide
for Assessing Risk-Based Capital
(March 11, 2010)
Rating Banks in a Changing World
(Oct. 13, 2011)
Related Research
2 May 17, 2012
Basel III: Return and Deleveraging Pressures
Basel III Measuring the Road Ahead
Although Basel III will be phased in over time, with the fully phased-in
rules set to take effect in end-2018, banks are already well underway
in planning and preparing for implementation (see the From Basel
II to Basel III: Same Concept, More Capital text box for background
on Basel III on page 5). Many banks will likely seek to achieve and
demonstrate full Basel III compliance prior to this deadline given both
market and supervisory pressures, as exemplified by the European
Banking Authority stress tests requiring major EU banks to achieve a
9% Tier 1 common equity ratio by end-June 2012.
To assess where banks currently stand in their Basel III preparations,
this study quantifies the capital shortfall of the 29 global financial
institutions identified as G-SIFIs by the Financial Stability Board
(FSB). This cohort of banks represents a global mix of institutions
spanning a range of banking models, including traditional credit
intermediation, trading and market making, processing and custody,
and universal. From a systemic risk perspective, these banks are
interconnected with other important financial institutions, asset
markets and sectors of the economy. Finally, given their significant role
within the banking sector, the G-SIFIs might represent a benchmark
for other institutions working towards Basel III compliance.
The G-SIFIs are subject to higher capital requirements than other
banks under Basel III. In addition to the Basel III Tier 1 common
equity ratio of 7%, G-SIFIs are subject to an additional Tier 1 common
equity buffer of between 1.0% and 2.5%, depending on the systemic
importance of the particular institution. Thus, the potential minimum
required Tier 1 common equity ratio is 9.5% for some of these banks.
Since the level of this G-SIFI surcharge for each institution has not
been revealed publicly, this study assumes that each G-SIFI must
achieve a 9% Tier 1 common equity ratio and will hold an additional
discretionary 1% buffer above the regulatory minimum, resulting in a
projected Basel III Tier 1 common equity ratio of 10%.
To provide as current a view as possible of where these banks stand
in relation to the Basel III requirements, this study analyzes financial
reporting as of Dec. 31, 2011. These findings are illustrative and
have no current rating implications. An important component of the
analysis is the use of Fitch core capital (FCC) as a proxy for Basel III
Tier 1 common equity (see Fitchs special report Fitch Core Capital:
The Primary Measure of Bank Capitalization). FCC is the primary
measure used by Fitch analysts to assess a banks capitalization. In
calculating FCC, Fitchs objective is to arrive at a comparable figure
across countries, which measures a banks highest quality, going
concern capital. FCC is broadly similar to Basel IIIs Tier 1 common
equity measure (see the Fitch Core Capital table on page 3), but it
Deleveraging Affects Broader Markets: Given the global scale and
scope of the G-SIFIs, their deleveraging in preparation for Basel III will
likely affect credit markets and the financial system more broadly. First,
since Basel applies relatively higher capital charges to riskier activities,
institutions are likely to focus on reducing their exposure to lower
rated and more volatile sectors. For example, a high-yield corporate
loan subject to a 150% risk weight would command a more than
14% Tier 1 common equity charge under Basel III (assuming a 9.5%
G-SIFI minimum common equity ratio). This exposure would consume
significantly more minimum required equity capital than Basel II,
which in effect only requires a 3% equity charge on the same asset
(based on a 2% minimum Tier 1 common equity ratio). Higher Basel III
capital charges for these activities could result in increased borrowing
costs, diminished availability of credit, reduced asset liquidity, a shift
to securitization and capital markets funding or migration to less-
regulated segments of the financial system (e.g. shadow banking).
Basel III Overview: Changes Relative to Basel II
Higher Quality Capital
Basel III : Capital > Minimum Ratio x RWA (Market + Credit + Operational)
Predominantly common equity (common
shares; retained earnings).
Harmonization of deductions (e.g., goodwill
and deferred tax assets).
No more innovative capital instruments
(e.g. trust preferred)
Increased Minimum Ratios
Tier 1 common equity: 7%
Total capital charges: 10.5%
G-Sifi surcharge: 1.0%2.5% (common
equity)
Market Risk RWA
Trading book review (May 2012)
VaR based on stressed model inputs
Incremental risk charge for default
and migration risk of unsecuritized
credit products in the trading
Specific risk charge for securitization
exposures held in trading book
Credit Risk RWA
Securitization
1,250% RW (versus capital deduction)
of low quality exposures.
Higher RW for re-securitizations.
Counterparty Credit Risk
CVA charge for potential MTM losses
from counterparty deterioration.
Higher IRB correlation parameter for
financial institution exposures.
Stressed Effective EPE.
3 May 17, 2012
Basel III: Return and Deleveraging Pressures
is not dictated by regulatory capital considerations. For the purposes
of this exercise, FCC provides a useful current approximation of how
banks will ultimately measure Tier 1 common equity under Basel III.
The other important aspect of gauging the capital impact is to
adjust RWA upwards to reflect the greater conservatism in Basel
IIIs treatment of counterparty credit exposure and other areas. For
all but a few of the G-SIFIs, Fitch was able to source banks own
estimates of their anticipated increase in RWA under Basel III from
investor presentations and other publicly available disclosures.
In the instances where this information was not available, this
study uses the recent Basel Committee quantitative impact study
estimate of a 19.4% RWA increase and then nets out the impact
from Basel 2.5, which European and Japanese banks in the sample
have implemented as of end-December 2011.
The estimated Basel III capital shortfall is derived for each bank
by calculating its ratio of Fitch core capital (numerator) to Basel
III-adjusted RWA (denominator) as a proxy for Basel IIIs Tier 1
common equity ratio. The projected Basel III capital shortfall
for each institution is the amount of additional common equity
needed to achieve a 10% ratio. The corresponding estimate of how
much each bank would need to shed in RWA (as an alternative to
increasing common equity) is calculated by dividing the projected
capital shortfall by 10% (i.e. the assumed equity ratio). In order
to size the potential reduction in each banks ROE under Basel III,
Fitch calculated the median average return on common equity for
each bank over the 20052011 period and then adjusted this ratio
downward based on the percentage increase in common equity
needed to fulfill the projected Basel III capital shortfall.
$566 Billion Projected Capital Shortfall, 8.5%
Median ROE
According to these projections, the 29 G-SIFIs in aggregate would
have to raise roughly $566 billion of equity capital in order to meet a
10% Tier 1 common equity ratio, with the median institution needing
to raise $18 billion (see the table below). The average shortfall is
about $19.5 billion. These estimates are based on applying Basel III
(whose formal implementation will occur in stages through end-2018)
on G-SIFI financial results as of end-December 2011. For the median
bank, equity capital would need to increase by 23% in order to meet
this threshold, although there is some dispersion across institutions,
Capital Impact Similar Across Regions, but Varies by Bank
Total Assets
12/31/11
($ Bil.)
Common
Equity
12/31/11
($ Bil.)
Additional
Common Equity to
Reach Basel III
Target ($ Bil.)
Projected
Common Equity
(Basel III) ($ Bil.)
Increase in
Common Equity
to Reach Basel III
Target (%)
Ratio of Basel III
Capital Shortfall to
Annual Net Income
(20052011 Median)
Median 1,528 72 18 92 23 3.0
25th Percentile 1,115 57 7 60 10 1.1
75th Percentile 2,266 110 28 135 30 5.0
Total 46,808 2,513 566 3,079
APAC Median (4) 1,986 105 24 134 23 3.7
EMEA Median (17) 1,508 71 19 87 23 3.0
USA Median (8) 1,119 99 14 128 21 2.5
Source: Fitch Ratings, BIS, company nancial statements, and investors presentations.
Fitch Core Capital: A Useful Proxy for Basel III
Tier 1 Common Equity
Fitch
Core
Capital
Basel III Tier 1
Common Equity
Credit Spread On Fair Value of Own Debt Out Out
Fair-value (FV) Changes On Loans
Classied as AFS In In
FV Changes On Equities in AFS In In
FV Changes On Debt Classied as AFS In In
Cash Flow Hedge Item In Out
FV Change on Land and Buildings In In
Investments In Insurance Companies Out Out
Expected Loss Adjustment Out In
Deferred Tax Assets on
Losses Carried Forward Out Out
Large Investments In Non-FIs In 1,250% Risk Weight
Source: Fitch Ratings, BIS.
Mix of Strategies to Meet the Basel III Capital Challenge
Banks are likely to cover their Basel III shortfall through some
combination of retained earnings, equity issuance, and RWA
reduction.
The averages for the 29 G-SIFIs in this study, as of end-December
2011, are:
Total Assets: ........................................$1.6 trillion
Risk-Weighted Assets: ...................... $615.0 billion
Median Earnings (20052011): ........... $6.0 billion
Common Equity: ................................ $87.0 billion
Basel III Capital Shortfall: .................. $19.5 billion
Thus, assuming a roughly proportionate mix of strategies,
the average bank could meet its estimated shortfall of
$19.5 billion through:
One year of retained earnings ($6 billion).
$6 billion equity issuance (equal to about 7% of $87 billion).
$75 billion RWA reduction (equal to about 12% of $615 billion).
4 May 17, 2012
Basel III: Return and Deleveraging Pressures
with a 25th percentile increase of 10% versus a 30% increase at
the 75th percentile. The median projected equity raise is roughly
comparable across APAC (23% increase), EMEA (23% increase), and
the U.S. (21% increase).
In addition to increases in the minimum required ratios, another
important driver of the projected Basel III equity shortfall is the more
conservative recalibration of RWA, which particularly affects banks
with significant trading activity and counterparty exposure. Many of
the G-SIFIs, specifically the European and Japanese institutions,
have recently implemented Basel 2.5, which on average increased
their RWA by 6% (see the table above). The Basel 2.5 RWA increase
ranged from 0% to 23%, with the Asian G-SIFIs less affected than
their European counterparts. The projected average Basel III RWA
increase of 26% is much higher, ranging from a minimum increase
of 3% to a maximum increase of 72% for the banks sampled. U.S.
banks are most affected, with an average RWA increase of 46%,
although this estimate includes the impact of both Basel 2.5 (which
has not yet been implemented in the U.S.) and Basel III. As a
reference point, the Basel Committee recently published a Basel III
quantitative impact study, which estimated a 19.4% RWA increase
for the roughly 100 large banks in their sample as of end-June 2011.
Banks are likely to pursue a range of approaches for achieving Basel
III compliance (see the Mix of Strategies to Meet the Basel III
Capital Challenge text box on page 3). Reducing RWA is a focal
point for many banks. RWA reduction might involve selling, hedging,
or winding down riskier assets (including exit from entire business
lines); the application of less conservative Basel risk inputs and
calculation methodologies; or regulatory arbitrage, in which the
same or similar economic risk exposure attracts preferable capital
treatment. Regulatory arbitrage includes tactics such as structuring
or booking an exposure in a manner designed to minimize regulatory
capital charges. Given the risk sensitivity of Basel capital charges,
banks face a tradeoff in shedding riskier exposures that consume
more capital, but are also likely to generate higher yields.
Retained earnings will also likely play a significant role in achieving
Basel III compliance. As a benchmark, the ratio of the median
projected Basel III capital shortfall to the median net income for
20052011 is 3.0, implying that three years of earnings, if fully
retained, could satisfy the requirement. To the extent that future
bank earnings exceed their 20052011 median, banks might be
able to meet these targets more readily through retained earnings.
Nevertheless, working to meet the Basel III target might constrain
both dividends and share buybacks in the coming years.
Based on the projected Basel III increase in equity capital, median
ROE could in turn drop to 8.5%, down from the roughly 10.8% median
ROE for the period 20052011. The Basel III ROE estimate of 8.5% is
based on rescaling each banks median ROE for the period 20052011
by the projected increase in equity capital needed to meet a 10% Tier
1 common equity ratio. The 10.8% median ROE from 20052011
encompasses a range of environments and, as a point of reference,
exceeds the median ROE of 7.3% experienced in 2011.
In addition to considering a 10% Tier 1 common equity ratio,
Fitch also performed this analysis based on a 9% ratio. Based on
this lower threshold (which means that any G-SIFI subject to the
full 2.5% surcharge would fall below the 9.5% Tier 1 common
equity minimum), these banks, in aggregate, would face a
$342 billion, rather than $566 billion, shortfall. Thus, relatively
subtle differences in banks minimum requirements and target ratios
can significantly affect the projected capital shortfall under Basel III.
Under a 9% minimum ratio, the median capital increase is roughly
13% (versus a 23% increase under a 10% Tier 1 common equity
ratio), it would take two years rather than three to meet this shortfall
through median retained earnings, and median ROE would decline to
roughly 9% (versus 8.5% median ROE under a 10% ratio).
Basel III Greater Impact on RWA Than Basel 2.5
(% Increase in RWA)
Basel 2.5 (Already
Implemented,
Except in U.S.) Basel III
Europe 7 16
U.S.
a
N.A. 46
Asia 1 9
Mean 6 26
Median 4 16
Maximum 23 72
Minimum 0 3
Basel QIS Study 19.4
a
U.S. Basel III increase reects combined impact of Basel 2.5 and Basel III and shift
from current standards, which are based on Basel I. N.A. Not applicable.
Source: Fitch Ratings, BIS, company nancial statements, and investors presentations.
Basel III and Lower ROE: How Will Banks and
Investors Respond?
(%)
Median ROE
20052011
ROE
(2011)
Projected ROE
(Basel III)
Median 10.8 7.3 8.5
25th Percentile 7.5 5.0 6.0
75th Percentile 13.2 10.3 10.9
APAC Median (4) 11.1 9.2 8.5
EMEA Median (17) 11.2 6.5 8.5
USA Median (8) 9.8 7.5 8.5
Source: Fitch Ratings, BIS, company nancial statements, and investors presentations.
5 May 17, 2012
Basel III: Return and Deleveraging Pressures
29 Institutions Designated as G-SIFI by the FSB
Banco Santander, S.A.
Bank of America Corporation
Bank of China
Bank of New York Mellon Corp.
Barclays plc
BNP Paribas
Citigroup Inc.
Commerzbank AG
Credit Agricole
Credit Suisse Group AG
Deutsche Bank AG
Dexia
Goldman Sachs Group
Groupe BPCE
HSBC Holdings plc
ING Bank NV
JPMorgan Chase & Co.
Lloyds Banking Group plc
Mitsubishi UFJ Financial Group
Mizuho Financial Group, Inc.
Morgan Stanley
Nordea Bank AB
Societe Generale
State Street Corporation
Sumitomo Mitsui Financial Group
The Royal Bank of Scotland Group plc
UBS AG
UniCredit S.p.A.
Wells Fargo & Co.
From Basel II to Basel III: Same Concept, More Capital
Both Basel 2.5 and Basel III are essentially recalibrations of Basel II. The Basel II methodologies for deriving risk-weighted assets (RWA)
remain largely unchanged, although Basel 2.5 and Basel III introduce additional conservatism in the RWA calculations for market risk
and credit risk, respectively.
Basel 2.5, which Australian, European, and several Asian banks have already implemented, addresses market risk RWA by introducing:
Stressed Value at Risk (VaR), which is based on a one-year historical period of significant market-related losses (e.g. 20072008
market volatility) and is additive to existing VaR calculations;
A new incremental risk charge (IRC) within VaR calculations to capture default and migration risk for unsecuritized credit products
in the trading book;
Specific risk charges for securitization exposures held in the trading book based on the same treatment (e.g. ratings-based
approaches) as applied in the banking book, higher risk weights on resecuritization exposures, and a more conservative treatment of
liquidity facilities on asset-backed commercial paper programs.
Basel III, whose implementation formally begins in end-2012 and concludes by end-2018, strengthens the quality of regulatory capital,
minimum capital ratios, and risk coverage, particularly for counterparty credit exposure.
Basel III requires that the regulatory capital base consist predominantly of common shares and retained earnings, which provide
the purest form of going concern loss absorption. Additionally, the rules harmonize deductions from capital and phase out the
qualification of innovative capital instruments, such as trust preferred securities.
Minimum capital ratios, particularly for Tier 1 common equity, increase relative to Basel II. Notably, while Basel II effectively requires
a 2% ratio of Tier 1 common equity to RWA (i.e. the Tier 1 common equity ratio), Basel III requires a minimum ratio of 4.5%,
which in effect will be a 7% ratio when including the 2.5% capital conservation buffer. For G-SIFIs, an additional Tier 1 common
equity surcharge of between 1% and 2.5%, depending on the institutions systemic importance, could bring the Tier 1 common
equity ratio up to 9.5% for some banks. While the Basel II minimum total capital ratio of 8% remains unchanged, the capital
conservation buffer effectively increases this ratio to 10.5%.
Basel III increases RWA for counterparty credit risk, for example on repo and derivatives exposures, including the use of stressed
inputs in the calculation of exposure (i.e. effective expected positive exposure, or EPE) and a charge against credit valuation
adjustments (or CVA) that arise from potential mark-to-market losses due to a counterpartys deteriorating creditworthiness. While
EPE addresses default risk, CVA is driven by migration risk. Basel III also increases RWA on exposures to financial institutions by
increasing the asset value correlation parameter within the internal-ratings based capital formula. Additionally, banks must now risk-
weight low-quality securitization exposures at 1,250% rather than deduct these positions 50/50 from Tier 1 and Tier 2 capital, which
in effect amounts to a more conservative capital treatment since minimum total capital ratios exceed 8% under Basel III.
The Basel Committee is also in the process of a fundamental review of trading book capital requirements, including the trading book/
banking book boundary, calibration to stress periods, the metric used for quantifying market risk (i.e. VaR versus expected shortfall),
and incorporating the risk of market illiquidity.
Other important elements of the Basel III revisions are the introduction of a leverage ratio, which assesses capital relative to accounting-
based definitions (rather than risk weightings) of exposure, and new ratios for measuring both short-term and structural funding liquidity.
6 May 17, 2012
Basel III: Return and Deleveraging Pressures
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