March 5, 2015

Are remaining G-SIB shortfalls of Basel III capital more problematic than it seems?

At an eight month lag to the base reported data it is based on, BCBS's half yearly Basel III monitoring report was published recently looking at banks' progress towards meeting Basel III capital and liquidity rules.  On the surface the report seems to have a pretty positive message. Reading between the lines and combining with other information there is a more interesting story behind the numbers on what it will take to meet the minimum ratios.  

At an eight month lag to the base reported data it is based on, BCBS's half yearly Basel III monitoring report was published recently looking at banks' progress towards meeting Basel III capital and liquidity rules.  On the surface the report seems to have a pretty positive message.  Banks are becoming safer through more capital and liquidity reserves.  Without saying so out loud, the graphs and statistics seem to imply the shortfalls are under control.  Reading between the lines and combining with other information there is a more interesting story behind the numbers on what it will take to meet the minimum ratios.  

Just to mention – I haven't bothered to convert all the figures to dollars.  The report can be read in euro well enough and the exchange rate is not that far of parity ($ per € = 1.1186 (mid) as of March 3rd close according to 
Capital and Leverage Ratios – mixed news
The good news is that all G-SIBs meet the current minimum requirements and says that "Moreover, capital shortfalls relative to the higher target levels have been further reduced."   (G-SIBs are the 30 largest global banks out of 98 Group 1 banks (30 billion or more of capital) – with 126 Group 2 banks completing the sample) 
The target levels "include G-SIB surcharges" which come in over time.  The surcharges mentioned are the capital conservation buffer which increases the risk-based capital ratio minimum from 8% to 10.5% and a further G-SIB surcharge of 1% to 2.5%.  However, what does not seem to be covered is the US G-SIB specific higher leverage ratio minimum of 5% (6% for their FDIC insured subisdiaries) which is live now.
The bad news is quite a lot of the problem is concentrated in G-SIBs (see below).
When does this bite?  Disclosure now
Though the hard leverage ratio minimum is not formally met until 2018 and the the G-SIB surcharges and conservation buffer on the capital ratio ratchet up through 2019, public disclosure is the main impact as it will influence among other things bank share prices.  Leverage ratio is formally disclosed in financial statements starting Q1 2015 (though was already being done electively on a proforma basis by the big banks).  Several banks notably issued equity in 2014 partly led by this requirement (e.g. DB).    
To get an idea of the difference between proforma and full disclosure the disclosure templates give a breakdown (already being submitted to regulators) of the leverage ratio exposure by instrument type.  The EBA Basel III monitoring report – available here helpfully aggregated these across all banks (see figure below).  Now for each bank as well as maybe total leverage ratio exposure and the actual ratio we'll also get this breakdown for that bank specifically to enable more detailed cross comparison.

How are the G-SIBs doing?  Significant remaining total capital shortfall obscured by historic reductions
Digging around the report reveals that G-SIBs dominate the total capital shortfall covering about 2/3 of the total (€83.4bn of €129.7 billion) after both risk based capital ratio and leverage ratio are factored in.  The graph below takes attention away from this point given the scale.   The second graph shows that this has mainly been achieved up to end Q2 2014 by increasing capital issuance by 40+% rather than reducing RWA (only reduced by 10%) and LRE (slight increase).
How many G-SIBs have shortfalls?  Maybe a minority of the 30 with significant shortfalls each
The €83bn shortfall is likely concentrated in a small subset of the 30 G-SIB banks because of the way it is calculated – the shortfall is measured if it only includes those banks falling short.  Hence a bank which eliminates a shortfall drops out of the numbers – explaining the steep drop in total shortfall.  The report is selective in which figures it gives for G-SIBs specifically but only a subset of the 30 G-SIBs comprise the €83.4bn shortfall.   What we can say is:
  • Of 98 Group 1 banks (which include the 30 G-SIBs) 11 didn't meet one or both of the 3% minimum leverage ratio and the target total capital ratio of 8.5% (i.e. fell out side the top-right quadrant formed by the dotted lines in the graph)
  • There are some higher G-SIB specific standards for which I added two red lines.  The horizontal red line represents: a total capital ratio minimum of 11.5% including the 2.5% capital conservation buffer and the minimum 1% G-SIB surcharge.  The vertical red line represents: the US G-SIBs have to maintain a leverage ratio minimum of 5% instead of 3%.  (An implication for example is that we have to hope that the US G-SIBs were or become red dots in the top right quadrant formed by thes red lines)
What can the shortfall G-SIBs do about it?   1.  Drastic measures
As well as comparatively drastic measures such as raising more capital or closing business lines or product lines within businesses (e.g. RBS curtailment of investment banking, DB's curtailment of single name CDS trading), banks can also withdraw balance sheet from market making by changing their business model to an agency / riskless principal / less inventory-intense model with potential assistance of ECNs and in house e-trading tools.  Here's my post chain on the topic.   I don't have any figures on the likely benefits from these activities.  I suspect however that ECNs alone are not a silver bullet and that bank business models / in house e-trading tools are a big part of the answer as well.
The pie chart above also helps to understand why there's so much noise about market making withdrawal (as this includes a big chunk of the grey "on-balance sheet' slice as well as the "off-balance sheet" derivatives and securities financing).
What can the shortfall G-SIBs do about it?   2.  Optimize
To minimize the need for drastic measures with capital-cost-incurring or revenue-line-crimping impacts, they can also focus on the many optimization activities going on.  Though these are focused in derivatives and securities finance and are therefore only tackling about a quarter of the total problem, there's still a lot of potential given these have been historically largely off balance sheet and therefore not so heavily optimized:
  • Lobbying to change leverage ratio rules – for OTC derivatives (especially FCM cleared) and futures 
  • Compression expansion (line-item compression ramped up in 2014, risk compression may follow) – cleared OTC derivatives today, bilateral in future?
  • CCP expansion (the coming EU OTC clearing mandate, CCP portfolio margining, elective OTC legacy backloading, expanding repo CCP participation to the buy side, expanding CCP product eligibility)
  • Bilateral innovation (the coming IM mandate, bank portfolio margining, selective unwinding of portfolios, elective IA/IM to mitigate RWA)
The good news for the "shortfall G-SIBs" is that these also benefit those already meeting the target because they provide strategic flexibility to allocate capital to new or more profitable businesses.  The bad news is that while the short fall banks are eliminating the shortfalls by participating they are providing capital headroom to their competitors to free up capital to invest in new businesses.  For now though the shortfall G-SIBs will be glad not to be painted into a corner.

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