How Basel III will constrain banks’ Asia ambitions

Europe’s ongoing debt crisis plus forthcoming Basel III deadlines have placed enormous pressure on leveraged European banks to reform. It will force institutions across the board to cut activity in countries they no longer see as core.

  • 14 Feb 2012
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On November 17, Credit Suisse closed its only bank branch in Taiwan.

The closure, which entailed the bank pulling out of any fixed-income operations, ended a brief 20-month affair with the country (although the bank promises that it will continue to offer brokerage services).

In years to come this might be seen as a humbling but run-of-the-mill event, as an international bank opted to slim down operations in a country in which it had no real competitive advantage.

But these are far from normal times.

The office closure was part of a larger plan by Credit Suisse to cut another 1,500 jobs, mostly in the developed world, as the Swiss bank attempts to reduce costs and instead place its focus on fast-growing markets in Brazil, China, Russia and South-east Asia.

The closure of Taiwan, a market still ostensibly emerging, is an indication of the fact that even Asia will not be spared as banks attempt to slash costs, improve capital ratios, and re-shape investment banking strategy to make money in the post Basel-III world.

“It’s a perfect storm,” one European banking insider remarks. “The Basel III deadlines, the European crisis cramping liquidity, and the public feeling of banking and bankers is at a low ebb.”

European financial institutions, in particular, are grappling with a combination of regulation, solvency, liquidity, the fragility of the euro and the European Union, and damaged reputations.

The truth is that all of Europe’s banks are hurting to some extent, caught between the rock of a sovereign debt crisis and the hard place of looming self-imposed Basel III deadlines.

The combination has left the continent’s largest lenders struggling to raise capital to hit the target ratios. The cost of raising highly subordinated debt in the debt markets is just too high right now.

If new funding cannot be found, balance sheet and assets will have to be sacrificed and with them some long-term plans.

The Asian operations of these institutions will not be immune. Any European financial institution without market-leading operations in the region will be looking at what they have with a view to dramatic cost savings.

Basel III’s demands

The demands of Basel III basically require banks to hold 4.5% of common equity – up from 2% in Basel II – and 6% of Tier I capital – up from 4% in Basel II – of risk-weighted assets. These levels are minimums and subject to the particulars of local governments, so could be higher in some countries.

Among its host of other requirements, the Basel Committee also wants to dramatically strengthen the levels of capital that are set against bank credit exposures arising from derivatives positions and securities financing transactions.

These new regulations will have a big impact. Management consultancy firm McKinsey estimates that the average return on equity (ROE) of the top 13 global banks in the years after the global financial crisis was about 20%. But using 2010 data as a baseline, the consultancy estimates that the banks’ ROE would fall to about 7% post-Basel III implementation.

That would be well below the cost of keeping those respective capital markets activities alive.

If mitigating actions are put in place effectively, McKinsey believes the 13 banks could ensure that their ROE slips to a more respectable 11% to 12%, but this only provides a thin margin of profitability for capital market activity.

“Structured-credit and rates business are most adversely affected; their ROEs may fall 80%-85%, and could potentially fall below the cost of equity, even after mitigation actions,” McKinsey wrote in the cheerily titled September report, ‘The Day of Reckoning’.

These are dramatic assumptions, with major ramifications. Historically the fixed income, currency and commodities (FICC) businesses of banks accounts for as much as 70% of industry revenues. For these divisions to suffer a “significant decline” in fee-making compared to equities is a major worry.

In contrast, McKinsey believes foreign exchange and cash equities will witness a “relatively light” decline in ROE of 40%-45%, in large part because they employ capital-light products of short duration.

Adaptability is key

Even if McKinsey is overstating the point, the impact of the Basel III changes is clearly very bad news for the traditional business model of pure investment banks. What’s vital is how they adapt their businesses to respond.

The strategic response of the banks can be distilled into four major categories: making their portfolios more risk-efficient (i.e. more hedging, and selling or unwinding capital-intensive positions); raising capital; improving internal risk and capital; and cutting costs.

Financial institutions are already well on their way with this process.

McKinsey believes extensive changes to operational and financial efficiency, better collateral and risk management, and tighter data quality control could potentially restore up to five percentage points to return on equity (ROE) lost from new regulation.

“It could be as simple as cleaning up the data on which risk models and regulatory capital calculations are based; simply ensuring that the industry sector of borrowers or counterparties is accurately recorded – and at least not recorded as ‘other’ – can save a few percentages in risk weighted assets,” remarks Emmanuel Pitsilis, a Hong Kong-based director at the management consultancy firm.

Under Basel III, for example, banks need to hold more capital for over-the-counter (OTC) derivatives transactions that have not been centrally cleared. Due to their nature, some deals will never be viable for clearing but there are still ways to reduce the pain.

At the moment there are a lot of OTC transactions that don’t contain collateral agreements, whereby collateral is exchanged between counterparties depending on the mark-to-market value of the trade. Simply by putting one in place, a bank can reduce its capital burden.

Jean-Remi Lopez, a consultant for technology company Sunguard, says: “What hasn’t been taken into account is the very inefficient allocation of capital and collateral in the past. There are a lot of opportunities for optimising that capital: you can potentially offset that.”

While the Basel III regulations have yet to be set in stone, it makes sense for financial institutions of all shapes and sizes to look at making these types of efficiencies before swinging the axe deep into business divisions.

Where the river flows

Post-efficiency improvements, the numbers suggest that in the FICC space, foreign exchange, flow interest rates and, to a slightly lesser degree, flow credit businesses will be able to provide decent ROE after the cost of equity is deducted (see table on next page).

This is where the majority of international banks will want to continue business. For example, in 2010 the top 13 international banks accounted for 50% of global flow rates revenues.

As a business line, FICC accounts for about 20% of banking revenues, according to McKinsey. Banks won’t want to give that up easily if they can help it.

And Asia is the place to do it. Many believe that FICC will in fact emerge as both the largest and fastest-growing business opportunity, with roughly 15% annual growth being predicted by strategists from here on in.

This will largely be driven by the need for better FX servicing of corporate clients in the region. As Asia-linked trade flows increase, the currency needs of medium and large corporates will increase dramatically.

Corporate friends

Given all this change, some banks are better placed than others to react and benefit (or at least see less of an impact on their business activity, which amounts to the same thing).

Asiamoney believes the large well-integrated banks with extensive corporate relationships in the region are naturally well placed.

This means that out of the 13 major global banks, the likes of HSBC, Standard Chartered, and Citi are prime candidates for growth. They still have access to their balance sheets and have large, diverse corporate relationships in the region.

“The FICC revenue pool they can potentially tap is at least three times larger than for pure play investment banks,” Pitsilis says.

Broader-based banks that can lend at cheap levels will more easily be able to leverage off that and supply their corporate customers with various FICC services as well, if they are set up to do that. Banks like Citi do that well.

Institutions that are more investment banking-orientated may struggle to engineer profits as easily.

“I bet Goldman Sachs would like to have a stronger balance sheet for lending,” one Hong Kong bank observer wryly remarks.

There’s a grain of truth in the tongue-in-cheek-comment. The top global institutions whose Asia operations traditionally focus on capital markets and investment banking – think J.P. Morgan and Deutsche Bank – have been hard at work putting together new corporate banking franchises. They can see where the money will be.

Nomura, a bank with little corporate banking presence outside of its home territory, has been looking to build up in that space. It bought the Asia operations of Lehman Brothers, which was not known for diverse Asia corporate coverage.

In August, the Japanese firm lured 10 bankers away from Deutsche Bank’s capital market and treasury team in Asia, including its co-head Daniel Mamadou. At Deutsche, the team had focused on corporate coverage, providing transaction banking, foreign exchange, rates, and debt capital market products.

The latest hires expand Nomura’s corporate solutions and financing group, a joint venture between the investment banking and fixed-income divisions with responsibility for corporate sales, risk solutions and private financing.

Deutsche Bank was a natural target for such activity due to its strong Asian rates, FX and fixed income franchise.

The corporate conundrum

But it’s not as easy as just hiring high-quality corporate banking staff. There will still be many complications along the way that will make life hard for old banking hands.

One worry is that while flow FICC is the way to go in Asia, there will still be issues in efficiently conducting OTC trades with corporates in this region.

Traditionally offering such tailored instruments has been a profitable business for the banks, but under Basel III they will have to stump up some collateral when offering non-centrally cleared forwards to such companies.

The new calculations for additional collateral take into account the 10-day value at risk (VaR) level of the currency pairing together with the stressed 10-day VaR, which incorporates the most stressed period of the currency pairing in recent history.

VaR is the probability of the risk of a complex mark-to-market loss on a portfolio of financial assets over a certain period of time. For example, if a portfolio of stocks has a 10-day 10% VaR of US$1 million, there is a 10% probability that the portfolio will fall in value by more than US$1 million over 10 days.

The riskier, or lower rated, the corporate is, the greater the deal’s VaR will be, meaning the bank has to stump up more collateral to engage with the swap.

The worry among some banks is that this new rule will hit Asian corporates particularly hard because many have lower credit ratings. This would raise their FX hedging costs, and would also impact on the cost of loans and other basic financing products where a bank has to take on counterparty risk.

Of course, as Basel III would like it, there is another option to reduce the cost of FX forwards: centrally clearing the derivatives. Basel III has said that the spread cost of a centrally cleared forward will be zero, an intentional move as it is geared to luring as much derivatives activity as possible to be centrally cleared.

However companies need to be members of a central clearing house to participate in central clearing, and the lower the credit quality of the applicant the more it costs to join. As a result, it will cost low-credit Asian corporates a lot to get involved in central clearing, making it an unappealing choice for those that don’t regularly use derivatives.

The best bet is that corporates grow accustomed to working with their financial institution partners by using collateral: it’s that or pay a higher price for the product. The banks, if they are lending cheaply, will not also be able to fully absorb the increased cost of providing OTC trades.

Asia’s banking benefits

Ultimately the regulatory changes seem to offer the most opportunity for well-capitalised banks. International banks such as Citi, HSBC and Standard Chartered look set to be the most prepared among the international banks to tolerate the new era.

These institutions have been putting their balance sheets in Asia to good use for some time. They take deposits, have good all-round corporate banking capacity and a presence in many Asian jurisdictions that they would be extremely hard pressed to let go of.

Several regional banks could do well too, especially those based in jurisdictions that are in less of a hurry to import Basel III. That means leading banks in Singapore and Hong Kong.

Under Basel III, banks are required to hold a minimum Common Equity Tier 1 (CET1) ratio at 4.5% by 2015. The standard will subsequently be raised from 4.5% to 7% by 2019.

These requirements are placing a lot of pressure on Western banks, and have led many of them to suffer credit downgrades. At the same time several Asian banks are headed in the opposite trajectory, courtesy of their stronger credit profiles and new ratings methodologies.

On December 1 Standard & Poor’s (S&P) upgraded the parent entities of both United Overseas Bank and Overseas Chinese Banking Corp from ‘A+’ to ‘AA’. Additionally, in October it published a report stating that most rated Asia-Pacific banks will not struggle to comply with Basel III over the next eight years, especially compared to their global competitors.

The agency argues that regional banks should be able to hit the Basel III targets without too much difficulty, based on their present levels of pre-provisioning profits, relatively normal credit costs, and stable asset growth.

In addition, S&P believes that higher capital charges for securitisation exposures, market risk and counterparty risk are not likely to drastically impact Asia-Pacific banks’ risk assets. This is because they have limited exposure to these securities and rely less on capital market activity to make money.

This is where the crunch lies. If McKinsey is correct, and the only businesses set to make decent money in the capital markets space are vanilla equity and FX trading, international banks with a limited regional presence will struggle to remain competitive.

After all, equity and FX trading services are relatively simple to offer, which means that Asia’s well-capitalised banks can easily compete in these areas. And they will not have to battle the sort of stigma being attached to the names of several Western institutions.

As the impact of Basel III and the European crisis continues to be felt, the long-term prospects for Western international institutions in Asia looks a lot dimmer. It’s far too early to say that the days of some banks in the region are numbered, but their breadth of regional business looks set to take a hit.

And Asian banks are eagerly waiting to benefit from any fallout.

  • 14 Feb 2012

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 17 Oct 2016
1 Citi 38,857.97 184 9.39%
2 HSBC 38,447.58 227 9.29%
3 JPMorgan 34,744.34 142 8.40%
4 Bank of America Merrill Lynch 28,556.15 119 6.90%
5 Deutsche Bank 18,270.77 72 4.42%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 13,268.07 33 6.30%
2 Bank of America Merrill Lynch 11,627.56 29 5.52%
3 Citi 11,610.06 30 5.52%
4 HSBC 10,091.34 29 4.79%
5 Santander 9,533.17 25 4.53%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 Citi 13,617.40 57 11.05%
2 JPMorgan 12,607.77 55 10.23%
3 HSBC 9,327.72 50 7.57%
4 Barclays 8,643.78 30 7.02%
5 Bank of America Merrill Lynch 6,561.15 18 5.32%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 02 May 2016
1 JPMorgan 195.08 50 10.55%
2 Goldman Sachs 162.26 37 8.77%
3 Morgan Stanley 141.22 46 7.64%
4 Bank of America Merrill Lynch 114.20 33 6.18%
5 Citi 95.36 35 5.16%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 UniCredit 3,966.12 27 13.01%
2 SG Corporate & Investment Banking 2,805.90 16 9.20%
3 ING 2,549.27 20 8.36%
4 Citi 2,526.98 15 8.29%
5 HSBC 1,663.71 16 5.46%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 19 Oct 2016
1 AXIS Bank 5,944.45 123 18.53%
2 HDFC Bank 3,792.05 100 11.82%
3 Trust Investment Advisors 3,390.86 145 10.57%
4 Standard Chartered Bank 2,299.63 31 7.17%
5 ICICI Bank 1,894.86 51 5.91%