Equity has never been more expensive but the regulators wont let you have any other type of capital. But they do insist that you have to maintain a previously unheard of core tier one ratio. The politicians dont much care about that in itself but they are insistent that you keep the doors open to new lending. Whats a finance director to do? How do you square the circle?
On the face of it, its a pretty tough question, but plenty of banks in Europe appear to have it solved. The answer lies in the bottom half of the capital ratio equation: the calculation of risk weighted assets.
The capital ratio is just that: a ratio. Basel III has harmonised the definition of capital itself the numerator by creating strict rules for what counts and ensuring that there is more of it. Capital has been cleaned up, and tightened up.
But the calculation of risk-weighted assets, the denominator, is still for credit risk, which accounts for 80%-85% of risk-weighted assets made using rules and models that vary from jurisdiction to jurisdiction and bank to bank. Harmonised it is not.
By tweaking a few inputs here, a few there in the calculation of RWA, a yawning capital gap can be turned into a healthy surplus. That, at least, is the argument of an increasing number of regulators and bank analysts and points towards the next big regulatory push following the harmonisation of capital standards in Basel III and the Capital Requirements Directive IV.Indeed, far from being finished with new regulations when the Basel III regime is implemented, the drive for harmonised global rules on capital are at best only half complete and Europes banks could be short of 400bn, by some estimates.
The problem has been brewing a long time since the Basel Committee began thinking around the turn of the millennium about moving forward from the first Basel accord and introducing Basel II.
"Back in the days of Basel I, calculating a regulatory capital ratio was not especially taxing or time-consuming," noted Andrew Haldane, the Bank of Englands executive director for financial stability, in a January speech which showed the UK regulator beginning to take interest in the RWA problem. "It involved little more than half a dozen calculations. Basel II changed that calculus."
The number of risk buckets increased from around seven to around 200,000. The number of calculations required to compute the regulatory capital of a bank rose from single figures to over 200m, said Haldane.
It is so complex because under Basel II banks were encouraged to create their own credit risk models to calculate three inputs: the probability of default, the loss-given default and the exposure at default for each different type of asset. The output of those models gives a risk weighting for each asset and the amount of capital they need to hold.
The UKs Financial Services Authority first investigated the differences between banks models in 2007 and repeated the experiment in 2009. It asked a sample of UK banks to use their models to generate PDs for 64 corporate, bank and sovereign exposures. Haldane cited the results of that study in his January speech. "The range of reported capital requirements were striking," he said.
For bank exposures they differed by a factor of 100%. For corporates by 150%. And for sovereigns by 280%. Those are big numbers and equate to big differences in required capital.
But as long as a bank could show its regulator that its model had an agreeable internal logic, they were approved. For the banks, it was, and is, efficient. But big variations in the amount of capital banks hold for what are essentially the same assets mortgages, say, or triple-B corporate credit dont give investors any confidence in a crisis. There is, at best, a suspicion that banks are massaging their models to create seemingly strong capital ratios. Alex Koagne, a banks analyst at Natixis in Paris, explains.
"We switched from Basel I to Basel II with the aim of switching to a more economic approach to the way that banks calculate RWA. The backbone is an internal model. Even though each has to be approved by the regulator it is very different from one bank to another and the consequences are to reduce RWA. With the crisis investors have a feeling that banks are minimising RWA to reduce the capital consumption, and so they just feel that banks are short of capital."
But how short of capital?
Among the first equity research teams to pick up on the problem was Simon Samuels team at Barclays Capital, which has now published three reports on the subject.
He shows that the move from the IRB approach to the standardised approach (which uses ratings to calculate risk weightings) has resulted in a calculation of risk-weighted assets many times less than it would have been not that it is necessarily wrong, just that it is hugely different. Looking at the 529bn of sovereign, financial institution and corporate exposures on the balance sheet of Société Générale, for instance (and this analysis is repeated for all the banks under coverage), the BarCap team shows that the IRB approach gives 171bn less risk weighted assets than the standardised approach. That is the difference between a healthy 8.3% core tier one capital ratio and an anaemic 6.0%.
That is about in the middle of the range for changes across a swathe of banks.
"The recalculation of capital ratios, using for example, the standardised approach, is very damaging to certain banks," says Samuels. "It shows that for some of those banks, their apparent strong capital ratios are actually very much reliant on their risk weightings which either means they dont have the surplus capital they first looked like they might have or any expectations of some kind of capital return realistically just need to go on the backburner."
So what can be done? A regulatory revamp is clearly on the cards. "Theres a natural chronological timeframe to this," says Samuels. "Theyve cleaned up the definition of capital; theyve cleaned up the RWA definition within the trading businesses. This is the obvious next area for a revamp. The Basel Committees Standards Implementation Group is now likely to spring into life and focus on this."
Indeed Adair Turner, chairman of the FSA, made the point when introducing the Bank of Englands Financial Stability Report in June.
"Within Basel III a lot of work was done on the capital side," he said during a question and answer session. "...but as weve done that we have increasingly realised that the issue of the definition of risk weights is incredibly important. The integrity of the whole system depends on us really being confident that when we rate something as risk rate 0.25 in an American bank the equivalent risk in a Brazilian bank is also 0.25 and in an Indian and a German and a UK bank etc... I think there is a major project for the Basel Committee and the international authorities to really focus on the commonality of risk weights."
Koagne suggests that regulators may take a sample of banks, to see how the internal models are calculated. "They will try to see where the gap is, why there is such a gap, and try to find a rough average," he says. "If you dont do so, then the best thing to do is to go back to the rating agencies and make sure everyone is doing the same thing. Its a question of harmonisation."
But harmonising approaches to risk weightings across jurisdictions is one thing making the models acceptable to investors as a means of comparison within jurisdictions is even harder. There is good reason, after all, why mortgages should not have the same risk weight in Brazil as in Germany: they are very different assets. But why should Lloyds rate its mortgages differently from Royal Bank of Scotland, say they are, by and large, the same asset. Can the internal ratings-based approach be saved?
Samuels suggests three possible approaches. The first is to abandon IRB and move back to the standardised approach. That would be costly adding around 2tr of risk weighed assets to bank balance sheets, a 30% increase but it would at least be transparent. However, the standardised risk buckets involved imply hard-wiring external credit ratings into the banking system not something that regulators would now be keen on.
The second potential solution is to promote the leverage ratio. The BarCap analysts say that although in and of itself it is no panacea, it can provide a useful cross check. "Core tier one plus leverage ratio doesnt equal anything. But its potentially a useful way of assessing capital adequacy in a more holistic way," they say.
The third way includes softer solutions such as more peer review or global regulator review.
Given the absence of a perfect solution, though, Samuels says that banks will probably be allowed to keep using the IRB approach but that regulators could force some broad categories of assets mortgages, say to attract a minimum charge. And that could further influence behaviour.
"You could apply very high floor limits to the IRB process," he says. "The average risk weighting for mortgages for a lot of European banks is only 6% or 7% under IRB. So you could just say, look, you can adopt IRB, thats fine, but the minimum risk weighting for mortgages is 30%. Since the standardised approach is 35% some banks might just voluntarily say, you know what, I cant be bothered with all the extra cost and hassle and people dont trust us on it anyway; were just going to move on to the standardised approach."
Whatever happens though, given investors anxieties, finance directors have a lot to think about."There is much that needs to be done by the industry and regulators to regain investors trust in the risk weighting process, and ultimately that might involve a dumbing down on how RWAs are calculated in the interest of providing transparency and accountability," say the BarCap team. "Meanwhile, we believe that investors and analysts are likely to remain concerned, puzzled and in many cases sceptical."