making sense of increased capital requirements
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Risk Minds June 2012. Making Sense of Increased Capital Requirements. By J.V. Rizzi. The opinions expressed herein are those of the author. They do not reflect the views of CapGen Financial. Table of Contents. Change Reaction Reality Impact Response Conclusion. Change. - PowerPoint PPT PresentationTRANSCRIPT
By J.V. Rizzi
Making Sense of Increased Capital Requirements
The opinions expressed herein are those of the author.They do not reflect the views of CapGen Financial.
Risk MindsJune 2012
Table of ContentsChangeReactionRealityImpactResponseConclusion
2
Change
3
The Change(BIS III and Dodd Frank)
Message: more capital, more liquidity and less risk Specifics
- tightened capital definition- increased RWA weights- more liquidity
limit illiquid assetsrestrict unstable funding
- increased capital requirementsBIS III Dodd Frank (well capitalized)
CE 2 4.5 [5+]T1 4 6 > 6TC 8 8 > 10Buffer 0 2.5 --Lev 0 3 > 5
Why- Banking as an industry failed- Clear that prior capital rules were insufficient
4
(Capital goes where it is welcome…
…and stays where it is treated well)
Reaction
5
The Nonsense(Do you want to believe what you see…Higher Capital Requirements
Put aside more reservesCurtail lendingImpede growth
Decrease ROEIncreased Funding CostUn-American
…or what I am telling you?)
6
Reality
7
The Reality(Facts ignored… Set aside
Confuses liquidity reserves with funding mix Increased funding cost
Limited given proportion of equity in capital structure Ignores cost of forced capital raise at distressed price
Reduced ROE Cost of equity is not fixed Key is the spread between ROE and cost of equity
Un-American “The policy goal should be a healthier banking system, rather than high
returns for banks’ shareholders and managers with taxpayers picking up the losses and economies suffering the fallout.”
Bankers resistance of higher capital requirements: capital shifts risk from taxpayer to capital provider Vested interest in subsidies and compensation– especially for banks with
weak franchise value and Debt overhang: benefits to debtholders
…do not cease to exist.)
8
Impact
9
Impact(You cannot lever up a sow’s ear into a silk purse…Business Model
Balance sheet mixCapital generation and growth
Shareholder distributionsRestructuring
ShrinkBreak-up Merge
Capital structure…you may think you can during the good
times, but…)
10
CAPITAL STRUCTURE
11
Stakeholder Views of Capital Differ
12
Capital focus is primarily on tangible equity capital and capital replenishment capabilities.
Concern on through the cycle capital and buffers
Are focused on capital discipline and allocation
Capital Returns and bonuses
Rating Agencies
Regulators
Shareholders
(Is the glass half full or half empty…
… it depends on whether you are pouring or drinking)
Management
Introduction (Once set…
13
Return Opportuni
ties
Governance
Volatility LiquidityStrategic CapitalBudgeting (CEO)
Correlations
Risk Management
(CRO)Risk Appetite
Capabilities
External Stakeholders
ShareholdersRisk/Return Regulators
Performance
Capital StructureCFO
Rating Agencies
…Capital structure is continuously monitored and revised)
Overview(Capital structure is important not because it creates value…
Set capital structure independent of regulation Except for banks with limited franchise value and suffering from debt
overhang Enough capital to pursue strategy and weather cash flow shortfall
Positive relationship between value and equity thru the cycle Long term decline from insufficient capital going into crisis outweighs short
term leverage benefit Major determinant of capital is the market and rating agencies
Most banks hold more than regulatory minimum Framework
Estimate financing surplus or deficit through the cycle Surplus- shareholder distributions Deficit- raise additional capital
Ratings requirements Agencies CAMELS
Peers
… but because getting it wrong destroys value.)14
Capital Structure – Integration of Capital and Risk Management
15
Mix of securities (Capital Structure) and Risk Management Products
Capital structure optimization is the purpose of risk management – 2 sides of same coinRisk management is capital structure in disguiseRisk management as synthetic or substitute equity
Risk transfer transfer (Cause) Risk Finance (Effect)
Integration of corporate finance and risk management Cost/Benefit analysis regarding use of risk management or
risk financeIssue is whether it is more efficient to (self insure) hold
capital or to use risk management to eliminate the risk cause
(Risk never disappears….
…someone is always on the other side of the trade)
Capital Guidelines
16
S&P: RAC
Very strong >15%
Strong 15/≤ X <10%
Adequate 10 ≤ X < 7%
Moderate 7% ≤ X < 5%
Weak 5% ≤ X < 3%
Very Weak >3%
CAMELS – “C” and “A”:Classified Assets/T1 + ALL
1 - O ≤ X ≤ 25%
2 – 26%< X ≤ 40%
3 - 41% < X ≤ 80%
4 - 81% ≤ X ≤ 100%
5 - > 100
(How much is enough?…
…it depends
Scenarios: To Assess Possible Strategies Against Capital Structure Robustness
17
Financial policy implications:
The upside (U) and base (B) cases generate excess capital which points toward shareholder distributions
The downturn (D) scenario suggests possible changes in risk appetite and the development of appropriate contingency plans to maintain ratios, sell assets and raise capital.
Forward looking Core Tier 1 development under alternative scenarios
U- - - - - - - - - - - - - - - - - - - - - - - - -
B- - - - - - - - - - - - - - - - - - - - - - - - -
D
T
ReturnCapital
Raise/release Capital
Probably
May be
Unlikely
Unlikely
May be
Probably
(Can I survive and tolerate…..
…the worst plausible outcome?)
(Stress testing)
In a ‘sustained severe recession’ scenario, contingency measures may be required to meet target capital ratios
Assumptions Observations Downturn scenario is based on a net profit
decrease of EUR __ bln relative to the reference case to EUR __ bln in __, a drop of __bln to __bln in __ and recovery thereafter.
Decrease in RWA of EUR __ bln in __, __ bln in __ and a __% growth through __ and __ due to lower credit demand and reduction due to FX devaluation.
Divestitures __ according to plan (reference case)
Dividend payout of __ for __, __ thereafter
Share buyback as announced for __ and ongoing neutralisation of stock dividend, but no additional buybacks.
The ratios as presented would trigger a regulatory response as the Tier Total ratio is < __%. Additionally, ratings would be pressured resulting in possible downgrade.
The scenario would lead to a significant shortfall from the 6.0% Core Tier 1 ratio target.
Compared to the mild recession, additional contingency measure to replenish the capital meet target ratios would be required, e.g. Suspend or reduce dividend Suspend stock dividend neutralisation Increase divestment programme18
Sust. Sev. Recession (EUR bln)
YE YE YE YE YE
Net profit
x x x x x
RWA x x x x xCore Tier 1 x x x x x
Gearing x x x x xTier 1 x x x x xTotal BIS
x x x x x
Excess CT1 Capital
x x x x x
Time
Capital Ratios
Elements of Strategy Based Capital Structure Management
19
Choice of Markets with Attractive economics inwhich the organization enjoys a competitive advantage
Risk the organization is willing and able to accept in
pursuit of its strategy
Risks underwritten and retained
Capital relative to Ratings Agencies, Regulators and peersActual Capital
Return capital to shareholders when actual capital exceedsneed, or raise capital when exceeds actual capital
Allocation to business units based on an economiccapital determination
(Risk and capital as inputs into strategic planning….)
(…and not just consequences)
Strategy
Risk Appetite
Risk Assessment
Capital Need and
Capital Assessment
Capital Plan
Capital Allocation
How Much?(Better to be approximately right…
…than precisely wrong.)
20
REITS(29%)
LNYC Pre-Depression
Banks(20%)
Asset Value Losses/Cushion
(7% / 7%)
15-20%Depending on risk of Business Model
High CREDerivatives/ Trading
Conclusion
21
Conclusion
22
Need to incorporate capital structure and risk considerations as an input versus consequence of strategyCapital as cost of riskReturn as cost of capitalRisk as cost of return
Capital structure links strategy, risk and return–represents total risk exposure an organization is capable of accepting and retain in pursuit of its strategy
Market factors have a larger impact on bank capital structure than regulation
(Capital structure as a Process…
… Not a Number)