EBA impact study - The stuff of nightmares
The European Banking Authority (EBA) this week published the results of an impact study to assess how Europe's banks will fare under the new global capital standards known as Basel IV.
Basel IV was agreed by global banking rule-setters (the Basel Committee on Banking Supervision, or BCBS) in December 2017. It is a package of measures that changes the way banks calculate how much capital they need to cover risks in their balance sheets, partly in response to lessons learned during the 2008 financial crisis. It is due to come into force in 2022 with a phased implementation to 2027.
In Europe, it will have to be codified into law by the European Commission in agreement with national banking regulators, a process of horse-trading that may mean the final European version looks quite different to what has been proposed by BCBS. Consequently, the final outcome in Europe is still quite hard to predict, and most banks have so far held back from giving guidance on the impact.
The EBA impact study is an important first glimpse, albeit it assumes the rules are implemented exactly as conceived by BCBS, which probably won't be the case in Europe.
For investors in banks, the conclusions are the stuff of nightmares and include the following:
- The EBA reckons Basel IV will lead to an increase in required capital for banks in Europe of 24.4%.
- For Europe's largest banks, those classified as "globally systemically important" (G-SIIs), the average increase is 28.6%. There are 11 European G-SIIs, which I've listed below.*
- Individual banks aren't named. But the study does include an unlabelled distribution chart showing that the most affected European G-SII will need over 175% more capital. Many investors will conclude this is DB.
- In total, Europe's banks face a shortfall in capital of €135 billion from Basel IV. Of this, the G-SIIs account for €82.8 billion.
*Deutsche Bank (NYSE: DB), UBS Group (NYSE: UBS), Credit Suisse (NYSE: CS), BNP Paribas (OTCQX: OTCQX:BNPQF), SG (OTCQX: OTCPK:SCGLF), Barclays (NYSE: BCS), UniCredit (OTCPK: OTCPK:UNCFF), Standard Chartered (OTCPK: OTCPK:SCBFF), Banco Santander (NYSE: SAN), ING Groep (NYSE: ING), HSBC Holdings (NYSE: HSBC)
(Source: European Banking Authority)
Basel IV - A riddle wrapped in a mystery
Basel IV is complicated, technical and multi-faceted. It's easy to get hopelessly lost in the detail. It's also almost impossible to estimate bank-level impacts with any accuracy. Most market analysts have given up trying and are simply waiting for the banks to give guidance themselves.
That being said, it is possible to identify the more important drivers that make some banks more vulnerable than others.
The EBA impact study is helpful in this regard because it breaks out, from its assessment of total additional required capital, the individual components of the Basel IV package that drive the increases.
The breakdown is outlined in the next table. I won't try to explain all of the abbreviations. The key line is the line for G-SIIs, the largest European banks. It shows an aggregate increase in "MRC" (minimum required capital) for this set of banks under Basel IV of 28.6%, as well as all the sub-components that underlie this number. Four stand out:
- The largest is "OF", short for Output Floors. It contributes a 7.6% increase in required capital for the G-SIIs under Basel IV. Output Floors are an attempt by global regulators to stop banks "gaming" the capital requirement system by using their own internal models to assess the riskiness of their balance sheets (and hence, how much capital they need to hold against them). Unsurprisingly, some banks arrive at suspiciously low risk-adjusted numbers for their balance sheets when they use internal models. Under Basel IV, there will be a limit/floor to how low these model-based numbers can be relative what they would be if a non-model, "standardised" methodology were used. Basel IV sets this floor at 72.5%, i.e., a bank's model-based risk-adjusted asset number cannot be less than 72.5% of what it would be if it were calculated using standard, non-model assumptions.
- The second- and third-largest drivers of higher required capital in the EBA study are "CVA" and "MKT", standing for Credit Valuation Adjustment and Market Risk. They together contribute to a 9.3% increase in required capital for the G-SIIs. CVA and Market Risk stem from banks' trading activities. They attempt to quantify the relative riskiness of individual banks' trading books and the amount of capital that needs to be held against them. Banks with larger investment banking activities obviously need more capital to cover market risk than banks that focus, say, on lending (credit risk). The riskier the investment bank, the higher the market risk number, in theory. It has been a continual criticism of the banking rules that existed prior to the financial crisis that they underestimated banks' exposures to market risk. A big component of the Basel IV changes is, therefore, aimed at beefing up the market risk rules in an initiative called the "Fundamental Review of the Trading Book" (FRTB).
- The final noteworthy component of the EBA test is "OP", contributing a 5.5% increase in required capital for the G-SIIs. This is Operational Risk and means capital held against potential operational failures within a bank can lead to losses. In the recent past, operational risk has mainly come in the form of the huge litigation settlements that have hit global banks to pay for their misdeeds during and after the financial crisis (mis-selling of mortgage-backed securities, money laundering, rigging the forex and Libor markets, breaking US sanctions laws, mis-selling Personal Protection Insurance in the UK, etc). Like market risk, it has become abundantly obvious in recent years that the old capital rules woefully underestimated the loss potential from operational risks. Basel IV tries to rectify this by changing the way banks assess operational risk and the amount of capital that needs to be held against it.
(Source: European Banking Authority)
What's this got to do with DB?
As I said, it's almost impossible from the outside to calculate precisely how much more capital an individual bank will need under Basel IV. There are simply too many moving parts and too many necessary inputs that only specialists working within the banks have access to.
However, it is possible to say broadly where the pinch points lie. For large banks, the EBA study confirms that three of these stand out: output floors, market/CVA risk and operational risk.
It stands to reason that banks with more market and operational risk under the current capital rules are likely to experience bigger increases in required capital under Basel IV. It also stands to reason that banks with the lowest risk-adjusted asset numbers calculated using their own internal models also have the most to fear from output floors.
How does DB stack up relative to its peers on these measures? The short answer is: poorly
DB has a higher exposure to market and operational risk than peers
Because of the size of its investment banking business, DB has higher exposure to market risk than peers. Market risk assets make up 11% of DB's total risk-adjusted assets (the denominator used to calculate regulatory core equity ratios). Of Europe's G-SIIs, only Barclays has a higher exposure. The peer average is 6%.
Added to this, DB also has more operational risk assets than peers. These make up 25% of total risk-adjusted assets, second only to UBS among Europe's G-SIIs. This is the result of the various litigation scandals DB has been involved with in recent years, as well as its much-publicised run-ins with regulators over lax controls and internal procedures, especially in the US. The peer average is 12%.
Source: My calculations from company disclosures
DB also looks especially vulnerable to Output Floors
In addition, DB relies on internal models to a greater extent than peers for calculating the risk weightings it applies to its risk-adjusted assets. The consequence is the DB stands out as having a suspiciously low level of risk-adjusted assets relative to the size of its balance sheet. Risk-adjusted assets as a percentage of total assets are the lowest of the European G-SII peer group at 26%. The peer average is 32%.
This is possibly DB's greatest vulnerability to Basel IV. If we were just to take the average risk-adjusted to non-risk adjusted ratio of the G-SIIs and move DB up to that level, it would imply a 22% increase in its risk-adjusted assets. On this basis, the regulatory core equity ratio would fall from 13.7% today to 11.3%.
We have no way of knowing what the actual impact is, because it requires knowing what DB's risk-adjusted asset number is under standardised inputs (this is the reference point Basel IV uses for applying the 72.5% floor to the model-derived number). But it clear it will be bigger than for other banks.
Source: My calculations from company disclosures
DB doesn't have a capital buffer to absorb Basel IV
Many banks are starting to manage their capital planning for the Basel IV future. Some already disclose their Basel IV ratio (e.g., ABN AMRO (OTCPK:ABNRY)). Others remain reluctant to do so because the rules are not yet set in stone and may change as they get codified into European law.
But there is enough certainty emerging around the rules that banks need to be thinking about how they will build a buffer into their capital ratios to cushion the blow when it comes.
I argued in my last article that DB doesn't even have a buffer to fund the restructuring and bad bank it is planning. It certainly doesn't have a buffer for Basel IV, and it is unlikely to create one organically unless return on equity improves dramatically from present levels.
To give an example, if we took the average increase in risk-adjusted assets for European G-SIIs of 28.6% and applied it to DB, the bank's regulatory core equity ratio would drop by around 300bps to under 11%. Management's current target is >13%, and DB's required regulatory minimum is 11.8%. The cost of the restructuring that looks likely to be announced imminently could knock another 100bps off the ratio (assuming €4 billion of restructuring charges as per my last article).
(Source: My calculations based on company and EBA data)
And as I explained above, there are plenty of reasons to think the Basel IV hit for DB will be greater than the peer average, possibly materially greater. As I said at the beginning, the EBA study didn't name names but it did show at least two big outliers, one of which would see its MRC increase by over 175% if Basel IV were introduced today in its current form. Given its sensitivities, many investors will fear this outlier is DB.
(Source: European Banking Authority)
Basel IV is not imminent, and a lot could change as it gets codified into European law. But enough is known about its impacts that banks are starting to build it into their capital planning.
For several reasons, DB is more vulnerable than other banks and is likely to see a bigger hit. The prudent course of action would be to start building a buffer now.
Unfortunately, DB is moving in the opposite direction as the more immediate priority of restructuring takes precedence. Recent press reports suggest the bank will actually lower its target core equity ratio as a way of "financing" the restructuring, exactly the opposite of what prudence would dictate.
Management is probably hoping it can kick the Basel IV can far enough down the road that investors forget about it for the time being. The danger in this approach is that many of its peers will start guiding soon on the impact for them. The pressure for DB to follow suit could become irresistible. If the company finds itself in the position of having to disclose a big Basel IV number at the same time as it is financing a large restructuring programme and cutting its capital ratio, there is a real risk of a crisis of confidence.
As I've also argued for the restructuring and bad bank plans, all roads lead inexorably towards a capital increase at some not-too-distant point in the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.