Basel III: Macro Consequences of Regulatory Reforms. DIFC Economic Workshop on Banking Sector & Regulatory Reforms Dubai, May 2 nd, 2011

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1 : Macro Consequences of Regulatory Reforms DIFC Economic Workshop on Banking Sector & Regulatory Reforms Dubai, May 2 nd,

2 Disclaimer The present document is only intended for participants of the Economics Workshop on Banking Sector & Regulatory Reforms organised by DIFC, May 2 nd, 2011, quotation or reproduction in full or in part to third parties is not permitted. The text and the graphics contained herein have been used for purposes of presentation; they do not constitute an official or prudential disclosure on Basel II / III and/or related topics by Emirates NBD. The views stated in this presentation do not necessarily reflect the official views of Emirates NBD. 2

3 Macro Consequences of Regulatory Reform Consequences, highlights The OECD has estimated that the medium-term impact of implementation on GDP growth is in the range of to percentage point per annum. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015, banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy (in the future) will no longer be constrained by zero rates, the impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates. Source: Chief Economist, Public Disclosure 3

4 Macro Consequences of Regulatory Reform Consequences, highlights Regulatory supervision has rightly become much more intensive in the wake of the financial crisis. It is essential that there is international consistency and coordination in implementing : To ensure a level playing field Because risks will migrate towards the weakest point And to avoid the costs and complexities that arise when countries do their own thing However, regulatory reform is no panacea to prevent a repeat of the recent financial crises. Regulation and structural change to the banking sector, while important, is a relatively blunt instrument carrying the risk of unintended consequences. Making banks hold higher levels of capital will not necessarily make them safer, but it will probably make them more expensive. The root cause of past crises lie in too much lending, something that tighter regulation only partially addresses. Source: Chief Economist, Public Disclosure 4

5 Pendulum in action Source: Volkssternwarte Radebeul, Germany 5

6 Capital Requirements, conceptual Common Equity Capital Other Tier 1 Capital Tier 2 Capital Capital Requirements, in % of Risk Weighted Assets 20.06% Total Minimum plus Conservation Buffer = 10.5% SiFi Buffer Counter Cyclical Buffer Total Minimum = 12% 12.75% Objective: reduce systemic risk by increasing loss absorbing capital and reducing the leverage of financial institutions Furthermore, don t allow another bank being too big to fail Total Minimum = 8% Conservation Buffer Basel II (current) (01/2019) CBUAE (current) Emirates NBD (Q4/2010) Source: Group Economic Capital & Risk Strategy, Central Bank of United Arab Emirates, Bank for International Settlements 6

7 Optimal Capital for Economy Without permanent effects (on GDP growth) With permanent effects Interdependencies, illustrative Common Equity, in % of Risk Weighted Assets 52% 4.1x Firm Well capitalized, Low Risk, Low Interest Equity (limited) Bank Well capitalized, Low Risk, Low Returns Objective, reduce the social cost of bank failure by increasing capital requirements Without regulatory intervention, banks can (and will) not raise a socially efficient level of capital as they compete with firms for limited equity (01/2019) 1 1 Full event distribution (MPC 01/2011) 19% w/o extreme events (MPC 01/2011) 12.75% Emirates NBD (Q4/2010) Bank Low capitalized, High Risk, High Returns Result Bank needs to gamble to achieve sufficient return on equity Firm Undercapitalized, High Credit Risk, High Interest Result Reduced growth of GDP due to Credit Constraint It is understood, that an equilibrium with socially desirable equity levels can t exist since banks can not refrain from taking risk and offer sufficiently high equity returns (despite Modigliani- Miller theorem) Source: Group Economic Capital & Risk Strategy Bank of England, Bank for International Settlements, Stanford University 7

8 (Un-) Level Playing Field Common Equity Capital Contingent Capital Supervisory Developments, selected Total Capital well capitalized Total Capital adequately capitalized Dodd-Frank has a number of provisions that are in conflict with, e.g. higher risk weighting of certain positions or shorter grandfathering rules for deductions (Collins Amendment). 10.5% 8% 10.5% Swiss Finish, pacemaker for regulatory developments driven by the need to protect the real economy from default risk of two major banks. Promoting the concept of Contingent Capital. (01/2019) (01/2019) US (current) 19% FinMA (SiFi) Though foresees a transition period till 01/2019, a race for early compliance and adjustment has started on both sides of the fence, i.e. within the banking industry as well as the regulatory community Vickers Commission and Turner Report, with a focus to improve stability of the financial institutions, while improving the competition in UK banking, and to implement a framework of resilience and resolvability ( living wills ). Favouring bail-in debt over Contingent Capital. Ring-fencing opens a door for nationalization of banking supervision. (01/2019) ICB (proposed) Source: Group Economic Capital & Risk Strategy, Public Disclosure 8

9 (01/2019) (MPC 01/2011) (MPC 01/2011) (Q4/2010) Financial Impact Impact Analysis, overview Capital Requirements, in % of Risk Weighted Assets SiFi Buffer Counter Total Minimum plus Cyclical Conservation Buffer = 10.5% Buffer Conservation Buffer Total Minimum = 8% Total Minimum = 12% 20.06% 12.75% Capital Requirements 1 Increase of Capital Base, e.g. through rights issuance and / or alternative capital measures Question, is there enough demand for bank capital and / or capital replenishing products by investors Basel II (current) (01/2019 Common Equity, in % of Risk Weighted Assets 4.1x 52% 19% 12.75% 1 1 Full event distribution w/o extreme events Emirates NBD CBUAE Emirates NBD (current) (Q4/2010) Equity (limited) Firm Bank Well capitalized, Well capitalized, Low Risk, Low Risk, Low Interest Low Returns Bank Firm Low capitalized, Undercapitalized, High Risk, High Credit Risk, High Returns High Interest Result Result Bank needs to Reduced growth gamble to achieve of GDP due Sufficient return to Credit Constraint on equity 10.5% 8% US (01/2019) (current) 19% FinMA (01/2019) (SiFi) ICB (01/2019) (proposed) Interdependencies (Un-) Level Playing Field 2 3 Deleveraging of Balance Sheets, e.g. through reduction of those portfolios with adverse return to capital requirements Increase Pricing to cover for the increased cost of capitalization (and to ensure risk differentiation) 4 Regulatory Optimization, e.g. adjusting a bank s legal set-up and residency McKinsey estimates the capital shortfall at 1,750bn EUR / 2,500bn US0$ (by 01/2019) Further, what is the risk of escalating the next crisis through such products? Example, Deutsche Bank is about to reorganize its US operations in order to avoid raising additional capital (20bn US-$) and to meet Dodd- Franck act Source: Group Economic Capital & Risk Strategy, Wall Street Journal, Financial Times, McKinsey 9

10 Thank You! Contact Details: Torsten Kleine Buening Head of Group Economic Capital & Risk Strategy Director Basel II Program Tim Fox Chief Economist Tel: TorstenK@emiratesnbd.com Tim.Fox@emiratesnbd.com 10