Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress

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1 Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress Primary Credit Analyst: Bernard De Longevialle, Paris (1) ; Secondary Credit Analysts: Alexandre Birry, London (44) ; Stuart Plesser, New York (1) ; Mehdi El_mrabet, Paris (+33) ; mehdi.el-mrabet@spglobal.com Mathieu Plait, Paris (33) ; mathieu.plait@spglobal.com Table Of Contents Related Research NOVEMBER 29,

2 Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress As recent months have reminded market participants, banking remains a confidence-sensitive industry. Although they have much stronger capital bases than before the financial crisis, banks around the world remain exposed to capital-related confidence shocks. This apparent paradox reflects the effectiveness of the significant increase in minimum regulatory capital requirements in ensuring that systemically important financial institutions (SIFIs) have enough bail-in-able resources to absorb stress losses in a resolution. However, at the same time, the higher requirements have also lead to a parallel shift in what the market believes are the minimum capital levels banks should permanently respect to keep its confidence. As a result, in period of stress, banks might react with many of the same procyclical behaviors that we've seen in the past. Current considerations by Europe's Single Supervisory Mechanism to split Tier 1 Pillar II requirements into a hard "requirement" and a softer "guidance" component may give welcome additional flexibility to Europe's large banks to absorb unexpected shocks without triggering confidence-sensitive coupon suspension. Regulators have been successful in forcing the banking system to build a much stronger capital base than before the crisis. Enhanced common equity Tier 1 capital, combined with the existing or expected build-up of significant buffers of total loss-absorbing capacity (TLAC), means that bail-in-able capital and debt would allow banks, as part of a resolution plan, to absorb stressed shocks similar or bigger than those registered over the past 30 years--without having to tap taxpayer funds. In the opinion of S&P Global Ratings, the absolute level of risk-adjusted capital is satisfactory for the vast majority of SIFIs in mature markets. For example, out of the top 100 banks we rate globally, risk-adjusted capital was a negative rating factor for only 17% at year-end Furthermore, we believe the constitution of TLAC buffers is, or will become (once built), a positive rating factor that will effectively compensate for less predictable government support. Overview Regulators have been successful in pushing banking systems to build much stronger capital bases than before the 2007 financial crisis. Banks' limited capacity to use their enhanced capital bases without breaching much stricter minimum regulatory requirements undermines the benefits of having a stronger capital base. As a result, we believe that banks' procyclical behaviors and exposure to confidence shocks might not have improved as significantly as could have been expected. This achievement should not, however, hide the fact that most of these capital resources would be available only as part of a resolution. Over the past six years, new forms of concurrent regulatory requirements (such as the leverage ratio and TLAC) have emerged in addition to going-concern risk-sensitive metrics. Regulators have also introduced additional layers of capital buffer requirements, such as the capital conservation buffer, systemic buffers, and Pillar 2 requirements. Each of these more stringent regulatory metrics, and the related buffer add-ons, can potentially trigger NOVEMBER 29,

3 Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress regulatory actions in case of breach. In assessing where large banks in Europe and the U.S. stand according to these metrics, we observe that their effective loss-absorbing margins above regulatory requirements have not improved on average since before the crisis (see chart 1). Chart 1 The capacity of large European and U.S. banks to absorb unexpected shocks without potentially triggering automatic regulatory restrictions stood at year-end 2015 on average more than 460 basis points above transitional Basel III ratios, but only 208 basis points above Basel III fully loaded ratios the focus of market participants. At year-end 2007, the same banks showed an average Tier 1 ratio of 8.5%, 260 basis points above a 6% Tier 1 ratio, which the market viewed at that time as an acceptable level for a large diversified institution. Furthermore, the deduction from regulatory capital of mark-to-market losses on available-for-sale securities, which was not in place before the crisis, has created some additional ratio volatility risk in periods of stress. International standard setters didn't intend for these regulatory buffers to be viewed as establishing new minimum capital requirements. They see their role as generally to encourage capital conservation measures in the event of a material stress, rather than to constitute a new, more stringent definition of the point of nonviability. However, as seen earlier this year, the perceived risk of restrictions on distributions to shareholders or hybrid instrument holders can NOVEMBER 29,

4 Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress spread to the wider credit markets. Banks' distance to what market participants interpret as points of severe stress (or even nonviability) is no further away today than it was in The benefits of much stronger absolute capital are undermined by the limited capacity to use it without stigma in a period of stress. The steady increase in minimum regulatory requirements, be it in terms of TLAC, the leverage ratio or Tier 1 capital, could therefore have unintended consequences. The higher the minimum required levels, the more difficult it will be for banks to manage their capital bases with a wide margin above perceived point of severe stress. This could hold true especially in today's environment where banks are struggling to generate returns in line with their cost of equity. While the perception problem might be in part one of market education and gradual desensitization to breaches in regulatory capital requirements, we also see a role for regulators. Failure to address the rigidity of buffers could undermine many of the benefits of higher capital ratios, such as reducing banks' vulnerability to confidence shocks and capacity to withstand a recession without resorting to procyclical behaviors. Beyond minimum common equity Tier 1 requirements, buffers above TLAC and leverage ratio requirements are other areas that market participants will focus on. The recent decision within the European Banking Union to set up a more flexible Tier 2 framework, including a "guidance" element, with clarity for market participants that banks can temporarily dip into such buffers without automatically risking hybrid coupon suspension, looks like a step in a good direction. The first disclosures by French banks on Pillar II 2017 guidance suggest additional flexibility in the region of 100 basis points. A further increase in regulatory minimum capital requirements could have unintended consequences, but flexibility to use capital buffers when needed would in our opinion benefit the resilience of the world's banking system. Table 1 Banks' Distance To Confidence-Sensitive Capital Triggers (%) 2007 Tier 1 ratio Buffer above 6% Tier 1 ratio (basis points) 2015 CET1 (fully loaded, unless only transitional reported) 2019 CET1 requirement* Distance between fully loaded 2015 CET1 and 2019 requirement (bps) KBC Group Danske Bank A/S Nykredit Realkredit A/S Groupe Credit Agricole** Societe Generale** BNP Paribas** BPCE** Deutsche Bank AG Bank of Ireland Intesa Sanpaolo SpA UniCredit SpA Rabobank ABN AMRO** ING Groep DNB Bank ASA Nordea Bank AB NOVEMBER 29,

5 Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress Table 1 Banks' Distance To Confidence-Sensitive Capital Triggers (cont.) (%) 2007 Tier 1 ratio Buffer above 6% Tier 1 ratio (basis points) 2015 CET1 (fully loaded, unless only transitional reported) 2019 CET1 requirement* Distance between fully loaded 2015 CET1 and 2019 requirement (bps) Swedbank AB 5.80 (20) Svenska Handelsbanken AB Credit Suisse UBS Barclays PLC Santander UK Group Holdings Royal Bank of Scotland Group PLC Lloyds Banking Group HSBC Holdings PLC Bank of America Corp. Bank of New York Mellon Corp Citigroup Inc Goldman Sachs Group JPMorgan Chase & Co Morgan Stanley State Street Corp Wells Fargo Co Average *2019 CET1 requirement is based on public information as of Nov. 30, 2016, and constant countercyclical buffer. S&P Global Ratings estimate of 2019 CET 1 requirement. Requirement by Under Swiss capital requirement. **2019 CET 1 requirement does not include Pillar 2 guidance Tier 1 ratio Tier 1 ratio. Related Research The Road More Traveled: The Latest EC Proposals Bring EU Banks Closer To Completing A 10-Year Regulatory Overhaul, Nov. 29, 2016 Only a rating committee may determine a rating action and this report does not constitute a rating action. Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@spglobal.com NOVEMBER 29,

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