Bank Capital under Basel 3: Open Issues

Bank Capital under Basel 3: Open Issues and Foreseeable Effects Giuliano Iannotta - Andrea Resti www.carefin.unibocconi.eu carefin@unibocconi.it

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Agenda The definition of capital: from Basel 2 to Basel 3 New opportunities (?): contingent capital New limits on bank capital securities An impact analysis based on issues performed by large European banks in 2000-2009 New deductions from bank common equity Minority interest Deferred tax assets Final remarks

From Basel 2 to Basel 3 min 8% Tier 1 (min 4%) Tier 2 Tier 3 Core (min 2%) Lower Upper Lower Basel 2 Common Equity Perpetual, deferrable/non-cumulative coupons Sub, Min 10y maturity, deferrable coupons Sub, Min 5y maturity, non-deferrable coupons Short-term sub notes to cover market risk Step-up ( incentive to redeem ) allowed in Lower T1 and T2 Basel 3: Simplification, Quality, Quantity Simplification - Tier 1 and Tier 2 only Quality Focus on common equity and deductionsd Quantity From 8% to 10.5% (or even higher)

From Basel 2 to Basel 3 (cont d) Basel 2 Basel 3 Min 2% 4.5% Common Equity (CE) Conservation Buffer 0-2 2.5% Required 7% Tier 1 Min 4% 6% Required 6% 8.5% Total Capital Min 8% 8% (Tier 1+Tier2) Basel 3: Simplification, Required Quality, 8% Quantity 10.5% Macro-pru Counter-cycl. Buffer 0-2.5% SIFIs tbd - Incentives to redeem (e.g. step up are banned) - Contingent t capital may be allowed (Tier 1) - Deductions from CE : e.g. minority interests and DTAs

Contingent Capital (CC) Might be used as regulatory capital under Basel 3 Can be classified as follows First generation: the issuer as the right but not an obligation (eg, RBC s instrument issued in 2000 to Swiss Re) Second generation: automatic conversion Equity purchase: sub notes which convert into equity (eg, Lloyds issue in 2009) Loss guarantee: write offs or cash payment (eg, Rabobank issue in 2010) Only second generation CC for regulatory purpose Smart idea: why not used yet?

Trigger event and conversion price Discretionary (Self-fulfilling prophecies? ) (Late response?) Bank-specific (Moral hazard?) Trigger Event Dual Objective Systemic (Incentive to take systemic risk?) (Keep out of troubles in crisis?) Discretionary (Self-fulfilling prophecies? ) (Late response?) Book values (Not forward looking?) (Manipulated by managers?) Market values (Market manipulation?) (Noisy Unintended triggers?) Conversion Price (Equity purchase only) Fixed (Uncertainty? - Death Spirals?) Current Flexible

Lloyds Enhanced Capital Notes Second generation Equity purchase type Exchange offer - Sub notes (Lower Tier 2) for outstanding Tier 1 and Tier 2 securities Trigger Event: Core Tier 1 ratio < 5% Conversion Price: Fixed Outcome: extremely successful, but... Exchange offer on impaired outstading securities 200 bps over 5y subordinated debt

Rabobank Senior Contingent Notes Second generation Loss guarantee type Senior notes (not eligible as regulatory capital) Trigger Event: equity ratio < 7% Upon conversion: 75% write-off and 25% redeemed Outcome: extremely successful, but... 68 6.875% coupon (premium on Lower Tier 2 sub bdebt) b) Trigger event is extremely unlikely: equity ratio at 12.5%, bank always profitable, profits retained carefin.u uniboccon ni.eu www.

Open issues on Contingent Capital Potentially important role Details to be fine-tuned Raters very concerned : will CC have a rating? Swiss supervisors introduced (Oct 2010) CC for SIFIs (Credit Suisse and UBS): Max 3% as conservation buffer (trigger at 7% equity) Systemic surcharge - 6% (trigger at 5% equity) Though... conservation buffer is 8.5% (vs 2.5%) carefin.u uniboccon ni.eu www.

Bank capital issues in Europe (00-09) Purpose: How many issues are not Basel 3-compliant? Term structure on non-compliant securities Focus on the incentive to redeem Scope: top 5 banking groups (by 2009 assets) in France, Germany, Italy, Spain, and UK Data: DCM, Thomson, Bloomberg, annual reports Results: 982 issues (including govenment plans), about 800 bn 128 non-compliant issues out of 775 (non-expired, non-govt) 79% will expire by the end of 2013 carefin.u uniboccon ni.eu www.

Composition Lower Tier 2 30% Tier 3 1% Core Tier 1 29% Upper Tier 2 6% Govt. plans 14% Lower Tier 1 20%

Distribution by year of issuance 230 bn 180 130 carefin.u uniboccon ni.eu www. 80 30-20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Govt. support plan (*) Core Tier 1 Lower Tier 1 Upper Tier 2 Lower Tier 2 Tier 3

Compliance to Basel 3 400.000 350.000 Compliant 300.000 250.000 200.000 Compliant 150.000 Noncompliant 100.000 50.000 Noncompliant 0 Tier 1 Tier 2 Compliant 347.408 172.871 Non-compliant 7.495 64.183 Loss absorbtion? Full discretion? carefin.u uniboccon ni.eu www.

Term structure of non-compliant issues 35.000 30.000 carefin.u uniboccon ni.eu 25.000 20.000 www. 15.000 10.000000 5.000 0 2010-2011 2012-2013 2014-2015 2016-2017 2018-2019 2020+ Tier 1 1.819 516 2.494 1.564 121 118 Tier 2 31.044 22.411 3.828 2.664 3.892 104 Tier 3 1.075 0 0 0 0 0

Incentives to redeem callable securities Incentives to redeem: a taxonomy Economic Explicit Step up Implicit Fix-to-float with implicit step up Reputational Bad signal to the market if not redeemed carefin.u uniboccon ni.eu www. Economic Explicit Implicit Total Reput. Non-call. Total Tier 1 2% 47% 48% 45% 6% 100% Tier 2 25% 20% 45% 12% 44% 100% Total Cap. 10% 19% 29% 15. % A hard rule addressing only explicit step-ups would hardly be effective

Main deductions from common equity under Basel 3 Minority interest of subsidiaries for the amount exceeding the subsidiary s minimum capital; Deferred tax assets (DTA) due to loss carry-forwards due to timing differences between accounting standards and tax rules, for the amount exceeding 10% of common equity Goodwill and other intangibles Unconsolidated investments in financial institutions exceeding 10% of common equity Defined benefit pension fund liabilities

Minority interest Any minority interest exceeding a subsidiary s regulatory capital requirement (on a pro quota basis) will have to be deducted from consolidated common equity Concern: while minority interest can support risks in the subsidiary to which it relates, it is not available to support risks in the group as a whole in some circumstances it may represent an interest in a subsidiary with little or no risk Such limited recognition of minority interest creates an incentive towards keeping the subsidiaries common equity close to the regulatory minimum i

Impact analysis 10 banking ggroups top 2 groups for France, Germany, Italy, Spain, UK 3options 1.Basel 3 rule (setting the subsidiaries minimum common equity at 7%) 2.Modified rule (setting the subisidiaries eligible capital in line with the group s Core Tier 1 ratio) 3.Basel 3 hard rule (December): any minority interest has to be deducted

Impact analysis: results 12% 10% 8% 1,6% Basel 3: CE Tier 1 down by 60 bps (min 10, max 171) Hard rule: - 110 bps carefin.u uniboccon ni.eu www. 6% Other 4% 8,8% 8,2% 8,3% 7,7% CE Tier 1 2% 0% Current Option 1 Option 2 Option 3 Modified rule: -50 (min 8, max 92) May differ more as CE Tier 1 ratios go up over the next years

Basel 3 groups with high CE ratios would be hit more CE in exc cess of 7% (rho: 74 %) 5% 4% 40% 4,0% 3% 2,1% 2,4% 2,3% 2% 17% 1,7% 16% 1,6% 1,8% 1% 1,0% 0,6% 0% 0,1% 0% 5% 10% 15% 20% 25% 30% carefin.u uniboccon ni.eu www. Minority interest / Common Equity (rho: 95%)

Deferred Tax Assets Deferred tax assets (DTAs) have to be deducted from common equity as they may provide no protection in insolvency and can be suddenly written off in a period of stress While DTAs originating from losses must be deducted d d in full, DTAs originating i from timing i differences must be deducted only for the amount exceeding 10% of common equity Avoid creating wrong incentives, e.g. on provisioning Avoid an unlevel playing field due to local tax laws

Impact analysis Four options 1. Basel 3 2. Basel 3 with exemption threshold at 20% 3. Basel 3 with exemption threshold at 5% 4. 50% of the DTAs due to losses carried forward deducted from Tier 2 capital (only 50% deducted from common equity) The most likely scenario where DTAs due to losses must be written off is the bank s default, hence gone concern capital (Tier 2) should also be used

Impact analysis: results 12% 10% 8% 1,6% Basel 3: CE Tier 1 down by 100 bps (min 1, max 196) carefin.u uniboccon ni.eu www. 6% Other 4% 8,8% 7,8% 8,1% 7,4% 8,1% CE Tier 1 Option 4: CE Tier 1 2% down by 70 bps (min 1, max 138) 0% Current Option 1 Option 2 Option 3 Option 4

Impact analysis: minorities and DTAs The two Basel 3 deductions would bring about a 160 bps decrease in the CE Tier 1 ratio (with a 227 bps min/max range) Using Dec 2009 as a starting point, 5 out of 10 groups (including Italy and Spain) would drop below the capital conservation buffer In the case of Italian groups, also because their Core Tier 1 ratios at end 2009 exceed the 7% threshold only slightly

Final remarks Basel 3 seeks a trade-off between stability and growth Once this is set, optimize results and minimize unintended effects Contingent t capital design remains a challenge but banks should be cautiously incentivized to use it the lack of a uniform structure across issues may undermine liquidity of the new market Innovative capital securities: Beware of soft incentives or new rules will be circumvented by evolving market practices. Minority interest and DTAs deductions Still some room for further fine-tuning

Bank Capital under Basel 3: Open Issues and Foreseeable Effects Giuliano Iannotta - Andrea Resti www.carefin.unibocconi.eu carefin@unibocconi.it

Back up slide 1 Tier No Size ( mm) Matur. Perpetual Step up Callable Core Tier 1 103 222,195 9 92% 0% 5% Lower Tier 1 250 155,689 20 94% 3% 92% Govt. plans (T1) 30 106,490 0 100% 23% 73% Upper Tier 2 72 46,267 10 82% 14% 81% Lower Tier 2 488 226,970 12 0% 31% 52% Tier 3 39 9,219 3 0% 3% 0% Total 982 766,830 11 43% 18% 58% carefin.u uniboccon ni.eu www. - Maturity is the computed excluding perpetuals and at the first call date - Government plans are all T1