It appears to be bank capital week here at FT Alphaville (see previous posts linked to below) and UBS’s Alistair Ryan has conveniently released a banking bonanza — 41 pages on European capital ratios and adequacy.
Having undergone something of a revamp in recent years with the introduction of Basel II, the relative importance of capital ratios has been thrown into confusion. Which should investors be looking at, core Tier 1, equity Tier 1, leverage ratios? Regulators, it should be noted, focus on core Tier 1 and governments across the region have therefore tended to support banks — so far — via preferred shares and subordinated debt which feed directly into those ratios.
For Ryan at least, what really matters is equity Tier 1 — the stuff that first takes losses (like tangible common equity).
Why equity tier 1? Because this best captures the ability of a capital base to absorb losses; other contributors to capital have limited relevance from an equity investor’s perspective… A bank with a reasonable loan/deposit ratio (120% or below), a reasonably high deposits/assets ratio (more than 35%), and a relatively low proportion of market risk assets (which tend to be under-charged for capital) could justify an equity tier 1 ratio of 5% after absorbing the losses to be incurred in the impending recession and the pro-cyclicality of capital requirements. Sadly, very few banks fit this description.
The pro-cyclicality of capital requirements being the idea that capital requirements under Basel II change to fit economic conditions, as discussed in a December 2007 paper by the Bank of England. Loan books are more likely to generate losses in a downturn, so logically, the capital required to maintain them should increase — by as much as three-fold according to this paper. Consequently regulators, if they want to get banks lending again, could temporarily lower capital requirements to accomodate the downturn. That may well be particularly relevant to the UK and whether more recap programmes are on the horizon.
As Ryan notes:
The UK has a specific problem: without a declared benchmark level of acceptable capitalisation, and with the penalty for misjudging the authorities’ undeclared view a zero share price and managements’ heads, there is little incentive for the banks to lend. The more the FSA and the Bank of England governor discuss the possible need for further capital injections, the more rational it is for banks not to lend to anyone, as each pound extended moves reported capital closer to the unknown level at which further regulatory intervention occurs. We believe a minimum equity capital ratio – logically 4% – needs to be declared very soon or the Bank and the FSA will get (at taxpayers expense) what they oddly seem to be wishing for.
Furthermore:
The sums involved would be potentially very large indeed: it seems unlikely that one bank could be recapitalised and the others allowed to carry on without, as in the last round of recapitalisations (October 2008) it was recognised that the key risks now are systemic. Therefore, the authorities deciding that, say, RBS required more equity would invite the same discussion over the other banks, including Barclays.
And this is where the maths get very difficult for the UK: to put enough extra equity into the banks as going concerns would be bad enough, but we believe that a state-controlled Barclays would struggle to justify continuing to operate BarCap and shifting this business from a going concern to run-off could crystallise very significant losses (the same issue we have with Credit Suisse seeking to exit more than CHF200 billion in assets from areas it has now European Banks 7 January 2009 UBS 24 decided are non-core). Even a small proportionate loss on disposal would likely add up to a large figure, given BarCap’s £966 billion in gross assets.
Whether the UK can raise the £50 billion or more in funds that would be necessary to put into the banks in such an event is a question for the economists, but an uncomfortable one to say the least for sterling.
Eek.
On the plus side, Ryan thinks a £50bn bailout is an unlikely possibility:
This debate on whether the UK can actually fund another bank bailout is one that ought to be avoidable for the simple reason that falling capital ratios at the banks will largely be the result of realising the losses that the last round of capital was explicitly made to bear. For example, we expect RBS to report an equity tier 1 ratio of 7.1% at the end of [2008]. However, there is considerable uncertainty around this figure.
But there is a caveat:
We believe the government, FSA and Bank of England need to make collectively clear that they are of one mind, and what that mind is. Stating clearly that lower capital ratios would be wholly acceptable, while putting in place policies that allow for UK asset price declines to be ameliorated would likely avoid the need for further recapitalisations.
And double eek.
Related links:
Bailing out bank assets – FT Alphaville
What is Lloyds TSB up to? – FT Alphaville
Whitney: Tarp funds going down the downgrade drain – FT Alphaville