UK Banks were weaker across the board on Wednesday. What gives?
Here’s one suggestion from Evolution Securities’ Gary Jenkins:
FTSE 100 [fell 1.67% on Wednesday], not helped by further bank weakness led by a combination of factors, not least further analyst reports on the potential capital shortfalls under the proposed Basel requirements. Lloyds at 4.4% was one suggestion, which wouldn’t do a lot for holders of the new ECN’s (or Coco bonds). Coco pops indeed. I didn’t see the research so it might be that they have not taken into account any addition to capital via profit over the next few years.
FT Alphaville has seen the research, from London-based brokerage Matrix, and we’ve reproduced a summary below. The good news is that Lloyds’ Coco bonds, a kind of convertible bond which changes into equity should the bank’s Core Tier 1 capital ratio fall below 5 per cent, shouldn’t be affected by the proposed Basel III requirements, which call for stripping weaker components from regulatory capital.
The bad news is that that 4.4 per cent does indeed take into account expected future addition to capital via organic profit-generating at Lloyds.
Here’s the basic premise from Matrix’s Andrew Lim:
We believe that changes in bank capital regulations are going to be a ‘game changer’ for the sector. The proposals from the Basel Committee, published in December 2009, will increase the quantum of capital in the system, improve its quality, force out complexity from balance sheets and ultimately drive down ROE. We undertake a detailed analysis of what happens to the banks’ capital in an attempt to replicate as closely as possible the anticipated findings of the Basel Committee’s own impact study, due H2 2010. The results are very interesting.
The UK banks Lloyds and HSBC are significantly impacted by the proposals. We see Lloyds, in particular, having a new Core Tier ratio of only 4.4% by the end of 2012. We also see HSBC’s Core Tier 1 ratio falling to 6.0%, significantly below peers. The other banks are reasonably capitalised, with the Nordic banks in particular having substantial excess capital.
The fall in Lloyds Core Tier 1 ratio is mainly due to the full deduction from common equity of investments in other financial institutions of circa £10bn, according to Matrix. Under present FSA rules those investments are only deducted at the total capital level — which means Lloyds has been able to sort of double-count the capital it has in other financial entities on its balance sheet, Matrix says.
In any case, according to Matrix, banks’ capital ratios under Basel III should end up looking like the below (Figure 14) by 2012. The components of the change to Core Tier 1 (2009) is in Figure 16:
You can see that the problem for Lloyds, according to Matrix, is really that investments-in-other-financials issue, coupled with a lack of future profit-generation. Meanwhile HSBC, the next lowest-capitalised bank under Matrix’s scenario, is `saved’ by its expected future profit generation.
Back to Matrix:
The saving grace for HSBC is that strong expected organic capital generation will aid its capital ratios up to 2012 (when full implementation of Basel III is expected), but only to the extent that it can meet minimum capital requirements and nothing more. (We use an anticipated minimum Core Tier 1 capital ratio of 6.0%). HSBC may feel the need to raise more equity capital to establish a suitably large buffer above the regulatory minimum capital.
However, HSBC has been at pains to point out in recent days that only a small portion of its £12bn Assets For Sale reserve (AFS) will be deducted under Basel III. The bank claims only £2bn of the reserve is owned — the rest is managed.
Anyway, back to the CoCo issue:
The lack of substantial organic capital generation up to 2012 means that there is a real risk of the Core Tier 1 ratio being below 5.0%. Whilst this is below the trigger level at which the £8.5bn of COCOS are converted to equity (at a conversion price of 59.2p) our understanding is that the terms of the COCOS specifically state that the Core Tier 1 ratio is as calculated on a Basel II basis. Dilution via the conversion of COCOS is therefore not a concern from this angle (we do not see the Core Tier 1 ratio on a Basel II basis falling below 5.0%) but it does not detract from the fact that Lloyds is particularly undercapitalised under the new regime and should require new equity capital. We estimate Lloyds’ capital deficit (against a minimum Core Tier 1 ratio of 6.0%) to be approximately £7.8bn, which is 17% of shareholders’ funds expected at the end of 2012.
So CoCos aren’t expected to *pop* because of Basel III, since the definition used in their documentation uses an older definition of Core Tier 1, but there’s still the general issue of a lack of capital at Lloyds.
Much more on capital, plus some interesting analysis on the general banking environment, in the full Matrix note.
Related links:
Counting the costs of more bank capital – FT Alphaville
Erste Basel-bothered is Austria – FT Alphaville
BarCap calculates the cost of ‘Too Big Too Fail’ – FT Alphaville