Universal bank model challenged by global divergence in bank regulation

Synopsis: Bank regulation appears to be diverging globally, with doubts that Basel will provide a reliable and consistent basis for international co-operation on bail-ins involving depositors. The flexibility to change VaR models, re-classify financial assets and adjust risk weights is driving regulators to set rules that cannot be gamed away by banks. This will involve floors on risk weights and simple minimum capital ratios. The complexity of regulation, and investors’ resulting low valuation of universal banks could encourage break-ups. This would spin out investment banking businesses and release value.

Bank shares have enjoyed a strong rebound from last summer, but there are challenges ahead. Investors may be overlooking headwinds coming from the increasing complexity of regulatory regimes and conflicting approaches. Regulators are now questioning complex models and gaming, bringing in prudence and common-sense. This means more capital will be needed by UK and European banks, via disposals, contingent capital and equity issues. And, on both sides of the Atlantic, the very complexity of regulations could force a break-up of universal banks.

Regulators now recognise that banks have too much discretion to set their own risk measures and capital requirements. One major US bank has changed its Value at Risk model in credit derivatives four times in the last 18 months, and not with minor adjustments. But, overall, US banks are not the main culprits; a number of UK and European banks have taken more advantage of risk weighted asset calculations. While this gap persists, there is little prospect of Basel III being accepted globally.

Already, there are signs that Basel is being overtaken by events. The US appears particularly sceptical, and has proposed a flat floor for capital requirements for US subsidiaries of European banks. This 5% leverage ratio cannot simply be gamed away. Although the EU has complained, banks such as Deutsche Bank have quickly moved to recapitalise, others are likely to follows. Trust between regulators internationally appears to be crumbling.

In the UK, the FPC recently signalled a new approach. Details are not yet clear, but the Committee has identified that a £12bn capital shortage would result from adjusting the calculation of risk weights. The FPC also looked at the impact of applying a floor to the risk weights for UK mortgages and a floor to minimum losses on corporate loans. This effectively puts boundaries on the current flexibility, and UK banks will need to meet the tougher regulatory requirement target by the end of 2013. Lloyds has already begun disposals, but stated that it will not need to issue equity. The new targets may have been a factor in the problems of Co-op Bank.

Regulators are set to make more use of simple leverage rules and boundaries to other complex ratios. Even where a bank on average across a mortgage portfolio exceeds the floor level, there could still be an impact. Some of the lowest weights in the bank’s portfolio would be caught, pushing up the overall average. Investors do not yet have the information that would let them assess the impact of this – the market focus currently is on averages.

This month, the New Zealand Central Bank was the fourth to take this approach, joining Norway, Sweden and Switzerland. These central banks are going beyond the Basel models, with concern about new bubbles. The flawed construction of the Basel capital ratios has been challenged. Increasingly, the discretion given to banks to model looks like pupils marking their own homework. The public demands greater transparency.

In the UK, the PRA has criticised “outrageous gaming” in risk calculations, suggesting that regulators are set to cut through the complexity and flexibility of bank modelling. And Andrew Haldane of the Bank of England, has commented that a regulatory response grounded in simplicity, not complexity, is needed.

Questions have also been raised about re-classification of financial assets, which is meant to be rare. Now, illiquidity across asset classes is so frequent, it is hard to define what is truly rare. Overall, re-classification appears to have delayed recognising unrealised losses at times, and the overall flexibility it allows has assisted smoothing. Regulators are likely to be concerned about re-classification that arises simply from a change in management intention.

Outside the US, banks are not growing their way out of problems. Delays in Basel III and European banking union have turned the focus on bank resolution, bail-ins and more objective and transparent risk measures. Politicians and regulators know they must deliver on “too big to fail”, but the Basel process may be too late. The onus on regulators now is to be pro-active, and this may mean moving the goalposts. Bank restructuring, asset disposals and equity issuance seem likely.

Divergence in regulatory approaches globally threatens the new rules that are needed on bank resolution for global banks. The US and UK are well ahead of Europe in drafting this, but ultimately no single set of taxpayers will volunteer to bail out a global bank. Bail-ins of depositors will look like a wealth tax, with significant political implications. And, Cyprus has shown on a small scale what can happen without international co-ordination. For a bank with branches in many countries, it will be hard to stop deposit leakage everywhere as a bail-in plan is organised. Even the definition of which uninsured depositors should take the hit needs agreement. All central banks wish to exempt financial and monetary institutions from penalties, but this could dramatically increase the impact on other businesses.

And, it may be that investors already recognise this. The likely outcome of this new twist of the regulatory knife is that the major universal banks may be encouraged to split. Investors may discount the earnings at investment banks sufficiently to encourage a full separation from retail business. Valuations could achieve what regulations have not yet done.

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