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Fitch sees potential for worse deals for customers, riskier activities and regulatory arbitrage from 'too big to fail banks' needing US$566b to meet Basel III rules

Fitch sees potential for worse deals for customers, riskier activities and regulatory arbitrage from 'too big to fail banks' needing US$566b to meet Basel III rules
Picture from Re-Define.

By Gareth Vaughan

Credit rating agency Fitch Ratings says because the world's official too big to fail banks face higher new capital adequacy standards than other banks, they may be incentivised to cut costs, increase costs for customers and even favour riskier activities to maximise returns, including through new forms of regulatory arbitrage.

A total of 29 banks have been named as global systemically important financial institutions, or too big to fail, by the international bank regulatory body the Basel, Switzerland based  Financial Stability Board. The 29 include five that are registered as banks in New Zealand. All up, Fitch says the 29 may need to raise about US$566 billion (about NZ$745 billion) worth of common equity - a 23% increase on their current combined holdings - to meet the Basel III international capital adequacy rules being phased in over the next few years.

In a report entitled Basel III: Return and Deleveraging Pressures, Fitch says although Basel III won't be fully implemented until the end of 2018, banks face market and supervisory pressure to meet the new criteria ahead of that. The too big to fail banks will be subject to higher capital requirements than other banks under Basel III, requiring an additional Tier 1 common equity buffer of between 1% and 2.5%, on top of the standard 7% Tier 1 common equity ratio.

"Banks will likely pursue a mix of strategies to address these shortfalls, including retention of future earnings, equity issuance, and reducing risk weighted assets," says Fitch.

"Absent additional equity issuance, the median global systemically important financial institution would be able to meet this shortfall with three years of retained earnings, which might constrain dividend payouts and share buybacks."

Fitch says the 29 banks, as a group, hold about US$47 trillion in total assets. The US$566 billion of common equity it estimates they could need, represents a 23% increase relative to their combined existing US$2.5 trillion of common equity.

The five too big to fail banks registered with the Reserve Bank of New Zealand are HSBC, Deutsche Bank, Citigroup, JP Morgan Chase, and Mitsubishi UFJ. The 29 were named last November. See more on them here and the full list below. None of the Australian parents of New Zealand's big four banks - the ANZ Banking Group, Commonwealth Bank of Australia, National Australia Bank or the Westpac Group - are on the list.

Returns on equity heading south

Meanwhile, Fitch says the expected capital increase implies an estimated reduction of more than 20% in the too big to fail institutions' median return on equity (RoE) from about 11% over the last few years to 8% or 9% under Basel III.

"Basel III thus creates a trade-off for financial institutions between declining RoE, which might reduce their ability to attract capital, versus stronger capitalisation and lower risk premiums, which benefits investors," says Fitch.

"For banks that continue to pursue mid-teen RoE targets (eg 12% to 15%), Basel III creates potential incentives to reduce expenses further and to increase pricing on borrowers and customers where feasible. Additionally, since it is impossible for regulators to perfectly align capital requirements with risk exposure, banks may seek to increase RoE by favouring riskier activities that maximise yield on a given unit of Basel III capital, including new forms of regulatory arbitrage," Fitch adds.

New Zealand's ASB recorded a 21.2% RoE in its latest half-year financial results, and BNZ a 15.4% one.

Fitch estimates the 29 would need to raise the US$566 billion of equity capital to meet a 10% Tier 1 common equity ratio, with the median institution needing to raise US$18 billion. The average shortfall is put at US$19.5 billion. The Fitch report doesn't break out individual banks' needs by name.

The credit rating agency also crunched the numbers on a 9% Tier 1 common equity ratio. This dropped the common equity minimum needed by the 29 by US$224 billion to US$342 billion.

Trade-offs

Fitch suggests that the too big to fail banks face a trade-off with higher capital requirements potentially offset by competitive advantages due from their official status as being systemically important.

"Some investors and counterparties might perceive these institutions as more likely to receive government support in a distress scenario," Fitch suggests.

"This perception, coupled with the global systemically important financial institutions higher capital standards, could in turn reduce funding costs and stimulate business flow from more risk-averse customers. Conversely institutions that deem global systemically important status as a regulatory burden might seek to reduce or limit their size and complexity in order to avoid this designation."

The Financial Stability Board pulls together national authorities responsible for financial stability in significant international financial centres, international financial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. Members include the Reserve Bank of Australia and the International Monetary Fund. See the full list here. The Basel III reforms are being introduced in the wake of the global financial crisis which saw taxpayers' money used to bailout major financial institutions such as AIG, Citigroup, Bank of Scotland, The Royal Bank of Scotland and Dexia.

The world's 29 "too big to fail banks" as named by the Financial Stability Board:

Banco Santander
Bank of America
Bank of China
Bank of New York Mellon
Barclays
BNP Paribas
Citigroup
Commerzbank
Credit Agricole
Credit Suisse Group
Deutsche Bank
Dexia (rescued for a second time last October, by Belgium, France and Luxembourg)
Goldman Sachs Group
Group BPCE
HSBC Holdings
ING Bank
JP Morgan Chase & Co
Lloyds Banking Group
Mitsubishi UFJ Financial Group
Mizuho Financial Group
Morgan Stanley
Nordea Bank
Société Générale
State Street Corporation
Sumitomo Mitsui Financial Group
The Royal Bank of Scotland
UBS
Unicredit SpA
Wells Fargo & Co

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