Tag Archives: Tier 1 capital

The Sociopathic Banking System of Europe

In spite of the recently conducted stress test of European banks, concluding that most of them have enough core capital to weather a “worst case scenario,” we now learn that they will need at least EUR 200 billion more to be on the safe side – and probably more. Here at the EconoTwist’s we’re not the only ones who think this is getting way out of hands: It seems like no one is really sure of the banks real risk exposure, not even the banks themselves, the stress test have once again proved to be a joke, and who the Hell do they think they are? – the IMF and the banking associations who think they just can demand the euro zone governments to fill up their bottomless buckets?

“This is the second time it has happened.”

 Elena Salgado

Yesterday, the IMF leaked its calculations of required capital for a recapitalization of the banks in the euro zone, well ahead of the publication of IMF’s financial stability report later this month. This amount is now  EUR 200 billion. And of course it has triggered a debate within the euro zone. But the discussion is also rather skewed: the main issue is the actual number, 200? 300? Who cares? The real problem is that we still don’t know the health of our financial system – three years after the crisis hit!

The staff at the International Monetary Fund  have triggered another fierce dispute with euro zone authorities over their estimates, showing even more cracks in the European  banks’ balance sheets, related to their holdings of troubled euro zone sovereign  debt.

Christine Lagarde

(Yeah, another quarrel – just what we need….)

The analysis, which was discussed by the IMF’s executive board in Washington  on Wednesday, are strongly rebutted by the European Central Bank and the euro zone governments, which say it is partial and misleading.

Is there anybody trustworthy, these days?

According the Financial Times, the IMF’s analysis, currently in a drafted version of its regular Global Financial  Stability Report (GFSR), uses credit default swap prices to estimate the market  value of government bonds of the three euro zone countries receiving bailout money from the IMF – Ireland, Greece and Portugal – in addition to the bonds of Italy, Spain  and Belgium.

Although the IMF analysis may be revised, two officials says one estimate  show that marking sovereign bonds to market would reduce European banks’ tangible common equity – the core measure of their capital base – by about EUR 200 billion (USD 287 billion), a drop of 10-12 per cent.

The impact could be increased  substantially, perhaps doubled, by the knock-on effects of European banks  holding assets in other banks, Financial Times writes.

In other words: the IMF estimates are just as worthless as the stress tests – the only thing that is certain is that most banks will need more substantial capital injections if they are going to survive.

Anyway – the ECB and the euro zone governments strongly rejects these estimates.

Elena_Salgado

Spanish finance minister, Elena Salgado, told the Financial Times yesterday that the fund makes a mistake by  looking only at potential losses without also taking account of holdings of German Bunds, which have risen in price.

“The IMF vision is biased,” she said. “They only see the bad part of the  debate.”

Now, that’s another “truth with modifications,” because the gains in Bunds are comparatively small in relation to the losses on other sovereign bonds.

“This is the second time it has happened,” the Spanish finance minister points out, referring to the fund’s  October 2009 GFSR, which estimated that euro zone banks had only written down USD 347 billion of USD 814 billion of probable losses from the financial crisis. IMF later revised down that total of probable total losses.

Well, I’m afraid it will not be the last time, either…

Mrs. Salgado goes on saying that the European stress tests of banks is a better indication of  their vulnerabilities.

Now, that’s just plain wrong!

The stress tests do not only lack credibility, they also assume no losses on sovereign debt holdings in the bank’s books.

As www.eurointelligence.com rightfully underlines, it is very likely that investors in Greek and peripheral debt securities will ultimately face losses, especially given the European Council has already agreed to accept a degree of private-sector participation.

Considering the decline in economic growth, now evident throughout the whole euro zone, those losses will increase substantially.

This means that the IMF estimate of an additional EUR 200 billion in bank aid most probably is overoptimistic underestimation.

But this line of argument is really a total derailing of what’s ought to be the real discussion:

In the view of the EconoTwist’s we’re looking at a 3-part problem.

First, the accounting system that has developed into a untransparet jungle of techniques, making it totally impossible for both regulators, analysts and policy makers to gain complete oversight of the bank’s real risk exposure.

This includes the off-balance sheet financing, that once upon a time was created as a special solution to fund important high-risk projects, but now being used for pure speculation – just as the traditional derivatives.

Then we have the cross-border activity. The fact that the financial industry have globalized faster than any other industry, and faster than national (local) authorities are able to handle, have created a situation where banks may speculate, taking advantage of different rules in different countries, taking on more risk with little or no need for reporting and disclosure.

To make things even more confusing, international regulators invoked a special set of rules in the aftermath of the Lehman collapse, allowing the banks to put whatever price tag they see adequate on the toxic, worthless assets they possess.

This is called a “mark-to-mark” principle.

However, new rules, now being implemented through the Basel III regulations requires that banks return to the old principle of “mark-to-market.” That means putting the actual market valuation of their assets on their balance sheet.

EU officials involved in the debate say the “mark-to-market” principle explains much of the recent fall in EU’s commercial banks’ share prices, including  French and German institutions that have large holdings of euro zone sovereign debt.

“Marking to market is a fairly brutal exercise, but these are the estimates  that hedge funds are currently making,” one official says to the FT, following criticisms  of European banks made by the International Accounting Standards Board, which sets the common bank accounting rules, to the European Securities and Markets Authority,  EU’s markets regulator.

And the third unresolved problem is called the “shadow banking system.”

See also: Major Banks Still Hide $Trillions In The Shadows

Officials say the IMF staff do not claim their estimate is a comprehensive  measure. But they say that the analysis strongly suggests European banks need to  raise more capital, an argument  recently made by Christine Lagarde, the fund’s new managing director.

No one disputes that fact.

The final report will be published in three weeks’ time just before the  IMF’s annual meetings, and is subject to revision depending on the debate  between fund staff and the fund’s executive board.

But these authorities and their officials can evaluate, calculate and estimate all they want:

Before the regulatory mess is cleaned up, things are not going to look any better and more nasty surprises can be expected.

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Central Bankers Announces A Higher Form Of Capital Standards

At yesterday’s meeting, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of existing capital requirements. In addition the central bankers fully endorsed the agreements reached in July this year. Under the agreements, the minimum requirement for common equity will be raised from the current 2% level to 4.5%. The Tier 1 capital requirement will increase from 4% to 6%.

“Their contribution to long-term financial stability and growth will be substantial.”

Jean-Claude Trichet

In stores January 2011 (Limited Edition)

According to the press release, “systemically important banks” should have loss absorbing capacity beyond the standards announced Sunday, and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams. The Basel Committee and the FSB are also developing an integrated approach to the “systemically important” financial institutions which could include combination of capital surcharges, contingent capital and bail-in debt.

However, which banks that are regarded as “systemically important” are yet to be determined.

But even more interesting will be the list of banks that are “systemically unimportant.”

One might also wonder what the bankers mean by “a higher form of capital”

“This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011,” Bank of International Settlements writes in its statement.

After its meeting on Sunday, The Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a strengthening of existing capital requirements and fully endorsed the agreements it reached on 26 July 2010.

“These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November,” Bank of International Settlements says in the press release.

The Committee’s package of reforms will increase the minimum common equity requirement from 2% to 4.5%.

In addition, banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.

This reinforces the stronger definition of capital agreed by Governors and Heads of Supervision in July and the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011.

Contribution To Stability And Growth

Jean-Claude Trichet

Jean-Claude Trichet

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Mr. Jean-Claude Trichet, President of the European Central Bank and Chairman of the Group of Governors and Heads of Supervision, says that “the agreements reached today are a fundamental strengthening of global capital standards.” Adding that “their contribution to long term financial stability and growth will be substantial. The transition arrangements will enable banks to meet the new standards while supporting the economic recovery.”

Mr Nout Wellink, Chairman of the Basel Committee on Banking Supervision and President of the Netherlands Bank, adds that “the combination of a much stronger definition of capital, higher minimum requirements and the introduction of new capital buffers will ensure that banks are better able to withstand periods of economic and financial stress, therefore supporting economic growth.”

Sound Supervision

Under the agreements reached Sunday, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments.

This will be phased in by 1 January 2015.

The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period.

The central bankers agree that the capital conservation buffer is a the regulatory minimum requirement and must be met with common equity – after the application of deductions.

“The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions,” BIS says.

This is described as “sound supervision.”

National Countercyclical Buffers

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to “national circumstances.”

“The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.”

“These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above.”

“In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration,” BIS adds.

Systemically important – Or Not?

“Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue in the Financial Stability Board and relevant Basel Committee work streams,” the central bankers informs.

The Basel Committee and the FSB are also developing an integrated approach to systemically important financial institutions which could include  a combination of capital surcharges, contingent capital and bail-in debt, according to the statement.

In addition, work is continuing to strengthen resolution regimes.

The Keeley Triangle

The Keeley Triangle

The Basel Committee on Banking Supervision have recently issued a consultative document proposal to ensure the loss absorbency of regulatory capital at the “point of non-viability.”

The point of non-viability refers to the contingency that a bank becomes unable to support itself in the private market such that it needs rescuing by the public sector, rather than in the narrow sense of insolvency or liquidation.

BCBS have considered three different options which could help ensure that, as a pre-condition of being treated as regulatory capital, an instrument (in particular a Tier 2 instrument) is capable of bearing loss at the point of non-viability:

Option 1: Developing national and international bank resolution frameworks that enable losses to be allocated to all capital instruments issued by internationally active banks that have reached the point of non-viability.

Option 2: Identifying systemically important banks and prohibiting them from including Tier 2 instruments in their regulatory capital.

Option 3: Mandating that all regulatory capital instruments include a mechanism in their terms and conditions that ensures they will take a loss at the point of non-viability.

BCBS ultimately chose to propose Option 3.

Option 1 was regarded as unrealistic in the short term, due to the need to achieve convergence of national insolvency laws and bank resolution regimes.

Option 2 would entail the practical difficulty of trying to identify systemically important banks, which itself gives rise to possible moral hazard issues and, therefore, would probably mean prohibiting all banks from including Tier 2 instruments in their regulatory capital, to the detriment of smaller, non-systemically important banks.

Here’s a copy of the proposal.

The Transition Arrangements

Since the onset of the crisis, banks have already undertaken substantial efforts to raise their capital levels, BIS points out.

Adding that the preliminary results of the Committee’s comprehensive quantitative impact study show that as of the end of 2009, large banks will need, in the aggregate, a significant amount of additional capital to meet these new requirements.

Smaller banks, which are particularly important for lending to the SME sector, for the most part already meet these higher standards, according to the statement.

The Governors and Heads of Supervision have agreed on transitional arrangements for implementing the new standards to help ensure that the banking sector can meet the higher capital standards through reasonable earnings retention and capital raising, while still supporting lending to the economy.

The transitional arrangements include:

* National implementation by member countries will begin on 1 January 2013. Member countries must translate the rules into national laws and regulations before this date. As of 1 January 2013, banks will be required to meet the following new minimum requirements in relation to risk-weighted assets (RWAs):

o 3.5% common equity/RWAs;

o 4.5% Tier 1 capital/RWAs, and

o 8.0% total capital/RWAs.

The minimum common equity and Tier 1 requirements will be phased in between 1 January 2013 and 1 January 2015.

On 1 January 2013, the minimum common equity requirement will rise from the current 2% level to 3.5%.

The Tier 1 capital requirement will rise from 4% to 4.5%.

On 1 January 2014, banks will have to meet a 4% minimum common equity requirement and a Tier 1 requirement of 5.5%.

On 1 January 2015, banks will have to meet the 4.5% common equity and the 6% Tier 1 requirements.

The total capital requirement remains at the existing level of 8.0% and so does not need to be phased in.

A Higher Form of Capital

The usual capital structure

The usual capital structure

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The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 and “higher forms of capital.”

* The regulatory adjustments (ie. deductions and prudential filters), including amounts above the aggregate 15% limit for investments in financial institutions, mortgage servicing rights, and deferred tax assets from timing differences, would be fully deducted from common equity by 1 January 2018.

* In particular, the regulatory adjustments will begin at 20% of the required deductions from common equity on 1 January 2014, 40% on 1 January 2015, 60% on 1 January 2016, 80% on 1 January 2017, and reach 100% on 1 January 2018. During this transition period, the remainder not deducted from common equity will continue to be subject to existing national treatments.

* The capital conservation buffer will be phased in between 1 January 2016 and year end 2018 becoming fully effective on 1 January 2019. It will begin at 0.625% of RWAs on 1 January 2016 and increase each subsequent year by an additional 0.625 percentage points, to reach its final level of 2.5% of RWAs on 1 January 2019. Countries that experience excessive credit growth should consider accelerating the build up of the capital conservation buffer and the countercyclical buffer. National authorities have the discretion to impose shorter transition periods and should do so where appropriate.

* Banks that already meet the minimum ratio requirement during the transition period but remain below the 7% common equity target (minimum plus conservation buffer) should maintain prudent earnings retention policies with a view to meeting the conservation buffer as soon as reasonably possible.

* Existing public sector capital injections will be grandfathered until 1 January 2018. Capital instruments that no longer qualify as non-common equity Tier 1 capital or Tier 2 capital will be phased out over a 10 year horizon beginning 1 January 2013. Fixing the base at the nominal amount of such instruments outstanding on 1 January 2013, their recognition will be capped at 90% from 1 January 2013, with the cap reducing by 10 percentage points in each subsequent year. In addition, instruments with an incentive to be redeemed will be phased out at their effective maturity date.

* Capital instruments that no longer qualify as common equity Tier 1 will be excluded from common equity Tier 1 as of 1 January 2013. However, instruments meeting the following three conditions will be phased out over the same horizon described in the previous bullet point: (1) they are issued by a non-joint stock company 1 ; (2) they are treated as equity under the prevailing accounting standards; and (3) they receive unlimited recognition as part of Tier 1 capital under current national banking law.

* Only those instruments issued before the date of this press release should qualify for the above transition arrangements.

“The supervisory monitoring period will commence 1 January 2011; the parallel run period will commence 1 January 2013 and run until 1 January 2017; and disclosure of the leverage ratio and its components will start 1 January 2015. Based on the results of the parallel run period, any final adjustments will be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.”

Here’s the full statement from Bank of International Settlements.

Annex 1: Calibration of the Capital Framework

Annex 2: Phase-in arrangements

Related by the Econotwist:

Basel III And The Fawlty Towers

Will Basel III Crush the Global Economy?

German Banks With More Than 200 Billion Euro In Faul Credits

European Banks Hunting For EUR 1,65 Trillion

Morgan Stanley: Governments WILL Default

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Wolfgang Münchau: A Cynically Calibrated Test To Fix The Result

If you tried to test the safety of cars or children’s toys using the same method the European Union applied in its stress tests on banks, you would end up in jail, columnist Wolfgang Münchau at Financial Times Deutschland writes.

“The purpose of the exercise was to ensure that the only banks that failed it were those that would have to be restructured anyway.”

Wolfgang Münchau


“The supposedly clever idea was to demonstrate to the outside world that the rest of the banking system remained sound. The purpose of this cynical exercise was to pretend that the EU was solving a problem, when in fact it was not. The testing mechanism was calibrated to fix the result,” Münchau writes.

It is too early to judge whether the ploy worked. But from the informed reaction on Friday night, I suspect not. Expectations were not very high. But the EU undershot the lowest of them.

There were three fundamental problems with those tests – and each one would have invalidated them. The first, and least serious of the three, is that the tests left out some important institutions, whose financial health is not entirely clear. One of those is KfW, the German state-owned institution that is legally not a bank but carries out bank-like functions – such as accumulating lots of toxic assets.

The second problem is the definition of the pass rate – a tier-one ratio of 6 per cent, which refers to various categories of capital, as a percentage of a bank’s total assets. The problem with this definition is that it does not tell us what we need to know. The reason we are interested in capital ratios is not because we are afraid that a bank may fall short of some legal requirement but that it could be insufficiently insured against an exogenous shock.

Tier one capital includes equity and retained earnings but also various types of hybrid debt instruments. For example, government support from Germany and Spain comes in the form of hybrid instruments, whereby the state does not become an owner of the bank.

Hybrid capital has some characteristics of equity but also some characteristics of a bond, including an entitlement to a guaranteed payment stream. As the question is how the system performs under stress, we are interested in the risk-absorbing elements of core capital – not some bureaucratic or legal definition.

The current definition of tier one capital is the reason why all the German Landesbanken have passed the tests. If one had used a narrower definition – equity and retained earnings only – the results would almost surely have been different.

The third problem is the most severe, and knocks the credibility of the entire exercise. There was no provision for the possibility of sovereign default.

Banks hold most of their bonds on their banking books – where they usually keep them until maturity – and a small minority on their trading books. The stress tests assumed some further loss only on the value of those bonds in the trading books. Yet the pricing of Greek bonds already implies a non-trivial probability of a default – and that would affect both books.

Certainly, the stress tests should be based on what one might call a plausible worst-case scenario, not one that represents the absolute worst. Nobody is asking the bank supervisors to stress-test the impact of an alien attack. But sovereign default in the case of Greece is not such a far-fetched scenario – even if you believe it to be unlikely. It is irresponsible for the stress testers to ignore that sort of event. That is like a car crash tester failing to consider the possibility of an oncoming vehicle.

In their briefing on Friday evening, officials from the Committee of European Banking Supervisors (CEBS) were reported to have made a strange statement. They calculated that the probability of the adverse stress scenario was 5 per cent. But how can they know? If this estimate is based on some variant of normal distribution, as I suspect, then the 5 per cent threshold must surely include an assumption of a partial Greek default, as that is the probabilistic inference from current market prices.

Wolfgang Münchau

Default probabilities are admittedly a very complicated subject. An easy but very dirty method is to take the square root of the spread to some supposedly safe asset. If the spread for Greece is, say, 900 basis points, that implies a 30 per cent chance of a 30 per cent default. If you really want to include stress scenarios that have only a 5 per cent probability of occurring, surely under current market prices you cannot ignore the possibility of a Greek government default.

The stress tests follow a pattern that has been evident since the outbreak of the acute phase of the financial crisis in September 2008. The EU’s approach to the financial sector has been to apply patchwork fixes – a blanket bail-out, some not very serious recapitalisation plans, plus loads of liquidity – rather than solve the problem.

A notable exception is Spain, where the situation is the most severe, and where a serious attempt is under way to address it.

But while in Madrid the stress tests are part of a political commitment to resolve the banking problems, that is not the case elsewhere. A stress test without a resolution strategy – which is what is absent beyond Spain – is entirely pointless.

By Wolfgang Münchau

Financial Times columnist

eurointelligence.com

Related by the Econotwist:

Weekly Outlook: The European Post Stress Test Syndrome

EU Bank Stress Test: Commentaries & Market Reactions

EU Bank Stress Test: Here’s The Full Package

To Europe From Goldman Sachs On The Stress Test Eve

Financial Authorities See No Point In Stress Testing Norwegian Banks

All Nordic Banks Will Pass Stress Test, Nordea Says

European Bank Stress Tests Are Loosing Credibility

The EU Stress Test: Working The Media

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