Making Sense of Increased Capital Requirements - Joe Rizzi by malj


									                                                          Risk Minds
                                                          June 2012

                      Making Sense of Increased Capital

                                                         By J.V. Rizzi

The opinions expressed herein are those of the author.
They do not reflect the views of CapGen Financial.
    Table of Contents
     Change
     Reaction
     Reality
     Impact
     Response
     Conclusion


        The Change
        (BIS III and Dodd Frank)
        (Capital goes where it is welcome…
     Message: more capital, more liquidity and less risk
     Specifics
               - tightened capital definition
               - increased RWA weights
               - more liquidity
                            limit illiquid assets
                            restrict unstable funding
               - increased capital requirements
                            BIS III                 Dodd Frank (well capitalized)
      CE                    2 à 4.5                              [5+]
      T1                    4à6                                  >6
      TC                    8à8                                  > 10
      Buffer                0 à 2.5                               --
      Lev                   0à3                                  >5
     Why
               - Banking as an industry failed
               - Clear that prior capital rules were insufficient
4                                                           …and stays where it is treated well)

    The Nonsense
    (Do you want to believe what you see…
     Higher Capital Requirements
         Put aside more reserves
           Curtail lending
           Impede growth
       Decrease ROE
       Increased Funding Cost
       Un-American

                                            …or what I am telling you?)


    The Reality
    (Facts ignored…
     Set aside
         Confuses liquidity reserves with funding mix
     Increased funding cost
         Limited given proportion of equity in capital structure
         Ignores cost of forced capital raise at distressed price
     Reduced ROE
         Cost of equity is not fixed
         Key is the spread between ROE and cost of equity
     Un-American
         “The policy goal should be a healthier banking system, rather than high returns for banks’ shareholders
           and managers with taxpayers picking up the losses and economies suffering the fallout.”
     Bankers resistance of higher capital requirements: capital shifts risk from taxpayer to capital
         Vested interest in subsidies and compensation– especially for banks with weak franchise value and
         Debt overhang: benefits to debtholders

                                                                                  …do not cease to exist.)


     (You cannot lever up a sow’s ear into a silk purse…
      Business Model
        Balance sheet mix
        Capital generation and growth
      Shareholder distributions
      Restructuring
        Shrink
        Break-up
        Merge
      Capital structure
             …you may think you can during the good times, but…)

     Stakeholder Views of Capital Differ
(Is the glass half full or half empty…

                                   Capital focus is primarily on tangible equity
     Rating Agencies
                                         capital and capital replenishment capabilities.

                                   Concern on through the cycle capital and

     Shareholders                  Are focused on capital discipline and

     Management                    Capital Returns and bonuses

                                         … it depends on whether you are pouring or drinking)
Introduction                                     (Once set…

                                                                   Strategic Capital
 Volatility             Liquidity                                  Budgeting (CEO)

                                       Capital Structure                Capabilities
                                             CFO                                                 Risk
                                         Risk Appetite                                        Management
              Return                                                                            (CRO)

       Correlations                                                   Performance

                                    External Stakeholders


                                     Rating Agencies

13                                     …Capital structure is continuously monitored and revised)
     (Capital structure is important not because it creates value…

      Set capital structure independent of regulation
          Except for banks with limited franchise value and suffering from debt overhang
          Enough capital to pursue strategy and weather cash flow shortfall
      Positive relationship between value and equity thru the cycle
          Long term decline from insufficient capital going into crisis outweighs short term leverage benefit
      Major determinant of capital is the market and rating agencies
          Most banks hold more than regulatory minimum
      Framework
          Estimate financing surplus or deficit through the cycle
                Surplus- shareholder distributions
                Deficit- raise additional capital
          Ratings requirements
                Agencies
                CAMELS
          Peers

                                                                     … but because getting it wrong destroys value.)
 Capital Structure – Integration of Capital
 and Risk Management
     (Risk never disappears….
 Mix of securities (Capital Structure) and Risk Management Products
  Capital structure optimization is the purpose of risk management – 2 sides of same
     Risk management is capital structure in disguise
     Risk management as synthetic or substitute equity
          Risk transfer transfer (Cause)
          Risk Finance (Effect)

  Integration of corporate finance and risk management
       Cost/Benefit analysis regarding use of risk management or risk finance
       Issue is whether it is more efficient to (self insure) hold capital or to use risk
        management to eliminate the risk cause

15                                          …someone is always on the other side of the trade)
     Capital Guidelines
(How much is enough?…
     S&P: RAC
       Very strong    >15%
       Strong         15/≤ X <10%
       Adequate       10 ≤ X < 7%
       Moderate       7% ≤ X < 5%
       Weak           5% ≤ X < 3%
       Very Weak      >3%
     CAMELS – “C” and “A”:Classified Assets/T1 + ALL
       1 - O ≤ X ≤ 25%
       2 – 26%< X ≤ 40%
       3 - 41% < X ≤ 80%
       4 - 81% ≤ X ≤ 100%
       5 - > 100

16                                                     …it depends
          Scenarios: To Assess Possible Strategies
          Against Capital Structure Robustness
(Can I survive and tolerate…..

  Financial policy                 Forward looking Core Tier 1 development under alternative scenarios
     implications:                                    (Stress testing)

      The upside (U) and
       base (B) cases
       generate excess                                                                    Return      Raise/release
       capital which points                                  U
                                                                                          Capital        Capital
       toward shareholder                    -------------------------
       distributions                                                                      Probably        Unlikely
      The downturn (D)                                       B
       scenario suggests                     -------------------------                     May be         May be
       possible changes in
       risk appetite and the                                                               Unlikely       Probably
       development of
       appropriate                                                       D
       contingency plans to
       maintain ratios, sell
       assets and raise capital.

  17                                                                     …the worst plausible outcome?)
                In a ‘sustained severe recession’ scenario, contingency measures may be
                required to meet target capital ratios
Sust. Sev.
Recession         YE            YE             YE              YE          YE
(EUR bln)
Net profit             x             x              x               x           x
RWA                    x             x              x               x           x
Core Tier 1
                       x             x              x               x           x
Gearing                x             x              x               x           x
Tier 1                 x             x              x               x           x
Total BIS              x             x              x               x           x
Excess CT1
Capital             x       x                       x               x           x                                                            Time

                Assumptions                                                         Observations
                Downturn scenario is based on a net profit decrease of                The ratios as presented would trigger a regulatory response
                 EUR __ bln relative to the reference case to EUR __ bln in             as the Tier Total ratio is < __%. Additionally, ratings would
                 __, a drop of __bln to __bln in __ and recovery                        be pressured resulting in possible downgrade.
                                                                                       The scenario would lead to a significant shortfall from the
                Decrease in RWA of EUR __ bln in __, __ bln in __ and a                6.0% Core Tier 1 ratio target.
                 __% growth through __ and __ due to lower credit
                 demand and reduction due to FX devaluation.                           Compared to the mild recession, additional contingency
                                                                                        measure to replenish the capital meet target ratios would be
                Divestitures __ according to plan (reference case)                     required, e.g.
                Dividend payout of __ for __, __ thereafter                                Suspend or reduce dividend
                Share buyback as announced for __ and ongoing                              Suspend stock dividend neutralisation
                 neutralisation of stock dividend, but no additional
18                                                                                          Increase divestment programme
Elements of Strategy Based Capital Structure Management
(Risk and capital as inputs into strategic planning….)

    Choice of Markets with Attractive economics in
    which the organization enjoys a competitive advantage
                                                                              Risk Appetite
    Risk the organization is willing and able to accept in
       pursuit of its strategy                                                Risk Assessment
    Risks underwritten and retained
                                                                              Capital Need and
    Capital relative to Ratings Agencies, Regulators and peers
    Actual Capital                                                            Capital Assessment

    Return capital to shareholders when actual capital exceeds                Capital Plan
    need, or raise capital when exceeds actual capital
                                                                              Capital Allocation
    Allocation to business units based on an economic
    capital determination

  19                                                             (…and not just consequences)
                            How Much?
     (Better to be approximately right…
                                   LNYC Pre-
         REITS                                                   Asset Value
         (29%)                       Banks                     Losses/Cushion
                                     (20%)                        (7% / 7%)

                         Depending on risk of Business Model
                                     High CRE
                                Derivatives/ Trading

20                                                …than precisely wrong.)

     (Capital structure as a Process…

        Need to incorporate capital structure and risk considerations
          as an input versus consequence of strategy
              Capital as cost of risk
              Return as cost of capital
              Risk as cost of return
        Capital structure links strategy, risk and return–represents
         total risk exposure an organization is capable of accepting
         and retain in pursuit of its strategy
        Market factors have a larger impact on bank capital structure
         than regulation

                                                       … Not a Number)

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