Despite Significant Progress, Capital Is Still A Rating Weakness For Large Global Banks
Following a review, Standard & Poor’s Ratings Services considers that the risk-adjusted capital (RAC) positions of large banks in mature markets around the globe are generally a rating weakness. Our opinion is consistent with the results of studies published last month by the Basel Committee and the Committee of European Banking Supervisors, which concluded that there is a significant capital shortfall under the Basel III computation rules for global banks compared with the final Basel III minimum requirements. Specifically, some of the 75 large banks included in the studies would need an additional €577 billion ($763 billion at the current USA exchange rate) to meet the final 7% minimum common Tier 1 ratio (see “Basel’s Global Quantitative Impact Study Exposes Large Banks’ Regulatory Capital Shortfall,” published on RatingsDirect on Dec. 20, 2010).
Several key aspects of the Basel III reform package are yet to be determined, however, including the potential capital surcharge for systemic banks. In addition, some technical details of Basel III that are likely to have a material impact on regulatory ratios remain unknown (such as the final details of the Credit Valuation Adjustment charge). We believe that these factors, as well as the lengthy transitional arrangements, including the grandfathering by regulators of certain hybrid debts until 2023, may continue to blur comparability and consistency over time of banks’ Tier 1 ratios.
In this context, and given the observed limitation for global comparisons of regulatory capital ratios, we base our opinion of banks’ capital adequacy on our criteria for our risk-adjusted capital framework (RACF) because we believe it provides a globally consistent metric of financial institutions’ capital and risks. It also reflects our opinions on credit, market, and operational risks (see “Bank Capital Methodology And Assumptions,” published Dec. 6, 2010).
This report provides an update to “S&P Ratio Highlights Disparate Capital Strength Among The World’s Biggest Banks,” published Nov. 30, 2009, in which we compared banks’ risk-adjusted capital adequacy with regulatory Tier 1 ratios using a global sample of 45 large banks. In our latest report, we have extended our sample size to include 75 of the top 100 banks by asset size. The RAC ratios presented in this report reflect the changes made in our computation methodology in our December 2010 RACF criteria update, which had a material impact on some banks’ RAC ratio levels.
Key Findings Of Our Analysis
We note that:
- Significant disparities in capital strength persist among the large banks despite high regulatory ratios. The relative differences of our calculation of risk-adjusted capital (RAC) ratios do not match those of regulatory Tier 1 ratios. In our view this reflects both discrepancies in the computation of Tier 1 ratios as well as our different approach to risk assessment and defining capital compared with national regulators;
- Capital adequacy has been improving steadily for most banks in our sample, but in our view it remains a relative weakness for the majority of large banks around the globe. Despite most banks averaging double-digit Tier 1 ratios, a minority of banks in our sample achieved RAC ratios before and after diversification of more than 8% at mid-year 2010. Under our RACF methodology, we consider that a RAC ratio of 8% indicates that a bank should have sufficient capital to withstand an ‘A’ or substantial stress scenario in developed markets.
- The correlation between existing RAC ratio levels and banks’ counterparty credit ratings is only moderate, however. While we consider a bank’s capital position to be an important rating factor, we consider factors such as sovereign support, business position, risk-adjusted earning levels, and funding profiles to be important as well;
- Of the 75 banks in our sample, banks in Australia, Singapore, Hong Kong, and the Nordic countries had the highest average RAC ratios; banks in Japan and Austria had the lowest;
- The rankings for some banks changed substantially between June 2009 (as published in our November 2009 survey) and June 2010, which in our view highlights differences in the speed and aggressiveness of de-risking and recapitalization policies. Several of the banks with the lowest RAC ratios at June 2009 managed to catch up, at least partially, with the average ratio of the banks in the sample;
When we assess a bank’s capital adequacy, we complement the RAC ratio with a qualitative analysis of that bank’s capital position. This includes looking at the quality of capital (for example, the amount of hybrids versus core equity), the quality of underwriting (compared with banks within the same market), and the bank’s capital-generation ability and financial flexibility (that is, the capacity of a bank to raise equity in times of crisis). We also look at other forms of loss-absorbing securities that may have been issued by the bank and that may not be part of our measure of capital (such as the full amount of government hybrids in some instances);
We expect some convergence over time between Basel III ratios and our RAC ratios, as our RAC framework already anticipates several aspects of Basel III;
The implementation of Basel III is unlikely to remove all consistency issues in regulatory Tier 1 ratios. We expect some divergence to persist owing to the impact of national discretion, the expected long transition period, as well as differences in banks’ internal model calibrations, which could continue to generate competitive distortions and weigh on market discipline.
Capital Is Still A Negative Rating Factor For The Majority Of Large Banks, Despite Some Improvement
In our view, most banks’ RAC positions demonstrated steady improvement in 2010. The banks in our sample appear to have started to prepare for a future structural increase in regulatory capital requirements under Basel III. Capital raising, conversion of hybrids into common equity, suspension of dividends, asset disposals, and a reduction in risk assets have allowed a number of banks to significantly increase their capital ratios in the past 18 months.
Having reached a low point in 2007, the average Tier 1 ratio of banks in our sample had increased by about 300 basis points (bps) as of June 30, 2010, with acceleration since year-end 2008.
As of June 30, 2010, our average estimated RAC ratio for the 75 banks in our sample was 7.0% before diversification/concentration adjustment and 8.0% after, compared with an average of 5.7% and 6.7%, respectively, at June 30, 2009. This 130 basis point (bp) rise primarily reflects an increase in banks’ risk-adjusted capital positions. About 40 bps of this reflects the application of our revised RACF criteria published in December 2010–see “Bank Capital Methodology And Assumptions”. Beyond this 40 bp criteria-related average improvement in RAC, significant disparities must be noted with some banks’ RAC ratios that have experienced a significant negative impact related to the deduction of tax loss carried forward and others that report a gain that is higher than 40 bps. The increase in sample size from 45 to 75 banks has had no material impact on the average RAC ratio. We consider that this average level remains a relative rating weakness for banks, which are mostly in the ‘A’ and ‘AA’ categories.
A minority of banks in our sample achieved a RAC ratio of 8% both before and after the impact of diversification/concentration adjustment. Under our RACF, we consider that a RAC ratio of 8% indicates that a bank should have sufficient capital to withstand an ‘A’ or substantial stress scenario in developed markets. However, we expect some further improvement in RAC ratio levels. Under our proposed new bank criteria, we intend to apply RAC ratio ranges to projected RAC ratios rather than current RAC ratios (see “Criteria | Financial Institutions | Request for Comment: Banks: Rating Methodology,” published Jan. 6, 2011).
Our estimated RAC ratios include a numerator that is computed as of June 30, 2010. However, owing to a lack of comprehensive Pillar 3 disclosure at that time, the denominators of the estimated RAC ratios at June 30, 2010 for non-U.S. banks are mainly based on our estimated risk-weighted assets (RWAs) at June 30, 2010 (with a few exceptions). We assessed the variation in regulatory RWAs between the date of calculation with comprehensive Pillar 3 disclosure and June 30, 2010 and applied the same variation to our RWAs. In the absence of timely global disclosure, we believe that this methodology, despite its imperfections, should provide a good estimate of the June 30, 2010 RAC ratios. For U.S. banks we used different data sources. Detailed assumptions used in the case of U.S. banks are available in Appendix 2. We believe that the different information sources and assumptions used to compute RAC ratios could translate into marginal discrepancies in ratio levels.
The RAC ratios published in this article reflect our existing criteria at the time of publication (please see Related Research And Criteria section below for a list of our criteria, as well as our Request For Comment articles on hybrids and BICRA methodology).
Table 1 shows the major differences in our calculation of banks’ RAC ratios both before and after diversification. Capital is one of the main factors driving the below-average ratings of the banks with the lowest RAC ratios in our sample. Conversely, banks with the highest RAC ratios both before and after diversification on average have the highest ratings in this sample.
We view the correlation between RAC ratios and ratings as moderate, however. The RAC is just the starting point for our capital analysis, which we complement with a qualitative analysis of other measures and instruments. We also take into account numerous other rating factors that are not related to banks’ capital positions.
Qualitative analysis of banks’ capital positions complements RAC ratio for a more balanced picture
When we assess a bank’s capital adequacy, we complement the RAC ratio with a qualitative analysis of that bank’s capital position. For example, in the case of Credit Suisse we assess that the bank’s RAC ratio would be more than 200 bps higher without the deduction of tax loss carried forward. In our analysis of Credit Suisse’s capital position, we factor in our view that the bank would recover a large part of those taxes in the next few years and, as a result, would likely demonstrate a higher ability than its peers to build capital in the near future.
The impact of our decision to systematically deduct tax losses carried forward from our total adjusted capital (TAC) measure (published in our RACF criteria in December 2010) has been negligible for the ratios of the majority of banks in our sample for which tax loss carried forward was already deducted or was not material. It has been more material, however, for a minority, which includes UBS, Credit Suisse, Lloyds Banking Group PLC, Societe Generale, Canadian Imperial Bank of Commerce, Banco Santander S.A., Deutsche Bank AG, Bank of Nova Scotia, Commerzbank AG, KBC Group N.V., BPCE, Royal Bank of Scotland Group PLC, and BNP Paribas.
Our analysis of banks’ RAC positions also leads us to make qualitative adjustments to our RAC ratios to reflect differing underwriting standards within the same market, as well as variation in banks’ capital-generation capacity and financial flexibility. For example, when we compare the RAC computation of Caja de Ahorros y Monte de Piedad de Madrid (Caja Madrid) or Banco Popular Espanol, S.A. (Popular) with that of Banco Bilbao Vizcaya Argentaria, S.A. (BBVA) and Caja de Ahorros y Pensiones de Barcelona (la Caixa) we take into consideration our view of the latter two banks’ lower risk appetite, more conservative underwriting standards, and stronger financial flexibility than the first two.
The low RAC ratios for KBC Bank N.V., Danske Bank A/S, and Commerzbank at June 30, 2010 do not include the full amount of hybrid capital instruments injected by their respective governments (for example, out of the €16.4 billion of hybrids provided by the German government in the case of Commerzbank, only €3 billion are included in the TAC). We consider, however, that these hybrids support the banks’ capital positions, at least in the medium term.
We believe that some actions taken by banks after June 30, 2010 have already had a significant impact on their respective RAC ratios. On a pro forma basis, we estimate that Deutsche Bank’s RAC ratio gained 100 bps following the €10.2 billion rights issue in October 2010 and the acquisition of the majority of Deutsche Postbank AG’s capital. Standard Chartered Bank also injected $5.2 billion of pure equity by way of a rights issue in fourth-quarter 2010. According to our estimates, the bank’s pro forma RAC ratio after diversification as of June 2010 would reach 11.4% (up from 9.5%). In addition, we estimate that the impact of BBVA’s €5.1 billion rights issue completed in November 2010 would increase our estimated RAC ratio at mid-2010 by 111 bps before diversification and 130 bps after. Under our methodology, however, we note that this capital increase is projected to be almost entirely consumed by the expected €4.2 billion acquisition of a stake in Turkiye Garanti Bankasi A.S. (expected to close in the second quarter of 2011) and BBVA’s contribution to the CITIC Group’s planned capital increase in 2011. Our RAC ratio for Popular is likely to increase from our 8.9% estimate at June 30, 2010 as a result of the impact of the €500 million issuance of mandatory convertible bonds, the €179 million share capital increase to allow Credit Mutuel to enter in Popular’s capital, and the decreasing impact on RWAs of the transfer of assets to the joint venture created with Credit Mutuel. We estimate the combined impact of these developments to be in the range of 60-80 bps.
Finally, the three Chinese banks included in our sample (China Construction Bank, Bank of China Ltd., and Industrial and Commercial Bank of China) made significant capital injections since June 30, 2010, which, we estimate, would increase their RAC ratios by more than 50 bps.
In addition to these significant capital raisings, a number of other banks in our study have undertaken capital-raising exercises since June 30, 2010 that generally would have the potential to raise their RAC ratios by less than 50 bps. Furthermore, this does not take into account other post-June 30, 2010 items, including changes to RWAs, earnings, or losses, and dividends and other items that may also impact the RAC calculation. We note, for example, that our RAC ratio estimates as of June 30, 2010 for la Caixa reflect a relatively low point over the last year (see table 4), and that its RAC ratio is likely to increase over the following few quarters by about 50 bps.
Our bank ratings also reflect additional factors that are not related to capital:
- More than one third of the banks in this sample benefit from explicit government support, for example, Citigroup, KBC, and Mizuho. We anticipate that the capital position of many of these banks will improve significantly by the time government support is removed.
- Funding position is also an important factor: We view Dexia’s unbalanced structural funding position as a key factor contributing to its lower-than-average rating; this is only partially mitigated by its better-than-average RAC ratio.
- We consider that some banks in the ‘AA’ rating range, for example BNP Paribas, BBVA, or Wells Fargo, and ‘AAA’ rated Rabobank, have RAC ratio levels that are not a rating strength for the very high ratings. However, in our view this is balanced out by the strength of their business franchise, their strong management track record, and better risk-adjusted earnings performance than peers’ that they demonstrated throughout the crisis.
- The ratings on the large Chinese banks included in this sample are lower than average despite them achieving average RAC ratios, which could be even higher when we take into account their sizable rights issues completed in the fourth quarter of 2010. Their ‘BBB’ category stand-alone credit profiles primarily reflect our view of the higher-than-average risks associated with the operating environment in China.
New Reforms Could Narrow The Gap Between Our RAC Ratios And Regulatory Tier 1 Ratios
Our current RAC ratios are not only significantly lower on average than Basel I and II Tier 1 ratios, but also outline significant differences in the relative capital strength among financial institutions (see table 1). This primarily reflects differences in opinion regarding definitions of capital and the riskiness of trading operations equity portfolios and securitization tranches. Our view of the magnitude of credit risk also explains the larger gaps with Tier 1 ratios that we observe in countries which we consider to be higher risk than those in countries of lower economic risk. Australian banks, whose Tier 1 ratios are computed more stringently than the international average, achieve both the lowest Tier 1 ratios and among the highest RAC ratios before diversification adjustments. In our view, these discrepancies between our calculations and those based on Basel requirements result from more stringent definitions of capital and a more conservative computation of risk weights for some asset classes (such as residential mortgages). This modest difference with RAC ratios in our sample of Australian banks is also the result of their limited trading operations and equity portfolios.
German commercial banks, Austrian banks, and Japanese banks in our sample clearly achieve weaker-than-average RAC ratios despite achieving Tier 1 ratios that are similar to the international average. We attribute this larger-than-average gap with Tier 1 ratios to a high proportion of hybrids in their Tier 1 capital and in some instances to large equity participation portfolios, or significant holdings of non-investment-grade securitization in the case of some German banks. Higher credit risk embedded in Austrian banks’ Central and Eastern European banking activities also places pressure on RAC ratio levels. Banks with large investment banking activities, equity, and private equity portfolios also have a large gap between Tier 1 and RAC ratio levels.
We attribute the significant gap between Chinese banks’ RAC ratios and their reported Basel 1 core capital adequacy ratios to the higher risk weights for their assets under our RACF, particularly for corporate loan portfolios and interbank exposures. This in turn reflects our view of moderately high credit risks embedded in the economy. The gap between our RAC ratios and reported Basel ratios also reflects the absence of operational risk charges in countries such as China or the U.S., where the Basel I framework is still being used. The magnitude of tax loss carried forward that is still recognized by local regulators is also a material driver of the differences in countries such as Switzerland, Germany, or France.
The expected implementation of the trading book reform (otherwise known as “Basel 2.5″) in January 2012 and the Basel III framework should, in our view, reduce the gap between RAC and regulatory ratios. Our RAC ratio appears much closer to future Basel III Tier 1 ratios than the existing double-digit Tier 1 ratios published around the globe. The average RAC ratio before diversification in our current sample of 75 banks was slightly below 7% at year-end 2009 and would have been below 6% if we had computed a common equity RAC, excluding all hybrids. In the Bank for International Settlements Quantitative Impact Study results disclosed last December, the average Tier 1 common ratio of 74 large banks–defined as internationally active banks with Tier 1 capital of more than €3 billion ($4 billion)–would have almost halved to 5.7% from 11.1%.
Basel III definition of regulatory capital could lead to a much cleaner regulatory capital base over time
The full implementation of Basel III, expected by 2023, should in our view significantly reduce the gap between regulators’ definition of Tier 1 capital and our own capital measure, total adjusted capital (TAC). We believe the disparities observed primarily reflect our stricter criteria and lower acceptance of hybrid capital in TAC compared with Tier 1 capital that regulators compute. We expect that the dominant part of Basel III regulatory Tier 1 capital will be composed of common equity and reserves and that recognized hybrid capital will have a higher loss-absorption capacity on a going-concern basis than today. Other material differences that are likely to disappear include the treatment of pension deficits, revaluation reserve, and tax loss carried forward that we systematically deduct from our definition of capital (see “Bank Capital Methodology And Assumptions,” published Dec. 6, 2010).
Calculation Of Total Adjusted Capital
Common shareholders’ equity
Add minority interests: equity
Deduct dividends (not yet distributed)
Deduct revaluation reserves
Deduct goodwill and non-servicing intangibles
Deduct interest-only strips
Deduct deferred tax loss carry forwards
Add or deduct postretirement benefit adjustments
Add or deduct cumulative effect of credit-spread related revaluation of liabilities
Add or deduct other equity adjustments
= Adjusted Common Equity (ACE)
Add preferred stock and hybrid capital instruments (subject to limits)
= Total Adjusted Capital (TAC)
We believe we will continue to see some differences between regulators’ definition of capital and our own capital measure, such as in the treatment of insurance subsidiaries and unconsolidated interests in financial institutions that we will risk weight at 1250%, equivalent to a one-for-one capital charge, whereas the Basel III standards require deducting them from Tier 1 above a certain ceiling.
Conversely, while Basel III will not allow full consolidation of minority interest in operating subsidiaries beyond local regulatory minimum requirements, we fully recognize this in our capital ratio. We may subsequently adjust qualitatively to factor in our view of potential capital fungibility limitations.
Upcoming Basel III capital requirements may result in fewer differences between RAC and regulatory ratio risk charges
The two main areas where we expect some convergence between the RAC risk weights and Basel risk weights are trading risk and securitization. Regarding the computation of RWAs, the implementation of the stress value-at-risk (VaR) and incremental risk charge planned for year-end 2011 (under the Basel 2.5 rules) will significantly reduce the gap with our existing RAC charge, which is currently 3-4x higher than the Basel VaR-based charge for the trading book.
Likewise, we believe that this gap will disappear with the proposed risk-weighting of securitization equity tranches at 1250% under Basel III–a treatment that we already apply in our current RAC framework.
The remaining material differences that we expect to see between our RAC risk weight and those under Basel III are, in particular, our higher risk weights for equity and private equity portfolios, for which we believe that existing regulatory charges are generally too low (Basel III will not modify the regulatory charge for equity portfolios, which range from 8%-32%, depending on the nature of the portfolio and the methodology used by the banks). We also expect our credit risk weights that set benchmark charges through the cycle at asset class and country levels to remain on average higher than those under Basel II’s internal rating-based approach, which are set using a stressed one-year horizon. Operational risk charge, which is primarily revenue based, should also remain higher on average than Basel III computation, especially for trading operations.
Inconsistencies In Basel III Implementation Look Set To Continue
We believe that the G20 leaders have taken a very clear stance toward implementing regulatory reforms in the global banking system. In particular, we expect significant improvements in the global consistency of the regulatory capital definition. Nevertheless, we believe that the likelihood of continued material discrepancies in Basel III implementation on a national basis is relatively high. For example, the Swiss regulator seems likely to implement more demanding capital requirements with shorter transition periods than those currently contemplated by the Basel III framework.
We consider that some regulators may wish to accelerate or slow down the implementation process depending on the health of their local banking industries and their performance during the crisis. The more demanding Basel III regulatory regime may, in our opinion, be implemented in a more or less stringent way across the globe. Likewise, we anticipate that differences in regulatory risk weights will remain as much driven by differences in banks’ risk profiles than by variation in the methodology used (for example, differences in internal models or in regulatory approaches) to assess the risk weights.
In order to maintain international comparability and transparency in our approach, we expect to continue applying our standard risk weights to credit, equity, and operational risk exposures as we believe that internal models are too specific for a like-for-like comparison. Despite our RACF being less granular and issuer-specific than internal-rating-based Basel ratios, we believe that it will remain a more consistent starting point for our capital analysis globally than those ratios under Basel I, II, and III.
For a complete copy of tables and appendix, etc go to: