Efficient capital management under Basel III Challenges and perspectivesChris Matten28 May 2011www.pwc.com

PwC

AgendaPerspectives on Basel IIIThe financing challengeImportance of capital planning and stress testing*

PwC

Key Basel III components

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AreasMain Basel III componentsCapital ratios and targetsCapital definitionCountercyclical buffersLeverage ratioMinimum capital standardsSystemic riskRWA requirementsCounterparty riskTrading book and securitisation (also known as Basel II.5)Liquidity standardsLiquidity coverage ratioNet stable funding ratio

PwC

Evolution of Basel I to Basel III*

Basel IBasel IIBasel II.5Basel IIILiquidity StandardsRWA RequirementsCapital Ratios and TargetsTier 1 and 2 definitionTighter capital definitionCapital buffersLeverage ratioHigher minimum ratiosSystemic add-onNew Pillar-1 Credit riskPillar-1 Operational riskPillar-2 ICAAPPillar-3 DisclosurePillar-1 Credit riskPillar-1 Market riskSecuritisation revisionTrading book revisionsIncremental riskCoverage ratioNet stable funding ratioCounterparty risk123456789

PwC

Capital buffers: procyclicality and capital conservationOn-going analyses needed to determine extent procyclicality of minimum capital requirementsRole of Pillar 2 internationally remains unclearEssential to identify appropriate indicators to take timely action/release buffersConsider alternative methods such as tightening underwriting standards and reducing credit supplyProcyclical amplification of financial shocks in banking system, financial markets and wider economy. Amplified through:Basel II risk sensitivityAccounting standards for both mark-to-market assets and held-to-maturity loansBuild up and release of leverage among FIs, firms, and consumersMeasures to dampen cyclicality in IRB minimum capital requirementsForward-looking provisioningCapital conservation bufferDiscretionary countercyclical bufferStress buffer range*

IssuesBasel III proposals

PwC view

PwC

Leverage ratioPre-crisis build up of excessive leverage in the banking systemCrisis market pressure to reduce leverage, amplified downward pressure on asset pricesCapture Off-Balance Sheet (OBS) itemsConstrain build-up of leverage in the banking sectorMitigate destabilising deleveraging which damages financial system and economyReinforce risk-based requirements with a simple, non-risk-based backstop measure based on gross exposureLimiting excessive credit growth

Better as a backstop measure in Pillar 2 not a hard Pillar 1 measure Range of ratios needed for different types of firm and business units within groups Rate of change likely to be a key indicator*

IssuesBasel III proposals

PwC view

Basel II minimum (2.0%)1.TTC adjustments.2. Basel III RWAsBasel III minimum (4.5%)6. Systemic buffer (tbc)Basel III3. Definition change10. Impact of future accounting changes7.Economic growth buffer8. Market buffer 5. Countercyclical buffer (0.0% - 2.5%)11.Volatility buffer4.Conservation buffer (2.5%)Target CT1 ratio9. Management buffer Basel III and other regulatory changesAdditional considerations in setting target CT1 ratioPwC*The approach to buffers is complex and can double-count

PwC

Liquidity and Net Stable Funding Ratio (NSFR)Improve liquidity risk management and buffers30-day stress bufferReduce maturity mismatch through NSFR

Ensure that inventories, OBS exposures and securitisation pipelines are funded with a minimum amount of stable liabilitiesBanks struggled to maintain adequate liquidityLack of focus on liquidity riskInaccurate and ineffective management of liquidity riskUnprecedented levels of liquidity support were required from central banksLiquidity concentration riskImplications for availability, costs and maturity transformationTrade-off between size and quality of bufferNSFR should be used as a Pillar 2 backstop measureNeed for more harmonisation of liquidity risk regulatory / supervisory frameworks*

IssuesBasel III proposals

PwC view

PwC

Systemic effectsInterconnectedness of financial institutions transmitted negative shocks across the financial system and economySystemic impacts are beyond the control of a single FI or supervisorDevelop practical approaches to assist supervisors to measure importance of banks to financial stability and economic growthReview policy options to reduce the probability and impact of failure of systemically important banksEvaluate pros and cons of a capital surcharge for systemically important banksConsider liquidity surcharge and other supervisory toolsFocus macro-supervision first on oversight of market-wide macroeconomic indicatorsFocus on the overall impact of failure, not the riskCapital is usually not the answer: raise capital levels as a final option, not the firstBe aware of market distortions caused by excessive regulation*

IssuesBasel III proposals

PwC view

PwC

Much still to be done: regulatory agendaClarify Definitional changesBuffer approach: countercyclical/ in aggregateRole of Pillar 2Develop recovery and resolution approachLegal frameworkContingent capitalDecide how to address SIFIsStrengthen supervisionImplement consistently across countries

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PwC

Much still to be done: bank agendaManage/communicate expectationsPeers more important than formal timetablePlan and manage capital10 year viewCapital/liquidity management processesStress testingComplement capital and liquidity defences (partial solution)Strengthen risk governance and managementFTPChange risk cultureBusiness planningAdapt business models

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PwC

Basel II in India: Key challenges in adoption by Indian banksRe-structuring:Asset quality and NPL levels?M&A?Bias towards banks with better risk management:Cost efficiencies and economies of scale?IRB modelsData?Implementation costAccording to estimates, Indian banks, especially those with a sizeable branch network, may need to spend over $ 50-70 mn. Need to enhance levels of risk management expertise*

PwC

Basel III in the Indian context (1)Regulators are now focusing on financial stability of the system as a whole rather than just micro regulation of any individual bank. Existing stringent capital requirement in India may help the banks to transition to Basel IIIThe capital requirement as suggested by the proposed Basel III guidelines would necessitate Indian banks raising Rs. 600,000 crore in external capital over next 8-9 years, out of which 70%-75% would be required for the Public sector banks and rest for the private sector banksLowering of leveraging capacity impacting RoEsEach one percentage point rise in bank's actual ratio of tangible common equity to risk-weighted assets (CAR) could lead to a 0.20 per cent drop in GDP*

PwC

Basel III in the Indian context (2)Key challengesIndian banks on average have Tier 1 capital ratios of around 7.5% to 8%, which prima facie meet the proposed Basel III requirementsBUT: beware of definitional changesTransition to Basel III may not impact earnings much, but the upside potential associated with higher leveraging would decline. Further, as the countercyclical buffer has to be set periodically by the RBI, this could introduce an element of variation in lending rates and/or the ROE of banksImplementation of the liquidity coverage ratio (LCR) from 2015 may necessitate banks to maintain additional liquidity; also some assumptions on the rollover rates and the required liquidity for committed lines may be more stringent. However, considering the period of one month and the fact that most Indian banks have upgraded their technology platforms, the transition to LCR may not be a very difficult oneWhile the proposal to make deductions only if such deductibles exceed 15% of core capital would provide some relief to Indian banks , the stricter definition of significant interest and the suggested 100% deduction from the core capital (instead of 50% from Tier I and 50% from Tier II) could have a negative impact on the core capital of some banks.*

PwC

AgendaPerspectives on Basel IIIThe financing challengeImportance of capital planning and stress testing*

PwC

Going Concern Vs Gone Concern*Expected LossLoss distribution (not to scale)Accounting insolvencyProbabilityProfit = zeroTier 1 = x%; regulatory insolvency triggeredEarningsSurplus core equityTier 2Going concernGone concernTier 1

PwC

Basel III putting the squeeze on capital*

PwC

Bringing it all together the overarching capital challengeBanks: cost of equity vs return on equity-20-15-10-5051015202519981999200020012002200320042005200620072008201020112012TimePercentageSource: Capital IQ; PwC analysis UK banksCoERoE*2009

PwC

Bringing it all together the overarching capital challengeBanks: cost of equity vs return on equity-20-15-10-5051015202519981999200020012002200320042005200620072008201020112012TimePercentageSource: Capital IQ; PwC analysis UK banksCoERoE2009*

PwC

Issues with financingSize of the problemTiming market supply vs bank demandBasel III transition periodsCoCosGrowth especially for PSU banksImpact on RoE*

PwC

Capital re-financing is going to be a major issueThe BCBS own quantitative impact survey (QIS), the results of which were published in Dec 2010, shows that for 94 Group 1 banks (Tier 1 capital > 3 billion, well-diversified and internationally active), gross CET1 ratios (before deductions) today of an average of 11.1% will fall to net CET1 ratios of 5.7% - equivalent to a shortfall of 165 billion to meet a CET1 ratio of 4.5% and 577 billion to meet a CET1 ratio of 7.0%.Tier 1 ratios for the same banks would fall from 10.5% to 6.3%.From this we can deduce that each additional 1%-point in CET1 is equivalent to 165 billion for these banks alone the global impact is likely to be much larger.The fall is driven largely by the changes in the way deductions in capital will made in the future, as these come entirely from CET1 (no longer from total capital). The changes to RWAs are expected to give rise to an increase in RWAs for the Group 1 banks of 7.3%.However, the subsequent announcement in January 2011 that all non-core Tier 1 and all Tier 2 instruments will have to have a contingent convertible feature means that, on our estimates, some USD 600-800 billion of hybrid Tier 1 and approx. USD 1,500 billion of Tier 2 will have to be refinanced. Although the transition period runs from 1 January 2013 for 10 years, the addition of a 10% haircut, increasing by the same amount each year, is a strong incentive to get the refinancing done as soon as possible, ideally by 31 December 2012. These numbers were not reflected in the QIS.

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PwC

AgendaPerspectives on Basel IIIThe financing challengeImportance of capital planning and stress testing*

PwC

Capital Base Transitional arrangements*From 1 January:

201120122013201420152016201720182019Min Common Equity Ratio3.5%4.0%4.5%4.5%4.5%4.5%4.5%Capital conservation buffer0.625%1.25%1.875%2.5%Min common equity + cap conservation buffer3.5%4.0%4.5%5.125%5.75%6.375%7.0%Phase in of deductions from Common Equity20%40%60%80%100%100%Minimum Tier 14.0%4.0%4.5%5.5%6.0%6.0%6.0%6.0%6.0%Minimum Total Capital8.0%8.0%8.0%8.0%8.0%8.0%8.0%8.0%8.0%Min Total Capital + cap conservation buffer8.0%8.0%8.0%8.0%8.0%8.625%9.25%9.875%10.5%Capital instruments that no longer qualify as Tier 1 or Tier 2Phased out over 10 year period starting 2013

PwC

Capital planningWas always required under Basel II Pillar 2But is now much more importantNeed to map supply and demand against the transition timetableBe wary of comparing ratios under Basel II with Basel III (definitional changes)Look at internal capital structure for efficiencies (esp changes in deductions)

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PwC

Capital stress tests illustrated (1)*Capital ratiosTime horizon of forecast and stress testMinimumBase case forecastGross stress testNet stress testBank will need to show how it intends to ensure that this gap is eliminated, usually by adding this amount to the initial ICA as a buffer or by raising additional capital in the plan

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Capital stress tests illustrated (2)*Capital ratiosTime horizon of forecast and stress testMinimumBase case forecastGross stress testNet stress testAdditional capital raised

PwC

Some concluding thoughtsTransition calibration, sequencing and timing of Basel III is criticalBasel III - part of an eye-wateringly complex set of changeCapital and liquidity defences are only part of the solutionStrengthened risk management and governanceStrengthened supervision is keyNew business and operating models likely to follow Need to do detailed capital planning and stress testingAn internal capital clean up may be required

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