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Competitive Effects of Basel II on U.S. Bank

Credit Card LendingWilliam W. Lang

Loretta J. Mester

Todd A. Vermilyea

Federal Reserve Bank of Philadelphia

2006 FDIC/JFSR ConferenceArlington, VirginiaSeptember 13 ,2006


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Purpose

Basel II creates a more risk sensitive capital requirementto reduce market distortions created by capitalregulations

However, different banks will operate under differentregulatory capital rules

Different regulatory requirements could create

competitive inequities

Analyze this issue for credit card portfolios


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Outline of presentation

Structure of U.S. credit card (CC) market

Conceptual Framework

Are Basel I requirements binding?

Basel II affect on regulatory capital

Will Basel II Changes Matter?


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Summary of findings and main implications

CC markets are highly concentrated; only a few bankssignificantly affected by CC rules

Community banks and most regional banks not affected

Basel I capital requirements on CCs are not binding

Basel II substantially raises requirements for CC lending

Most of the increase is in tier 2 capital

Capital requirements for CC may be extremely procyclical

Basel II increases incentives to securitize CCs

CC lenders not subject to Basel II may receive a modestcompetitive advantage


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Credit Card Market is Highly Concentrated

40

50

60

70

80

90

100

1997 1998 1999 2000 2001 2002 2003 2004 2005

Top 5 issuers Top 10 issuers

% of total industryoutstandings

Source: The Nilson Report, 1998-2005.


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Other Structural Elements of the U.S.

Credit Card Market Credit Card Specialty Banks (CCSB)

Monolines

Credit Card operations of large banks oftenplaced in a separate charter

Nonbanks issue CCs through bank subsidiaries

CCs largely funded through wholesale market

60% funded through securitization


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Capital concepts

Economic capital: capital that banks wouldchoose if there is no regulatory minimum

Regulatory capital: refers to pillar 1 capitalrequirements

Binding regulatory capital:

bank capital > economic capital

can occur even if:bank capital > regulatory capital

economic capital > regulatory capital


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ActualCapital

Regulatory Capital

45

EconomicCapital

kb

kb is point of binding capital requirement

Buffer Capital


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Capital Levels at Credit Card Banks Are FarHigher Than Regulatory Requirements

Ratio

CreditCard S ecialty

Banks

Non-CreditCard

S ecialty Banks

EquityCapitaltoRisk-

Weighted Assets 17.84% 12.17%

Tier1CapitaltoRisk-

Weighted Assets 15.04% 10.46%

TotalCapitaltoRisk-Weighted

Assets 18.47% 12.06%


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Securitization Rates and Capital Demand atCredit Card Banks

Securitization rate for CC loans has risen over time

Higher securitization rate lowers regulatory capitalrequirements relative to managed assets

Capital to assets ratio has risen in response, while capital

to managed assets ratio has been stable


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Capital levels and securitizationrates over time

5

7

9

11

13

15

17

19

92 93 94 95 96 97 98 99 00 01 02 03 04

0

10

20

30

40

50

60

70

Equity Capital/Assets(left axis)

Securitization Rate(bars, right axis)

Equity Capital/Managed Assets (left axis)

Percent Percent


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Regression Analysis of Capital Demand at CreditCard Banks

Regression models:

Dependent variables: different bank capital ratios

Controls for growth and risk

Sample of banks with: Over $1 billion in assets

Managed loans to managed assets 60 percent

Equity to assets 25 percent

Contrast managed assets to balance sheet assets


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Equity capital ratio regressions

*** Significantly different from zero at the 99% level ** significantly different from zero at the 95%, level

* significantly different from zero at the 90% level

Model 1 Model 2 Model 3

Dependent Variables

Equity Capital

to Total

Assets

Equity Capital

to Managed

Assets

Equity Capital to

Risk-Weighted

Assets

Independent Variables

Intercept 0.09041*** 0.09021*** 0.1196***Coefficient of Variation in ROE 0.00373*** 0.00366*** 0.00506***

Total Assets -0.000252** -0.000231* -0.000382**

Total Assets Squared 0.000000667 0.000000586 0.00000105*

Growth in Total Assets 0.00295306*** 0.00295*** 0.00268*

Growth in Total Assets Squared -0.0000131*** -0.0000131*** -0.0000114*Credit Card Bank Indicator 0.09623*** 0.00917 0.06209***

Adjusted R2 0.3944 0.1057 0.1741

Number of Observations 275 275 275


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Are Basel I requirements binding for bankcredit card activities? No.

CCSBs high capital buffers cannot be explained by growthor risk

CCSBs demand for capital is more in line with their

managed portfolio rather than their on-balance-sheetcredit card assets

Model indicates that CCSBs demand for capital is similar to peerbanks when CCSB assets are measured as managed assets ratherthan on-balance-sheet assets

Conclusion supported by prior research and views ofcredit rating agencies


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Basel I vs Basel II: Risk Weighted Assets

On Balance Sheet CC Loans

Basel I 100% risk weight

Basel II risk sensitive risk-weight for loans andunused lines

Depends on PD, LGD, EAD

Regulators set asset value correlation to 8%


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Basel I vs Basel II: Risk Weighted Assets

Securitized CC: normal times

Approximately the same for total capital withslightly higher effective tier 1 requirements

Securitized CC Loans: stressed times

Much higher regulatory capital requirements

under Basel II


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Basel I vs Basel II: Definition of Capital

Total Capital

Basel I: reserves are a component of capital

Basel II: reserves minus EL a component of capital

(UL only)

Tier 1 Capital

Basel II: deduction if EL > reserves (typically truefor CC lenders)


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Formula for Basel II total capital requirement

T D EL = 0.08 RWA

RWA = RWAON + (CCFSEC x RWASEC)

=>

T = 0.08 x [RWAON + (CCFSEC x RWASEC)]+ EL + D

Gross totalregulatory

capital

Deductions Expectedlosses

Risk-weightedassets


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Estimated impact of Basel II on typical CCbanks required capital in normal times

No Adjustment for Eligible Reserves Adjustment for Eligible Reserves(Monoline CC Bank Assumption)

Average 44.3% 23.6%

Min 19.1% 6.7%

Max 67.0% 32.2%

Percentage Change in Required Tier 1 Capital

(Assuming Securitized Assets Are Healthy)

No adjustment for shortfall of reserves from

expected losses

(Diversified Bank Assumption)

Deduction of half of shortfall of reserves from

expected losses

(Monoline CC Bank Assumption)

Average 2.2% 13.2%

Min -5.4% -1.7%

Max 14.8% 25.8%


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Estimated impact of Basel II on typicalCC banks capital ratios in Normal and

Stressed Times

Total Capital to Risk-Weighted Assets

No Adjustment for Eligible Reserves(Diversified Bank Assumption)

Adjustment for Eligible Reserves(Monoline CC Bank Assumption)

Basel I 18.5% 18.5%

Basel II, healthy portfolio 12.8% 14.9%

Basel II, stressed portfolio 10.4% 12.1%

Tier 1 Capital to Risk-Weighted Assets

No adjustment for shortfall of

reserves from expected losses

(Diversified Bank Assumption)

Deduction of half of shortfall of

reserves from expected losses

(Monoline CC Bank Assumption)

Basel I 15.0% 15.0%

Basel II, healthy portfolio 14.7% 13.3%

Basel II, stressed portfolio 11.9% 10.8%


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Summary of estimates for typical large CClender in normal times

Substantial rise in total capital requirements for CCactivities; total capital requirements might becomebinding

Modest rise in tier 1 requirements; unlikely to feelsignificant impacts on actual tier 1 capital

However, some CCSBs may see a substantial tier 1impact.


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Summary of estimates for typical large CClender in stress periods

If stress is sufficient to trigger a 15% CCF forsecuritized CCs, then increase in capital requirementsignificant for total and tier 1 capital

If stress is sufficient to trigger a 50% CCF forsecuritized CCs, then severe capital pressures

Note that Basel I banks might also face substantial pressurefrom supervisors and the market to increase capital underthese circumstances


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Implications of our findings

There may be a cost advantage for large CC lenders that are

not subject to the Basel II capital requirements

Disincentives for independent monoline CC banks to adoptBasel II

Any cost advantage would likely be modest since Basel IIbanks may be able to meet additional capital needs throughadditional tier 2 capital (rather than more expensive tier 1capital)

There will be no substantial competitive effect on communitybanks and most regional banks, as credit cards are not amajor product line


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Implications of our findings (contd)

Basel II could generate extremely large increases in required

capital for CCs during stress periods

This might result in CC lenders holding higher capital even innormal times

Differential in pillar 1 capital requirements may overstatethe effects of Basel II since Basel I banks in financial distresswill face increased supervisory and market demands forhigher capital Basel II likely raises incentives to securitizecredit cards and possibly mitigate the increase in requiredcapital for on-balance sheet exposures

Basel II likely raises incentives to securitize credit cards andpossibly mitigate the increase in required capital for on-balancesheet exposures

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