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EU Fights Back

23 September 2016 by Felipe Villarroel

We came across an interesting story this morning, which we thought was worth a comment. According to an official, the EU has opposed one of the Basel Committee measures due to be implemented later this year as part of Basel III regulation. The measure in question is the introduction of risk-weighted floors for banks. In a nutshell, the most important capital ratio for banks, the Common Equity Tier 1, is calculated by dividing the Tier 1 capital balance by the sum of the risk-weighted assets on the balance sheet. In the aftermath of the financial crisis, these risk weights came under scrutiny due to the fact that some assets, that were deemed to be low risk assets (and consequently carrying a low risk weight), turned out to be riskier than expected. The upshot was that the capital ratios reported by the banks were not as robust as investors and regulators expected.

These weightings had been determined by the banks themselves using internal models, and the regulators proposed to standardise these weightings and leave less discretion to the banks. While we can see the theoretical point to this, the implementation of this regulation seemed to be creating the most problems for the safest institutions. For example, regulators were rumoured to be drafting an increase in the risk weightings for assets such as UK prime mortgages, which have actually displayed some of the strongest risk characteristics of any asset class during the financial crisis. The consequence for building societies such as Coventry or Nationwide, or retail banks such as Lloyds, which have large amount of mortgages on their balance sheets, would potentially be very negative. These institutions could have been forced to have higher capital requirements due to the fact that they hold the least risky assets!

Of course we think regulators need to keep a closer eye on these internal models and this would be beneficial to markets, but replacing them with a one-size-fits-all policy across all banks, does not seem to be the best solution. Different countries and regions have different risks and we think they should be taken into account. In addition the leverage ratio already serves this purpose.

The bottom line is that this is a very welcome development for the safest financial institutions – thankfully, common sense looks to be prevailing. We see no reason why their capital requirements should be higher.

For AT1 bondholders this is also positive, as these banks would have had less headroom to their MDA (Maximum Distributable Amount) had risk weights been increased. It also makes it more likely that some of them, namely Coventry and Nationwide, won’t need any AT1 bonds at all in a couple of years’ time when the bonds become callable – which isn’t a big surprise with capital ratios at circa 30% and 24% respectively.

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