Published: June 01, 2014
The financial sector continues to face big changes and challenges in prudential regulation. The new Capital Requirements Directive (CRD IV) and the associated Capital Requirements Regulation (the CRR) came into effect in January 2014, but the journey to full implementation of CRD IV has only just begun. Many banks, building societies, brokers, asset managers (and indeed regulators) are still getting to grips with these complex prudential rules. Firms have not yet felt the full impact of CRD IV on their capital management and treasury functions. Laura Cox and Ian Kelly of PwC’s Financial Services Risk and Regulatory Centre of Excellence take a look at where the industry is now - and what is still to come.
The basic requirement to maintain regulatory capital at least equal to 8% of risk weighted assets hasn’t changed. But firms now have to meet a much bigger proportion of this (4.5% of risk weighted assets) with share capital or reserves. These ‘high quality’ capital resources are referred to as Common Equity Tier 1 (CET1) capital.
Banks may also boost their Tier 1 capital to a certain extent by using contingent capital instruments - so called because they are designed to convert into CET1 capital in a financial emergency. These instruments (sometimes called ‘cocos’) are more costly to service and market than previous debt-capital bonds because investors are exposed to the potential risk of a loss of their capital investment should the conversion occur.
One of the most interesting aspects of the CRD IV roll-out in the UK has been the divergent approaches of the UK regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The PRA prudentially regulates all UK banks, insurers and a small number of systemically important investment firms. The FCA prudentially regulates all non-systemic investment firms, asset managers and brokers.
The true ‘cost-of-capital’ impact of CRD IV has not fully hit banks and large investment firms.
The PRA has decided to require banks to attain an end-point implementation of CRD IV almost immediately. As a result, UK banks are unable to use many the transitional provisions and allowances in CRD IV. Conversely, the FCA has chosen to allow investment firms to benefit from most of the transitional provisions, but the transitional provisions are quite complex. So the FCA’s genuine effort to ease the regulatory impact on investment firms may have inadvertently increased the regulatory complexity and cost for investment firms and asset managers.
The true ‘cost-of-capital’ impact of CRD IV has not fully hit banks and large investment firms. This effect will only be felt when the new capital ‘buffer’ requirements are phased in between 2016 and 2019. These buffers are effectively extra capital requirements which apply in addition to the minimum 8% basic capital requirement - and they must be met using expensive, high quality CET1 capital. They are made up of:
In addition, under CRD IV regulators can apply additional capital requirements to a firm in the form of Individual Capital Guidance (ICG). After all these capital requirements are added together, a bank or large investment firm could easily end up with a capital requirement in the region of 10%-15%. At those levels, banks may struggle to remain competitive and to maintain profitability levels that satisfy their investors.
In the UK, the PRA is putting behind-the-scenes pressure on banks to start aiming for these higher ratios already. Indeed, in June 2013 the Bank of England’s Financial Policy Committee recommended that the eight largest UK banks attain a 7% CET1 capital ratio by January 2014. That’s far in excess of the minimum amount required by CRD IV. The PRA has been working with those banks to ensure they reach and maintain that higher ratio.[[[PAGE]]]
Next, the banks will face a further big regulatory burden - minimum leverage requirements, which are due to kick in from 2018 onwards. The leverage ratio is simply the ratio of a bank’s capital to its total on-balance sheet assets and certain off-balance sheet exposures. The minimum leverage requirement has not yet been finalised, but the Basel Committee on Banking Supervision has suggested a minimum ratio of 3% capital-to-assets. It seems likely that the European Commission will adopt this minimum in CRD IV.
The Basel Committee on Banking Supervision has suggested a minimum ratio of 3% capital-to-assets.
The leverage ratio has proved quite controversial. Some regard it as unfair because it does not take account of the varying riskiness posed by different banks’ mix of assets and business models. For example, a retail bank with low risk assets such as AAA rated Government bonds and low risk mortgage lending will be expected to maintain the same leverage ratio as an investment bank with high risk assets such as investments in emerging markets and loans to start-up corporations.
The banking sector won a minor reprieve in January when the Basel Committee announced that it would revise the leverage ratio methodology to allow some limited netting of assets and liabilities owed to the same counterparty. Soon after, the European Banking Authority (EBA) announced that EU authorities would adopt this relief in CRD IV. Regulators’ willingness to engage with and respond to the genuine concerns of the industry is reassuring, and should help lead to more practical outcomes for firms.
Financial regulators have a deep and abiding unpleasant memory of banks’ over-reliance on short-term wholesale funding in the run-up to the financial crisis. When those markets seized up in 2007/2008, some banks became illiquid. The resulting chaos threatened the stability of the entire global financial system, and brought heavy criticism of the regulators as well as firms. Unsurprisingly then, the CRR includes tough new rules on liquidity.
A new Liquidity Coverage Ratio (LCR) will start to apply from 2015. Under this rule, all banks (and some complex investment firms) will have to hold a buffer of highly liquid assets which are sufficient to fund 30 days of outflows. The assets held to meet this requirement must be quickly and easily realisable. The LCR will be phased in between 2015 and 2018. The requirement to hold such a large quantity of liquid assets will clearly impact banks’ treasury management functions and will force banks to structure their balance sheet in ways that may not be commercially optimal.
This plethora of simultaneous new prudential requirements clearly presents enormous challenges for firms. Nevertheless, we can draw some positive views. Firstly, in some of these areas the regulators are simply playing ‘catch up’ with the industry, particularly on capital ratios. Market and investor sentiment has already forced many banks to beef up their capital ratios.
Secondly, these new prudential requirements may well end up boosting confidence in the financial sector by reducing the risk of insolvencies and defaults. The financial sector has shown time and again that it is resilient and innovative. We can be hopeful that it will meet these challenges head on, and find commercial advantages to benefit the banks, their investors, and most importantly their customers.
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