Pilot fatigue: how capital rules overwhelmed bank strategy

Regulators shouldn’t run a bank – but Basel III and stress tests have put them in the cockpit

Bank capital pilot
Illustration: Stephen Lee, NB Illustration

  • Gone are the days when banks used their own internal risk measures to allocate capital among their businesses. Capital allocations are now dictated by regulatory requirements, with researchers warning of an increasingly homogenised system where banks no longer play to their particular strengths.
  • Banks say regulatory capital requirements are often out of kilter with their own economic assessments, and the gap will only get wider with the advent of standardised output floors for internal models.
  • Faced with multiple, overlapping rules, banks have developed blended measures of capital consumption, which can be applied with discretion to boost strategically important business lines.
  • Low returns on equity, especially among European banks, suggest banks have yet to figure out the best way to satisfy regulatory capital requirements without diluting shareholder value. 
  • Stressed capital requirements are more risk-sensitive, but banks must find a way to smooth the effects of ever-changing supervisory scenarios.

Bankers with long memories may recall a capital-planning seminar organised by the British Bankers’ Association in 2006. Matthew Foss, a senior regulator at what was then called the UK Financial Services Authority, had some advice.

“We would recommend against using Basel II as a way of allocating capital internally for business decisions,” he said.

Instead, he urged his listeners to continue using their economic capital models to decide where to put money to work, instead of funnelling it to strictly regulatory ends.  

Times change. The BBA and FSA are gone. Foss retired. And those still in the industry are finding it difficult to heed his advice.

“From our thinking, regulatory capital plays a front and centre role in the capital allocation process,” says a senior capital manager at a US global systemically important bank (G-Sib). “If you look at economic capital versus what the regulation requires for big US banks, the delta is huge. That is one of the reasons why economic capital is not as usable as it used to be.”

Economic capital is an individual bank’s own estimate of the amount of capital needed to cover the specific risks it takes. After its failure to hold the ramparts in the financial crisis, it looks quaint in the bramble of regulatory strictures that have grown around it. But bankers and even regulators say regulatory capital requirements have begun to warp business decisions at banks – resulting in a homogenised system that gives banks reason to abandon their particular strengths. 

Under Basel III, banks must meet a varied set of risk- and leverage-based capital ratios; while maintaining enough headroom to pass supervisory stress tests, such as the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR). For G-Sibs, there is also a capital surcharge, determined by things like their interconnectedness and substitutability. And then, there are liquidity requirements – the liquidity coverage ratio and the coming net stable funding ratio.

With so many metrics in play, deciding whether specific business lines are earning their keep, and which to invest in has become far more fraught. Adrian Docherty, head of financial institutions group advisory at BNP Paribas, compares it to flying a plane.

“You have to go fast enough to fly, but slow enough to brake, maintaining your forward speed so your vertical speed is correct,” he says. “It’s not easy. There are multiple variables, and no single parameter you can go for.”

From our thinking, regulatory capital plays a front and centre role in the capital allocation process
Senior capital manager at a US G-Sib

Investors would like to see banks fly a little faster, and higher. 

In Europe, few are earning more than their cost of capital: returns on equity (RoE) are around 7%; while the cost of capital is estimated at 9.5% on average. Many, however, trade below book value, implying an even higher capital cost ­­– around 13%.

US banks are in better shape, with an RoE of around 12% on average. Still, that’s barely enough to keep shareholders happy.

For regulators, the questions are thorny. Banks are exiting once-core businesses, such as derivatives clearing and government bond trading that no longer generate an adequate RoE – and doubling down on ones that do.

Kevin Stiroh, head of supervision at the Federal Reserve Bank of New York, noted in a  speech last November that banks facing multiple capital requirements can gravitate towards similar business models and “become ‘systemic as a herd’ and be susceptible to the same shocks”.

He continued, “Research suggests that in a world with multiple capital constraints, eg, a leverage ratio and a risk-based capital [requirement], banks face incentives to do the same thing rather than specialising in areas where they each have a natural competitive advantage.”

credit-suisse-zurich
Credit Suisse: moved out of most European government bond primary markets

Many agree, and point to business decisions sculpted by the regulatory capital framework. A few outcomes: derivatives clearing, government bond market-making and repo trading look good under risk-based ratios, but are unappealing under the leverage ratio. A 2017 presentation by HSBC showed 10 European countries had lost primary dealers over the previous five years; among them, five banks left the business in Belgium and three in France. The most dramatic was Credit Suisse’s exit from most European government bond primary markets in October 2015.

Meanwhile, the number of firms providing clearing services in the US has fallen from 84 at the beginning of 2008 to just 55 last year, according to the Financial Stability Board (FSB).

The more volatile businesses suffer under risk-based ratios and have also witnessed large exits: Societe Generale, one of the largest remaining European players in commodities trading, closed the unit in April. That followed pull-backs by Barclays from energy trading 2016, and Deutsche Bank from most physical commodities dealing in 2013.

The exodus from riskier business is reflected in the decline of market risk-weighted assets at the largest US banks (see figure 1).

Corporate lending – especially to small or unrated companies – looks unappealing under risk-based metrics, especially when standardised floors are introduced.

One capital manager at a foreign bank intermediate holding company (IHC) in the US says Stiroh has a point. “We are all stuck on the same feedback loop,” he says. “You end up crowding into the products that are capital-friendly, and we will never know what happens as a result of that, until it happens.”

With growth opportunities in developed markets scarce and concentrated, global banks are  striving to distinguish themselves among competitors, preserving some type of specialty and focus in their business, as they also satisfy regulators.

“The biggest failing is, you have to manage all that [prudential regulation] in terms of the vision and purpose of the company,” says Mike Rees, former deputy chief executive of Standard Chartered Bank. “That’s before we even talk about whether you manage that to a product line or a customer segment, you already have complexity there.

“If you don’t know what you are trying to be as a bank, you have nothing to anchor it to,” adds Rees, who now runs his own consultancy, Strategic Vitality.

Rees touches on one of the most intense debates: how fine-grained should capital allocation be? Should it be calculated at the unit level, at the team level, or even at the customer and trade level? 

If you don’t know what you are trying to be as a bank, you have nothing to anchor it to
Mike Rees, Strategic Vitality

Regulators have been adamant that regulatory capital requirements – the leverage ratio in particular – be applied at a consolidated level, instead of on an individual business line.

In reality, banks may limit capital to individual business lines because of constraints on the bank as a whole. Alternatively, they may charge desks a specific price for the use of money, using an internal transfer pricing model. The desk would then have to demonstrate it could earn enough to beat the internal price and justify its serving of capital.

This is especially true for any bank struggling to hit an RoE target.

“You are going to say if I don’t, on a marginal basis, do that repo business or make those low-risk mortgage loans, I will have a better return on assets and that will ultimately feed through into a better return on equity,” says Docherty.

The complexities are magnified for global banks, which may have hundreds, or even thousands, of legal entities in dozens of jurisdictions. Some of those may be treated as an extension of the parent company, but others – US intermediate holding companies (IHCs), for instance – must be capitalised on a standalone basis, at the local level. In such cases, the parent and subsidiaries could face very different regulations.

“We have two primary questions to solve for: one at a group level, to get into businesses globally. And secondly, if the business sits in an IHC, what are the local constraints, is there anything in that second set of constraints that tells us not to get into that business?” says the capital manager at the US IHC. “When we have global businesses booking in several local entities, it becomes a lot more complicated.”

Will it blend?

In the US, most large banks are using ‘blended’ capital measures, which meld the various regulatory capital metrics into a single figure.

The bank can then apply the blended measure either to impose hard capital limits on a business, or to assign each unit a blended cost of capital that serves as the foundation for setting return goals.

In their 2018 annual reports, five of the eight US G-Sibs explicitly mentioned using some form of blended regulatory capital measure, while Citi and BNY Mellon referred to internal economic capital calculations. Wells Fargo did not specify its method.

Capital managers say the blend is as much a judgement call as a calculation – one source says managers still want to see the breakdown of individual measures as well as the blend, and often place different emphases on different components.

The capital manager at the US G-Sib says the blend is likely to place greater weight on regulatory measures that are similar to those used inside the bank. The value-at-risk measure for market risk (which is due to be replaced with expected shortfall under Basel III) is used by risk managers as well as capital managers. Similarly, advanced internal ratings-based approaches to credit risk coincide fairly well with the bank’s own credit risk metrics. But he is reluctant to put too much emphasis on Basel operational risk capital methodology.

“The [op risk] models are heavily influenced by the crisis-era losses. We are not in those businesses any more, they are not relevant for our risk profile, and unfortunately the way the regulation works, our RWAs are heavily dominated by those losses, which don’t reflect our current risk-taking behaviour,” he says. “So in those cases, I would not heavily rely on those types of metrics.”

Strategic decisions

Banks can also modify the way the blend is applied to each desk for strategic objectives. Most lean towards using blended capital to set a return target and then allocate capital accordingly in the first instance. Hard limits on capital consumption are seen as more of a second-order tool to deter excessive concentration of risk, or desks sailing too close to management capital buffers.

When specific desks want to raise their capital allocation, the IHC manager says his first question is whether the capital can be put to work immediately, and at what extra profitability.

“If you are good in a business line, you are not going to not go after it,” he says. “You have to go back to your marginal utility of money in areas where you have the right people. It’s a combination of the rules and individual banks’ core competencies.”

This is where the broader strategy comes into play. Rees gives the example of Standard Chartered’s focus on small and medium-sized enterprises (SMEs) and its role in trade finance – he says the bank funds around 7% of global trade. 

“If you want to be an SME bank, you are going to have to be in trade finance. On a risk-weighted model, trade finance is very uneconomic, but you need to be in it to be an SME bank,” he says. “You have to make the macro calls about how it fits the strategy, can you make a return on the overall strategy at an aggregate level, and how do the individual parts contribute to that?”

You have to take into account the differences between different businesses, and say I’m going to charge you not the average for the group, but a specific amount for that business
Xavier Pujos, Sionic

Applying the average blended capital cost across every business equally may not be the right idea, says Xavier Pujos, a managing partner at consultancy Sionic and former head of resource management for BNP Paribas’s fixed-income division. 

“You have to take into account the differences between different businesses, and say I’m going to charge you not the average for the group, but a specific amount for that business, because I want to encourage that business or not,” says Pujos. “That’s fine, you effectively translate your diversification objectives into the right incentives for each unit to develop their business.”

If necessary, he adds, the transfer pricing for a specific business line can be raised to deter further expansion once its cash consumption has reached a certain level.

Or conversely, a bank may also want to go the extra mile to acquire and keep clients with attractive risk profiles and revenue potential.

“I would not say we change our behaviour in terms of servicing our client; we are very careful not to overreact to a certain segment because certain parts of regulation are negative,” says the capital manager at the US G-Sib. “We want to have a holistic view and a customer-friendly view.”

BNP Paribas’s Docherty sounds a note of caution on allowing too much discretion into capital allocation, especially where regulatory metrics are, in practice, the binding constraint for the bank.

He questions the logic of swallowing poor RoE on specific products or trades in the hope of generating additional revenues from the affected clients: “A lot of people struggle with measuring relationship profitability and revenue synergies.”

And he warns that European banks in particular tend to hold onto legacy “trophy businesses” and prestigious corporate clients that don’t generate much in the way of returns.

“The metrics can be quite complex, but it is probably the case that across the industry a large chunk of what goes on has real structural profitability problems,” says Docherty. “If that can’t be repriced and there are no ancillary revenues to justify it, then you have to ask why you are in this business.”

Hit the floor

European banks must still calculate economic capital, which is enshrined in the European Union’s internal capital adequacy assessment process (ICAAP), part of the Capital Requirements Regulation. Supervisors may impose Pillar 2 capital add-ons if the ICAAP is considered inadequate, or shows significant gaps between Pillar 1 regulatory capital requirements and the bank’s own assessment of risk.

“Banks in Europe are meant to run their own internal economic model based on historical behaviour. That can then show a completely different picture from the regulatory risk-rating measure,” says Rees.

And the divide between economic and regulatory capital is getting wider. In December 2017, the Basel Committee on Banking Supervision introduced a capital floor for banks using internal models, set at 72.5% of the standardised approach.

“Basel keeps adding those floors to undermine the economic reality of those models in favour of trying to get more comparable data between banks. The whole of Basel IV is trying to get consistency rather than alignment with economic value,” says Rees, using the industry nickname for the 2017 amendments to the Basel III rules.

Low-default exposures – for example, trade finance and mortgages in Netherlands and Nordic countries, where repossession rates are very low – are likely to be the most harmed by the floors. Loans to unrated corporations also fare poorly.

The changes will add to pressures on banks to exit low-risk businesses that drag on RoE.

Photo of Adrian Docherty
Adrian Docherty

“It is leveraging up on risk density – we are pushing people into greater risk density because some regulations have chased them out of low-risk areas,” says Docherty. “That is the impact of anything that is floor-based or standardised.”

To address this, many expect Europe to be forced to take the US approach, where a greater share of bank-originated assets are dispersed into capital markets via securitisation vehicles, like collateralised loan obligations. In April, Standard Chartered and nine other banks announced the creation of a trade finance distribution scheme, which will get these assets off their books and into the hands of investors.

But EU policy-makers have long been uneasy about the prospects of leaving smaller businesses exposed to the vagaries of capital markets, where funding conditions could dry up suddenly and the lender and borrower have no direct relationship. The alternative for European banks would be synthetic credit risk transfer trades, where the borrower remains the bank’s customer.

“Some [risk transfer] trades are getting done at a very attractive equivalent cost, because basically the market-perceived risk and the regulatory-perceived risk are so out of kilter. It is not a huge market, but it is definitely growing and it is material,” says BNP Paribas’s Docherty.

Effective capital planning is more than just a numbers game. To generate the desired results, capital planning teams must be attuned to the realities of the business lines, and vice versa.

For instance, a client with a solid credit rating may seem attractive from a risk-based capital perspective. But if traders know that client is aggressive in seeking prices from several dealers, and routinely moves the market against the dealer who picks up the trade, that’s a reason not to allocate too much capital to the relationship.

“Having the right governance to ensure the information circulates properly is critical,” says Pujos. “The banks where it works well are the ones where the strategy is promoted, distributed and pushed to all levels and understood at all levels – and the feedback loop comes back up very quickly if people have questions about the strategy.”

Those banks are in the minority. Most are still struggling to find an approach that can satisfy regulatory capital requirements and still deliver acceptable returns for shareholders. 

“I’d like to tell you we’d cracked the code, but we haven’t. Can we knowingly double down on something to catch up on P&L, or do we take the portfolio approach, try to diversify risk management and take the risk somewhere else? Or just forgo the opportunity?” says the capital manager at the IHC. “These are the kind of discussions we are having.”

The CCAR divide

The US Federal Reserve’s annual stress test, the Comprehensive Capital Analysis and Review (CCAR), is a divisive topic among capital managers. On the one hand, its integration into the capital allocation process offers a partial antidote to misaligned Basel calibrations.

“Like it or not, CCAR gives you a view of the riskiness of a portfolio, especially from a credit or traded risk perspective,” says the capital manager at a US global systemically important bank.

But factoring the results into business decisions can be tricky. The capital manager at a European bank’s US subsidiary says he avoids setting outright capital limits based on CCAR, which measures losses in extreme events, although he still finds it useful for setting return hurdles for specific business.  

“Do I decide not to push it that far out because hypothetically I could lose a lot of money? Or do I just recognise that the business takes up more stressed capital, and I ask for higher returns accordingly?” he says. “That’s where we get into a challenge in terms of are you really going to pass up an opportunity to make more money just because your stress-proofing is high? If you have ample capital, the answer is you are going to go for making money today.”

Another wrinkle is that the Fed changes its scenarios each year; elevating the level of stress in emerging markets one year, for instance, and commercial real estate the next. Interest rate risks can also vary dramatically: in 2018, the Fed’s scenario included a flat or upward sloping yield curve; in 2019, the yield curve sloped downward.

Ugur Koyluoglu, vice-chairman for Americas financial services at consultancy Oliver Wyman, suggests two approaches for smoothing the impact of CCAR when calculating capital budgets for individual business lines.

“One approach is to look at the CCAR allocations of different businesses in the past few years and allocate the average,” he says. “Or, alternatively, assuming the impact of CCAR is equal to a 375 basis points drop in capital ratio at the bank level, one could construct an allocation scheme that is actually going to follow the historically developed economic capital methodology at business or even more granular levels,” he says.

In other words, the overall capital depletion from CCAR’s severely adverse scenario is the same as the official outcome, but the distribution of it to more granular parts of the bank could be allocated based on the bank’s own internal risk calculations rather than the Fed scenario.

 

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