Return on Equity (RoE) is one of the most well used metrics employed by listed companies and investors as a method of communicating whether there is a “reasonable rate of return” on funds invested. The financial services industry is no exception in this respect. Nevertheless, there has been a recent backlash from European and international regulators to the use of not only the term itself, but the very reliance placed on the concept. The regulatory community is now challenging the assertion that RoE targets are an appropriate aim for the financial sector, and a relevant consideration in assessing the impact of the sweeping set of new international banking rules proposed by the Basel Committee on Banking Supervision (BCBS).
As all readers will readily agree, a reasonable rate of return is one of the principal pillars of a market-based economy. Although banking is only one of many possible sectors where investors can place their funds, it is the principal channel for maturity transformation and credit supply; through leverage, a dollar invested in banks can be transformed into $20 or $30 made available to the wider economy. There is concern that the cumulative and individual impact of the proposed new rules—referred to as Basel 3—is not only going to have unintended consequences for investors and the economy at large, but will also adversely impinge on emerging markets.
It is also important to bear in mind the delicate timing of these proposals. First, the USA and a number of emerging markets have not even fully implemented Basel 2 yet. Second, where Basel 2 has been implemented, e.g. in Europe, it has been done so differently. A notable example, several large continental European countries opt out of supervising institutions at Solo, and only look at the Consolidated level. This implies that some institutions are able to issue guarantees to their subsidiaries when these do not hold high enough levels of capital, whereas the Solo-supervised entities have to hold adequate capital.
The proposed rules were subject to a consultation that ended on 16 April 2010. The BCBS is now reflecting on the many responses submitted, with a view to issuing the final rules by the end of the year.
Assessing Key Issues
In regards to the definition of capital, the rules propose the clear distinction between Common Equity as “going concern” capital for Core Tier 1, and “gone-concern” capital in non-Core Tier 1, such as hybrid instruments. The proposals also entail the elimination of the distinction between Upper and Lower Tier 2 capital, and the elimination of Tier 3 as a recognized form of capital for regulatory purposes. These are all broadly sensible, so long as there is appropriate grandfathering of existing capital instruments. The exclusion of tax deductibility as a criterion for recognition as regulatory capital is also welcome.
One of the consequences of the distinction between “going” and “gone” concern capital is the proposal to write down the principal amount of non-Core Tier 1 instrument—or its conversion to Core Tier 1, if a trigger is breached. A temporary write-down would seem sensible, but a permanent write-down would put the holders of those instruments at a disadvantage compared to pure equity investors, whether in the event of liquidation or recovery. Furthermore, as discussed in my article in the March issue, the use of hard-wired triggers in a contingent convertible (CoCo) instrument could lead to a rapid downward spiral of market confidence in the institution as investors rush to exit their positions and counterparties cut the lines to the institution. There is every risk that this would be likely to outweigh any loss-absorbing feature of the instrument.
There is a political drive to implement leverage ratios across the industry, despite the fact that these were in place in some jurisdictions where institutions were central to the crisis and subsequent downturn. The question, therefore, is not whether there will be a ratio, but what purpose it would serve, and what assets are included in the definition.
It would seem sensible for there to be a “backstop” leverage ratio, which would serve as an additional indicator for supervisors. For this reason, the industry is broadly supportive of including such a ratio in the reporting and monitoring requirements under Pillar 2 of Basel. However, there is pressure in some quarters of the regulatory community to include it under Pillar 1, which would hardwire it into an institution’s capital structure, rather than leave it to regulatory discretion. The key to addressing the different positions might be by ensuring that a) derivatives are included, after netting and credit risk mitigation and b) it is applied universally, including to US firms. It would also seem sensible to use “going concern” Core Tier 1 capital as the measure in any definition of leverage.
As regards counterparty risks, regulators are concerned about the ability of institutions to adequately assess their exposure to any individual risk, and therefore have proposed a crude capital add-on, derived using a bond-equivalent as a proxy for Credit Valuation Adjustment (CVA) risk. There are a number of serious objections to this; first, on a ready calculation, the add-on seems to be considerably in excess of the underlying risk; second, banks that do not use market-implied adjustments, but historic Probability of Default movements, are not exposed to volatility in CVA, and the bond-equivalent would not address the risk appropriately for these banks. Of most concern, however, is the fact that many counterparties, especially in the “emerging” markets are not traded, and would leave banks having to use proxies such as credit indices. This would not only add basis risk to the bank’s exposure, but also result in an increased correlation of risk, as all banks would have to use the same indices.
A second proposal would entail an indiscriminate multiplier for large financial institutions, and in relation to an increased scope of exposures, including those inherently low risk facilities that support trade finance. The result would be to disproportionately impact the better-rated counterparties, which could see business driven to smaller and less well-rated institutions, as well as reducing the incentives of banks to engage in trade finance. Both these proposals will also effectively move risk outside the regulated system, which was part of the reason why this crisis came about.
There seems to be little doubt that, despite the range and depth of concerns expressed about some of the proposals, not only by the financial services industry itself, but also by many other interested parties, political pressure will ensure that the BCBS pushes through even some of the more obviously unwise elements. The reason is simple: They fear that if they do not do it now, the impetus for change will fade. What that will do to RoE remains to be seen.
Edward Bowles - Head of Public Affairs, Europe, at Standard Chartered Bank. The views expressed here are his own and do not necessarily represent the views of Standard Chartered.
