A majority of banks could see reduced capital requirements under the optional Basel II Standardized Approach. Some, however, would be required to hold more capital. Here’s why.
By Geoffrey Rubin, Ph.D. and William Nayda, Ph.D. The authors are principals at Second Pillar Consulting, a firm that helps community, regional, and super-regional banks comply with Basel II. They can be contacted at
A majority of banks could see reduced capital requirements under the Basel II Standardized Approach—some, however, will need more capital
Bankers could be forgiven if they had a few misconceptions about the new Basel capital rules. Even calling them “new” seems odd considering they have been in development for almost a decade with various versions being proposed, then withdrawn or reworked.
Many small and midsize banks also have been alarmed by the prospects of being at a competitive disadvantage to the largest banks that will use the full-scale Advanced approach of the new Basel rules.
But as the long-running Basel saga nears its climax, these smaller banks may in fact have reason to cheer, as we explain in this article. First, a little background for those who haven’t kept up with the Basel progression.
The two flavors of Basel II
The Basel II Accord represents the efforts of global bank regulators to update bank capital regulation and better capture true risk exposure. Basel II identifies three core principles or “pillars” of sound capital regulation. Pillar One establishes minimum capital requirements with more complex and risk-sensitive risk-weights than the current regime has, and also includes a new capital requirement for operational risk. Pillar Two enhances the role of supervisory oversight in setting capital standards. U.S. banks are well-accustomed to supervisory oversight in all areas of operation, but Basel II extends this relationship and requires a formal demonstration of risk management and capital adequacy. Pillar Three requires heightened disclosures that allow the market to better judge capital adequacy. Together, the three pillars of Basel II represent regulators’ best attempt at judging and managing bank capital in a world of increasing complexity.
Two distinct flavors of Basel II are available in the U.S. The Advanced version, with its complex formulae and burdensome risk architecture demands, has garnered press and industry attention, but the vast majority of compliant U.S. institutions will ultimately adopt the simpler Standardized approach. The Advanced approach is mandatory for the largest dozen or so banks, while the Standardized approach is voluntary—banks and thrifts have the option of continuing to use the current rules (Basel I).
Based on our analysis, adopting the Standardized rules could make sense for many institutions.
On June 26, the four federal bank regulatory agencies released a Notice of Proposed Rulemaking (NPR) that anticipates the application of Standardized Basel II in the U.S. The proposed Standardized rule is detailed in the NPR; regulators will issue a final rule early next year, after digesting public comment on this interim document. NPR rules are subject to change, but they convey clear regulatory intent and are typically enshrined in the final rule with only minor modification.
We estimate that half of the 7,500 banks and thrifts in the U.S. will see regulatory capital savings of at least 4.5% by adopting the Standardized approach, and a quarter will save at least 8.6%. However, 22% will not see any capital benefit. The remainder of this article identifies the characteristics that separate winners and losers under this regulation.
Lower risk weights for many assets
Pillar One of the proposed Standardized rule establishes a slightly revised means of calculating the Tier 1 and Total risk-based capital ratios. Table One compares the current and proposed Standardized risk-weights for a variety of exposures. The preponderance of assets held by most U.S. institutions—first and second lien mortgages, consumer loans, and small-ticket commercial and industrial and commercial real estate loans—have lower risk-weights under Standardized Basel II. Delinquent assets, short-maturity commitments, and ABCP (asset-backed commercial paper) liquidity facilities are among the few asset classes that require more regulatory capital under Basel II. For example, the 20% risk-weight currently drawn by FHA and VA mortgage loans are not risk-weighted under Standardized. This represents significant capital savings for an asset class championed by recent federal legislation. (See Briefing, p. 7.) Overall, Standardized risk-weights represent a material capital savings over existing rules
One particularly important element of Table One is the new risk weight for C&I and CRE exposures smaller than $1 million. Standardized Basel II assigns a 75% risk-weight to assets in the “regulatory retail” category, a group that includes not just traditional consumer loans but any exposure (other than residential mortgage) smaller than $1 million, so long as it is managed within a well-diversified portfolio. One can only speculate on how regulators will ultimately assess portfolio diversification, but we assume here that all C&I and CRE exposures under $1 million in size will qualify for regulatory retail treatment and the lower risk weight. Given that small-ticket C&I/CRE makes up 22% of the median bank’s balance sheet, the ability to demonstrate portfolio diversification is critical.
The offset: operational risk
This Basel II capital advantage is somewhat offset by the introduction of a capital charge for operational risk that does not exist under Basel I. The operational risk capital charge serves to cover unforeseen loses that might arise due to failed systems and processes, fraud, human error, or natural disaster. Under the Advanced version of Basel II, banks calculate this charge with complex models and varied data sets on operational events and controls. The Standardized version takes a far simpler approach—the operational risk capital charge is a multiple of trailing three-year average gross income (the sum of net interest income and non-interest income).
Profitability might seem a perverse proxy for operational risk. Banks with large processing units might have proportionally higher profitability and larger operational exposures, but the link seems tenuous. In fact, one could argue that the internal pressures faced by less profitable banks will increase the likelihood of operational failure. Nonetheless, the proposed Standardized rule is quite clear: more profitable banks must hold more capital. Depending on the institution’s balance sheet, the capital savings of lower asset risk-weights may or may not outweigh the additional operational risk capital levied against profits.
To assess the overall impact of Standardized compliance, we built a model that calculates prospective capital requirements for each U.S. bank. We culled most of the necessary bank-specific data from publicly available 2008 first quarter call report, Y-9, and TFR (thrift) filings, though we make assumptions when the Standardized rule requires information not currently disclosed by banks. For example, existing call reports list each bank’s total first lien mortgage exposure but not the proportion of this exposure that falls into the various Standardized loan-to-value buckets shown in Table Two.
The Standardized calculation also a) consolidates senior and junior liens a bank might hold on a single property, absent any intervening liens held by others, and b) reflects third-party insurance obtained on the mortgage, further complicating any attempt to derive bank-specific estimates of LTV distribution.
So for the purposes of estimating Standardized capital impact, we assume that the LTV distribution at each bank mirrors the industry distribution shown in Table Two (data derived from the Federal Reserve’s 2004 Survey of Consumer Finance). As shown in this table, the industry weighted-average risk weight for first-lien exposures is 34%, a significant reduction from the 50% risk weight required by current rules. Banks that skew towards lower or higher LTV mortgages will enjoy greater or lesser capital savings than we estimate here.
We caution that the actual capital required of banks that ultimately comply might differ from our estimates for a number of reasons: the industry-level assumptions we make in the absence of certain bank-specific observations might not accurately reflect a particular bank’s balance sheet, the balance sheet of record when banks ultimately comply will differ from the 2008Q1 snapshot used here, and the final rules might vary slightly from those in the NPR. But we believe that our model quite reasonably anticipates Standardized Basel II capital requirements for U.S. banks.
Results for one small BHC
Detailed model results for a sample bank, Mercantile Bancorp of Quincy, IL, are shown in Figure One (p. 52). Mercantile is a $1.7 billion bank with typical Standardized capital savings. Figure One shows the capital savings contributed by each asset class. Mercantile has a relatively balanced portfolio, with all four major portfolios—first lien mortgages, consumer, small commercial, and small C&I—providing significant capital savings.
These contributions are partially offset by the new capital requirements for operational risk, short-term commitments, and delinquent loans. Compliance alone, without any other balance sheet changes, would increase its total risk-based capital ratio from 10.3%—a figure perilously close to the 10.0% minimum for “well-capitalized” status—to 10.8%.
Alternatively, Mercantile could preserve its existing 10.3% total risk-based capital ratio and return the $6.2 million in capital savings to shareholders, by either issuing a special dividend of 71 cents per share or by repurchasing 365,000 shares at $16.90 per share (as of the 7/29/2008 closing price). The latter strategy would increase their earnings per share by five cents, again without diminishing their risk-based capital ratios.
Finally, Mercantile could use the regulatory capital windfall to underwrite an additional $71 million in organic growth while maintaining its current 10.3% total risk-based capital ratio. These are the fruits of Standardized Basel compliance.
More gainers than losers
Table Three (p. 48) similarly decomposes capital savings for the entire industry and provides summary statistics for the 7,629 U.S. banks in our sample. The median bank sees a 4.5% increase in capital, and a quarter of the sample reap benefits of 8.6% or more. Fully 1,000 banks enjoy gains of 11.6% or more. On the other hand, almost a quarter of all banks see a decrease in the capital ratios under Standardized. Remember, though, that Standardized compliance is voluntary, so we would not expect to see these banks comply unless they had other compelling reasons (or were compelled by their regulator) to do so. In total, over 5,900 banks enjoy a capital benefit under the Standardized approach; the total potential capital savings for this group is $31 billion.
Median capital savings vary somewhat by region, charter type, and bank size. Table Four shows the median capital savings for institutions in each of the six FDIC regions. The median savings of 7.9% for the 954 banks in the New York region greatly exceeds the 1.8% savings enjoyed by banks in the Kansas City region. Table Five shows that thrifts receive greater capital relief than banks.
Table Six shows that the benefits of Standardized compliance fall somewhat unevenly across the size spectrum, with the smaller institutions enjoying less capital relief than institutions with assets in excess of $100 million.
Capital differences explained
The Standardized rule makes no distinction by geography, charter type, or asset size, so what can account for the differences in capital benefits shown in tables four through six? Differences in asset composition and profitability separate capital winners and losers under Standardized Basel II. Table Seven, for example, breaks banks into quartiles by the proportion of their loans that are first-lien mortgage exposures. The lowest quartile of banks, those with less than 6.4% first-lien mortgages, enjoy only 2.7% median capital savings, while those in the highest quartile, with portfolios comprised of more than 22.1% first-lien mortgages, have median capital savings of 6.5%. Similar analysis shows that the portfolio concentration of small-ticket C&I and CRE also drives capital savings.
Profitability is the other key determinant of Standardized capital savings. Table Eight shows the impact of gross income margin on capital quality. Top quartile banks, or those with gross income margin of more than 4.5%, receive a median benefit of just over one percent, while the least profitable quartile, banks with less than 3.1% gross income margin, enjoy a median capital benefit of 9.3%. As mentioned earlier, the profitability proxy for the operational risk capital charge drives this result. In fact, after accounting for differences in asset composition and profitability, the regional, charter type, and size differences shown in tables four through six disappear.
Why capital relief may be illusive
At this point, readers would be forgiven a strong skepticism of regulators’ willingness to allow $31 billion of capital to up and leave the system, particularly in the current environment. Will regulators grant capital relief to any bank that raises its hand? The answer, of course, is “no,” and Pillar Two provides the mechanism for corroborating, slowing, or even reversing any capital benefit realized under Pillar One.
Pillar Two empowers regulators to review Pillar One calculations and any other pertinent institutional information in setting a final capital requirement. The centerpiece of Pillar Two is the Internal Capital Adequacy Assessment Process, or ICAAP. Banks that wish to comply with Standardized Basel II must produce a comprehensive document of 50 or more pages that demonstrates the quality of risk management, reliability of internal controls, and adequacy of the bank capital position. Economic capital modeling, stress testing, peer benchmarking, and scenario analysis are among the tools that regulators expect to find in the ICAAP.
Pillar Two brings a richness to capital regulation that Standardized Basel II might otherwise lack. Unlike the Advanced version, Standardized capital calculations are technically simple, perhaps no more difficult than under Basel I. Pillar Two is where the regulators seek evidence of a genuine commitment to thoughtful capital management. Pillar One opens the door to capital savings for many, but only those demonstrating strong risk management philosophy and capability will be allowed through.
The Basel II table stakes also include the heightened reporting requirements of Pillar Three. To qualify for Standardized capital savings, banks will need to provide a range of quantitative and qualitative information described in Table Nine (p. 52). This list might appear intimidating, but many items do not pertain to smaller banks. In addition, banks already disclose much of this information, but it will be consolidated and annotated in a fashion that heightens public scrutiny of the risk of bank portfolios and operations. BJ
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