core capital ratio as proportion of risk-weighted assets mandated under Basel III by 2019
Falling income and lack of cost savings since the financial crisis of 2008 are pushing the European banking sector to a tipping point; in the face of a blizzard of regulation, decisive action is needed to avoid profitability falling to a level where banks risk consolidation or takeover
Banks in Europe have never operated in such an inhospitable environment. Demands from regulators are crippling banks’ ability to do business, just as they face a growing threat from non-traditional rivals unencumbered by legacy systems and burdensome regulation, including digital companies and captive banks.
At the root of the current pressures is the introduction of Basel III, under which banks are obliged to significantly increase their core capital ratios to at least 18.5% of risk-weighted assets by 2019. Even outside the constraints of regulation, banks have become much more conservative and have significantly reduced risk appetites.
Of the two ways for banks to build up the high quality capital buffers demanded by regulators – either raising more capital or decreasing the size of their balance sheets – banks generally chose the latter.
Banks in Europe have seldom operated in such an inhospitable environment. On the one hand copious demands from regulators are crippling their ability to do business , whilst on the other they face a growing threat from non-traditional rivals unencumbered by legacy systems and burdensome regulation. These include digital companies and captive banks. Banks have taken some action, but there are still difficult decisions to make. To better navigate this environment, banks need to understand their options. This process begins with the awareness of where they stand in relation to other banks.
To offer this crucial guide for banks, the BearingPoint Institute conducted an analysis of 156 banks’ financial information between 2009 and 2013, including assets, risk weighted assets (RWAs), interest income, net fee and commission, operating costs, general and administrative costs, staff costs, Tier 1 capital ratio and cost-to-income ratio.
Banks were divided into three groups sorted by asset amounts as at 2013, allowing a granular view of specific attributes for each size of bank. Using technical analysis, BearingPoint reveals that, whilst there is a wide degree of variation between banks of different sizes and in different regions, detailed benchmarks and trend highlights can help banks see their current positions and plan their strategies.
At the root of the current pressures is the introduction of Basel III: the regulation, supervision and risk management framework for banks.
Under Basel III, banks are obliged to significantly increase their core capital ratios to at least 18.5% of risk-weighted assets (RWAs), which are used to calculate the capital requirement (Capital Adequacy Ratio or CAR) by 2019. This burden is intensified by enormous political pressures for banks to become safer. Even outside the constraints of regulation, banks have become much more conservative and have significantly reduced risk appetites.
core capital ratio as proportion of risk-weighted assets mandated under Basel III by 2019
Still, this conservatism seems inadequate for regulators determined that there should never again be another major financial crisis. One of their main safeguards is to press banks to hold higher levels of capital in the form of high-quality assets such as low-yielding government bonds.
The European banking market was expected to face problems in meeting stricter Tier 1 capital requirements. Surprisingly, banks are on course to do this, but of the two ways for banks to build up the highquality capital buffers demanded by regulators – either raising more capital or decreasing the size of their balance sheets – banks generally chose the latter.
Balance sheet shrinkage has not been accompanied by costs falling at a similar pace, leaving many banks with dwindling profits
Unfortunately, balance sheet shrinkage has not been accompanied by costs falling at a similar pace, leaving many banks with dwindling profits.
This has helped create a vicious circle whereby banks reduce their assets but are left with a similar level of costs, which then constrains their ability to invest to create growth.
For banks, this spiral of stagnant costs and falling profits is clearly unsustainable. As authorities’ demands continue to increase the problems may even worsen.
In this article we analyse the stages in the spiral in detail, consider three scenarios in which banks have found themselves and the actions that might be appropriate in similar circumstances, and provide a checklist of questions to help frame thinking about your own situation.
Based on data acquired from the FT – TheBankerDatabase.com, incorporating approximately 400 European banks, BearingPoint conducted an analysis of important financial information of banks, addressing assets, risk-weighted assets (RWAs), interest income, net fee and commission, operating costs, general and administrative costs, staff costs, Tier 1 Capital ratio and cost-toincome ratio.
The data was first narrowed to a final sample of 156 banks, which was subsequently analysed by investigating fundamental values as well as by developing value relations. This enabled BearingPoint to gain significant insights into how the values behaved between 2009 and 2013. By allocating the banks into three groups, sorted by asset amounts as at 2013, a more detailed view on specific attributes for each size of bank was derived. Using technical analysis, BearingPoint revealed important insights on the business of banks as well as about their challenges, risks and discovered potential solutions to these issues. Combined with BearingPoint’s expertise, knowledge and experience, a unique and crucial guideline for banks was developed.
Increased capital requirements leave banks with a difficult choice
Among the many regulatory headwinds that have been blowing across the banking landscape since the financial crisis of 2008 (box out), Basel III exerts the greatest pressure.
The Basel III rules, which deal with the regulation, supervision and risk management of banks, were adopted by G20 countries and are being translated into the European Capital Requirements Directive IV. This in turn will be transposed into national laws in individual EU countries. The rules apply to all credit enterprises and institutions that conduct deposit-taking and lending, and aim to tackle the systemic risks that led to the 2008 bailout debacle.
Intending to encourage banks to hold higher levels of high-quality capital such as low-yielding government bonds, Basel III demands that they increase their core capital ratio to at least 18.5% of risk-weighted assets (RWAs) by 2019. This leaves them with two options: to increase capital or to decrease assets. Given the strict deadlines and difficulties raising capital, many banks are choosing the latter route.
Across the board, the regulation that has squeezed banks is increasing. The year 2015 sees the introduction of the Basel III Liquidity Coverage Ratio (LCR) and a further observation period for the Net Stable Funding Ratio (NSFR). Other measures include disclosure requirements relating to the leverage ratio and the implementation of minimum common equity and Tier 1 capital ratios.
Banks also need to prepare to implement other regulatory requirements scheduled for 2016 and beyond. A blizzard of regulatory initiatives with relentless deadlines blowing in between now and 2019 means that, even if regulators delay some of the implementation dates and water down some of the rules, the scale of the task remains enormous.
reduction in risk-weighted assets (RWAs) for German banks between 2009 and 2013
Banks have focused on meeting the Tier 1 capital ratio requirements by reducing their risk-weighted assets and total assets (note 1) . RWAs decreased in all groups on average by approximately 12.4% from 2011–13. However, a more varied picture emerges when looking at RWA for each country between 2009 and 2013:
When considering the Tier 1 capital ratio to RWA development per group between 2011 and 2013 it is noticeable that an increase of the ratio has taken place. The increase is mainly attributable to the higher RWA reduction rather than the slight increase in Tier 1 capital.
Banks have focused on meeting Tier 1 capital ratio requirements by reducing riskweighted assets and total assets
decline in interest income among analysed medium-sized banks between 2009 and 2013
Considering the total asset development, BearingPoint developed the theory that reducing total assets was a strategic decision to meet the regulatory requirements.
When analysing the European banking sector, we initially expected to see total assets drop soon after Lehman Brothers’ bankruptcy in 2008. In fact that drop only happened after 2011, with assets continuing to increase until that point (note 2). All banks across Europe have started to reduce their total assets in the last three years by about 11.2%. This implies that the reduction of total assets has occurred faster that the reduction of RWAs.
The overall shrinking of the balance sheet means that, in the past two years, banks (especially small and large banks), have begun to hold a higher percentage of RWAs, which is counter-productive. A reduction of total assets is no guarantee of an equivalent drop in RWAs so banks can no longer rely on this strategy.
Despite individual differences, the general picture is of a smaller asset base which, along with a growing threat from non-traditional competitors (box out) restricts banks’ opportunities to generate revenue. This in turn narrows banks’ options in generating profit and meeting regulatory requirements.
Banks generate income from net fee and commission income and interest income. The impact of a shrinking asset base can be seen on both these income sources, with historically low interest rates also affecting the latter.
And a varied downward trend can be seen for interest income:
The drop in interest income can be linked back to RWA reduction. These riskier assets, which also yield higher returns, have been sold off to grateful less risk-averse competitors, such as hedge funds.
decline in interest income among analysed small banks between 2009 and 2013
Just as their revenue opportunities have dwindled, nimble competitors have emerged looking to muscle in on traditional banking business.
Hedge funds have become lenders to corporates, for instance, and many corporates have established captive banks to support the sale of their products (note 3).
Captive banks of car manufacturers, such as BMW (see related story on page 100) [note 4], Mercedes, Toyota and Volkswagen have entered the market for automotive loans. Even metals engineering firm TRUMPF was recently granted a full banking licence: in future the company will be able to provide finance to its customers to help fund purchases of their products (note 5).
Many of these new operations benefit from lower costs. As these corporates are typically not deposit-takers, they have a narrow product focus and are not weighed down by the same heavy regulatory burdens as banks.
Banks’ margins are being eroded by these competitors, putting more pressure on banks to focus on profitable products that provide income.
Earnings are only half the story. Becoming lean can drive up profits too. Banks should be aiming to keep operating costs low: ideally, relative to RWAs, they should be falling.
Instead we are seeing a steady increase in operating-coststo-RWA ratio for all banks. With RWAs expected to drop further, banks should try to stabilise the ratio by reducing operating costs.
Staff expenses are a significant issue
Staff expenses represent a substantial cost in banks’ existing business models. Any change in business model will need to reconsider staffing levels and composition.
The costs related to staff expenses have been subject to different pressures:
This reduction in assets could suggest greater effort by banks to respond to the regulations, competitive threat and/or mismanagement of personnel or matching staff to the right tasks. Other problems may be arising from age, skills or training.
General and administrative costs are rising steadily
When general and administrative costs are considered together with staff costs, the problem is compounded.
Whilst the general and administrative expenses for small banks stayed stable from 2010 to 2013, they increased for mediumsized and large banks by 9.5% and 5% respectively.
Large banks saw a continuous increase in these costs, to the point where they are equivalent to almost three-quarters of staff expenses. The need to reverse this trend is clear.
average fall in operating costs identified in research, putting pressure on banks’ CIR
The cost-to-income ratio (CIR) is a useful indicator of banks’ efforts to create return relative to their benefits. Looking at both costs and income and then bringing these together helps to build a clear picture of the past, the present and the possible future outlook for banks.
Our research found that average operating costs have been stagnant, falling only 0.01%, which puts pressure on banks’ CIR. One reason for this mismatch arises because the disposal of a loan portfolio can be done relatively quickly, but reducing associated costs takes longer.
The three biggest cost positions of European banks – operating, general, and administrative and staff costs – are crucial components of the CIR. Generally speaking, the problem with liquidating assets, such as loan portfolios, is that this raises the CIR. Costs are already uncomfortably high for many banks, and selling more assets will merely raise the CIR to the point of becoming unprofitable.
increase in general and administrative expenses for mediumsized banks 2010 –13
We have developed three typical scenarios in which banks may find themselves. For each scenario below we suggest a possible course of action to help reverse the downward equity spiral. And the selfassessment checklist opposite will help you decide which is most appropriate for your own situation.
Bank has successfully reduced its risk-weighted assets (RWAs) to achieve the Tier 1 capital ratio, but income has decreased, due in part to declining private and corporate banking performance. The forecast for operating profit in subsequent years is not particularly positive.
Bank has only partially reduced its RWAs and the Tier 1 capital ratio is still outside the target range. Costs and processes have not been optimised and commission and net fee income has decreased substantially in recent years.
Bank has successfully reduced its RWAs to achieve the Tier 1 capital ratio, but costs to meet regulatory requirements are growing significantly, and the current CIR is 85%.
There is still a short window of opportunity to turn the situation around. Banks need to commit to greater automation, create more inter-departmental cooperation, reduce operating costs and modernise their business models.
Bank management teams must move away from being too heavily focused on compliance challenges and also make it an urgent priority to develop new sources of profitability. They also need to reduce their cost bases more quickly, to catch up with the large reductions made to RWAs.
The appropriate management of operating costs is crucial. Banks’ operating costs are relatively high, so decreases could offer wiggle room for important decisions. A stabilisation of RWAs and a decrease in general and administrative expenses should be primary goals in the short- to medium-term. The reduction of costs has been positive, but banks might find external assistance helpful in avoiding the same mistakes that marred big banks’ initial reductions in assets.
Cuts, however, will not be enough – investment is needed. Greater automation of business processes can bring down staff costs, but more proactive spending to evolve business models is the only way to meet regulatory requirements and to take the fight to competitors.
Bank management teams must move away from being too heavily focused on compliance challenges
Although banks have been investing to match the pace of the onslaught of new rules, most are only just keeping up. Instead of fretting over this cost, banks could view it as a positive incentive to upgrade IT systems and change compliance processes to keep up with competitors. Digital platforms, for example, are becoming more popular with customers, but the adoption of these also has other advantages. Data about users can be used to analyse customer trends, from which valuable market insights can be developed. This data can also help appease regulators, who want banks to improve their reporting systems and to have a better grasp of their own risk profiles (see our paper on regulatory reporting).
Improvements in technology can help in other ways. A harmonised IT architecture means better sharing of data across banking divisions, making it easier to cross-sell targeted products to existing corporate and retail customers. Adopting a digital foundation layer is a pre-requisite (see our paper on the connected digital economy note 6).
Existing relationships and infrastructure can also be leveraged through bundled services in the same way that telecoms companies encourage customers to buy mobile, fixed telephony, internet access and television subscriptions in one package.
Developing existing relationships could offer significant improvements to banks’ prospects, with a focus on basic client needs
Banks need not suffer ’death by a thousand cuts’. In the face of agile competitors (box out), banks’ strengths should not be overlooked. Banks have a much longer history and a deeper connection with the economy, typically servicing many different clients across a much wider spectrum of products. From an economic perspective, banks are still vital in channelling savers’ money towards those that need to borrow it, especially in Europe, and are also in a strong position to evaluate the viability of investments made by their clients.
Developing existing relationships could offer significant improvements to banks’ prospects, with a focus on basic client needs – short-term borrowing, bridging finance, mortgages and so on – to provide more innovative and customer-oriented products and services. Selling expertise is an area where banks can generate extra revenues across many business lines.
Banks find themselves at the eye of a storm that shows no sign of abating. By assessing their current position and outlook against the benchmarks and trends we have identified, banks have the opportunity to take action to protect themselves from inclement weather in the future.