Banking StandardsWritten evidence from the Association of British Insurers
The UK Insurance Industry
The UK insurance industry is the third largest in the world and the largest in Europe. It is a vital part of the UK economy, managing investments amounting to 26% of the UK’s total net worth and contributing £10.4 billion in taxes to the Government. Employing over 290,000 people in the UK alone, the insurance industry is also one of this country’s major exporters, with 28% of its net premium income coming from overseas business.
Insurance helps individuals and businesses protect themselves against the everyday risks they face, enabling people to own homes, travel overseas, provide for a financially secure future and run businesses. Insurance underpins a healthy and prosperous society, enabling businesses and individuals to thrive, safe in the knowledge that problems can be handled and risks carefully managed. Every day, our members pay out £147 million in benefits to pensioners and long-term savers as well as £60 million in general insurance claims.
The ABI
The ABI is the voice of insurance, representing the general insurance, protection, investment and long-term savings industry. It was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK.
The ABI’s role is to:
Be the voice of the UK insurance industry, leading debate and speaking up for insurers.
Represent the UK insurance industry to government, regulators and policy makers in the UK, EU and internationally, driving effective public policy and regulation.
Advocate high standards of customer service within the industry and provide useful information to the public about insurance.
Promote the benefits of insurance to the government, regulators, policy makers and the public.
Main comments
1. The reform of the banking model is an important process that needs to be completed and we are grateful for the opportunity to comment on the Bill. We fully support the intention of the Government that the banking sector should not be subsidised by taxpayers and that banks must be resilient and resolvable. Structural reform has an important part to play in achieving this and in making UK banking sector efficient, competitive and stable. It is important that banks should be able to return to operating efficiently in their central role of providing finance to business and retail customers to support growth through the channelling of savings and the productive use of their capital resources. It is essential that the legislative proposals are specified in a manner that ensures the greatest chance of achieving these economic objectives.
2. Making banks an investable proposition is an inescapable part of this process. It is also necessary in order to provide an exit route for the Government, on behalf of the UK taxpayer, to achieve a sale of its banking sector shareholdings. It is of particular significance to our members as major investors historically and prospectively in UK banks. We are preparing a report on the investability of UK banks for completion by the end of November and we outline the progress to date on this in the document which follows. Our preliminary conclusions and observations on these financial aspects of investability are:
Asset value uncertainty, Eurozone risks and mis-selling investigation are all weighing on investor confidence, reflected in very low share price: tangible net asset values. However, regulatory “opacity” also remains a significant investment risk for investors.
A robust banking ROE is beneficial for the wider economy and not just equity shareholders. A robust ROE boosts internal capital generation, which in turn supports additional loan capacity, augments core tier 1 capital, i.e. loss absorbing capacity, and creates dividend distribution capacity. Banks are inherently more highly geared, with greater earnings cyclicality, compared with corporate non-financial companies. It therefore follows that investors should be compensated for the increased risk in the investment and a bank’s Cost of Equity will reflect this.
By contrast, failure to achieve at least cost of capital across the cycle is likely to lead to banks’ businesses being unsustainable in the longer term and will inevitably constrain asset growth and lending to the wider economy.
Dividends remain a key signal of management confidence and will be interpreted as an indicator of regulatory rehabilitation. Banks’ management across the entire sector need to articulate a dividend policy to investors with the confidence and backing of regulators.
The Basel 2-IRB approach to risk-weighting has become too complex and susceptible to individual bank interpretation, which distorts any inter-bank comparison by investors. A return to a simpler risk based measurement system, or improved disclosure of the “bridge” from gross assets to RWA, should be considered.
Universal banking is not viewed by most investors as an inherently broken model. Whilst accepting that it will happen, investors so far are unconvinced about the real benefits of ring-fencing and/or separation and are sceptical about the benefits relative to the operational costs and disruption.
Isolation of higher risk trading books may be better achieved via a Liikanen/Volcker approach rather than an ICB approach. Higher risk trading books are already being unwound in response to Basel-3 and ahead of any ring-fencing legislation.
Ease of resolution may be better achieved by marginally higher core tier 1 ratios determined by portfolio mix.
The risk-return of additional loss absorbency or bail-in capital is confusing the market and requires clarification.
For debt investors:
there has been a significant move towards secured funding rather than unsecured;
the longer-term implications of this for the costs of unsecured debt funding and the effectiveness of bail-in remain unclear.
There are some concerns that a requirement to maintain a certain level of bail-inable debt (effectively “Tier 3 capital”) could cause difficulties if the average tenor is, say, five years and so an amount needs to be “rolled over” each year. A failure to roll over, or roll over on unattractive terms, could itself undermine confidence in the bank.
In the absence of significant incremental demand for bank equity, instruments such as Cocos, which offer “near-equity” returns on a fixed income basis, are attractive to a number of investors. However, differentiation in terms of cost—and so maintaining a viable capital structure, mean that tax deductibility is viewed as essential. In addition. Cocos do not account as Core Tier 1 and “gear” the equity further and so may have longer-term negative effect on the ability of a bank to achieve a sustainable ROE and so, in turn, on equity demand.
Observations on other aspects of the proposals
Delegated powers and accountability and the ring-fence
3. The key theme to whole reform package, as initially developed by the Independent Commission on Banking under Sir John Vickers, is ring-fencing. Of particular significance are the parties that ring-fenced banks can have commercial relationships with and the governance structures that are necessary to safeguard independence while allowing overall group structures and accountabilities to operate effectively. It is essential that the design parameters be got right. However, given that many details are still to be properly nailed down and international environment continues to evolve, this imposes significant challenges as regards legislation at this early stage.
4. We are not comfortable with the “enabling” nature of the legislation, nor with the extent of the response by Government to the consultation on the White Paper where conclusions have not been reached on key matters of importance. We think a clear commitment to further consultation on the elements of any eventual secondary legislation is required.
5. Considerable reliance is still proposed to be made on the nature of counterparties with which a ring-fenced bank may contract as opposed to the nature of the activities it may engage in. The White Paper proposed substantial restrictions on insurance companies and on investment firms, funds and fund management companies and non ring-fenced banks. HM Treasury’s “Sound Banking” paper outlined the objections of many respondents to this view, including that transactions with insurance companies should not be prohibited since they are unlikely to transmit financial shocks to the ring-fenced bank. It is disappointing that the Government has as yet been unable to reach a view on this but is proceeding with legislation that would enable them to enforce such a prohibition.
6. We consider that the ability of banks to sell insurance—or indeed to take out insurance themselves –is fundamentally necessary for the banks to conduct their business. It is the nature of the transaction that is relevant. If it does not create prudential [balance sheet/market] risk, or indeed is a transaction designed to hedge business risks, then it should be entirely reasonable to permit, indeed facilitate, such exposures. It is necessary for this principle then to be defined in a manner suitable for its application within the regulatory framework. This, together with financial conduct aspects of the sale of investment products, should be matters for regulatory supervision of the bank concerned. Restrictions here would actually reduce the resilience of the banking system by preventing them from passing on risks that insurers are better placed to carry.
7. We believe that these are all matters which should be resolved during the passage of the Bill and the principles by which future restrictions may be imposed carefully defined.
Governance of ring-fenced entities
8. The broad design of governance arrangements as proposed in the White Paper we think is workable. However, a key unresolved question is the extent to which the board of ring-fenced entities may be composed of independent non-executive directors at group level who are treated as holding an analogous status at the level of the ring-fenced subsidiary. If they may be so treated it is right that a majority of the board should be independent though we consider that the board might still need to include at least some individuals who are wholly independent by virtue of having no relationship to the group and who should provide an independent safeguard of the interests of those with whom the ring-fenced bank has a business relationship.
9. We think that model would be operational, and balanced and reasonable, for a relatively broad specification of the ring-fence. Accordingly, we support the suggestion in the White Paper that firms whose business is predominantly conducted from within the ring-fenced entity should have exemptions from the more rigorous specification of independent governance. It is important that directors of each board within the group, whether at holding company or subsidiary level, are able to take unfettered decisions on what is in the best interest of the company concerned, bearing in mind its regulated status. It is also important that the holding company, as owner of its subsidiary companies is able to exercise its rights as shareholder, including to elect the directors. Good governance and public policy objectives may well justify some constraints around how such powers are exercisable, for example to provide for a nominations committee but this should not extend to appointing a majority of non-Group directors to the board concerned. It must be understood that the UK Corporate Governance Code does not provide that a majority of a listed company board should be independent of shareholders but of management.
10. We would expect these listed company standards regarding board structure to be replicated in a subsidiary that is the primary or “ring-fenced” entity, if this is different from the holding company. The arrangements within any non ring-fenced entity undertaking investment, wholesale or higher-risk activities should depend on its circumstances, including the extent to which employees and others are responsible for providing the subsidiary’s capital backing.
11. We are less convinced that the rigorously specified model allied to a tightly drawn ring-fence, will result in constructive relationships between the different group entities that remain under common ownership if such subsidiaries are required to have a majority of directors who are not members of the group board or executives within the group. We do not think this is obviously incompatible with directors’ duties but it does not accord with what we consider the proper lines of accountability i.e. ultimately to shareholders, nor does it sit well with the effective management of the business. It is not clear how such directors would be appointed nor how they would be accountable. We consider that such accountability needs to be to shareholders which, given the importance of safeguarding their independence, might most appropriately be defined as the shareholders of the parent entity which for the most significant groups will be a “UK-listed” company. This could be achieved by making such directors subject to election by those shareholders.
12. We emphasise that design of the ring-fence, and the implications for good governance of the entities that issue debt and equity securities in which our Members invest will have an important bearing on the overall investability of the banking sector which we address in the document which follows.
Investability of UK Banks—preliminary report to the Parliamentary Commission on Banking Standards
Background and summary
The Association of British Insurers (ABI) is preparing a report on the investability of UK banks for completion by the end of November. The purpose of the report is to incorporate UK investors’ views in the continuing debate on UK banks’ capital structure, funding, liquidity and balance sheet risk weighting. We will aim to submit an interim draft of our report to the Parliamentary Commission on Banking Standards (PCBS) by mid-November. Discussions so far, whilst at an early stage, have included major UK and international long only funds, UK banks at the CFO and Chairman level and UKFI.
So far, the public debate on banks’ capitalisation has reflected the views of regulators, politicians and policy makers, e.g. The Independent Commission on Banking (ICB), but not the providers of the capital—the investors. If more capital is indeed required in the UK banking system, as recently suggested by the Financial Policy Committee (FPC committee meeting 14 September 2012), then investors need to understand first, why this is the case and, secondly, what is the likely return on the capital invested and associated risks. We hope the ABI final report will go some way to representing investors’ questions and concerns and welcome the opportunity to contribute to the PCBS’s review of the banking bill. This report is based on meetings so far and has been prepared at an early stage in the process: our conclusions and views are therefore necessarily preliminary.
In this document, we set out the areas for attention and discussion with investors and banks and we have linked the points, where appropriate, with the questions raised in the PCBS’s call for written evidence. It is not our intention to represent banks’ management; however, management input is vital to understand the issues associated with the implementation of current regulatory proposals. Banks’ management teams are naturally fully engaged with regulators and, within reason, will create a banking model that regulators require. The question is whether equity and debt investors are willing to invest in the new model.
Our preliminary conclusions and observations so far are:
Asset value uncertainty, Eurozone risks and mis-selling investigation are all weighing on investor confidence, reflected in very low share price: tangible net asset values. However, regulatory “opacity” also remains a significant investment risk for investors.
A robust banking ROE is beneficial for the wider economy and not just equity shareholders. A robust ROE boosts internal capital generation, which in turn supports additional loan capacity, augments core tier 1 capital, i.e. loss absorbing capacity, and creates dividend distribution capacity. Banks are inherently more highly geared, with greater earnings cyclicality, compared with corporate non-financial companies. It therefore follows that investors should be compensated for the increased risk in the investment and a bank’s Cost of Equity will reflect this.
By contrast, failure to achieve at least cost of capital across the cycle is likely to lead to banks’ businesses being unsustainable in the longer term and will inevitably constrain asset growth and lending to the wider economy.
Dividends remain a key signal of management confidence and will be interpreted as an indicator of regulatory rehabilitation. Banks’ management across the entire sector need to articulate a dividend policy to investors with the confidence and backing of regulators.
The Basel 2-IRB approach to risk-weighting has become too complex and susceptible to individual bank interpretation, which distorts any inter-bank comparison by investors. A return to a simpler risk based measurement system, or improved disclosure of the “bridge” from gross assets to RWA, should be considered.
Universal banking is not viewed by most investors as an inherently broken model. Whilst accepting that it will happen, investors so far are unconvinced about the real benefits of ring-fencing and/or separation and are sceptical about the benefits relative to the operational costs and disruption.
Isolation of higher risk trading books may be better achieved via a Liikanen/Volcker approach rather than an ICB approach. Higher risk trading books are already being unwound in response to Basel-3 and ahead of any ring-fencing legislation.
Ease of resolution may be better achieved by marginally higher core tier 1 ratios determined by portfolio mix.
The risk-return of additional loss absorbency or bail-in capital is confusing the market and requires clarification.
For debt investors:
there has been a significant move towards secured funding rather than unsecured.
the longer-term implications of this for the costs of unsecured debt funding and the effectiveness of bail-in remain unclear.
There are some concerns that a requirement to maintain a certain level of bail-inable debt (effectively “Tier 3 capital”) could cause difficulties if the average tenor is, say, five years and so an amount needs to be “rolled over” each year. A failure to roll over, or roll over on unattractive terms, could itself undermine confidence in the bank
In the absence of significant incremental demand for bank equity, instruments such as Cocos, which offer “near-equity” returns on a fixed income basis, are attractive to a number of investors. However, differentiation in terms of cost—and so maintaining a viable capital structure, mean that tax deductibility is viewed as essential. In addition. Cocos do not account as Core Tier 1 and “gear” the equity further and so may have longer-term negative effect on the ability of a bank to achieve a sustainable ROE and so, in turn, on equity demand.
We welcome the opportunity to submit these early comments to the PCBS. The ABI will submit an interim document to the PCBS mid-November, aiming for completion of the final report by the end of November.
What equity investors require to gain confidence in UK banks
We set out below, based on early discussions, the recurring themes raised by investors so far and the areas to be explored in more detail during the coming weeks.
There is no doubt that equity investors want a secure and properly capitalised banking system and are supportive of regulatory reform. However, investors also require, above all:
Confidence in both the future operating and regulatory environment. A subdued macro-economic outlook and anxieties regarding the Eurozone have undoubtedly impacted investor confidence. However, it is clear, that at present investor confidence continues to be affected not only by a number of operational matters and legacy issues, but also by apparent indecision around capital levels, capital structure and structural change, e.g. ring-fencing; and, in turn,
Confidence in the future ability of the sector to achieve sustainable returns above the cost of equity and to re-establish dividend payments across the whole sector.
Investors require certainty in the regulatory outlook, but also consistency in regulation with other jurisdictions, (Relates to Q.30 & 31 in the PCBS document). They are concerned by, for example, the contrasting treatment of life company capital under CRD IV by the FSA compared with some EU member states regulators. The evolving global nature of capital markets heightens the need for a level international regulatory playing field. Approximately 40% of the UK stock market is owned by overseas institutions. Since 2009, the value of ABI members’ overseas equity investments has exceeded the value of domestic investments.
The ability to forecast sustainable post tax Return on Equity (ROE)
(Relates to Q.32 in the PCBS document)
Importance of ROE
Investors need a framework in which they can assess the potential post-tax ROE of the banks at both any given point in time and through the cycle. Basic financial economics dictates that, if ROE remains structurally below cost of equity, the equity of banks will remain essentially uninvestable. We acknowledge that ROE, in isolation, without considering risk adjusted returns and leverage can be mis-leading. However, equity investors ultimately value a bank by reference to the sustainable earnings power of its tangible net assets and that must start with ROE.
It is the responsibility of the banks’ boards and management, on behalf of investors, to invest only in business where ROE exceeds cost of equity, ensuring cost of equity for the whole group is exceeded. If a bank continues to generate a low ROE, future asset growth will be naturally constrained, unless the bank can gear up on its core tier 1 by issuing additional tier 1 debt. This, of itself, is unlikely to be sustainable in the longer term.
A robust, sustainable post-tax ROE means a bank will internally generate sufficient capital to support future asset growth, whilst bolstering capital ratios, i.e. loss absorbing capacity, and enabling it to distribute a dividend. The apparent regulatory conflict between resilience and recovery is then effectively removed, as a robust ROE enables both of these objectives to be achieved, under the control of a bank’s management team. In this respect, a robust sector ROE will have a significant beneficial effect on the broader economy, through enhanced direct lending and income distribution to pension funds and other investors, whilst improving capital ratios and loss absorbing capacity, counter-cyclically. If a bank can consistently deliver an ROE above cost of equity, equity investors will be more prepared to invest and recapitalise the bank if and when required. A strong ROE across the sector is also required to attract new entrants to the UK banking sector.
Whilst underlining the importance of ROE, we recognise the difficulties and risks in calculating it, and of the behavioural risks of capital allocation decisions in a bank run solely or primarily on the basis of ROE:
The ROE numerator will contain some profit or loss from trading activities, part of which will be struck on a “mark-to-model” basis. The financial crisis highlighted the limitations of many of these models. Investors are mindful of this, and would need to assess the extent to which profitability is being driven by trading revenues and the basis on which those revenues are being accounted for.
Accounting convention dictates that potential future losses on larger ticket loans cannot be recognised as a provision in current reporting. Therefore assets may, to some extent, be overstated at the point of “fair valuation” in any period’s accounts. Investors need to consider “through-the-cycle” provisions when analysing a bank’s profitability. Under UK GAAP, general provisions went some way to addressing this issue, enabling a management team to strike provisions based on their own assumptions around economic cycles, interest rates and unemployment.
ROE is the product of return on assets (ROA) and leverage. The consequences of driving up profitability, by driving up leverage, remains all too fresh in investors’ minds from the financial crisis, particularly leverage based on high levels of securitisation. Investors recognise the need to focus on the fundamental drivers of a bank’s ROA, i.e. net interest margins (asset yields and blended funding costs), efficiency ratios, the credit cycle and capital structure, whilst also looking at assets on a risk adjusted basis.
An attempt to “maximise” ROE, particularly in the short-term, can create excessive risk taking, under-investment, or short term uncompetitive pricing. If a bank appears to be generating an ROE that appears out of “synch” with the banking cycle or with its peer group, investors will need to understand why.
We believe these risks are recognised by both banks’ management and investors, with management teams attempting to focus on medium term sustainable ROE targets, although lack of clarity on capital levels makes this particularly challenging.
We recognise that public perception of the banking industry is such that the very notion of a bank making a profit may, for many, be quite abhorrent. We would therefore stress that:
a profitable banking system can self-fund loan growth, increase resilience through internally generating loss-absorbing capacity and pay dividends to shareholders. A healthy banking system, with sustainable profitability, is beneficial to the broader economy;
arguably, shareholder value (one measure of which is the profitability generated above cost of equity) can only be based on successfully creating customer value, i.e. the combination of attractive products, competitively priced, backed up with superior service. Under-investing or over-pricing is unlikely to deliver sustainable growth and profitability.
Assessment of sustainable ROE
ROE is, as stated above, the product of (i) return on assets and (ii) leverage. Certainty around acceptable regulatory leverage levels, whether a simple assets : equity ratio or risk weighted, will determine appropriate capital levels and is therefore a vital first step in determining a sustainable ROE.
Ring-fencing or separation, once complete, should enable investors to assess risk and return both within and outside the ring-fence. For banks’ investability to improve, a number of questions need to be addressed:
Retail Banking
Profitability is a function of (i) product mix, including the secured nature of mortgage lending versus the unsecured nature of credit card lending (ii) efficiency ratios, and (iii) charges and provisions relating to prior year practices, e.g. PPI claims, interest rate swap mis-selling.
At the 2012 half year stage, Barclays, for example, reported a UK Retail & Business Bank ROE (which excludes credit cards) of 16.6%, before PPI mis-selling claims, or 9.9% after accounting for the claim. Similarly, we estimate Lloyds Banking Group’s H1 2012 annualised core Retail Banking ROE was 23% (including credit cards), or 14% after adjusting for the H1 £1,075 million PPI mis-selling charge (not annualised).
Whilst it is appropriate for prior mis-selling processes to be addressed, investors are mindful of (i) the profound impact mis-selling charges may have on the prospective profitability (and capital levels) of Retail Banking businesses, with, for example, interest only mortgages and bundled current account charges now likely to come under investigation (ii) the longer-term risk that strong headline ROE’s may be capped through further regulatory scrutiny in the form of, for example, price controls.
Strong profitability is not, in our view, a function of low competition. At the time of writing, MoneySupermarket.com listed more than 25 current account offerings (excluding multiple accounts from one provider). We would support the ICB’s recommendations to ensure that current account switching mechanisms are made as simple and streamlined as possible. However, banks stress that detailed knowledge of customer transactions and financial behaviour, built up over a long period of time, makes for a more effective banking relationship. (Relates to Q.8 in the PCBS document)
http://www.moneysupermarket.com/currentaccounts/CurrentAccountsResults.asp
Investment Banking
Profitability will vary significantly according to business mix and the broader macro-economic cycle. As Basel-3/CRD-IV is implemented, we would expect ROEs to come under further pressure with management seeking to exit higher capital intensity businesses and develop lower capital intensity (fee based) businesses. UBS’s announcement (30 October 2012) on reshaping its investment banking business, may provide a useful template of how restructuring could happen. Investors will want assurance that ring-fencing will not require “fast-forwarding” of Basel-3, with businesses outside the ring-fence immediately funded and capitalised on a standalone basis.
Cost of Equity
Cost of equity will in turn be influenced by (i) capital levels (ii) earnings volatility (ii) business mix. Levels of core tier 1 capital and degree of separation or ring-fencing are therefore pivotal in assessing cost of equity. Discussions so far would suggest that cost of equity for a Retail Banking business is in the range of 8–10%, with Investment Banking around 15%. Thus a blended Universal Banking cost of equity might initially be in the 11–12% range.
Deleveraging of Investment Banking and restructuring into less capital intensive activities, should, in theory, reduce the blended cost of equity for a universal bank, as should an increase in core tier 1 capital. However, a bank’s leverage and inherent earnings volatility will continue to be reflected in a relatively high beta creating a structural limitation to any reduction in cost of equity.
We will therefore be examining, in more detail, in the interim and final reports, the likely ranges of cost of equity for UK banks.
Confidence in the regulatory environment and that banks hold sufficient core tier 1 capital
(Relates to Q.22-Q.25 of the PCBS document)
Economic environment and legacy issues
Andrew Bailey (Managing Director, Prudential Business Unit, FSA and Executive Director, Bank of England) suggested in a recent speech (BBA Annual Banking Conference) that UK banks’ low price: tangible net asset values were indicative of investor concerns regarding banks’ capital ratios, with capital levels likely to be impacted by (i) further asset write-downs, exacerbated by the current accounting regulations which do not allow recognition of future loans losses (ii) tail risks, e.g. a disorderly Eurozone break-up, (iii) higher funding costs with limited asset re-pricing potential (iv) structural uncertainty and costs e.g. ring-fencing.
It is clear that UK banks’ valuations are also weighed down by a range of legacy issues, including: PPI mis-selling provisions, Ireland real estate exposure, UK commercial real estate exposure, potential LIBOR litigation, interest swap mis-selling and, now, the prospect of investigations into interest-only mortgages and “bundled” current account charges. Whilst these factors, by their very nature, are difficult to forecast, the equity market tends to stress-test net tangible asset values by deducting a likely “worst case” net provision, i.e. treating it as a “one-timer” and so applying a P/E of 1x.
UK banks’ share prices have enjoyed a recent rerating, effectively following the tightening of five-year credit default swap (CDS) spreads, in turn reflecting improved confidence in Eurozone resolution, Relaxation in liquidity requirements has also recently helped UK banks’ share prices. Five year CDS spreads have tightened by around 20% over three months for the domestic banks (Barclays, Lloyds Banking Group and RBS Group), with their respective share prices increasing by some 30–40%. HSBC and Standard Chartered CDS spreads have tightened by around 9% during the same period, with more muted share price movements.
Notwithstanding the recent domestic bank share price rally, Barclays, Lloyds Banking Group and RBS Group are still only trading on price to forecast 2012 tangible net asset values of around 0.6x, with HSBC and Standard Chartered trading on 1.36x and 1.70x respectively. Following this rally, we note a more cautious tone to recent sell-side broker reports, with some trimming of recommendations, reflecting essentially continued regulatory uncertainty, as discussed further below.
Regulatory uncertainty
Based on our investor meetings so far, regulatory uncertainty and inconsistency are a significant investor concern. Lack of clarity regarding capital levels, and the apparent conflict between resilience and recovery, are muddying the investment case for UK banks, limiting a further rerating of share prices relative to earnings and tangible net asset values. Particular concerns arise in a number of areas:
Investors so far are broadly of the view that resilience and competition are to some extent mutually exclusive, as increased regulation will inevitably raise barriers to entry for potential smaller entrants.
One investor has also suggested that regulation, or regulatory intervention, may well be a deterrent for potential hires into senior positions at UK banks.
Investors need to understand if the change of emphasis from core tier 1 ratio to absolute levels of capital is permanent or part of a more temporary mechanism to facilitate asset growth.
Investors are seeking a deeper understanding of the ICB’s 10% core tier 1 guidance. In fact, some investors believe the stock market, rather than regulators’ prudential risk analysis, may have led the debate to the conclusion that 10% was the “right” core tier 1 ratio, taking into account a counter-cyclical buffer or G-SIFI/SIFI layer above the Basel-3 minimum 7%.
Banks must be correctly capitalised but not over-capitalised. Downward pressure on ROE (through expansion of the denominator) can even—paradoxically—increase risk as management teams may be tempted into investing in higher return (and therefore higher risk) activities in order to meet cost of equity. Excess capital and low ROEs are also likely to result in upward asset re-pricing, with the customer picking up part of the cost for increased regulation. This trend is already apparent in mortgage pricing where spreads above the five-year GBP swap rate have widened by around 200 basis points since the end of 2010.
It is accepted by investors that the price of increased capital and regulation will reduce ROEs. However, investors need to be equipped with the information to assess the likely scale of ROE contraction. Only then can investors assess what can be done to mitigate the ROE impact through cost reduction and/or asset re-pricing. Conversations with banks’ management so far indicate that successful operating costs’ reduction will be key and perhaps the primary differentiator among banks in the near-term, where the revenue outlook remains subdued.
Investors are also seeking a better understanding of Pillar II capital and its allocation across banks’ business sectors. Pillar II is where supervisory judgement is applied to overlay the capital applied to risk assets under Pillar I. As Andrew Bailey highlighted in his BBA speech, Pillar II capital has increased from just under £20 billion to £150 billion, of which £100 billion is held across the sector in “Capital Planning Buffers”.
Clarification is also needed on whether ratios will be viewed by regulators under transitional rules or on a “fully-loaded” basis.
Confidence in measuring and comparing asset risk
At the recent Prudential Regulation Authority (PRA) launch conference (22 October), David Rule (Director, International Banks Division, Prudential Business Unit, FSA) emphasised, during Q&A, that the PRA’s prime objective was to ensure banks are adequately capitalised and will use a combination of Basel-standardised, Basel-IRB, simple leverage and banks’ internal models to assess risk and capital requirements. From a regulatory perspective, this is a pragmatic approach. However, it is likely to increase rather than reduce opacity for investors in understanding and comparing capital requirements across the sector.
Investors require consistency across the sector in calibrating risk weightings on banks’ asset portfolios and therefore in estimating capital requirements. It is already apparent from investor meetings that confidence in Basel-2 Internal Ratings Basis (IRB) as a basis for making these comparisons is low. Cross-sector risk comparisons are therefore distorted and international comparisons become extremely challenging.
Investors seek greater clarity in the linkage between gross (un-risked assets) and risk weighted assets, which would highlight the extent to which banks are basing risk-weights on alternative assumptions.
A clear understanding of Loss Absorbing Capacity in addition to Equity
(Relates to Q.22 to Q.25 in the PCBS document)
Investors need to understand the risk/return (yield/coupon) for each layer of the capital structure and have a clear understanding of what constitutes Primary Loss Absorbing Capacity (PLAC) as covered in the ICB submission. Equity investors need full visibility on the cost of each type of debt instrument, as this will have a significant impact ultimately on ROE. Debt investors have less immediate interest in CoE/RoE, but ultimately need the comfort of knowing the bank is capable of achieving an ROE greater than its cost of equity: if a bank is generating insufficient equity internally, it will only be able to fulfil growth plans through the fixed income/convertibles market via issuance of non-equity tier 1 capital.
Early conversations on the subject of PLAC, bail-in capital and contingent convertibles are raising more questions than answers.
Unsecured debt/bail-in
Discussions so far suggest that introducing a separate bail-in layer may serve only to confuse, particularly as it is widely believed that, at the point of resolution, all unsecured funding will be effectively be “bail-inable.”
Clarification is required in the areas of:
bail-in by contract or statute;
grandfathering of existing and soon to be issued debt instruments;
destination of new funding, i.e. within or outside the ring-fence, and in particular would banks need to be raising debt capital under two separate names in the market, with separate contracts, separate pricing structures and separate credit ratings. It remains to be determined what the supply of bail-in bonds outside the ring-fence really would be, and whether there would be a market for parallel bail-in bonds under two different issuing names;
definition of point of non-viability (PONV).
Investors are keen to understand regulators’ views on secured (securitisation, covered bonds) versus unsecured funding and in particular how much asset encumbrance regulators will tolerate. The European debt market is moving further towards covered bonds. At the end of September, covered bonds accounted for around half the Euro-denominated investment grade financial supply, broadly in line with 2011, but above the trend rate seen in earlier years. As the secured layers of funding increase within the debt capital structure, then the unsecured, potentially bail-inable, debt layers would be subject to greater loss absorption at the point of resolution. This will have implications both for the cost of unsecured debt and, potentially, the effectiveness of bail-in.
The notion that an unsecured bond purchased by a pension fund is bail-inable is a highly sensitive issue as indeed is the notion of bailing-in guaranteed deposits. Arguably, the effect would be that banks’ losses would be effectively “pre-funded” by pension schemes and the FSCS.
One potential unforeseen consequence of bail-in capital stems from its shorter tenor and the requirement for frequent roll-over and refinancing. A deterioration in market conditions could impact a bank’s ability to refinance effectively, which would potentially reduce the availability of bail-in capital during refinancing periods and reduce a bank’s loss-absorbing layers. This in turn could undermine confidence in the bank.
Cocos
Whilst contingent convertible bonds (“Cocos”) may offer (in a market where ordinary equity is difficult/impossible to raise) attractive yields (currently c.9%, and historically, significantly higher) to investors and, assuming tax deductibility, represent reasonable terms to issuers, our meetings so far have highlighted a number of concerns:
The “death-spiral” arguments around Cocos are now well rehearsed—as core tier 1 approaches the trigger ratio, equity holders fearing dilution through conversion will sell, share prices will fall, in turn creating concern among depositors and money market funds who will withdraw funds i.e. potentially a “run” on the bank. The key is therefore to set the coupon at a level which compensates bond investors for the risk at a core tier 1 trigger level which is unlikely to be breached in the normal course of events, but at a rate which is not seen as punitive for equity investors.
A potential risk for Cocos is the extent to which a core tier 1 trigger level could be breached through regulatory action, e.g. further mis-selling charges or provisions.
Logically, if a “Coco” coupon is, for example, 9%, cost of equity cannot be less than 9% and it may be materially higher.
Coco’s are ineligible for core tier 1 (until converted) and therefore do not increase loss absorption until point of conversion.
At present, therefore, Cocos are attractive to a number of investors as they offer near equity returns on a fixed income basis at a time when the equity of banks is difficult/impossible to value in a period when interest rates are likely to stay lower for longer. However, to maintain a longer-term viable capital structure:
it is important that the required yield on Cocos is materially less than the cost of equity. Investors see tax deductibility of the coupon as a critical factor here;
care should be taken in the extent of use of Cocos as they do not count as core tier 1 and, of themselves, further gear the equity. Regulatory persistence on the issue of increased loss absorbing capacity, in conjunction with difficulties/an inability to raise pure equity, may result in the forced issuance of Cocos—and so in turn make the market for bank equity more difficult for longer.
Depositor preference (relates to Q.21 in the PCBS document)
Investors are seeking clarity on the depositor preference mechanism and, in particular, whether this would really create additional “market discipline” (as suggested in the ICB final submission) on investors sub-ordinated to depositors.
Index eligibility
Investors have raised questions on the issues of bond-index eligibility and rating agency treatment of loss absorbing debt layers. We sense some resistance to inclusion of an instrument that is difficult to price.
Summary
In summary, investors need visibility on the risk-return characteristics of each layer of the capital structure. The degree to which capital instruments are “bail-inable” is clouding that judgement and may well drive debt investors further to secured funding.
To the best of our knowledge, investor demand for bail-in debt has not been assessed and we are concerned that the risk-return characteristics of bail-in versus the secured debt market may not be sufficiently compelling to provide substantial amounts of bail-in debt. A possible unforeseen consequence of bail-in may be that only the larger (SIFI and G-SIFI status) banks will be seen as sufficiently robust to issue investible bail-in debt.
Clarity on legislation for ring-fencing and/or full separation
(relates to Q.13 to Q.20 in the PCBS document)
Most investors so far are broadly of the view that the universal banking model was not the root cause of the financial crisis. Moreover, many banks that failed during the crisis were “narrow” banks and indeed would be inside the ring-fence rather than outside. This would be true in the UK of all of Northern Rock, Bradford & Bingley and Alliance & Leicester and, arguably, most of HBOS. Within the UK, banking cycles have been closely correlated to real estate valuations and “bubbles” rather than to investment banking cycles or structural limitations or weaknesses within universal banks.
Investors nonetheless recognise the potential pitfalls of universal banking, in particular, the risk of “cultural clash” between the investment bank and the retail/commercial bank and the potential for investment banking activities to be funded with retail/commercial deposits. However, the management of risk, which encompasses maturity transformation, managing liquidity, interest rate risk and credit risk is at the heart of a universal banking model. The role of a bank’s Asset & Liability Management Team is to fund a bank’s lending and investment activities, using a variety of funding, recognising the risk/return on each of those activities. (relates to Q.7 in the PCBS document)
We will be addressing the question of what is the underlying purpose of ring-fencing or separation. Is it to facilitate resolvability in the event of a repeat crisis or to protect the provision of Retail/SME banking services? If it is to protect the provision of Retail/SME services, from what is it being protected? A volatile, capital-hungry non-client facing business, consistently earning sub-cost of equity returns has no place in a bank, whether inside or outside the ring-fence.
Some investors have suggested, for example, that:
Resolvability might be better addressed through increased capital requirements, rather than the cost and customer disruption associated with ring-fencing.
Protection of vital Retail/SME services may be better achieved through isolation (Liikanen) or suppression (Volcker) of proprietary trading. (Relates to Q.26 and 31 in the PCBS document)
In assessing this, other factors need to be addressed, including:
the distinction between proprietary trading and market-making or client facilitation;
the location of derivatives to facilitate customer hedging contracts in or outside the ring-fence;
the location of Treasury and Balance Sheet Management teams to manage the deployment of liquidity and retail deposits;
the distinction between prudent bank balance sheet management and proprietary trading, i.e. would creating a short position in Eurozone sovereign debt, in order to reduce a bank’s net long position in its primary liquidity pool, in the face of a Eurozone crisis, be regarded as proprietary trading or prudent management?
Most investors so far have been sceptical on the cost-benefits of ring-fencing and have shown little appetite for full separation. Whilst both investors and the banks appear to accept that some degree of ring-fencing is inevitable, the costs and operational complexity plus disruption to clients and employees should not be under-estimated. In this respect, if isolation of trading activity is the heart of the issue, the cost benefits of a Liikanen/Volcker approach may be more appealing, possibly augmented by additional core tier 1 capital to reflect portfolio mix.
The Bank for International Settlements (BIS—“An assessment of the long-term economic impact of stronger capital and liquidity requirements”, August 2010) illustrated that an increase in tangible common equity (TCE) to risk weighted assets (RWA) from 6% to 10% would reduce the probability of a systemic banking crisis from 4.8% to 1.2%, assuming banks could meet their net stable funding ratio requirements. An increase from 10% to 11% in the TCE/RWA ratio would still reduce the probability of a systemic banking crisis from 1.2% to 0.9%.
Confidence regarding future dividend payments
There is broad agreement, so far, that the UKFI’s successful placing of its stakes in Lloyds Banking Group and RBS Group is likely to be contingent on re-establishing dividend payments.
Dividends remain a key signal of management confidence and will be interpreted as an indicator of regulatory rehabilitation. Banks’ management across the entire sector need to articulate a dividend policy to investors with the confidence and backing of regulators.
Banks once accounted for over 20% of the FTSE 100’s dividend income—a valuable income source to UK investors. Whilst lower pay-out ratios will prevail for the foreseeable future, the positive message that a restored dividend policy will convey, together with increased investment funds, should not be under-estimated.
31 October 2012