S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas

Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III
Publication date: 09-Jun-2011 10:35:09 EST

Contact Client Services

1-877-SPCLIENT 1-877-772-5436 Call Tree Options Contact Us

View Analyst Contact Information

Table of Contents

Banks around the globe are preparing for Basel III's higher capital requirements. The minimum common equity regulatory capital ratio will gradually increase to 7% in 2019 (including a 2.5% "capital conservation buffer") from its current 2%. Banks will also be subject to a variable countercyclical buffer set by national authorities of up to 250 basis points (bps). Institutions deemed systemically important will need to hold an additional but still unspecified capital buffer. Standard & Poor's Ratings Services believes this buffer could be up to 300 bps in several mature markets. We introduced our risk-adjusted capital framework (RACF) in April 2009 to address comparability issues with the regulatory ratios that we believe will persist under Basel III. The RACF also includes our opinion about potential unexpected losses, which may differ from bank models or regulatory approaches. (Watch the related CreditMatters TV segment titled, "Standard & Poor's Risk-Adjusted Capital Framework: How It Compares With Basel III Recommendations," dated June 9, 2011.) Although it is built independently from regulatory ratios, our RAC ratio provides insight into Basel III levels in a globally consistent manner. In particular, our RAC ratio already addresses several areas of Basel III, including multiplying market-risk capital charges by a factor of 3, deducting tax losses carried forward from capital, deducting the change in the fair value of debt from capital, and imposing a 1,250% risk weight (i.e., one for one) to securitization equity tranches. For example, on trading book market risk, our risk-weighted assets (RWA) average only 3% higher than Basel II.5 estimates (increased trading-book capital requirements to be implemented in 2011) for a sample of banks with large investment-banking businesses. Although Basel III ratios are subject to numerous assumptions, some banks started to estimate them (see chart 1).
Chart 1

For this sample of banks, the average RAC ratio after diversification is comparable to the common equity tier 1 (CET1) ratio estimated under Basel III. There is, however, significant volatility around this average. For example, the RAC ratio is 3% to 5% lower than Basel III estimates for U.S. trust banks. Our framework translates into higher operational-risk capital charges on assets under custody and assets under management, which are major businesses for trust banks (see U.S. Trust Banks' Off-Balance-Sheet Exposures Are Addressed In The Risk-Adjusted Capital Framework, published March 4, 2011, on RatingsDirect on the Global Credit Portal). We believe that asset managers' operational risk has increased significantly during the past decade. In particular, we apply a heavier capital charge for cash and money-market funds to reflect the financial support many independent asset managers (or parent banking companies) might provide to their funds.

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]

S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas

RAC Ratio Already Addresses Some Enhancements Of Basel III

Trading-book market-risk capital requirement will triple under Basel II.5 In April 2008, we highlighted the need for higher capital requirements related to the trading book (see Trading Losses At Financial Institutions Underscore Need For Greater Market Risk Capital, published Apr. 15, 2008). In particular, we highlighted that our approach is to scale up the regulatory capital by a factor of three. Banks in most mature markets, including the U.S., will have to increase their regulatory capital requirements with regard to the trading book at year-end 2011. These increased capital requirements, dubbed "Basel II.5" by the market, consist of higher charges for securitization exposures and the introduction of a "stressed" value at risk (VaR) and an "incremental risk charge" (IRC). The Swiss banks have already implemented Basel II.5 for Swiss Financial Market Supervisory Authority (FINMA) regulatory purposes since the beginning of the year. Overall, we believe that the average capital requirements for market risk in the trading book will triple with the implementation of Basel II.5 (see chart 2). However, regulators are still conducting the fundamental review of trading-book rules, scheduled to be completed by year-end 2011. These regulators have up to four market-risk internal models to validate, whereas they had only one previously.
Chart 2

Since its introduction in April 2009, our RAC ratio has integrated a capital charge for trading-book market risk that is three to four times higher than current regulatory charges derived from VaR models. Even after regulators implement the new trading-book regime in 2011, we expect the capital charge in our RAC ratio to remain higher than the charge under Basel II.5. We believe reported Basel II.5 ratios will begin to converge to our RAC ratio. As the stress VaR and the IRC metrics become publicly available, we expect the improved disclosure to help market participants' analysis of trading-book market risks. Under Basel II.5, banks have to compute a stressed VaR in addition to the current VaR-based capital requirements. The stressed VaR is computed using market parameters calibrated to a period of stress (e.g., 2008). We believe that the stressed VaR will reduce procyclicality of regulatory capital charges. Assuming that the current conditions are less stressful than the period used for the stressed VaR, the inclusion of the stressed VaR alone already at least doubles the capital requirements. We believe that Basel II.5 reduces capital arbitrage opportunities between banking and trading book. In particular, capital charges for securitization positions in the trading book will be aligned to charges for securitization positions in the banking book. This includes banks with an approved VaR model, and excludes "correlation trading" positions for which a "comprehensive risk measure" can be developed with supervisory approval. Finally, the introduction of the IRC aims to capture credit risk (default risk and migration risk) for securities in the trading book such as bonds, credit derivatives, or loans (i.e., leveraged loans and commercial real estate loans). In our opinion, this risk is poorly captured by specific-risk VaR models (which often merely capture spread risk at unchanged level of ratings). This new charge will capture risk at a

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]

S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas

one-year horizon (versus 10 business days for VaR models) with liquidity horizons of at least three months and a confidence interval of 99.9% (versus 99% for VaR models). The liquidity horizon appears more suited to these products than the classic 10-day VaR; the oneyear horizon and the 99.9% confidence interval will limit regulatory arbitrage with positions in the banking book. Comparability issues will persist under Basel III On Dec. 16, 2010, the Basel Committee on Banking Supervision (BCBS) released its final recommendations for "Basel III: A global regulatory framework for more resilient banks and banking systems." However, there is no single implementation of the Basel recommendations. Instead, each country exercises its own national discretions and potentially engages in "goldplating" (i.e., adding rules from local regulators) when translating the recommendations from the BCBS into local regulation. For example, the Commonwealth Bank of Australia's Tier 1 capital ratio as of December 2010 would be 13.5% under FSA rules instead of 9.7% under the Australian rules (see table 1). The Australian rules impose a minimum 20% loss given default compared with 10% in most other countries, including the U.K. This difference alone drives about 40% of the impact on the proforma CBA Tier 1 capital ratio.
Table 1 Regulatory Capital Frameworks Comparison For Commonwealth Bank Of Australia (%) Reported risk-weighted capital ratios RWA treatment-mortgages and margin loans IRRBB risk weighted assets Future dividends (net of dividend reinvestment plan) Tax impact in EL v EP calculation Equity investments Value of in force (VIF) deductions Total adjustments Normalised FSA equivalent Common equity capital* 7.40 1.30 0.40 0.60 0.10 0.30 0.50 3.20 10.60 Tier-one capital 9.70 1.70 0.60 0.60 0.10 0.30 0.50 3.80 13.50 Total capital 11.50 1.80 0.80 0.60 0.20 0.20 0.00 3.60 15.10

*Represents fundamental Tier 1 capital net of Tier 1 deductions. Based on APRA 20% loss given default (LGD) floor compared to the FSA's 10% and the group's downturn LGD loss experience. For standardized portfolio, based on APRA risk weights under APS 112 compared to the FSA's standard. VIF at acquisition is treated as goodwill and intangibles and therefore is deducted at Tier 1 by APRA. FSA allows VIF to be included in Tier 1 capital but deducted from total capital. Source: Commonwealth Bank of Australia Basel II 2010 Pillar 3 report.

Even within the same jurisdiction, we expect differences in regulatory risk weights to remain as much driven by differences in banks' risk profiles as by variation in the methodology and models they use to assess the risk weights. For example, a study conducted by the U.K. Financial Services Authority (FSA) on 13 banks revealed very different estimates of probabilities of default for the same underlying risk. For example, the most conservative bank estimated a probability of default for corporate obligors rated 'A' 10 times higher than the estimate of the most aggressive one. By contrast, we use our own globally consistent definition of capital and risk-weighted assets (see table 2). (See Bank Capital Methodology And Assumptions, published Dec. 6, 2010, for a detailed definition of each adjustment performed.) A significant part of Basel III is devoted to raising the quality, consistency, and transparency of the capital base. We expect this to neutralize some, but not all, of the national discretions affecting the numerators of the capital ratios.
Table 2 Calculation Of Total Adjusted Capital Common shareholders' equity Add minority interests: equity Deduct dividends not yet distributed Deduct revaluation reserves Deduct goodwill and nonservicing intangibles Deduct interest-only strips Deduct deferred tax loss carry forwards Add or deduct postretirement benefit adjustments Add or deduct cumulative effect of credit-spread-related revaluation of liabilities Add or deduct other equity adjustments = Adjusted common equity Add preferred stock and hybrid capital instruments (subject to limits) = Total adjusted capital

National regulators implementing the Basel III recommendation may be more conservative than our definition on some factors and less on others. On the one hand, Basel III rules require banks to deduct minority interests and deferred tax assets (DTAs) due to timing differences in some instances (particularly if they exceed 15% of the bank's CET1, jointly with mortgage servicing rights and significant minority financial institutions holdings). Even if they are not deducted from capital under Basel III rules, the risk weight on DTAs will be 250%, which is usually a higher risk weight than what we apply. Minority interests will be fully deducted from CET1 under Basel III,

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]

S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas

whereas we only deduct them on a case-by-case basis. On the other hand, significant minority financial institutions holdings (i.e., holdings for which the bank has a stake more than 10% but less than 50%) will continue to be risk weighted like other exposures under Basel III, as long as the total of these holdings does not exceed 10% of the entity's issued common share capital. Those investments are risk weighted at 1,250% under the RACF. Through this one-for-one risk weight, we neutralize double leverage in our capital metric. Another difference relates to accumulated other comprehensive income (AOCI), which can lead to significant volatility in the capital ratio through the cycle. For example, the change in AOCI for Citigroup in 2008 represented 17% of its Tier 1 capital (see table 3). Under Basel III, banks will likely include AOCI in CET1 capital. Under the RACF, we only consider unrealized gains or losses on equities in the denominator of the RAC ratio.
Table 3 Citigroup Consolidated Statement Of Changes In Stockholders' Equity (Mil. $) Accumulated other comprehensive income (loss) Balance, beginning of year Net change in unrealized gains and losses on investment securities, net of taxes Net change in cash flow hedges, net of taxes Net change in foreign currency translation adjustment, net of taxes Pension liability adjustment, net of taxes Adjustments to initially apply SFAS 158, net of taxes (1,647) Net change in Accumulated other comprehensive income (loss) Balance, end of year Total common stockholders' equity and common shares outstanding Total stockholders' equity Comprehensive income (loss) Net income (loss) Net change in Accumulated other comprehensive income (loss) Comprehensive income (loss) Data for year ended Dec. 31, 2008. Source: 2008 annual report. (27,684) (20,535) (48,219) (20,535) (25,195) 70,966 141,630 (4,660) (10,118) (2,026) (6,972) (1,419)

Concentration Matters
The RACF embeds explicit adjustments for concentration and diversification of credit, market, operational, and insurance risks. The adjustment aims to capture four different components: single-name concentrations in the corporate portfolio; industry-sector concentration or diversification of the corporate portfolio; geographic concentration or diversification of the credit risk and equity riskweighted assets; and concentration or diversification of business lines and risk types. Each of the adjustments except the single-name can be positive (i.e., increase the risk-weighted assets) or negative (i.e., a benefit) depending on the bank (see table 4). As indicated by the significant differences among the simple averages, the medians, and the weighted averages, the range of concentration and diversification adjustments are extremely varied and significantly affect the RAC ratio for most banks.
Table 4 Concentration And Diversification Adjustments In The RACF Single name as % of corporate portfolio RWA Asia-Pacific average EEMEA average Latin America average North America average Western Europe average Global unweighted average Global median Global weighted 14.6 18.2 32.6 12.7 40.8 Sector as % of corporate portfolio RWA 3.5 2.1 2.5 2.7 2.9 Geographic as % of credit risk & equity RWA 7.7 9.1 10.3 8.9 8.1 Business and risk type as % of total RWA (5.0) (4.3) (3.1) (4.5) (2.9) Total adjustments as % of total RWA 6.6 9.0 12.0 8.6 10.2

26.4

2.7

8.7

(3.8)

9.4

4.7 2.8

5.0 1.0

7.8 2.3

(4.3) (16.2)

7.1 (12.9)

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]

S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas average RWA: Risk Weighted Assets. Source: Standard & Poor's.

On the contrary, the Basel formula and hence Basel RWA assumes infinite granularity of the exposures and does not make any adjustment for institution-specific concentration or diversification. As part of the second pillar of Basel, banks are required to conduct an internal capital-adequacy assessment that regulators will review. But this assessment is not explicitly included in Pillar I risk-weighted assets.

Basel III Is A Step In The Right Direction, But Not Yet A Solution
We believe that Basel III will reduce but not eliminate the considerable discrepancies in Basel Tier 1 capital ratio computations. Despite a strong regulatory willingness to enhance the international consistency of Basel implementation--particularly regarding the definition of regulatory capital--we expect some material national discretions to remain. Also, we believe that the multiple methodologies and approaches of the Basel framework and the reliance on internal models will continue to make comparisons of Basel III ratios an arduous exercise (see table 5).
Table 5 Highlights Of Differences Between Basel And Standard & Poor's RAC Ratios Basel II Allows banks to use their own models to compute risk weights Explicitely adjusts for single-name, industry sector, geographic and business line/risk type concentration and diversification Limits arbitrage between banking book and trading book Allows to finely differentiate risk weights based on each counterparty Different implementations and "goldplating" rules in different jurisdictions Globally consistent definition of capital In IRB No No In IRB Yes No Basel III In IRB No Yes In IRB ? Maybe RACF No Yes Yes No* No Yes

IRB-Internal ratings based. *The RAC ratio uses a top-down approach calibrated at industry level. However, we seek to measure the quality of banks' risk-management practices in other parts of our rating process. There is a scheduled 10-year transition period to Basel III with several grandfathering clauses. Source: Standard & Poor's.

Basel III is not yet implemented--not even translated into local jurisdictions (Basel II.5 was still in "request for comment" status in the U.S. until April 17, 2011). Moreover, Basel III embeds transition arrangements to increase capital requirements gradually and phase out ineligible capital instruments during a 10-year period starting in 2013. This long road toward more comparability in regulatory capital ratios sheds new light on the statement made by the Basel Committee in 2005 that "Basel (II) is not a destination but a journey."

Related Criteria and Research

U.S. Trust Banks' Off-Balance-Sheet Exposures Are Addressed In The Risk-Adjusted Capital Framework, March 4, 2011 U.S. Banks' Risk-Adjusted Capital Has Improved, But Remains Neutral To Negative For Ratings, Jan. 18, 2011 Despite Significant Progress, Capital Is Still A Weakness For Large Global Banks, Jan. 18, 2011 Basel's Global Quantitative Impact Study Exposes Large Banks' Regulatory Capital Shortfall, Dec. 20, 2010 U.S. Banks Are Gearing Up For Capital Distributions, But Hurdles Remain, Nov. 18, 2010 Bank Capital Methodology And Assumptions, Dec. 6, 2010 Trading Losses At Financial Institutions Underscore Need For Greater Market Risk Capital, April 15, 2008 Primary Credit Analyst: Secondary Contacts: Elie Heriard Dubreuil, New York (1) 212-438-2949; elie_heriard_dubreuil@standardandpoors.com Rodrigo Quintanilla, New York (1) 212-438-3090; rodrigo_quintanilla@standardandpoors.com Bernard de Longevialle, Paris (33) 1-4420-7334; bernard_delongevialle@standardandpoors.com Thierry Grunspan, Paris (33) 1-4420-6739; thierry_grunspan@standardandpoors.com

No content (including ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P. The Content shall not be used for any unlawful or unauthorized purposes. S&P, its affiliates, and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs,

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]

S&P | Standard & Poor's Risk-Adjusted Capital Framework Provides Insight Into Basel III | Americas
expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P's opinions and analyses do not address the suitability of any security. S&P does not act as a fiduciary or an investment advisor. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. S&P may receive compensation for its ratings and certain credit-related analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees. Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact Client Services, 55 Water Street, New York, NY 10041; (1) 212438-7280 or by e-mail to: research_request@standardandpoors.com.

http://www.standardandpoors.com/prot/ratings/articles/en/us/?articleType=HTML&assetID=1245306237078[5/31/2012 6:12:30 PM]