August 5, 2013 / 11:45 AM / 4 years ago

Leverage shift hits European bank plans

By Gareth Gore

Aug 5 (IFR) - European banks have been forced to tear up years of planning and rethink the way they run their biggest businesses after an unexpected clampdown from regulators on leverage, with some firms already selling assets and warning of hundreds of millions in lost earnings.

Barclays and Deutsche Bank were first to respond to the shift, unveiling plans to cut up to 400bn in assets between them, with bankers warning that more firms will be forced to cut back on leverage - and sell assets - over coming months. Barclays would have had to cut deeper had it not announced a plan to raise £5.95bn in fresh equity.

The Basel Committee on Banking Supervision surprised banks at the end of June with proposed new rules that calculate "gross leverage" by taking total equity as a percentage of total exposure, in a move that banks say undermines separate risk-weighted capital rules.

"Leverage ratios are a very crude measure, and we think it would be very dangerous for regulators to shift away from all the work banks have done on regulatory capital," said Lars Machenil, chief financial officer at BNP Paribas. "Risks can be very different, and that needs to be reflected in the rules."

European banks are likely to be disproportionately hit because they tend to run bigger balance sheets than their US rivals. US banks fare better, because they tend to sell off pools of mortgages and loans rather than keep them on the books, and also because accounting rules in the US allow them to net their derivatives exposure to a much greater extent than is possible for European firms.

The proposed rule change is out for consultation until September 20 and banks are lobbying to get the proposal watered down. But, as it stands, banks will be required to meet the internationally agreed 3% leverage ratio by January 2018.

Some countries, however, want their banks to meet the target much sooner. The UK, for instance, has said it wants banks to meet the 3% level as soon as possible, pushing Barclays into its rights issue (see "Barclays pays steep price for PRA switch"). And while the Basel Committee would not require disclosure of leverage numbers until 2015, many banks published their current levels last week under pressure from investors.

DISAPPOINTED

While some kind of leverage component has been part of Basel III plans for some time, banks had hoped to convince regulators to calculate levels against risk-weighted assets, similar to the way capital requirements are calculated.

One of banks' preferred options is for leverage to be determined according to European Capital Requirements Directive IV rules. Using CRD IV, which entered into force in the EU earlier this month, banks can reduce total exposure by up to a quarter - and thus boost their leverage ratio - because the directive has provisions for netting certain exposures, including some derivatives, against each other.

Unsurprisingly, most of the banks that declared their leverage ratios last week did so using CRD IV derived numbers.

The Basel Committee, however, is keen to bring down leverage once and for all and wants a cleaner - though cruder - method in order to stop banks gaming the system. If the methodology proposed by the Committee is adopted, banks will be judged to have lower leverage ratios than those they claimed last week.

"We always said it was going to be tough, and that is one reason why there is a phased-in transition," said one member of the Committee, who asked not to be named. "But it is designed to make sure banks can't leverage up the way they did before the last crisis."

Indeed, the Committee recently found that banks could have understated their capital needs by as much as two percentage points because of differences in internal models which larger banks have used to calculate their capital requirements for much of the last decade. They want to avoid similar gaming on leverage.

"Maybe the pendulum has swung too far; maybe there's too much leniency on risk weightings," said one CFO at another large European bank. "But if that is the case, then we need to be talking about a simplified, standardised approach rather than focusing on leverage, which is a very bad idea."

RATIOS MAY TUMBLE

If the proposals come into effect as they are now written, reported leverage ratios will tumble. According to Morgan Stanley, Deutsche's ratio would come down to 2.1% from the 3% it claims it is at under CRD IV rules. Other banks that would drop below the 3% minimum level include Credit Suisse, UBS, Societe Generale and Barclays.

"We believe there will be significant adjustments before the final rules come into force," said the CFO. "CRD IV has been approved and is the best framework for us to work with at the moment. We are lobbying hard for regulators to stick to this rather than change it again."

Banks under the 3% threshold would have to increase capital through retained earnings or a capital increase, or reduce their assets. According to Machenil, leverage rules are likely to accelerate the trend towards originate-to-distribute activity in Europe, a process which some banks such as BNPP have already begun.

"Regulators quite clearly want banks to shrink their balance sheets - that's been the case for quite some time," he said. "In order to ensure lending doesn't decline, banks need to move towards more of an originate-to-distribute model, which is what we have been doing."

The effect of smaller balance sheets on earnings is unclear, however. Deutsche estimates that balance sheet cuts of between 200bn and 300bn will reduce profitability by about 300m a year, though that seems remarkably optimistic.

Bankers say the new rule could even prompt banks to take on more risk. They say banks will shrink their balance sheets, and then load up on riskier assets as a way of offsetting the resulting hit to profits.

"These rules just incentivise banks to take on more risk," said the CFO. "We have to gather capital to grow our business, and if the share of capital is high, the rest of the balance sheet has to work harder. It's a simple truth: banks will have to start dialling up risk again."

The new emphasis on leverage has many implications for specific business areas within banks, some of which may no longer be viable.

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