10 December 2011

2011 EU Capital Exercise: Funny Calculation of Transitional Floor

On 8 December 2011, the European Banking Authority (EBA) completed the 2011 EU Capital Exercise and published the final figures of the banks’ recapitalisation needs in Europe. As a result, the banks are required to establish an “exceptional and temporary buffer” so that the Core Tier 1 capital ratio reaches the level of 9% (after the revaluation of the EU government bonds) by the end of June 2012 (necessitated by the non-functioning funding markets). The total capital shortfall was found to be 114.7bn Euros. Without speculating if this amount will be enough or not, let’s take a look to an example which illustrates the confusion of the European financial supervisory authorities.

It’s about the advanced internal risk measurement approaches that allow banks to use their own internal models for the purpose of calculating capital requirements, of course (remember Basel II: IRB for credit risk, and AMA for operational risk?). We have discussed earlier how the Basel II capital adequacy framework has enabled running a bank with almost no capital. We know that the EBA has highlighted the differences between the banks’ internal models as an issue to be addressed (e.g. look at the materials of the 2011 EU-wide stress test results). That’s why the so-called Basel I transitional floors are still in place in several countries, meaning that the banks must hold capital at least 80% of the (old and much less risk sensitive) Basel I requirement. In the 2011 EU Capital Exercise the EBA wanted to be conservative and take the so-called Basel I transitional floor into account. Apparently, this did not happen but rather resulted in a misleading and controversial communication by the financial supervisors.

The case of the Swedish bank Svenska Handelsbanken serves as a good example: at first the bank was required to build up an extra buffer of nearly SEK 10 billion, but finally it was recognised to have the Core Tier 1 capital ratio of 14.7% (which is considerably higher than the required 9%). The difference was the change in the application of the Basel I floor rules. 

Namely, after discussing the original proposal, the EBA introduced two approaches for taking the transitional rules into account:
* Approach 1: Transitional floor capital requirement = Max [(80%*(Capital Requirement B1) – (Total Minimum Own Funds)),0], and
* Approach 2: Transitional floor capital requirement = Max [(80%*Capreq B1) – Total Own Funds, 0]
(For details, see: EBA, Methodical Note)
Needless to say that most of the banks chose Approach 2, because it was a joke. Only for two of the total 65 banks the results of which have been made publicly available (Italian bank Intesa Sanpaolo S.p.A and Norwegian bank DnB NOR Bank ASA), the floor was higher than zero, and these two banks did chose the Approach 1. Effectively, under the Approach 2 the additional capital requirement only arises when a bank’s total capital is less than 8% (not 9% as targeted in the 2011 EU capital exercise) when taking the transitional rules into account.

To illustrate the above, I have performed the comparative calculations for the Svenska Handelsbanken (see Table 1). As can be seen, the EBA’s Approach 1 is pretty similar to the current principle of applying the transitional rules in Sweden. The only problem is that Handelsbanken would have to raise additional capital (or reduce dividends or apply whatever other acceptable measures) in order to reach the targeted 9%. Instead, the bank has chosen the EBA’s Approach 2 according to which it can demonstrate the Core Tier 1 capital ratio of 14.7%, i.e. an indisputable surplus of capital. At the same time, the Approach 1 would have resulted in a ratio of 8.2%.

In its methodical note, the EBA indicates that the Basel I transitional floor is taken into account in the calculations: “Risk weighted assets (RWA) are computed by multiplying the total capital requirements (including the Basel 1 transitional floor) with 12.5.”

The Swedish Finansinspektionen puts it rather bluntly: “The EBA announced today how much capital the European banks need to contribute. One new component in the recapitalisation exercise is that the calculation for Swedish banks is no longer based on the transition regulations from Basel 1, which means that Svenska Handelsbanken and Swedbank will no longer need to make capital contributions.”

In other words, it very much looks like the EBA is trying to mislead us once again while keeping everything correct formally. Differently from what the EBA says, the vast majority of the European banks have not taken the Basel 1 transitional floor into account in the calculations, and fully rely to their own internal models (that often still seem to reflect the risk levels of the “good times”). Who are we fooling? Why? Ok, perhaps those who don’t know the answer are sleeping better... Just notice that the European banks have been basically forbidden to sell the debt instruments of the European governments, and forced to continue their lending activity even if under pressure for reducing the risk-weighted assets.

What concerns the specific Swedish case then in my opinion one should question the assumption of the low risk Swedish mortgages. For a reference, see the previous article Swedish Time Bomb Still Ticking but Signs of Imminent Explosion Becoming Harder to Ignore.

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