Back Matter
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Appendix I. Regional Inputs for the Credit Pricing Equation

Capital

The new Basel regulations affect European, Japanese, and U.S. banks differently. Table 7 summarizes the disclosures by 21 banks in the United States, 38 European banks, and 6 Japanese banks of their pro-forma Basel III common equity Tier 1 capital ratios, supplemented with estimates from Da Silva et al. (2011) and Cannon et al. (2010) for banks that have not provided any disclosure.22 Table 7 shows that the impact of the increase in RWAs and the qualification standards for capital (deductions) arising from Basel III reduces common equity Tier 1 capital ratios by 2.5–3 percentage points on average.23 However, the effects of increases in RWAs and deductions on U.S., European, and Japanese banks are asymmetrical. The effect of increases in RWAs is larger in U.S. banks than in European and Japanese banks on average while the effect of the deductions against capital is higher in Japanese banks than in European and U.S. banks.24 As a result of the two effects, pro-forma Basel III common equity Tier 1 capital ratios in European banks are larger than in U.S. and Japanese banks on average.25,26 Finally, Table 3 also shows that European banks plan to rely more on mitigating actions to comply with the Basel III minimum required ratios than U.S. banks. However, this also seems to be the result not only of new Basel III regulations but also of the current European financial crisis, which makes raising new capital unattractive, creating a premium for mitigation activities.

Table 7.

Pro-Forma Basel III Common Equity Tier 1 Capital Ratios by Region, End-2010

(In percent)

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Source: Staff calculations, Da Silva et al. (2011), Nozaki and Saito (2011), TCH (2011a) and bank reports.

Average across the sample of banks.

Instead of their initial common equity Tier 1 capital ratios, some European banks have reported their core Tier 1 capital ratios, which will generally be very similar.

Sum across the sample of banks.

The estimated long-term minimum capital levels are driven by the ratio of capital to risk-weighted assets, on which the three regions are very broadly equal. This contrasts with the ratio of capital to total assets, which appears to be the main focus of financial market fears, where Europe and Japan are at about 3 percent, with the United States at over 5 percent. This latter ratio is roughly the same as the Basel III leverage ratio, which appears likely to be the binding constraint only for a relatively small portion of the industry, in the long run.

The differential cost of meeting the higher target for capital to risk-weighted assets results from very different average risk weightings across the regions. Since European banks have an average risk weighting of about half the level the United States runs (roughly 40 percent versus 80 percent), they need to raise only half as much capital per dollar of total assets in order to meet any given increase in the ratio of capital to RWAs. An explanation of the complex topic of average risk weightings lies outside the scope of this study, but appears to reflect at least three principal factors.27 European banks have a different business model from U.S. banks, with larger balance sheets of lower-risk assets. Accounting differences between International Accounting Standards and U.S. Generally Accepted Accounting Principles play a substantial role as well. Finally, European banks appear to have worked harder to optimize their balance sheet on a risk-weighted basis, reflecting both their longer use of Basel II rules and the pressures they are currently under to minimize the need for additional capital.28

Liquidity

As previously mentioned, estimating the funding and liquid assets needed to comply with a 100 percent NSFR and LCR, respectively, is particularly difficult. In the U.S. case, there are no available estimates from official sector sources of the extent of the gaps under the LCR and NSFR. However, it is possible to make a rough estimate by starting with the figures compiled by the BCBS (2012) for 103 large banks around the world, which are likely to comprise most of the global banking assets. Given the estimates for European banks in EBA (2012) that include most of the banking system assets, the difference between BCBS and EBA totals should approximate the gaps for the rest of the world. Further subtracting the Japanese estimates from Nozaki and Saito (2011) provides an upper bound for the portion of the gaps associated with the United States, assuming that the rest of the world has no gap. This gives estimates of US$695 billion for the LCR and US$622 billion for the NSFR in the United States. In the case of the NSFR, Table 8 uses a significantly higher figure of US$1 trillion to reflect the fact that some private sector estimates are much higher.

Figures from EBA (2012) suggest Basel III liquidity ratios may also be modestly smaller than shown in Table 8. EBA banks reported an average LCR of 71 percent and an average NSFR of 89 percent as of end-June 2011, with a shortfall of liquid assets at approximately €1.2 trillion and of long-term funding at €1.9 trillion. The difference between Table 8 and EBA figures could also result from the EBA imposing a common definition across banks or from a sample bias in the figures in Da Silva et al (2011).29

Table 8.

Pro-Forma Basel III Liquidity Ratios, End-2010

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Source: Staff calculations.

Average across the sample of banks.

Sum across the sample of banks.

Derivatives

Estimates of the costs of derivatives reforms on European and U.S. banks contain a high degree of uncertainty.30,31 Even though the large dealers will be the most affected, the wide range of estimates in Table 9 is an indication that, without further clarity from the final rules, the effects of the derivatives reforms on banks cannot be pinned down easily. In addition, banks will need to post initial margins and default funds for any CCPs in which they will clear their derivatives transactions. The levels for these have yet to be determined and, therefore, their costs cannot be estimated. However, given the magnitudes in Table 10, it appears that the costs to the economy as a whole of derivatives reforms may not be substantial.

Table 9.

Effects of Derivatives Reforms on Banks per Year

(In US$ million)

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Table 10.

Annual Fees and Taxes on European and U.S. Banks

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Source: Schorer, Michael et all (2011) and Elmendorf (2011)

Taxes and fees

Table 9 includes anticipated cost increases of the following amounts, based on national fiscal estimates. The methodology here is quite straightforward, simply taking the expected tax costs based on official estimates over a period and dividing by the respective number of years.

Derivatives requirements

The primary risk in assuming that the net effects on all participants in the derivatives market other than the major dealers rounds to zero is that the effects of new collateral requirements might turn out to more than offset the other advantages for non-dealers. At first glance, this concern appears plausible, since there are estimates that CCPs may require US$1 trillion or more of initial margin for the positions that they clear, as a result of massive increases in central clearing, combined with more conservative margin requirements resulting from the lessons of the financial crisis.

However, a more detailed review suggests that this will not more than offset the benefits for non-dealers, although it is impossible to be sure. Heller and Vause (2012) estimate that the initial margin required by CCPs for all interest rate and credit default swaps might be US$0.7 trillion in an intermediate case. They indicate that such swaps account for about two-thirds of all swaps by both notional amount and by market value. Grossing the US$0.7 trillion up to reflect the missing one-third of swaps raises the figure to approximately US$1.1 trillion. Singh (2010) estimates that collateral at the major dealers already covered about 44 percent of their swap exposures. If this can serve as a reasonable proxy for the level of existing collateralization of the swaps which would be cleared by CCPs, then the net new collateral required as a result of moving to CCPs would be approximately US$0.6 trillion.

There will be a cost to funding the additional collateral. For dealers, this would likely involve either selling some longer-term securities to replace them with the short-term government notes that CCPs will generally require, using repos of longer-term securities to achieve the same effect, or raising some additional funding to purchase the necessary collateral outright. For non-dealers, the most likely approach will be to borrow funds in order to buy appropriate securities for the collateral needs. For newly raised funds, the net cost will be the difference between the rate on the borrowing and the rate earned on the securities to be used as collateral, since interest on the securities used as collateral remains with the owner of the securities. For a switch from longer-term to shorter-term securities or the use of repos, the cost will be the difference in interest earnings. On average, it appears reasonable to assume that the net cost will be in the range of 200bps.

Thus, the first-order effect of the higher collateral requirements would be to raise credit costs by approximately US$12 billion a year (US$0.6 trillion times 2 percent). Even without the offsets described next, this could be offset by raising lending rates by about 3 bps on the total size of assets held by banks in Europe and the United States. However, even this figure is likely to exaggerate the net effects, since there are a number of offsets:

  • Implicit credit spreads in bilateral derivatives transactions. The pricing of derivatives by dealers already includes a credit component when a counterparty does not provide collateral up-front. This cost is no less real for being unstated. It will no longer be necessary when dealing with a CCP or will be at a far lower level to reflect the much higher safety of a CCP. Unfortunately, it is impossible to make a good estimate of the total implicit credit spreads built into existing bilateral deals.

  • Lower capital requirements. Dealers will have lower capital requirements, and therefore lower costs, when clearing through a CCP rather than bilaterally.

  • Lower margins on exchange-traded products. There is a strong consensus that dealers will have lower margins on exchange-traded transactions than on their existing bilateral derivatives deals. This cost is built into the estimates in this study for the cost to dealers, but would be exactly offset by reduced costs for non-dealers.

In sum, it appears reasonable to assume, as this study does, that the various effects will at least net out for everyone but the major derivatives dealers, although it is impossible to establish this with certainty. More positively, it is also quite probable there would be a net benefit to the economy rather than the cost conservatively assumed here. It should also be emphasized that this study looks at the cost in non-crisis years, without taking account of the benefits of a reduction in the frequency of financial crises and the damage they cause. So, even if there is indeed a “cost” as shown here in the non-crisis years, this does not imply that the derivatives reforms do more harm than good.

Appendix II. Considerations in the Choice of Baseline Scenarios

A key consideration in any quantitative study of the effect of regulatory changes is the baseline against which to compare. This would be relatively simple if financial institutions always ran exactly at the minimum levels required by regulation or even if they always maintained the same buffer above those minimums, regardless of economic and financial market conditions. However, this is clearly not true.

Financial institutions decide their target capital and liquidity levels based on a number of factors, not just regulatory requirements. Managements will choose their levels of safety margins so as to meet the maximum of: (i) the regulatory requirements plus whatever chosen buffer the institution prefers to hold to lower the risk of regulatory intervention if things go wrong; (ii) the economic capital that their own risk models tell them they need in order to minimize risks of bankruptcy or other bad outcomes; (iii) the level the rating agencies demand for the institution to maintain its targeted credit rating; and (iv) the level that counterparties and financial markets demand.

The financial crisis substantially increased the safety margins demanded under all four methods, not just the requirements of regulators. Banks’ own economic risk models have been adjusted to reflect substantially higher risk perceptions, in addition to automatic increases as the data from the financial crisis became part of the historical database. Rating agencies clearly became more conservative, even aside from their perceptions about how regulators might change requirements. Finally, counterparties, financial markets, and customers have shed the considerable complacency that they exhibited prior to the financial crisis.

The fair test, therefore, would be to compare expected post-reform levels of safety margins, such as capital ratios, with what those levels would be in the absence of regulatory changes, but taking account of changes in the behavior of other parties as a result of the financial crisis. Unfortunately, the latter levels cannot be observed and some subjective judgment is necessary to determine the appropriate baseline. However, it is imperative to reflect changes in safety margins demanded by non-regulatory constituencies, including banks’ internal risk managers, even though it requires judgment to estimate the figures. Otherwise, the calculations would unfairly penalize regulatory changes for costs that would have been incurred anyway as a result of the demands of other constituencies.

The baseline assumptions are shown in the individual sub-sections dealing with the different regulatory changes. In general, end-2010 figures on capital and liquidity in the United States, Japan, and Europe are used as a reasonable approximation of what market forces would have demanded even without regulatory changes. This has the potential of understating the effects of regulation, since some in the industry argue that a substantial portion of the reaction to Basel III was already included in the capital and liquidity levels by then.32 This does not appear to the authors to be the case, however. There has been clear market pressure for banks to carry substantially higher capital ratios, post-crisis, and for the quality of capital to be increased. This has been most obvious in Europe, where the end-2010 figures for the European banks probably overstate the regulatory impact since markets are clearly demanding more capital and liquidity than those banks had at end-2010, at least in aggregate. For Japan, the end-2010 figures seem reasonable and consistent with the other continents, although it is less clear what a reasonable baseline is for that nation. A few figures illustrate the rationale for using end-2010 ratios for the three regions. Financial markets became much more focused on the ratio of tangible common equity to total assets as a result of the financial crisis. Yet, even by the end of 2010, the Basel III equivalent of this ratio was only at about 3 percent in Europe and Japan and a bit over 5 percent in the United States. 33 It is very unlikely that financial markets would be comfortable with lower ratios than this in Europe and Japan in the long run. This also appears unlikely in the United States, where asset holdings are generally riskier, and the accounting creates higher levels of the ratio than under International Accounting Standards.

It is even less likely that new requirements for minimum liquidity levels had a substantial impact on bank balance sheets by end-2010. The Basel liquidity rules take effect after a multi-year delay and it is already widely believed that there will be significant changes in the rules on the liquidity coverage ratio and probably even more substantial revisions to the net stable funding ratio rules. Since the balance sheet adjustments could, in practice, be put in place by banks within a couple of years, the long transition periods and regulatory uncertainty make it improbable that banks had already acted on this in any major way by end-2010. Indeed, there is little anecdotal evidence that they have. On the other hand, they have presumably already reacted to market forces resulting from the crisis. Thus, end-2010 levels appear to be a good baseline for liquidity.

Similarly, the other major categories of proposed regulatory changes are unlikely to have been reflected in banks’ financial statements by end-2010. Transition periods and regulatory uncertainties in these areas also appear to have given banks enough breathing space that they have not dramatically altered their activities yet.

Appendix III. Assumptions for the Credit Pricing Equation

Marginal tax rate: A 30 percent rate was used for the United States, based on the analysis in Elliott (2009). This assumes that tax management techniques reduced the effective marginal rate somewhat below the statutory 35 percent federal rate plus applicable state taxes. 30 percent was also used for Europe based on Kopp et al. (2010) and Schanz et al. (2011) for the United Kingdom. The effective statutory tax rate for Japan is currently higher, but it is assumed that tax management techniques lower this to 30 percent.

Minimum ratio of capital to RWA: This is explained in the text related to Table 2.

RWA as a percentage of total assets: This is taken from company reports in the sample and assumed to remain constant at end-2010 levels.

Required return on equity (ROE): As discussed in the body, the ROE in the loan pricing equation is 12 percent for European and U.S. banks. For Japanese banks, it is 7 percent.

Base cost of other funding sources: This is a rough estimate of the weighted cost of deposits and debt funding in equilibrium, some years hence. As such it is necessarily quite imprecise. Rates are assumed to be higher than the present historically low levels that have resulted from the financial crisis, ensuing severe recession, and resulting policy actions.

Administrative expenses: For Europe, this is based on Kopp et. al. (2010). For the United States, this is based on Elliott (2009). This figure is somewhat difficult to calculate since it requires the allocation of total costs to lending and to other activities. For example, non-interest expense at United State’s banks is much higher than 150 bps, but much of this is directly related to insurance brokerage and other activities which do not involve lending and which bring in higher levels of related income. Fortunately, the imprecision here is only tangentially relevant to the analysis, since it does not affect the marginal cost of the regulatory changes. The one impact is that it influences the authors’ estimates of how much expenses could be cut in response to the cost pressures on the banking industry.

Base liquidity gap: Taken from Table 8.

Percentage of capital that replaces short-term funding: For illustrative simplicity, the marginal cost calculation for capital requirements assumes that additional capital replaced other funding sources pro rata. Therefore, a portion of short-term funding was replaced with capital, which counts as longer-term funding for the LCR and NSFR calculations. It is assumed that 30 percent of the additional capital replaces short-term funding.

Increase in pre-tax funding cost or reduction in investment income: This represents the increased cost of shifting from short-term to long-term funding sources or the decreased investment earnings from switching from less liquid or longer-term assets to more liquid or shorter-term assets. As shown in Abouhossein (2011), European banks have multiple avenues to adjust their asset and liability portfolios. That analysis showed that the more expensive, but more likely, methods would cost modestly more than 200bps. The exact 200bps reduction in interest margin for Europe and the United States in Table 9 is based on the assumption that some of the adjustment would be done with cheaper methods. As noted in the body, BCBS (2010) assumes a 100 bps difference in short-term and long-term interest rates based on historical figures. For Japan, an adjustment cost of 125 bps is used. Kato et. al. (2010) suggests a significantly lower cost would exist currently, but it is assumed here that this would be higher in equilibrium, as rates and related spreads likely resume more normal long-term patterns.

Reduction in interest margin as percentage of total assets: Since no sources provided a breakdown of the liquidity gaps between lending and other activities, the costs of meeting the LCR and NSFR requirements is assumed to be spread evenly across the full range of bank activities.

Cost of derivatives changes: Taken from Table 9.

Cost of new tax and fee measures: Taken from Table 10. Taxes and fees are assumed not to be tax-deductible and therefore need to be offset by after-tax income from other sources.

Cost per dollar of assets, for derivative reforms and tax changes: The costs are assumed to be spread evenly across the full range of bank activities.

Appendix IV. Sensitivity Analysis

Changes in key parameter assumptions can have a significant impact on the estimated cost of regulatory reforms. Figure 1 shows the impact of changes in key parameter assumptions. Increases in the minimum required common equity Tier 1 capital ratio, the base ROE, or the marginal tax rate can have an adverse effect on lending rates while increases in the base cost of other funding sources and in the Modigliani-Miller adjustment on capital reduce costs. The first set of increases works as an additional cost to banks that needs to be covered with an increase in lending rates. The second set reduces the effect of ROE on lending rates by either replacing equity with a cheaper source of funding or by offsetting the costs of adding equity. Except for the marginal tax rate, lending rates are a linear function of key parameter assumptions.

Figure 1.
Figure 1.

Effects of Changes in Key Parameter Assumptions on Lending Rates

(In bps)

Citation: Staff Discussion Notes 2012, 011; 10.5089/9781475510089.006.A999

Source: Table 14 on page 21.

Appendix V. Supplementary Tables

Table 11.

European, Japanese, and U.S. Banks in the Sample

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Table 12.

Planned De-Risking Measures, End-2010

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Source: Company reports.

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1

We are grateful for the guidance and comments provided by José Viñals, Jonathan Fiechter, Aditya Narain, Jodi Scarlata, Sally Chen, Gianni de Nicolo, Lev Ratnovski, Francesco Columba, and other colleagues in the Monetary and Capital Market Department. The views expressed in this paper are those of the authors.

2

Douglas Elliott is a Fellow at the Brookings Institution and was a consultant to the IMF for this project.

4

The Basel Committee on Banking Supervision (Basel Committee or BCBS) is the global coordinating body for bank regulators. The Basel III accord is their latest comprehensive agreement on minimum regulatory standards for bank capital and liquidity requirements, which will be implemented starting in 2013.

6

It should be noted that a number of simplifying assumptions had to be made to put the results on a reasonably consistent basis for the table, given their disparate approaches.

7

MAG (2010) estimated loan spreads that are slightly higher over a period of 35 quarters than then ones estimated by BCBS (2010) and slightly lower over a period of 48 quarters.

8

Portions of the following discussion are taken from Elliott (2009). See also King (2010) for a similar approach.

9

This is especially true in economic and econometric models featuring neither bank capital nor bank liquidity.

10

Individual country studies that build on the pricing equation above include Koop et al. (2010), Schanz et al. (2011), de-Ramon et al. (2012), for instance.

12

Researchers include, for instance, Myers (1984) and Myers and Majluf (1984) who proposed the pecking order hypothesis in the capital structure.

13

The comparison to the 25 bps that generally represents the smallest increment in which major central banks adjust their short-term policy rates, is an approximation. For example, central bank moves usually only directly affect short-term rates, whereas loans have an average duration of several years. In addition, long-term rates could react to the tightening of short-term rates in different ways. They could move by the same amount of short-term rates in a parallel shift of the yield curve; they could move less than short-term rates with an inversion of the yield curve; or, finally, they could move more than short-term rates with a steepening of the yield curve.

14

The changes in lending rates in the United Kingdom and the United States in Miles, Yang, and Marcheggiano (2010) and Gorton, Lewellen, and Metrick (2011) are adjusted for a change in the capital-to-total assets ratio of 1.24 percent and 2.65 percent, respectively.

15

Haldane, Brennan, and Madouros (2010) point out that the high 20 percent ROE in international banks before the financial crisis was the result of increased leverage (on and off-balance sheet), increased share of assets held at fair value, and writing deep out-of-the money options.

16

An investor’s required expected return can be estimated by dividing the expected ROE of a bank by the multiple of book value paid by the investor. Thus, investors who paid twice book value for shares in a firm with a 20 percent expected ROE were implicitly willing to accept a 10 percent return on their own investment.

17

Appendix III shows how the starting points were arrived at for each region.

18

See Abouhossein (2011), for a particularly detailed analysis.

20

See Appendix I for further discussion on the effect of collateral requirements on other market participants.

21

McKinsey (2010) and Oliver Wyman (2011) support this belief.

22

The disclosures by the banks are incomplete in many cases, not homogeneous, and reported in different documents and ways. This implies that there is some interpretation involved to understand the effects of the new Basel III capital rules on the banks.

23

EBA (2012) reports that, for a sample of 48 European banks, the common equity Tier 1 capital ratio would fall from 10.2 percent to about 6.6 percent on a pro-forma basis under Basel III. In a sample of 103 global and regional banks from advanced and emerging economy member jurisdictions, BCBS (2012) reports that the impact of Basel 2.5 and Basel III on a pro-forma basis is a reduction in common equity Tier 1 capital ratio from 10.2 percent to 7.1 percent on average, as of end-June 2011.

24

Hansen et al. (2012) find similar asymmetric effects of Basel 2.5 and III on RWAs.

25

Samuels et al. (2012) also find that European banks have higher projected 2013 Basel III core Tier 1 capital ratios than U.S. banks.

26

If public sector capital injections in European banks are excluded, pro-forma Basel III common equity Tier 1 capital ratios for European banks would be slightly lower than in U.S. banks on average. As Basel III only grandfathers the public sector capital injections until 2018, most European banks with public sector capital injections plan to repay them before 2018. This would lead to a reduction in their pro-forma Basel III common equity Tier 1 capital ratios. Indeed, Dayal et al. (2011) report pro-forma Basel III core Tier 1 capital ratios that exclude public sector injections, resulting in lower pro-forma Basel III core Tier 1 capital ratios in European banks (5.8 percent) than in U.S. banks (6.7 percent) as of end-2010.

27

See Le Leslé and Avramova (2012).

28

Samuels et al. (2012) surveyed 130 Asian, European, and U.S. equity investors to collect their views on RWA calculations. They found that most investors mistrust reported RWAs. For investors, the major differences between European banks’ risk weightings reflect not only their business mix but also the Basel II approach (standardized or the IRB approach) used by banks, the way internal model works, and the way that national regulators apply the rules.

29

BCBS (2012) also reported that the average LCR and NSFR in the sample of 103 global banks are 90 and 94 percent, respectively, as of end-June 2011. The associated shortfall of liquid assets and of long-term funding are EUR1.76 trillion and EUR 2.78 trillion, respectively, as of end-June 2011.

30

While Japanese banks might be affected by the derivatives reforms, cost estimates are not available for them.

31

Abouhossein and Ranjan (2012) estimate that two thirds of the 7 percentage point reduction in the projected 2013 ROE in global investment banks are associated with Basel III capital and liquidity rules while the other one third is related to the Dodd-Frank Act, the Independent Commission on Banking, and the French proposal.

32

For comparison, end-2009 capital ratios were approximately 0.5 to 1.5 percentage points lower, depending on the region.

33

Tier 1 common equity under Basel III appears to be a reasonable proxy for the tangible common equity ratio and may even capture investors’ intent better.

Estimating the Costs of Financial Regulation
Author: Mr. Andre O Santos and Douglas Elliott