Friday, July 11, 2008

Speculations on bank strategy: Capital Adequacy perspective

On the whole, I see banks lending out much less in the foreseeable future.

Everybody already knows that, you say? Well, I’m not just talking about the deleveraging currently going on in the banking sector. I’m talking about bank prospects long after the current economic downturn and bank crisis are long gone.

That’s my prognosis, at least, if the securitization market does not go back, not to the same extent it was before this mess.

For a long time, securitization provided US banks with a cheap way to lend money. For much of the world, where the market for securitization was not as deep, banks have had to contend with the credit-tightening effects of the Basel II requirements for bank capital adequacy.

In a nutshell, Basel recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital. This in now way includes funds coming from bank deposits or bank borrowings.

Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. For a good summary of the capital adequacy rule, click here.

That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in terms of capital. So in fact, the more successful a bank is in raising its deposits, the more it needs to raise equity capital, so that it can in turn be able to lend out these deposits as risk-weighted loans.

The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards. A necessary metric to ensure that banks have enough capital on hand to absorb potential loan losses, it nonetheless increases the costs of lending, regardless of the credit-worthiness of the borrower.

As mentioned, US banks were able to circumvent the need for capital adequacy because they did not keep a large portion of their loans on their books. No, they securitized a lot of these assets which would otherwise have necessitated the banks to provide additional capital buffer on their books.

For as long as there was a ready market that invested in securitized loan assets, banks could go on recycling money by reinvesting securitization proceeds into newer loans. And for as long as the bank was able to securitize loans, there was no need to raise new capital. Any profits earned at the end of the year were dividended out, because there was no need to maintain increasing amounts of capital in their books.

Now that the securitization market has gone away, and I believe that it won’t be as big as it was when it comes back, banks now have to face the full effects of the capital adequacy rule.

What are the repercussions?

Well for starters, as I mentioned, there will be less bank lending. Banks will naturally gravitate more to assets with less risk weight. That means more investment in government securities, in place of the decreased lending.

There will be less bank stock dividends. As mentioned, the more banks lend out, the more capital it needs in its books. Therefore, as long as the bank’s assets are growing, there will less dividendable earnings at the end of the year (Less than what we saw in the last decade).

Because lending will become more expensive for banks, it will need to cut costs in other ways. The most obvious cost cuts will be in general operating costs. That means less investments in upgrading facilities, paying employee salaries, maybe less marketing expenses.

We will see more banks raising capital, long after the credit writedowns are gone. In fact, in the future, those banks most successful in growing their asset base will have to raise capital on a regular basis. In a way, this might be good for the market. Instead of looking at institutional investors as investors to prey on, banks will look to these as potential shareholders. There could be more transparency as a result.

To offset the higher costs, banks will need to have greater economies of scale. As a result, we will see more bank mergers. Smaller banks will no longer be as attractive an investment on a stand alone basis. The need for greater capital to maintain adequate capital ratio will make these unsustainable on their own. But when merged with a larger entity, the combined firm will be able to cut redundant costs. With a bigger market reach, the combined bank might be able to earn a return acceptable to shareholders.

So we might see lending more and more concentrated in the larger banks, which are able to afford the higher lending costs that come with Basel compliance, while the much smaller banks will become more adept at investing and trading government securities.

That’s my fearless forecast. Then again, these are mere speculations on my part. For all I know, the securitization market will go back, bigger and deeper than we ever saw. Or even better yet, banks might figure out another way around the Basel standards. Whatever that innovation will be, for sure it will involve re-packaging assets so they are assigned lesser risk-weights.

In an alternate future, will we see loans repackaged as government securities? It might sound ridiculous now, but even twenty years ago, I’m sure people would have found the concept of packaging good and bad loans together and selling the pool at credit-grade just as absurd.

Update: Similar-themed post here.

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