Including updates on capital shortfalls, internal audit functions and guidelines on CRD III


Capital, capital, capital

The capital shortfall at EU banks is 8% higher than originally thought, according to the latest assessment from the European Banking Authority (EBA) released on 8 December. In aggregate, European banks need to raise 114.7 billion euros as an exceptional and temporary capital buffer against sovereign debt exposures and to ensure Core Tier 1 capital ratio reaches 9% of risk weighted assets by the end of June 2012.

The EBA tests indicate that approximately one-third of banks sampled need stronger capital reserves to meet the June 2012 deadline. Banks in Italy and Spain will need to raise significantly more capital, while French banks have already built-up sufficient reserves to buffer against potential sovereign bond write-downs according to the EBA. German banks have a capital shortfall of 13.1 billion euros which is three times originally estimated in October, although is still small relative to the size of its banking system. In contrast, banks in the Ireland, Luxembourg, Sweden, UK and six other countries require no additional capital.

Some investors may be relieved that the overall recapitalisation figure isn’t higher in light of growing concerns about the eurozone, but others may be surprised that the gap hasn’t been reduced. In the last two months banks have taken a number of steps to bridge their capital shortfall, such as buying back their debt securities, hoarding profits, limiting bonuses and dividend payments, converting some debt to equity-like instruments and deleveraging. However, write-downs of sovereign debt have largely off-set those efforts.

In a press statement accompanying the publication of its capital assessment, the EBA stated that deleveraging could only be used in part to achieve a firm’s capital targets and only in cases where assets had been transferred to a third party (and not just dumped), to ensure the flow of lending was kept constant in the real economy. While difficult to enforce, this intent is sound; wholesale deleveraging could trigger a vicious spiral with a reduction in lending decreasing economic activity, which would in turn, damage banks’ balance sheets and result in a need for additional capital.

The deleveraging process has already begun in earnest. Banks in France, the UK, Ireland, Germany and Spain have already unveiled plans to slash a total of 775 billion euros of assets in the next year, according to data collected by Bloomberg. Specifically, the bank with the biggest single gap to close according to the EBA, Santander, has taken a number of steps to address its capital shortfall, including selling a number of its profitable businesses in Latin America.

Morgan Stanley analysts believe that this is just a start, and European banks will have to reduce their balance sheets by 1.5 trillion- 2.5 trillion euros over the course of the next 18 months to meet capital requirements. Many private equity firms and hedge fund managers are eying up opportunities for bargains in 2012 on the back of anticipated deleveraging. Others believe the correction will be more protracted, probably drawn-out over a ten year period similar to Japan’s financial woes during the 1990s.

However, so far most assets have been sold at close to market value and it seems unlikely that banks (or governments) will let assets go at any price in an effort to raise capital. This stand-off raises the probability of public bail-outs in 2012 for a number of weaker eurozone banks.

The European Commission is planning for this eventuality and has recently updated and extended its state-aid rules and accompanying support framework for banks in the context of the financial crisis. As a result, the Commission’s Banking Communication, Recapitalisation Communication, Restructuring Communication and Impaired Assets Communication will all remain in place during 2012, due to the increased financial tensions caused by the sovereign debt crisis. Moreover, in view of the changing regulatory and market landscape, the Commission anticipates that in the future capital injections by member states are more likely to take the form of shares bearing a variable remuneration, and has provided some clarification on the pricing rules for capital injections.

While this gives greater freedom for governments to support their banking sector next year (relative to other industries), supported entities will still be subjected to pretty stringent conditions. In March 2011, following negotiations between the Commission and the Irish government, state-supported Bank of Ireland and Allied Irish Bank were required to sell-off 53 billion euros of assets by 2013 to comply with state-aid rules. In the UK, following the injection of public funds into its banking system in 2008-2009, Royal Bank of Scotland had to divest 251 billion pounds of assets from its balance sheet and engage in a significant restructuring programme. Similarly, Lloyds Banking Group is required to dispose over 600 branches to limit the distortions of competition brought followings its state-sponsored acquisition of Halifax Bank of Scotland in 2008.

Banks which are vulnerable will note these cases and push hard to raise capital in the year ahead, to avoid ending up in state-aid scenarios. A forced public bail-out would have serious ramifications for a bank’s long-term strategy, remuneration policy and underlying profitability. Public sentiment has turned against government bail-outs in the past two years, and as a result politicians may be more inclined to let institutions fail rather than shoring them up with public money than they were a couple years ago.

The current patchwork framework on state-aid rules for the banking system will not remain in place in the longer-term. The Commission will keep the situation in the financial markets under review and will take steps towards more permanent rules for State aid used for rescue and restructuring of banks, as soon as market conditions permit. All this means EU banks would be well advised to address any capital shortfalls now.


Assessing the effectiveness of internal audit functions

The Basel Committee on Banking Supervision (the Committee) has issued revised supervisory guidance for assessing the effectiveness of internal audit functions at banks. The proposed guidance is intended to promote stronger internal audit functions in banks and incorporates lessons learnt from the 2008 financial crisis.

It is based on 20 principles, split into three sections:
  • supervisory expectations
  • the relationship between the supervisory authority and the internal audit function
  • supervisory assessment.
The Committee has outlined some high-level principles underpinning expectations of internal audit functions at banks. Independence, competence, integrity and sufficient experience are all necessary conditions for effective internal audits. An effective audit is where the internal audit team can ‘objectively evaluate the quality and effectiveness of banks’ internal controls, risk management systems and governance structures’.

For operational matters, the Committee recommends that each bank should have an internal audit charter which sets out the ‘purpose, standing and authority’ of the internal audit function. In particular, the scope of the internal audit needs to be sufficiently wide to ensure that all activities, including those outsourced, are captured. It should also outline the governance structures associated with the internal audit, clearly delineating the role and functions of the various actors involved, such as the board of directors, the audit committee and the head of the internal audit department.

The Committee also recommends that supervisors interact regularly with banks’ internal auditors to discuss the risks highlighted by both parties, understand the mitigation measures taken by management to address perceived weaknesses, and monitor the effectiveness of these corrective actions. As such, banking supervisors must not only ensure that effective policies and practices are in place on the internal audit side but also that management are taking appropriate remedial actions.

The final principles relate to the supervisor’s role in assessing the internal audit function. The Committee proposes that supervisors regularly assess the quality of the internal audit and be prepared to take informal or formal supervisory action to remedy any identified deficiencies.

The Committee’s work on the principles represents welcome progress towards finding ways to rebuild trust in our financial institutions. Banks need to put in place mechanisms which neutralise risks in a transparent and robust fashion, to try to keep their investors satisfied with lower returns as banks profitability falls as the costs of implementing Basel III and other regulations hits them. Internal audits provide vital assurance to a bank’s board of directors and senior management team, and bank supervisors, about the quality of a firm’s internal control system. In doing so, the function helps reduce the risk of loss and/or reputational damage to the bank which, in turn, can lower funding costs.


EBA consults on technical amendments to CRD III

The European Banking Authority (EBA) has released two consultation documents in response to amendments made to the Capital Requirements Directive (CRD) III, which will come into force at the end of the year. Both consultations relate to various mathematical modelling approaches used by banks to measure and estimate the impact on capital of future losses in the trading book — with the view to assisting banks and regulators to manage and assess risk. The new guidelines would apply to institutions using the Internal Model Approach for purposes of calculating their capital requirements for market risk in the trading book.

The CRD III/Basel 2.5 amendments regarding the value-at-risk-based trading book framework cover amongst others an incremental risk capital charge (IRC), which includes default risk as well as migration risk for unsecuritised credit products and a stressed value-at-risk (VaR) requirement . The EBA’s guidelines should not be viewed as a comprehensive set of rules but rather an additional guidance on compliance of IRC modelling approaches.

The first consultation relates to guidance on Stressed Value at Risk (VaR) modelling, and attempts to rectify the failings of the ‘normal’ VaR model which was found not to be a good measure of tail risk. CRD requires banks to measure historical data over a continuous 12-month period. The proposed guidelines elaborate on how to carry out the calibration of the Stressed VaR measure, including the number of stressed periods to be used and how to identify the appropriate historical period. The consultation also provides guidance on the frequency and monitoring of a stressed period, the methodology associated with Stressed VaR, how to document their justifications for their chosen approach and the requirements for ‘Use test’. The objective of the additional stressed VaR requirement is to reduce the pro-cyclicality of the minimum capital requirements for market risk.

The second consultation provides guidance on modelling approaches for the incremental risk capital charge (IRC) to determine the level of capital required for market risk in the trading book. Among other things, the guidance addresses the positions that are subject to IRC modelling, the permanent partial use of IRC models and the use and sources of individual parameters and ratings in IRC modelling. With the implementation of the incremental risk charge to the value-at-risk modelling framework in the trading book a more robust financial system should be achieved.

These proposals are aimed at harmonising how risk is calculated by EU banks, and is expected to contribute to achieving a level playing field, and enhancing convergence of supervisory practices amongst the competent EU authorities. Neither of these models is a panacea, and firms should always explore supplementary techniques to buttress standard methods to get a more accurate reflection of potential losses to their trading book. For example, research from JP Morgan has shown that stressed VaR does not measure the maximum potential loss, and does not capture liquidity and systemic risks.

The consultation period on these guidelines closes on 15 January 2012. We expect national competent authorities in the EU to implement both sets of guidelines by incorporating them within their supervisory procedures within six months of publication of the final guidelines. Thereafter, the competent authorities will have to ensure that firms comply with the guidelines effectively.