European Banks Face Capital Gap With Focus on Leverage
Europe’s biggest banks, which more than doubled their highest-quality capital to $1 trillion since 2007 to meet tougher rules, may have further to go as regulators scrutinize how lenders judge the riskiness of their assets.
Deutsche Bank AG (DBK), Barclays Plc (BARC) and Societe Generale SA (GLE) are among European banks that issued stock, sold units or hoarded earnings to bring capital, as a proportion of assets weighted by risk, into line with new global rules. Now some regulators are questioning the weightings, typically set by the banks’ own models, and embracing a broader measure of equity to total assets known as the leverage ratio that ignores risk.
“Europe’s banks are far from done on efforts to raise capital,” Lutz Roehmeyer, who helps manage more than 11 billion euros ($14.5 billion) at Landesbank Berlin Investment, said in an interview. “We have to take out the arbitrary method by which banks assign the risk of their assets.”
The focus on leverage is the latest effort by financial watchdogs to prevent a repeat of the taxpayer-funded bank rescues of 2008. The Basel Committee on Banking Supervision, which sets global banking standards, is taking a closer look at risk weightings after finding wide variations in a study of 32 lenders, Stefan Ingves, the group’s chairman, said this month.
Regulators say the leverage ratio provides a safeguard against the potential for gaming risk-based rules, which allow banks to assign weightings depending on how they judge the safety of assets on their balance sheets. Government bonds or loans to borrowers with good credit require little or no capital, while riskier assets such as subprime debt command a higher allocation.
The Bloomberg Europe Banks and Financial Services Index, which comprises 40 stocks, rose 1.1 percent by 2 p.m. Frankfurt time, extending its gain this year to 8.7 percent.
British and Swiss regulators have told banks to pay more attention to equity as a share of total assets, while the European Central Bank, slated to take over as the euro area’s banking overseer next year, will review the balance sheets of the biggest lenders in coming months, which may prompt some of them to reveal a greater proportion of bad loans.
Under current Basel leverage proposals, banks would have to hold equity equal to 3 percent of total assets by 2018. While the EU has said the rule needs more study, the U.K. and Switzerland are following a similar path as the U.S., where regulators this month proposed ordering eight of the largest lenders to hold capital equivalent to 5 percent of assets at their parent companies and 6 percent at their banking units.
“The goal posts have changed significantly for the banks over the past month in our view, with leverage coming from the appendix to the front page,” Keefe, Bruyette & Woods analysts, including Andrew Stimpson in London, said in a July 9 note.
Deutsche Bank, Continental Europe’s biggest bank, will cut assets by selling some loans and lowering liquidity reserves, Chief Financial Officer Stefan Krause said earlier this month, a plan that may lead it to shrink its balance sheet by as much as 20 percent, the Financial Times reported July 21. A Deutsche Bank spokesman declined to comment on the size of the reduction.
The confluence of regulatory energy could force some banks to sell stock, retain profit and cut lending, even as the region’s economy struggles to exit recession, Roehmeyer said. For shareholders, a higher leverage ratio could mean smaller dividends and less volatile results.
How much more capital Europe’s banks require will depend on where regulators set the threshold for leverage, what qualifies as equity and which assets lenders must hold on their balance sheets. Each part of that equation remains a matter of contention between regulators, banks and government officials.
About 200 euro-area banks would need to raise 400 billion euros to reach a 5 percent leverage ratio, the Paris-based Organization for Economic Cooperation & Development said in November. That calculation is based on international accounting rules, which permit banks to exclude fewer assets from their balance sheets than practices applicable in the U.S. allow.
The extra capital is in addition to about $500 billion of tangible equity -- the highest-quality capital -- that the 16 largest European banks added from 2007 through 2012, according to data compiled by Bloomberg News.
The EU hasn’t committed itself to imposing a binding leverage ratio on banks. Governments in the 28-nation bloc may apply the rule if they wish, and lenders will have to disclose how well they measure up to the standard starting in 2015.
The European Commission, the EU’s executive arm, has said it will report by the end of 2016 whether a binding leverage limit should be introduced. The Basel committee has said that nations should apply the rule alongside its capital standards, which require lenders to hold equity equivalent to 7 percent of their risk-weighted assets by 2019.
Even as the EU delays leverage rules, the committee is weighing tightening its 3 percent ratio by making the measure more consistent. The plan, which limits the securities and transactions lenders can exclude from balance sheets, could almost double the assets of U.S. investment banks Goldman Sachs Group Inc. (GS) and Morgan Stanley, Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London, wrote in a July 4 note.
While the six largest European investment banks would be able to net more derivatives under Basel rules than they can under international accounting standards, they would have to add some off-balance-sheet assets, such as unused credit lines, which aren’t counted under U.S. or international systems.
Deutsche Bank, whose asset base for calculating the leverage ratio would shrink by about 3 percent under the more stringent conditions, would still have “the highest mountain to climb,” according to Abouhossein. It would need to raise 12.3 billion euros in capital or cut assets by about 20 percent, or 409 billion euros, to reach the 3 percent goal in 2015, he said.
Morgan Stanley (MS) analysts estimate that the Frankfurt-based lender has equity amounting to 2.1 percent of total assets when defining capital according to Basel III rules, which would slide to 1.6 percent if the leverage requirement becomes stricter. Analysts at Berenberg Bank see Deutsche Bank at 2 percent and say it would have to delay dividends by setting aside four years of profit to exceed 3 percent.
Deutsche Bank sold $3.9 billion of shares in April and $1.5 billion of subordinated debt in May to boost capital levels. The bank previously sold stock in 2010, when it raised 10.2 billion euros to buy Deutsche Postbank AG (DPB) and shore up capital.
Banks that report under international accounting standards, including most European lenders, are starting to comply with new rules by disclosing assets left off the balance sheet because they were offset with equivalent liabilities.
In April, Deutsche Bank reported it had 395.5 billion euros of such assets, an amount that represents 19 percent of the company’s reported assets. Some secured loans to other banks are included in this amount, Bloomberg News reported July 11.
UBS AG (UBSN), Switzerland’s biggest bank, said in its first-quarter filing that the amount of offsetting, or netting, totaled 355.7 billion Swiss francs ($380.4 billion), about 29 percent of the Zurich-based lender’s reported assets.
Credit Suisse Group AG (CSGN) would have to raise 1.14 billion francs to meet Basel’s new leverage requirements in 2015, while Paris-based Societe Generale faces a 1.59 billion-euro gap, according to Abouhossein. Barclays, based in London, would have to boost capital by about 7 billion pounds ($10.8 billion) to meet the U.K.’s version of the 3 percent rule, the JPMorgan analyst wrote.
Marc Dosch, a spokesman for Credit Suisse in Zurich, declined to comment on the estimates as did Helene Agabriel at Societe Generale and Giles Croot at Barclays.
Bank of England deputy governors Paul Tucker and Andrew Bailey said this month that it’s right for a 3 percent leverage ratio to be imposed immediately, five years earlier than the Basel committee proposed. They also said the ratio should reflect potential losses, making the requirement even stricter.
The Swiss National Bank last month said the leverage ratio “is growing in importance as a measure of banks’ resilience.” The proportion of loss-absorbing capital to total assets on and off the balance sheets of UBS and Credit Suisse was 2.3 percent at the end of March, the central bank said. The ratio will have to rise to at least 3.1 percent by 2019 under Swiss too-big-to-fail rules. The SNB previously said both banks need to aim for higher leverage ratios in “good times.”
Some European bankers have denounced regulators’ newfound infatuation with leverage ratios rather than capital formulas that account for risk.
The “leverage ratio is too simplistic,” Deutsche Bank co-Chief Executive Officer Anshu Jain, 50, said last month in a speech in Frankfurt. “If we look at a bank’s total assets, we learn nothing about the quality of those assets.”
Societe Generale CEO Frederic Oudea, 50, said last month that European banks shouldn’t be subjected to the same leverage measures as U.S. competitors, which rely less on lending to finance clients. It’s “entirely unrealistic” for European banks to reach leverage requirements similar to those in the U.S., the KBW analysts wrote.
Some regulators don’t want to check banks’ internal models for assigning risk “because they think it’s too difficult,” and instead want to rely on the “totally meaningless” leverage ratio, Philippe Bordenave, co-Chief Operating Officer of Paris-based BNP Paribas SA (BNP), said in an interview this month.
Increased focus on leverage could encourage banks to load up on risky assets and “choke off the supply of low-cost financing to the economy,” Jain said.
By contrast, Danske Bank A/S (DANSKE) CFO Henrik Ramlau-Hansen said this month that he favors the use of a leverage ratio because it eliminates discrepancies created by using different models. The Copenhagen-based lender, with a balance sheet almost twice the size of Denmark’s economy, is resisting a June order by the country’s regulator to raise the risk weightings of its assets based on a comparison with other banks.
Reducing lending isn’t an option to meet leverage rules, the Bank of England has said. The European Banking Authority, the EU’s top financial regulator until the ECB takes on supervision, gave banks similar orders in 2011 after asking lenders to boost capital to restore confidence during the throes of the debt crisis.
Some banks will have little choice, Marc Hellingrath, a fund manager at Union Investment GmbH in Frankfurt, said in a July 16 phone interview.
“Most banks aren’t where they’ll need to be on the leverage ratio, so they’re cutting debt by reducing lending,” said Hellingrath, who helps manage more than 200 billion euros, including bank debt.
Even if they escape tougher leverage rules, euro-area banks will have to raise capital because the ECB probably will apply more stringent criteria for judging risk than national regulators, said Klaus Fleischer, a professor of banking and finance at the University of Applied Sciences in Munich.
Euro-area leaders are handing supervision to the central bank to help ease the debt crisis, which was stoked by concern that lenders and states were becoming too intertwined as governments bailed out firms that in turn bought their debt.
The ECB’s asset-quality reviews will highlight capital deficits with a focus on the economies of Germany, France, Italy and Spain, said James Chappell, a London-based analyst at Berenberg Bank.
“If the market is to believe the review is done properly, we expect banks in these countries to have to address capital needs,” said Chappell, who estimates that Europe’s biggest listed lenders have a shortfall of as much as 400 billion euros based on a measure of shareholder equity to assets.
France’s Credit Agricole SA (ACA), Credit Suisse, Deutsche Bank, Societe Generale, Spain’s Banco Santander SA (SAN) and Frankfurt-based Commerzbank AG (CBK) are the banks in Europe with the lowest leverage ratios, according to Berenberg.
The ECB review could accelerate capital-raisings as euro-area lenders still need to trim balance sheets by as much as 1.5 trillion euros, Ernst & Young LLP wrote in a July 1 report.
Roehmeyer at Landesbank Berlin said that while banks are “trying to shrink themselves healthy,” some firms may be able to raise capital with share sales.
“There’s not much readiness from bank owners to provide more funds, but banks are going to ask them for equity if it doesn’t cause too much damage to their reputation or share price,” he said.
The likelihood that European banks will have to boost capital is weighing on their market valuations, said Peter Braendle, who helps manage about $60 billion at Swisscanto Asset Management AG in Zurich.
The 40 financial companies tracked by the Bloomberg Europe Banks & Financial Services Index trade, on average, at 0.9 of their tangible book value, or what investors expect to receive if a company fails and liquidates its assets.
“Bank prices being at the bottom show that many people are considering capital-raisings inevitable,” Braendle said.
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