By Gareth Gore
Aug 5 (IFR) - European banks have been forced to tear upyears of planning and rethink the way they run their biggestbusinesses after an unexpected clampdown from regulators onleverage, with some firms already selling assets and warning ofhundreds of millions in lost earnings.
Barclays and Deutsche Bank were first to respond to theshift, unveiling plans to cut up to 400bn in assets betweenthem, with bankers warning that more firms will be forced to cutback on leverage - and sell assets - over coming months.Barclays would have had to cut deeper had it not announced aplan to raise £5.95bn in fresh equity.
The Basel Committee on Banking Supervision surprised banksat the end of June with proposed new rules that calculate "grossleverage" by taking total equity as a percentage of totalexposure, in a move that banks say undermines separaterisk-weighted capital rules.
"Leverage ratios are a very crude measure, and we think itwould be very dangerous for regulators to shift away from allthe work banks have done on regulatory capital," said LarsMachenil, chief financial officer at BNP Paribas. "Risks can bevery different, and that needs to be reflected in the rules."
European banks are likely to be disproportionately hit becausethey tend to run bigger balance sheets than their US rivals. USbanks fare better, because they tend to sell off pools ofmortgages and loans rather than keep them on the books, and alsobecause accounting rules in the US allow them to net theirderivatives exposure to a much greater extent than is possiblefor European firms.
The proposed rule change is out for consultation untilSeptember 20 and banks are lobbying to get the proposal watereddown. But, as it stands, banks will be required to meet theinternationally agreed 3% leverage ratio by January 2018.
Some countries, however, want their banks to meet the targetmuch sooner. The UK, for instance, has said it wants banks tomeet the 3% level as soon as possible, pushing Barclays into itsrights issue (see "Barclays pays steep price for PRA switch").And while the Basel Committee would not require disclosure ofleverage numbers until 2015, many banks published their currentlevels last week under pressure from investors.
DISAPPOINTED
While some kind of leverage component has been part of BaselIII plans for some time, banks had hoped to convince regulatorsto calculate levels against risk-weighted assets, similar to theway capital requirements are calculated.
One of banks' preferred options is for leverage to bedetermined according to European Capital Requirements DirectiveIV rules. Using CRD IV, which entered into force in the EUearlier this month, banks can reduce total exposure by up to aquarter - and thus boost their leverage ratio - because thedirective has provisions for netting certain exposures,including some derivatives, against each other.
Unsurprisingly, most of the banks that declared theirleverage ratios last week did so using CRD IV derived numbers.
The Basel Committee, however, is keen to bring down leverageonce and for all and wants a cleaner - though cruder - method inorder to stop banks gaming the system. If the methodologyproposed by the Committee is adopted, banks will be judged tohave lower leverage ratios than those they claimed last week.
"We always said it was going to be tough, and that is onereason why there is a phased-in transition," said one member ofthe Committee, who asked not to be named. "But it is designed tomake sure banks can't leverage up the way they did before thelast crisis."
Indeed, the Committee recently found that banks could haveunderstated their capital needs by as much as two percentagepoints because of differences in internal models which largerbanks have used to calculate their capital requirements for muchof the last decade. They want to avoid similar gaming onleverage.
"Maybe the pendulum has swung too far; maybe there's toomuch leniency on risk weightings," said one CFO at another largeEuropean bank. "But if that is the case, then we need to betalking about a simplified, standardised approach rather thanfocusing on leverage, which is a very bad idea."
RATIOS MAY TUMBLE
If the proposals come into effect as they are now written,reported leverage ratios will tumble. According to MorganStanley, Deutsche's ratio would come down to 2.1% from the 3% itclaims it is at under CRD IV rules. Other banks that would dropbelow the 3% minimum level include Credit Suisse, UBS, SocieteGenerale and Barclays.
"We believe there will be significant adjustments before thefinal rules come into force," said the CFO. "CRD IV has beenapproved and is the best framework for us to work with at themoment. We are lobbying hard for regulators to stick to thisrather than change it again."
Banks under the 3% threshold would have to increase capitalthrough retained earnings or a capital increase, or reduce theirassets. According to Machenil, leverage rules are likely toaccelerate the trend towards originate-to-distribute activity inEurope, a process which some banks such as BNPP have alreadybegun.
"Regulators quite clearly want banks to shrink their balancesheets - that's been the case for quite some time," he said. "Inorder to ensure lending doesn't decline, banks need to movetowards more of an originate-to-distribute model, which is whatwe have been doing."
The effect of smaller balance sheets on earnings is unclear,however. Deutsche estimates that balance sheet cuts of between200bn and 300bn will reduce profitability by about 300m ayear, though that seems remarkably optimistic.
Bankers say the new rule could even prompt banks to take onmore risk. They say banks will shrink their balance sheets, andthen load up on riskier assets as a way of offsetting theresulting hit to profits.
"These rules just incentivise banks to take on more risk,"said the CFO. "We have to gather capital to grow our business,and if the share of capital is high, the rest of the balancesheet has to work harder. It's a simple truth: banks will haveto start dialling up risk again."
The new emphasis on leverage has many implications forspecific business areas within banks, some of which may nolonger be viable.
Barclays (BARC)