Implications of Basel III for the European banking sector

Implications of Basel III for the
European banking sector
Euro Finance Week 2011
Frankfurt
November 14, 2011
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Current context of financial regulation and risk management in banking
CDS spreads sovereign bonds, bps
6,000
5,500
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
2009 2010 2011
Europ. Banks
- MtB ~0.9 ~0.7 ~0.5
- CDS (bps) ~120 ~320 ~470
1 European Banks ex UK
2 5 yr spreads, European banks
SOURCE: Datastream
Greece
Portugal
Ireland
Italy
Spain
▪ Significant volatility in
the financial markets;
liquidity markets drying up
▪ Short-term capitalization
requirements from
EBA stress testing vs.
depressed bank equity
valuation levels
▪ Significant risks of an
economic downturn
▪ Longer-term regulatory
reforms and business
transformation in banks
and market structure
changes overall in the
financial services industry
McKinsey & Company | 1

New regulatory regime will force significant capital and liquidity shortfall
for Europe and U.S. financial institutions
EUR billions; 2019
European U.S.
~ € 750 billion
of common
equity shortfall
1,050
Capital
1,300
Shortterm
liquidity
2,300
Longterm
funding
SOURCE: McKinsey Basel III Impact Assessments European and US Banks, Nov. 2010
600
Capital
600
Shortterm
liquidity
2,200
Longterm
funding
McKinsey & Company | 2

After implementation of Basel III regulatory measures, ROE of
global banks could decrease by 3-4 pp before mitigation
Percent; expected pre-tax ROE
Without
regulation 2
Capital
requirements
Liquidity/
funding
With
regulation
Capital quality/
deduction
RWA (market risk
and credit risk)
Capital ratios
Leverage ratio 3
Liquidity (LCR)
European banks 1
Funding (NSFR) 0.6
0.7 ▪ Introduction of NSFR in 2018
10.7
-4.3
1 Sample includes ~45 banks across Europe
2 EU: based on 2004-07 ROE for individual banks scaled down to average 1980-2008 levels across EU
3 Only additional capital need (after increase of minimum capital ratio and capital deductions) considered
1.3
1.3
0.1
0.2
0.8
15.0
SOURCE: McKinsey Basel III Impact Assessments European and US Banks, Nov. 2010
U.S. average
0.8
0.7
0.7
0.3
0
8.9
12.1
-3.2
Main drivers
ESTIMATES
BEFORE
MITIGATION
▪ Limited recognition of DTAs
and minority interest
▪ Significant increase in market
risk and CCR RWA
▪ Common equity and Tier 1
target ratios set at 9 and 11%
▪ Additional capital need from
leverage ratio constraint
▪ Introduction of LCR in 2015
▪ Impact after phase-in of
full Basel III requirements –
before mitigating actions
McKinsey & Company | 3

Resulting impact on the financial and banking market structure:
what trends we do expect?
1
2
3
4
Significant repricing of banking products – though
timing given the different competitive positions unclear
Disintermediation and more direct capital transfer
between Corporates and Investors (insurances, funds etc.)
New structure for banks’ capital and funding markets
(secured funding, collateral management)
Continued deleveraging/derisking of banks’ balance
sheets and an increase in non-bank/shadow banking
activities
McKinsey & Company | 4

1
Basel III will significantly change product costs
bps
Products
Retail
banking
Corporate
banking
Trading
book
securities
Offbalance
sheet
▪ ST Retail loans
▪ Residential mortgages
< 35% risk weight
▪ Other mortgages
▪ ST Corporate loans
▪ LT Corporate loans
▪ Specialized lending
▪ Government bonds
▪ Corporate or covered bonds > AA-
▪ Corporate or covered bonds A-
▪ Bonds < A- (or unrated)
▪ Financial Institution bonds
▪ OTC derivatives (relative to market
value/current exposure)
▪ Corporate credit lines (non-FI)
▪ Corporate liquidity lines (non-FI)
▪ FI credit and liquidity lines
∆ Capital cost 1 ∆ Liquidity cost 2
20
15
15
15
15
15
25
30
30
30
25
25
50
60
55
∆ Funding cost 3 ∆ Total
1 Assuming target Tier 1 ratio of 8% under Basel II and 11% under Basel III; in addition, 20% increase to account for capital quality and deductions measures
2 Introduction of LCR in 2014; assuming current liability structure and 7% liquidity holding per product under Basel II and 105% LCR target ratio under Basel III
3 Introduction of NSFR in 2019; assuming 105% NSFR target ratio
SOURCE: McKinsey Basel III Impact Assessments, European Banks Nov. 2010
-5
0
10
10
10
15
10
-35
-20
-30
-15
-10
-15
-5
-10
▪ Eligible for liquidity
buffer
▪ Potential liquidity cost
benefit dependent on
individual bank
30
35
30
60
60
-5
5
5
5
ESTIMATES BEFORE MITIGATION
10
10
25
25
30
Reduced liquidity cost due to
increased long-term funding
50
60
15
15
10
25
45
45
40
Cost increase
over 50bp
50
60
70
70
80
75
85
85
McKinsey & Company | 5

1
Significant re-pricing would be needed to restore ROEs,
especially in structured products
Percent
Asset class
FX ~19
Rates - Flow 11-12
Rates - Structured 7-8
Credit - Flow
Credit - Structured
7-8
Commodities ~11
Cash Equities ~18
EQD - Flow ~11
EQD - Structured 12-13
Prime Services 11-12
Proprietary Trading
Increase in client margin needed1 RoE post(!) immediate
mitigation2 Target RoE of 12% Target RoE of 15%
10-11
11-12
1 Increase in client margin in percent of current margin (to bridge the gap between post mitigation RoE and target RoE)
2 Incl. technical mitigations such as improvements in data systems, collateral management, adjustments to product structure
SOURCE: „Day of Reckoning“, McKinsey Whitepaper, Sept 2011
N/A
1-5
N/A
1-5
N/A
1-5
N/A
10-15
5-10
30-50
30-50
N/A
N/A
N/A
20-30
15-20
15-20
Level of margin increase
30-35
>50 20-50

2
Disintermediation of banks’ B/S will lead to a more
US type/disintermediated debt market structure
Percent
Off
balance
sheet
On
balance
sheet
Off
balance
sheet
On
balance
sheet
Corporate
Bonds
Securitized
loans
Bank
Lending
Corporate
Bonds
Securitized
loans
Bank
Lending
100% 100%
19 20
22
58
1990
SOURCE: McKinsey Global Financial Initiative; McKinsey Global Banking Pools
50
30
100% 100%
0 6 11
11
94
78
2010
ESTIMATES
▪ US debt capital markets driven by
corporate bonds and securitizations
(in particular MBS)
▪ However, current regulation, e.g., on
backup liquidity lines, securitization,
and trading will require adjustments to
current business model, incl. some
reintermediation (see new US proposal
on covered bonds)
▪ European debt markets very focused on
bank lending
▪ Disintermediation expected due to
– High capital/funding charges on bank
debt (e.g., infrastructure finance)
– Reduced appetite for banking
exposure by insurance companies
(SolvII) and other inst. investors
– Countereffects from current regulation
as experienced in the US
McKinsey & Company | 7

3 Secured funding and collateral management will play
a significantly increased role
100% = EUR tr
Large
corporates
Other
wholesale
SME
Micro
Consumer
Finance
Mortgages
12.5
15%
16%
18%
6%
7%
38%
70-80%
30-40%
40-50%
20-30%
30-40%
70-80%
SOURCE: McKinsey Global Banking Practice, McKinsey Global Banking Pools
ESTIMATES
▪ Long-term funding: Expansion of secured
funding markets (vis-à-vis DCM and other
disintermediations)
– Covered bonds
– Increased and new forms of securitizations/loan
funds
– Government-sponsored programs (SME)
– Funding substitutions: syndicated lending
with direct placements towards institutional
investors
▪ Short-term funding: further growth in the
collateralized short-term/repo funding markets
incl. more active collateral trading with
corporates and institutional investors
▪ Important prerequisite: new regulatory
liquidity and funding requirements
(LCR/NSFR) are appropriately adjusted!
McKinsey & Company | 8

4
Overall, the banking system will be disintermediated at the
expense of near-/shadow banking business models
Assets 1
USD trillion
100
90
80
70
60
50
40
30
20
10
0
2002
03
04
1 Based on flow of Funds data for the Euro area, Australia, Canada, Japan, Korea, UK and US.
SOURCE: Financial Stability Board
05
06
07
48
08
09
44
2010
Banks
Share of
total (percent)
MM-funds,
Hedge-funds
Insurance and
pension funds
Public
financial
institutions
McKinsey & Company | 9

Implications for the banks’ risk management
▪ Significantly increased complexity of risk
management frameworks (regulatory capital/
liquidity/leverage frameworks, revised accounting
standards, rating methodologies, …)
▪ More forward looking discretionary management
interventions to handle increased
complexity and market volatility
▪ Further industrialization of risk management
processes (given continued cost pressures, but
also regulatory information requirements) through
increased level of specialization/automation
▪ Higher relevance for risk function in managing/
guiding bank transformation (e.g., to ensure
sustainable business models, manage regulatory
pressures etc.)
McKinsey & Company | 10