BASEL III CHALLENGES FOR THE CARDS BUSINESS

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1 BASEL III CHALLENGES FOR THE CARDS BUSINESS BY CARL MOSESSON Central Bankers from the largest economies have published a set of guidelines which we will call Basel III designed to strengthen the ability of the banking system to better withstand events such as the failure of Lehman Brothers and the near-collapse of American International Group. One way they will do this is by requiring banks to hold more capital against their loans and other assets, thereby reducing the leverage of the banking system. Another way requires banks to have more liquidity, increasing the ability of a bank to meet sudden withdrawals or other funding needs. Demonstrating that a bank is Basel III Compliant will, over time, be a requirement of local regulators, lenders and bank counter-parties. With the advent of Basel III requirements, all banking businesses will need to justify the capital levels needed for the growth of loans and profit expectations, and that the capital is as productive as possible. While this capital allocation process has always happened, Basel III rules demand an active and informed response by any line of business that it touches, and it touches the cards and payment business extensively. Cards and payments executives must now challenge fundamental business assumptions to remain relevant within a bank. These business assumptions include: which customers to pursue, what are the optimal products to offer them and what is the best delivery model to serve them. CAPITAL REQUIREMENTS ARE GOING WAY UP: MINIMUM CAPITAL LEVELS WILL TYPICALLY INCREASE FROM 8% OF RISK ASSETS TO 13% % OF RISK ASSETS. BASEL III MADE SIMPLE The so-called Basel process (named for the home town of the Bank for International Settlements, a group of the world s top central banks) has been going on since the 1980s. It represents the attempts of a BIS working group to develop common definitions and rules for the types and level of capital banks across different banking systems must maintain in order to increase confidence in banks. It is up to national regulators and governments to actually implement these rules, with the incentive being that banks and systems that adhere to the standards will be more desirable counterparties and attract shareholder and borrower funds at preferential rates. While Basel I was largely limited to large banks, and Basel II had selective application of the standards, Basel III is slated to be applied to many more banks. For example, the European Central Bank (the ECB) has said that ALL banks that it supervises will be subject to Basel III standards and the US banking regulators (the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency) are likely to apply the standards to the vast majority of the banks they supervise. JANUARY 2013

2 After the worst financial crisis of modern times the regulatory regime has changed and Basel III is not only much tougher than anything that came before but far more complex, addressing liquidity buffers essentially how long a bank can operate without market funding as well as capital how much in the way of unexpected losses it can absorb. Even the US is not holding back this time and is, like most countries, applying the rules to all of its larger banks. In other words, Basel III can materially effect your business growth prospects and your regulatory relationships. On the other hand, understanding how Basel III works may provide the informed leaders with levers to proactively reduce the capital footprint of the card and payment businesses. The key facts credit card bankers need to understand are: Capital requirements are going way up: Minimum capital levels will typically increase from 8% of risk assets to % of risk assets Regulators have identified a group of firms deemed Systemically Important Financial Institutions (SIFIs) that will bear the higher capital requirements because of the impact their failure may have on the whole financial system Some countries like Switzerland have topped up capital requirements even more ( the Swiss Finish ) As a definitional matter, any unsecured credit or charge-card sales are considered bank assets, or loans, until they are paid-in-full The assets that require capital have been broadened and better defined, so even internal guidance lines and securitized assets now carry capital costs once limited to formal commitments and loans held on the balance sheet The quality of required capital (i.e., fewer types of Preferred Equity) has been considerably enhanced, which will drive up the ultimate cost of the capital necessary to either maintain or grow receivables Most leading economies (so-called G-20 countries) have committed to start implementing Basel III in 2013, with eventual compliance later this decade The even more onerous rules of local regulations such as Dodd-Frank still need to be reconciled with Basel III, predictably on the side of more, not less, stringency Regulators have identified a group of firms deemed Systemically Important Financial Institutions (SIFIs) that will bear the higher capital requirements because of the impact their failure may have on the whole financial system. 2

3 WHY BASEL III MATTERS A LOT TO THE CREDIT CARD BUSINESS Credit Cards were one of the most profitable lines of business in banking over the twenty years leading up to the panic of 2008 for a number of reasons: the ability to securitize and fund loan portfolios was capital friendly, loans could be priced dynamically for risk, and value-added product features such as co-brand rewards justified fee and other revenue streams. Securitization, in particular, facilitated much lower levels of capital since, in theory, third party investors stood to absorb any extraordinary losses. All of these profit levers have been sharply curtailed through legislation even as consumer credit capacity has been compromised by the ongoing economic crisis. The purpose of the new capital regime is to make banks as a whole better able to withstand market shocks of a kind consumer money-lending is most unlikely to produce. Card portfolio losses are among the easiest to manage in all of banking. The problem is that Basel III assigns capital weights based on the nature and amount of exposure rather than the more fine considerations of actual risk of catastrophic loss. A billion dollars in card loans or unused credit commitments to thousands of consumers has the same Basel III treatment as a billion dollar exposure to a single counterparty. All unsecured credit is more capital hungry than secured credit. The purpose of the new capital regime is to make banks as a whole better able to withstand market shocks of a kind consumer money-lending is most unlikely to produce. In the way of a concrete illustration we present an apples-to-apples (that is, no changes other than Basel III capital rules) comparison of one bank s credit card business under current and proposed capital rules. The business produced a very respectable ROE of 14% in 2010 but, had Basel III been in place, it would be a full 5 percentage points lower, at 9%. The average equity required to support the same loan book generated by the business increases from $15 billion to $22 billion, as the underlying table shows and the effective capitalization climbs from 10.4% to 15.4%. The credit business under Basel III rules doesn t throw off less cash, it simply consumes considerably more equity. The point here is that equity will likely not be easy or cheap for banks to raise, and the businesses with the highest returns on equity will attract the attention and resources of bank management. Lower ROE businesses will be prevented from receiving the capital they need to grow, and may even be pared down, as seen with the recent divestitures by Citigroup, Bank of America and GE both domestically in the US and globally. So, every business will be under a more intense capital-efficiency microscope. 3

4 FIGURE 1: BASEL III IMPACT EXAMPLE 2010 CARD BUSINESS IN BILLIONS Total Revenue $17.2 Provisions for Losses ($8.0) Risk-adjusted Margin $9.1 Expenses ($5.8) Pre-tax Income $3.3 Net Income $2.1 Average Loans $144.4 EQUITY BASEL I BASEL III 5% Average Equity Capitalization Rate % 15.4% ROE 13.9% 9.4% 1. The average equity reflects economic capital (the centerpiece of Basel III) as well as Goodwill associated with portfolio purchases 2. Represents average equity as a percentage of average loans 14% ROE BAU Basel I Increased Capital Buffers 9% ROE Post Basel III Implementation Source: MasterCard Analysis & the impact based on the 2010 Annual Report of a US bank. Note: All factors are held constant except for Basel III Banks are assigning ROE thresholds and investment hurdle rates to lines of business from the top down as part of an overall capital optimization program. Because it is at heart about credit, the cards business will face particularly daunting challenges. Essentially, there are two obvious responses (aside from quitting the business altogether, which given its high margin potential in normal economic conditions is seldom sensible) available to banks: Banks are assigning ROE thresholds and investment hurdle rates to lines of business from the top down as part of an overall capital optimization program. Sweat the conventional business model harder to improve profitability and ROE on assets booked by addressing pricing, risk appetite and operational costs Make real changes to the conventional business model that improve the cards business capital efficiency, hence helping (even marginally) to improve the Basel III capital efficiency of the whole bank The ways of doing the first are obvious, including cost control, portfolio management and culling profitable, but below-hurdle rate customers. These tools reach a point of diminishing returns quickly, however, given the wall of capital demanded by Basel III and the overall earnings the bank needs to attract and retain that capital. Doing the second represents a challenge simply because credit card business managers have never had to rethink their business model to conform to, and leverage, a detailed capital regime. 4

5 We believe that making real changes to the business model and customer treatments is imperative for two reasons. First, it places the card business in a proactive strategic dialog with top management about the future direction of the bank in the Basel III world, and has the potential to gain more control over its fate. Second, the Basel III capital challenge can unleash much needed creativity in rethinking and repositioning the business, its products and its customer value propositions. BASEL III CAPITAL RULES AS LEVERS OF PRODUCT INNOVATION There are three key levers that can be used to change the capital consumption of any business that takes on credit risk under the Basel III framework: Transform unsecured credit into credit secured by collateral such as real property or cash. This may also entail shifting certain customers from credit products to debit products Transform long credit exposure durations (grace periods, billing cycles, credit limits) into shorter durations, particularly for non-revolving customers Transform contingent liabilities, especially unused credit lines (even internal guidance lines), into just in time, or case by case, underwriting The entire history of the credit card business has shown how attractive unsecured revolving credit with ample grace periods and substantial known credit limits are to most consumers and small businesses. Transforming all of these key product parameters across the board for the sake of capital relief is probably not a feasible option for issuers. However, there are many discrete consumer and small business segments that need the transaction and working capital power of the card and may be open to new product constructs. Only by careful market research and test and learn can more capital efficient products be added to the mix. Given the Basel III regulations will be implemented, it remains for issuers to ask themselves three questions in order to assess their preparedness: 1. Which customers will be both capital and earnings friendly? 2. Should I alter my product propositions and attributes to better serve my desired customers in a more capital efficient manor? 3. When (and how) do I begin to recognize these changes in my investment analyses for marketing and product campaigns? AUTHOR Carl Mosesson Carl Mosesson is a Principal in the Strategy and Finance Knowledge Center of MasterCard Advisors. Mr. Mosesson is based in Purchase, NY, and can be reached at carl_mosesson@mastercard.com. For additional insights, please visit insights.mastercard.com and mastercardadvisors.com MasterCard. All rights reserved. Proprietary and Confidential. Insights and recommendations are based on proprietary and third-party research, as well as MasterCard s analysis and opinions, and are presented for your information only.