BASEL III CHALLENGES FOR THE CARDS BUSINESS



Similar documents
The New FDIC Insurance Premium Assessments: A Better Way Scott Hein and Timothy Koch April 6, 2009

How To Improve Profits At Bmoi

THE JESUIT UNIVERSITY OF NEW YORK GRADUATE SCHOOL OF BUSINESS ADMINISTRATION

The Goldman Sachs Group, Inc. and Goldman Sachs Bank USA Annual Dodd-Frank Act Stress Test Disclosure

Capital Cost Implications of Pending and Proposed Regulatory Changes

Guidance Note: Stress Testing Class 2 Credit Unions. November, Ce document est également disponible en français

FSB/IOSCO Consultative Document - Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions

Patrick M. Avitabile Managing Director Citibank, N.A. 111 Wall Street New York, New York 10005

Financing DESCOs A framework

Roche Capital Market Ltd Financial Statements 2009

Deutsche Bank UK Banks Conference 07 April 2011 Chris Lucas, Group Finance Director

Solutions for Balance Sheet Management

A leveraged. The Case for Leveraged Loans. Introduction - What is a Leveraged Loan?

Federal Reserve Policy on Payments System Risk

Rating Methodology for Domestic Life Insurance Companies

Supervisory Letter. Current Risks in Business Lending and Sound Risk Management Practices

Over-the-counter contracts for difference: Improving disclosure for retail investors

Morgan Stanley Reports Fourth Quarter and Full Year 2015:

2015 Survey of Credit Underwriting Practices

Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions

Financial System Inquiry SocietyOne Submission

HSBC FINANCE CORPORATION

Risk & Capital Management under Basel III

TRANSAMERICA SERIES TRUST Transamerica Vanguard ETF Portfolio Conservative VP. Supplement to the Currently Effective Prospectus and Summary Prospectus

Basis of the Financial Stability Oversight Council s Final Determination Regarding General Electric Capital Corporation, Inc.

PRIME DEALER SERVICES CORP. STATEMENT OF FINANCIAL CONDITION AS OF DECEMBER 31, 2014 AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Roche Capital Market Ltd Financial Statements 2012

NATIONAL FINANCIAL SERVICES LLC STATEMENT OF FINANCIAL CONDITION AS OF DECEMBER 31, 2015 AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Regulatory Practice Letter September 2013 RPL 13-18

Response to European Commission Consultation Document on Undertakings for Collective Investment in Transferable Securities ( UCITS )

J.P. MORGAN SPECIALTY FUNDS. JPMorgan U.S. Real Estate Fund (All Share Classes) (a series of JPMorgan Trust II)

State Farm Bank, F.S.B.

1. State and explain two reasons why short-maturity loans are safer (meaning lower credit risk) to the lender than long-maturity loans (10 points).

Office of the Comptroller of the Currency Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation

MBa. MORTGAGE DANKCRS ASSOCIAT Of'..

RISK FACTORS AND RISK MANAGEMENT

ABN AMRO CLEARING CHICAGO LLC. Statement of Financial Condition. June 30, 2015

2010 Portfolio Management Guidelines

BANCA SISTEMA: NET INCOME +36% IN H

Economic Commentaries

BOARD OF GOVERNORS FEDERAL RESERVE SYSTEM

2014 Survey of Credit Underwriting Practices

Research Update: Danish Mortgage Bank DLR Kredit A/S Assigned 'BBB+/A-2' Ratings. Table Of Contents

Indiana Community Business Credit Corporation

Weaknesses in Regulatory Capital Models and Their Implications

LIQUIDITY RISK MANAGEMENT GUIDELINE

INTERACTIVE BROKERS GROUP ANNOUNCES 1Q2016 RESULTS

Synthetic Financing by Prime Brokers

BNY Mellon Third Quarter 2015 Financial Highlights

STATEMENT OF FINANCIAL CONDITION

Morgan Stanley Reports Third Quarter 2015:

First Quarter Report January 31, 2015

The Ratio of Leverage. When you combine ignorance and leverage, you get some pretty interesting results. Warren Buffett

Ipx!up!hfu!uif Dsfeju!zpv!Eftfswf

Borrowing at negative interest rates and investing at imaginary returns

Loi M Bakani: Effective compliance, risk mitigation and control

Best Practices for Credit Risk Management. Rules Notice Guidance Notice Dealer Member Rules

Roche Capital Market Ltd Financial Statements 2014

Form. Account Disclosure Document for Licensed Corporation

Risk Management Structure

Financing and Liquidity Strategies

Presentation at Bank of America Merrill Lynch Banking & Insurance Conference

CITI REPORTS FIRST QUARTER NET LOSS OF $5.1 BILLION, LOSS PER SHARE OF $1.02

TEXTRON FINANCIAL CORPORATION

DISCOVER FINANCIAL SERVICES REPORTS FOURTH QUARTER RESULTS: NET INCOME OF $371 MILLION AND EARNINGS PER SHARE OF $0.63

Collateral Management Best Practices for Broker-Dealers

Meet challenges head on

Net Stable Funding Ratio

Instituting a Funds Transfer Pricing (FTP) - driven Decision Enablement Framework in Banks

What s on a bank s balance sheet?

COMMENTARY ON THE RESTRICTIONS ON PROPRIETARY TRADING BY INSURED DEPOSITARY INSTITUTIONS. By Paul A. Volcker

COMPUTERSHARE TRUST COMPANY OF CANADA BASEL III PILLAR 3 DISCLOSURES

Bank Capital Adequacy under Basel III

Basel II, Pillar 3 Disclosure for Sun Life Financial Trust Inc.

RISK MANAGEMENT REPORT (for the Financial Year Ended 31 March 2012)

Development of the Client-Focused, Capital-Efficient Business Model

Policy on the Management of Country Risk by Credit Institutions

The Search for Yield Continues: A Re-introduction to Bank Loans

Contingent Capital in the new regulatory regime Challenge or Opportunity?

Mediterranean Guarantees

JGWPT Holdings Inc. Reports Third Quarter Financial Results

INTERACTIVE BROKERS GROUP ANNOUNCES 2015 RESULTS

Measurement of Banks Exposure to Interest Rate Risk and Principles for the Management of Interest Rate Risk respectively.

Comments on the proposal are due by August 24, 2009.

How To Rate A Bank In Australia

The Goldman Sachs Group, Inc.

Ethiopian Institute of Financial Studies (EIFS) PROJECT FINANCE

CHAPTER 9: BANKING DOING BUSINESS IN GREATER PHOENIX, U.S.A. 9.1: THE U.S. BANKING SYSTEM 9.2: ESTABLISHING A U.S. BANK ACCOUNT

Lecture 16: Financial Crisis

Our Value Proposition

ZAG BANK BASEL II & III PILLAR 3 DISCLOSURES. December 31, 2014

Using the FRR to rate Project Business Success

TD Bank Financial Group Q4/08 Guide to Basel II

Counterparty Risk Management for Corporate Treasury Functions

Comments on the Basel Committee on Banking Supervision s Consultative Document: Supervisory framework for measuring and controlling large exposures

U.S. Securities and Exchange Commission

Interagency Guidance on Funds Transfer Pricing Related to Funding and Contingent Liquidity Risks. March 1, 2016

ADVISORY Private Funds

Trade Finance Update for Multinationals and Financial Institutions

Transcription:

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% 10.5-13% 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

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 10.5-13% 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

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

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 1 15.0 22.2 Capitalization Rate 2 10.4% 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

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. 2013 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.