March 1 (Bloomberg) -- Regulators have a new ally in their campaign to prevent banks from disguising their capital needs by massaging down asset holdings: bondholders.
Assigning lower asset values allows lenders to report higher returns by reducing the amount of capital they have to set aside. Holders of contingent capital notes, a type of debt banks have started selling to bolster their balance sheets, have a growing incentive to scrutinize how many loans banks are loading onto their equity bases.
The bonds, known as CoCos, convert to equity or are written off once an issuer’s capital ratios fall below a preset level. Investors who bought $3 billion of the securities that Barclays Plc issued in November, for example, will be wiped out if the London-based bank’s core Tier 1 ratio, a measure of its ability to absorb losses, slips below 7 percent.
“They’ll be watching like hawks,” said Georg Grodzki, who helps run the equivalent of about $585 billion as head of credit research at Legal & General Investment Management in London. “They have to be pretty mesmerized by capital ratios if they’re holding something with capital triggers.”
Banks set aside varying amounts of capital for different assets based on the likelihood and extent of a loss. A bond from Siemens AG, which has an Aa3 rating three levels down from the top grade from Moody’s Investors Service, carries a lower capital charge for the bank holding it as an asset than does a loan to Athens-based glassmaker Yioula Glassworks SA, which Moody’s rates eight levels below investment grade.
“With the banks, there’s a lack of transparency on how a risk weighting is arrived at,” said Roel Jansen, who is responsible for $8.4 billion as head of European investment grade credit at ING Investment Management in The Hague. “We don’t know what assumptions are made. If there is transparency and a bank is aggressive, it will come under market pressure. We’re at the beginning of a process that will be led not only by regulators but by investors.”
Regulators have signaled concern that large banks using their own models are generating different assessments of the same assets when assigning risk weights. The Basel Committee of international bank supervisors and the European Banking Authority have both set up working groups to study the issue.
“There’s a move to get away from the internal-model-based approach,” said Scott Bugie, former managing director of financial institution ratings at Standard & Poor’s in Paris and now a consultant. “That’s hugely complicated, it got regulators into a heavy-duty relationship and incentivized the institutions to reduce their risk-weighted assets.”
Bank supervisors in individual nations have a growing interest in how lenders decide how risky their various assets are, in some cases driving down capital ratios. Swedish authorities have imposed minimum risk weights, or floors, on mortgage loans. The Swedish regulator estimates Swedbank AB may need an additional 1.5 percent in core Tier 1 equity capital, and Svenska Handelsbanken AB an extra 1.1 percent.
In the U.K., regulators began reviewing banks’ capital in November, focusing on the effects of over-optimistic asset valuations, potential fines for misconduct such as rate rigging and mis-selling insurance and swaps, and risk weightings.
Royal Bank of Scotland Group Plc cited “model changes” for an increase in its risk-weighted assets by about 44 billion pounds ($67 billion), or about 9.5 percent of its 460 billion- pound total, the Edinburgh-based lender said yesterday. Barclays added almost 40 billion pounds after supervisors hardened their view of the risks in banks’ commercial property loans and sovereign bond holdings.
Barclays expects to issue “loss absorbing capital instruments” equivalent to 2 percent of risk-weighted assets, Chief Executive Officer Antony Jenkins said in the bank’s strategic review published Feb 12. These won’t necessarily have the same structure as the 7.625 percent notes due 2022 it sold in November, he said.
Barclays issued the bonds at 100 cents on the dollar to yield 604 basis points more than government debt. After widening to as much as 625 basis points on Nov. 15 as the bond lost value, the spread is currently 579 basis points.
The bank had a core Tier 1 ratio of 10.9 percent “as defined by prevailing regulation at the time of ratio calculation,” according to its website.
“You really need a big cushion between the trigger and current ratios, especially if regulators are going to start changing their minds,” said Simon Adamson, an analyst at CreditSights Inc. in London. “If the calculation base changes, you might suddenly find you have a much smaller cushion.”
Deutsche Bank AG, Germany’s biggest bank, is “an aggressive user” of internal models, according to Andrew Lim, an analyst at Espirito Santo Investment Bank in London. He estimates its ratio of risk-weighted assets to total assets is 18 percent, the lowest of Europe’s biggest lenders, and reckons standardization of internal modeling for credit portfolios might inflate its risk-weighted assets by 49 percent.
The arrival of the European Central Bank as Europe-wide banking regulator, scheduled for next year, will “provide extra teeth to make sure the German bank complies,” Lim said in a report.
While Deutsche Bank has yet to issue CoCo-style bonds, UBS AG has done so. The Zurich-based company’s risk-weighted assets amount to 19 percent of total assets, a tally that may rise to 25 percent by 2014, or 34 percent if adjusted to exclude cash and certain other assets, according to Lim.
Christian Streckert, a Deutsche Bank spokesman in Frankfurt, and Hana Dunn, a UBS spokeswoman in London, declined to comment.
UBS issued $2 billion of 7.625 percent, 10-year contingent bonds in August to add to the $2 billion 7.25 percent notes callable in five years that it sold in February. Both bonds will be written off if the bank’s Tier 1 ratio falls below 5 percent.
UBS cut group risk-weighted assets by 43 billion Swiss francs ($46 billion) in the fourth quarter as it seeks to reduce the total by about 100 billion francs by the end of 2017, the lender said Feb. 5. Of that, a reduction of 6 billion francs at the investment bank and 2 billion francs of so-called legacy assets was obtained by fine-tuning models.
“The key things are, what is a believable number for risk assets and how did they get to it?” said Steve Hussey, a London-based credit analyst at AllianceBernstein Ltd., which manages $430 billion. “We have to know what the number is that the banks are using and be sure it’s comparable across banks. At the moment, it definitely isn’t.”
--Editors: Mark Gilbert, Tim Quinson