Around the world in 25 megabanks

Posted by Joseph Cotterill on Jun 20 16:55.

…Around the world, and (potentially) sat on the face of the global recovery.

There’s an impressive note out from Morgan Stanley’s Huw van Steenis and his team of banks analysts on Monday, in which they ponder (actually, nothing short of reconstruct) how the Financial Stability Board will apply its capital surcharge on the G-SIFIs. It boils down to about 40 candidates in the big table above (click to enlarge) who might see capital ratios increased by a further 50 to 300bps, based on the factors in this chart:

You can see that the top eight banks match what’s been reported by the FT recently, although the ranking is still highly provisional.

There’s a lot to chew on in the index that Morgan Stanley have used to construct their rankings. For example, bank capital is based on how balance sheets will look in 2013, while G-SIFI charges won’t kick in until 2019 (or even 2024 according to one regulator polled by Morgan Stanley).

Chinese banks are off the index entirely despite balance sheets being huge relative to GDP. They aren’t particularly connected to other banking systems. British and Nordic banks by contrast face high SIFI charges because of their assets-to-GDP ratio, which may increase capital more than the G-SIFI rankings would suggest. US bank SIFI capital might get embedded into G-SIFI charges. There is also a whole host of SIFIs in each country who don’t quite retain global status.

It’s a rich tapestry, not least because of changes to risk-weightings of assets and the funding of those assets.

(Think for a second — eight to 12 years is a long time in financial engineering or for shifts in the geography of capital.)

There’s one thing binding it all together though – genuine mystery as to what the effects will be on the global creation of credit. Here’s Morgan Stanley on what Deux Ex Macchiato has aptly called the ‘last bucket’ – leaving the 300bps charge as a poison pill to stop M&A, without actually putting any banks in this bracket to begin with. Morgan Stanley think there’s also economic fear here:

Whilst it is quite possible the top tier of may require a 3% buffer, our conversations suggest it is more likely this bucket will remain empty initially, as a disincentive for any G-SIFI tempted to take part in any large scale M&A. Also, the economy rolling over is starting to prompt chancelleries to challenge the appropriateness of such high calibration…

But what’s really interesting is the argument that the G-SIFI surcharge won’t help smaller banks. In fact it will crush them. According to Morgan Stanley:

Our experience of the crisis has been that many, including some policy makers (particularly those of a more academic bent), have underestimated the importance of wholesale funding as a transmission mechanism for credit formation and risk in the Western banking systems, which have grown well beyond their local deposit funding. This has been a guiding theme for us for the last 3-4 years. Take one example we’ve made elsewhere. In the 2010 European stress tests, policy makers assumed Europe’s retail banks’ pre-provision earnings would only fall ~5% in the adverse case. But within one year almost every peripheral or Southern European bank we’ve looked at underperformed the stress case within 12 months of the test because the policy makers running the tests had not considered the impact of deposit wars or the huge cost of wholesale funding on margins and the strategic need to shrink the balance sheet.

The reason to make this point is that the response of credit and equity investors is a critical dependency to how the new rules will work in practice. For example, policy makers we have met and speeches we have read underscore a view that small and mid size banks will pick up market share from the larger banks, which will therefore offset some of the risk to the economy. We question how much share smaller banks will be able to win, in part as wholesale markets may demand higher capital ratios from the smaller banks too. A de facto implied 10%+ capital ratio for large banks with wholesale or international activities, and 8-9% for national retail looks plausible, with an overlay for sovereign risk…

Policy makers in Brazil, China, Hong Kong and many other emerging markets believe that modest changes in reserve requirements have material impacts on the flow of credit. In the last 6 months alone Brazil, Korea, HK, China, and Singapore have raised reserve requirements – alongside other policy measures like taxes and changes to LTV policies – to slow the extension of credit. Despite this, many influential policy makers we meet in the US/Europe does not believe higher capital ratios will have a major impact on economic growth. Whilst we are not saying G-SIFIS do not require substantially higher supervision and greater supervisory work, we wish to pose the question on the calibration of the premia when looked in the round with other measures…

Morgan Stanley even raise the spectre of the great Fed reserve requirements hike of 1937. There’s actually been a bit of work in (ahem) Fed circles that’s questioned whether doubling reserve requirements caused that year’s recession after all, however, and plenty of arguments that bank capital is less socially expensive than you think.

Still, heck of a historical parallel when the FSB publishes its proposals in November, no?

Full note in the usual place.

Related links:
The mistake of 2010 – Paul Krugman
Building a new investment bank – Deus Ex Macchiato
Why bank capital is rubbish – FT Alphaville
Dick Bove says folks at the Federal Reserve have ‘lost their minds’ – FT Alphaville

This entry was posted by Joseph Cotterill on Monday, June 20th, 2011 at 16:55 and is filed under Capital markets. Tagged with , , , , , , .

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