The Fed is to release the Basel 3 Final Rule and several capital, liquidity and debt structure proposals soon, perhaps by the end of June. Betsy L. Graseck, CFA of Morgan Stanley expects banks will cut commitments and derivatives ahead of cutting buybacks; and bank capital at 1-2.5% pts above minimums. Further details from Morgan Stanley on Basel III below.
We expect our thesis to hold. We have argued that the last major parts of Dodd-Frank (OLA, Volcker Rule, and derivatives clearing) and Basel (capital and liquidity rules) will be largely known in 2013. Clarity on regulation means we expect LC Bank multiples to expand on increased confidence on higher 2-year forward ROEs. LC Banks still attractive, even with higher capital requirements. We model Bank of America Corp (NYSE:BAC)/Citigroup Inc. (NYSE:C)/JPMorgan Chase & Co. (NYSE:JPM) to 11-12% CT1 ratios and the stocks still look cheap with rising ROEs.
What’s coming: Within the next few weeks we expect the Fed to release a final rule on Basel 3 capital and an initial proposed rule on OLA. We also expect to see proposed rules on SIFI capital buffer, countercyclical capital requirements, and increased leverage ratio.
Potential surprises: Will Fed size the counter-cyclical buffer? (We estimate 100bp.) Will it change RWA for high LTVs from big step up to graduated curve, helping loosen mortgage lending credit box? Reduce RMBS haircut in LCR? Nudge Bank of America Corp (NYSE:BAC) up from 8.5% B3 CT1 minimum to 9.0%? (This is already in our estimates.) Will the Fed set OLA at 17-20% of RWA (base case) or higher? Will BlackRock, Inc. (NYSE:BLK) be named a Financial Institution driving PNC Financial Services (NYSE:PNC) to reduce or sell its BlackRock stake?
Roadmap for Upcoming Basel 3 & Bank Regulation
Basel 3 Capital Rules
Our View: Expect a final rule by early July that includes a better outcome on the capital treatment of mortgages (less punitive). Expect treatment of MSRs and unrealized AFS gains/loss to be in line with the original proposal (no change). Potential announcement of SIFI buckets for US G-SIBs and leverage ratio proposal.
Market View: Lighter touch on mortgage RWAs expected and MSR/AFS stays as originally proposed.
Background: In June 2010, global banking regulators agreed to a new set of rules that would increase the quantity and quality of regulatory capital – known as Basel 3. In June 2012, the Fed published a proposed rule that would apply the Basel 3 accord to U.S. banks.
Basel 3 – Key Debates around:
1) Residential Mortgages
- What’s this? Fed’s Basel 3 proposal applies a punitive capital treatment for mortgage loans based on LTVs and loan performance.
- Why’s this important? The proposal applies capital requirements in a step-function which results in a cliff effect, with capital requirements rising significantly as the LTV moves higher than 80% or the loan becomes 90+ days delinquent.
- Our view: If the NPR is implemented in its current form, based on FDIC data and our estimates of the sizes of various LTV buckets, we estimate the industry will be required to hold 13% more capital against its resi/home equity portfolios, (driven by a 13% increase in RWA). However, we expect this current proposal will be moderated in the final rules, where the step function increase in risk-weights will be replaced by a more gradual increase. We expect this will result in a more manageable increase of 7% of resi/home equity RWA. As a result, we could see access to residential credit broadening out.
2) Unrealized AFS Gains/Losses
- What’s this? Basel 3 proposes to include in regulatory capital a bank’s unrealized gains and losses on available-for-sale (AFS) securities.
- Why’s this important? Inclusion of such unrealized gains and losses will increase the volatility of capital…likely incents banks to hold a capital buffer above the minimum to withstand the volatility of unrealized gains/losses such that an unanticipated unrealized AFS loss does not drive a bank’s capital ratio below the minimum.
- Our view: We expect regulators to leave this specific proposal as is, unchanged. The proposal is in-line with the Basel accord agreed to by regulators globally and we don’t expect the U.S. to diverge much generally, and don’t think U.S. regulators favor diverging on this point. Why? We think regulators want to have a realistic snapshot, point in time, of a bank’s capital position, reflecting of any unrealized losses embedded in the securities portfolio. This perspective was absent during the recent financial crisis to the casual observer because capital requirements at the time (Basel 1) did not require unrealized gains/losses to flow through capital.
3) Mortgage Servicing Rights (MSR)
- What’s this? Basel 3 proposes to require banks to deduct the value of their MSR from capital to the extent the MSR value exceeds a certain threshold.
- Why’s this important? Higher capital requirements for MSRs incents banks to sell their MSR portfolio or manage it to a lower level.
- Our View: Expect no change from the Fed’s initial proposal which is in line with the Basel accord. Some banks are pushing back arguing that the MSR treatment under Basel 3 is overly punitive, unfairly targets the U.S. banking system as most other jurisdictions don’t have MSRs. Some also argue the punitive capital treatment will push MSRs outside the banking system to less regulated non-bank financials. But, we think the CFPB will ultimately ratchet up regulation/scrutiny of non-bank servicers.
4) Definition of Financial Institution Deduction
- What’s this? Basel 3 requires banks to deduct from regulatory capital any common stock investments in unconsolidated Financial Institutions where the bank has a stake larger than 10%. Designation as a Financial Institution can increase regulatory requirements/scrutiny.
- Why’s this important? Outcome on this likely to drive a decision by PNC Financial Services (NYSE:PNC) on whether to continuing holding or to sell some or all of their 22% stake in BlackRock, Inc. (NYSE:BLK).
- Our view: If BlackRock, Inc. (NYSE:BLK) is deemed a Financial Institution, we expect that PNC Financial Services (NYSE:PNC) will lower its holding in BlackRock to sub 10%.
Other Capital Related Regulations
Systemic Capital Buffer (SIFI Buffer)
- Expect a separate proposed rule within the next several months that adopts for U.S. banks the Financial Stability Board’s (FSB) recommended capital buffer for systemically important financial institutions (SIFI). We wouldn’t be surprised if the rule also created a smaller domestic SIFI buffer requirement of 25-50bp for the largest domestic U.S. banks that are not included in the global SIFI requirement. Our models all already incorporate this.
- Bank of America’s 1.5% SIFI Buffer could increase to 2.0%, (above the 1.5% for GS/MS and below the 2.5% for C/JPMorgan) …which would increase Bank of America Corp (NYSE:BAC)’s minimum CT1 capital requirement from 8.5% (currently proposed) to 9.0%, in-line with Barclays PLC (NYSE:BCS) (LON:BARC) and BNP Paribas SA (EPA:BNP) and just under JPMorgan Chase & Co. (NYSE:JPM) and Citi. The FSB proposed a 1.5% SIFI buffer for Bank of America which is below the 2.5% buffer proposed for JPMorgan and Citigroup Inc. (NYSE:C). The FSB’s proposal was “provisional” and the buckets are set to be finalized by the FSB in November 2014 and the U.S. banking regulators have the sole jurisdiction and authority to apply the FSB’s “recommendation” for U.S. banks. Regardless, we expect the market will want to see Bank of America as well capitalized as JPMorgan and Citigroup and our models already assume Bank of America and Citi are at 12% CT1 under Basel 3 in 2 yrs time and JPMorgan is at 11%.
- Background: In November 2012, the Financial Stability Board (FSB) published a list of global systemically important banks (G-SIBs) and specifically the systemic capital buffers required for each bank. For more details, please see our note “Recommended G-SIB Buffers Out, Positive for Bank of America Corp (NYSE:BAC)” dated November 1, 2012.