Last year, European banks raised their fully loaded Basel III CET1 ratio in a major way. Some even implemented a huge 400 bps increase, with a subsequent devastating impact on profits and inner sustainability. As core capital in terms of risk-weighted assets is due to increase substantially, the banking industry faces tough times ahead.
If the rest of Europe follows the tough line currently enforced by Sweden’s supervising body, leading to capital ratios of around 20%, few credit institutions are likely to emerge unscathed from that pressure. And even if the ECB and the Bank of England refrain from going quite so far, the strong probability is that they will raise the bar on this key solvency requirement.
But the banking industry is more concerned about the leverage ratio, a straightforward measurement of Tier 1 capital in terms of overall exposure.
Basel III has described this ratio as a backstop. A simple, non-risk based tool for preventing an excessive build-up of assets which could have a destabilising effect in times of crisis. In practical terms, it forces banks to shift their business models as long-term derivatives and forex/commodities’ trade become highly penalized.
The high standards imposed on home holdings in the US represent a fierce challenge for European banks. On average, their leverage ratio is below 3%, while that of their US counterparts’ stands at around 8%.
Such a huge gap will force European lenders to embark on a major overhaul of their current business as they strive to cut exposure. Investment trade is likely to suffer the most. Dismantling forex, commodities and long-dated unlisted derivatives and CDSs will require long-lasting structural changes to their business model.
Few European credit institutions can cope with such a far-reaching asset and trade reshuffling. Only BBVA, with a 6% leverage ratio, is in a position to resist this pressure. Others trail well behind, with ratios below 4%.
No wonder both Santander and Deutsche Bank failed the Fed’s latest stress test. A telling warning for European banks to change their business model sooner rather than later.