Bank must be able to survive an extreme blow

As a key player in the financial sector, ING would like to contribute to the debate about the future of the sector. Het Financieele Dagblad, a leading Dutch newspaper, published a feature by Wilfred Nagel, ING’s chief risk officer.

There is a heated debate about banks’ buffers. Economists and politicians argue that banks have too little capital, meaning that their continuity is not sufficiently secure and that taxpayers are running too much risk. It is not clear how high those buffers should be. The recommendations do not go much further than ‘more is better’ and so the important thing is to establish a goal and which part of the liabilities can serve it.

It is virtually impossible to capitalise a bank to such an extent that it cannot fail. It is, however, possible to set up a bank’s capital structure and business model in such a way that it can survive an extreme blow. And, if a bank should nevertheless fail, to unwind it in an orderly fashion without cost for savers or the taxpayer. This is exactly what the ‘living wills’ that financial institutions have now drawn up are designed to do.

This means that ‘too big to fail’ is no longer an issue and the implicit government guarantee is no longer applicable. It is also clear that the buffer, about which so much has been said, is made up not just of equity but also of all liabilities subordinated to savings.

Under new European regulations, these are equity, all types of subordinated debt and unsecured bonds. This combination forms a bank’s total loss absorption capacity. If the core of this (equity plus subordinated debt) is sufficient, there is no reason to ask shareholders to guarantee continuity in all circumstances. The ‘bail in’ of bonds offers further protection.

Concern about the systemic effect of defaults on subordinated debt is understandable but overstated. Further protection could come from prohibiting banks from holding such securities. The Basel rules, traditionally the starting point for balance sheet management, impose requirements on the loss absorption capacity a bank must hold (including the core tier-1 ratio). They also mean that relatively more capital must be held against high-risk loans than against those that are almost certain to be repaid. The leverage ratio, a measure of the proportion of equity and (unweighted) total assets, is a further safety mechanism on top of this.

Although the method of risk weighting allows potential losses on large, well-diversified loan portfolios to be estimated accurately, the current crisis has shown that it works less well where there are large concentrations of certain types of asset on bank’s balance sheets. It is, therefore, essential to limit concentration risks.

In addition to the importance of proper diversification of assets, the current crisis has put other items on the agenda. The regulatory framework has introduced the term ‘resolution’. A bank must now be able to fail with the bill landing where it should: on the investors in shares and bonds and not on the taxpayer. In addition, the bank must be able to continue its vital functions until they are taken over in an orderly way by other banks, without public money being required.

Pending the outcome of the debate in Europe, I would like to put forward ING’s assessment of the loss absorption capacity required. I am assuming that the Basel system of risk-weighting and minimum requirements for the composition of loan absorption capacity will remain in force since an unweighted approach also has disadvantages, such as the possible incentive to make riskier loans to earn higher returns.

A bank such as ING would need €4.25 of loss absorption capacity per €100 outstanding, or 4.25%, to absorb unforeseen losses and cover operating expenses and possible book losses on forced disposals of operations during a resolution process (details of these calculations). In practice, such a bank would have higher buffers thanks to its operating profits and provisions for credit losses.

It would be preferable to build in a safety margin on top of the 4.25%. An additional margin would seem reasonable because, for example, there is always a chance that operations would raise less during resolution than is currently (conservatively) estimated. Overall loss absorption capacity of 6% of a bank’s balance sheet total is a healthy target for an unweighted approach.

Notes on the proposed 6% loss absorption capacity target

We assume a bank with a diversified balance sheet: for example, a portfolio consisting of one-third commercial lending, one-third residential mortgages, one-fifth retail and SME loans and over one-tenth of liquid assets.

Historical information shows that overall this bank can expect annual credit losses on this portfolio (through defaults, bankruptcies, etc.) of between 0 and 35 cents (an average, therefore, of about 18 cents) for each €100 outstanding. Currently, the point at issue is the adequacy of reserves in extreme situations, for example if there is a very long economic downturn.

If we assume that such a period will last, say, five years (N.B. this has never happened in the past), this bank would need reserves of €1.75 for each €100 outstanding. This rough estimate is conservative since operating profits create an additional buffer.

In addition to historical information, it also of course makes sense to use scenario analyses. These estimate possible losses in imagined, highly adverse economic conditions. This approach is certainly not new and has been commonly used for some time, for example when assessing interest rate and currency fluctuations. But the method has changed significantly in recent years, taking more account than in the past of the fact that correlations in default percentages and asset prices in times of economic stress may be significantly different from their normal values.

The exact scenario used for the purposes of this analysis is defined by the regulator and assumes a three-year period of exceptionally poor economic conditions. Based on this, the bank in the example needs to have reserves of €1.40 for each €100 outstanding.

In this case, as extrapolating historical analyses leads to a higher capital requirement than the scenario analysis, we take the €1.75 for each €100 outstanding as the starting point. But it is not only being able to absorb unexpected credit losses, the bank must also be able to offer assurance that it will maintain its vital functions at all times.

From this perspective, in brief, more will be required, for example to cover the operating expenses that a bank will incur in a resolution process. Some staff will be required and there will be legal and tax issues involving expense during the resolution of a bank.

For a bank such as ING, these operating expenses would initially be some 60% of the operating expenses in a normal situation, falling to about 20% after about three years. In a normal situation, each €100 outstanding involves about €1.05 of operating expenses; the operating expenses needed to ensure the vital functions are about €1.25 for each €100 outstanding.

All in all, the bank will have to have reserves of €4.25 (1.75+1.25+1.25) for each €100 outstanding (i.e. 4.25% loss absorption capacity) although, in practice, such a bank would almost always have even higher buffers thanks to its operating profits.

Al met al zal deze bank dus voor elke honderd euro die zij uitleent 4,25 euro(1,75+1,25+1,25 euro) aan reserves moeten hebben (oftewel 4,25%). Overigens zal zo’n bank in de praktijk -door haar operationele winsten- bijna altijd over nóg hogere buffers zal beschikken.

It is advisable to build in a safety margin on top of this. For example, because there will always be a degree of uncertainty as to whether operations that have to be disposed of during such a resolution process could be sold on reasonable terms. The resolution plans drawn up for systemically important banks ensure this. But, in all honesty, they still have to prove themselves and so an additional margin seems reasonable.

To sum up, loss absorption capacity of 6% of a bank’s (unweighted) balance sheet total would, therefore, most probably be sufficient to safeguard the funds entrusted and its vital functions in even the worst crisis.