How relocation of a bank’s headquarters increased the capital costs of Swedish Banks?

I.??????????????? Introduction

In Banking, under the broader context of risk management, Capital is often remarked as a cushion against unexpected losses. It is an indispensable, regulatory mandated ingredient, which fuels the sustainable growth of banks’ business. Globally, Basel-III norms on capital adequacy (hereinafter referred as Basel norms) are followed to ensure that the banks are well capitalized to absorb the unexpected losses, which may arise during the course of business.

Basel norms are built on three pillars: -

Minimum capital requirements for Credit, Market and Operational risks (Pillar-1): - For e.g. Indian Banks are expected to hold capital funds equal to at least 11.5 % of total risk weighted assets.

Internal Capital Adequacy Assessment Process (ICAAP) and Supervisory Review and Evaluation Process (SREP) (Pillar-2): -2 aspects are covered in this Pillar; ICAAP, which includes assessment and quantification of risks, which are not covered / inadequately covered in Pillar -1, SREP which includes the regulator’s assessment of the capital required to be maintained by individual banks to guard against Pillar-1 & Pillar-2 risks. Major pillar-2 risks include Interest Rate risk on Banking Book (IRRBB), Credit Concentration risk and Liquidity risk.

Market Discipline (Pillar-3): A set of disclosure requirements which would help the market participants to evaluate the capital adequacy of the banks is designed by the BCBS and different national regulators such as RBI. It is believed that that financial markets would influence the banks to operate efficiently and manage risks proactively by responding to the disclosures made under Pillar-3.

II.???????????? Does Market Discipline really work in practice?

As a practitioner, while I was a staunch believer of the efficacy of Pillar-1 and Pillar-2, I had serious reservations on the efficacy of Pillar-3 disclosures. ??Recently, On LinkedIn, I stumbled upon the working paper titled ‘Capital requirements in Pillar 1 or Pillar 2: does it matter for market discipline?’ authored by Niklas Witte of European Central Bank (ECB). In that paper, I found multiple examples of financial markets responding to the disclosures, thereby disciplining the banks with weaker capital metrics.

Some of the interesting examples are quoted below.

? “Using CDS spreads as a proxy to analyse the linkages between funding costs and capital ratios, Schmitz et al. (2017) estimate that increases of the capital ratio of 1 basis point can decrease funding costs by more than 1 basis point”

? “Babihuga and Spaltro (2014) find that a 9 bps increase in the total capital ratio reduces CDS spreads by 26 bps in the long term.”

?Besides, the above examples, the Niklas Witte’s research also suggest statistically significant negative relationship between disclosed CET-1 capital ratios and CDS spreads.? Before delving into the key finding of the working paper, let me narrate a short story.

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III.?????????? Nordea Bank Shifts its head office

In October 2018, Nordea Bank shifted its head office from Stockholm, Sweden to Helsinki, Finland.

By virtue of relocation, Nordea came under supervision of Single Supervisory mechanism (SSM), which comprise of ECB and national supervisors; Finland being a part of European Banking Union. Sweden, even though an EU member state is not part of Banking Union.

Nordea is an IRB compliant Bank and its capital requirements for Swedish mortgages were subject to the supervisory risk weight floor of 25% imposed by Financial Supervisory Authority (FSA) Sweden. FSA had implemented this floor as incremental capital requirement under Pillar-2.

Due to few defaults and low credit losses in Swedish mortgage portfolios since the Nordic financial crisis in the 1990s, IRB-modelled risk weights dropped significantly to around 5%. Hence FSA had imposed risk weight floor of 25% to ensure prudent capitalization of credit risks from 2014 onwards.

Since incremental capital requirement was laid down as part of Pillar-2, Pillar-1 capital ratios of Swedish Banks did not change.

ECB/ SSM could not accommodate this incremental capital requirement as Pillar-2 add on, since its holistic methodology does not permit its inclusion. Hence, FSA invoked Article 458(2)(d)(iv) of CRR and made this incremental RWA as part of Pillar-1 RWA. To avoid double counting, these requirements were removed from Pillar-2.

Even though capital requirements did not change this shift from Pillar-2 to Pillar-1 resulted in a sharp drop in reported CET-1 ratios. Refer the graphs below (Page- 9 of working paper).

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IV.??????????? Key Insight: -Pillar 1 RWA- more sensitive as compared to Pillar-2 risk add on.

After execution of multiple statistical techniques, Nikolas has isolated the effect of change in Pillar-1 capital ratios of the Swedish banks. The most relevant portions (in my view) are quoted below.

“In the first quarter after the capital requirement was shifted to Pillar 1, the senior CDS spreads of the affected Swedish IRB banks increased by 9.13 basis points. After three quarters, the effect weakened to 6.72 basis points but remained significant at the 90% confidence level. By the end of the observation period in Q4 2019, the average increase of the treatment group’s CDS spreads amounts to 7.78 basis points and is still significant at the 90% level. This constitutes approximately 22% of the 35.54 basis point average 5-year senior CDS spread of the four treatment banks between Q4 2018 and Q4 2019. The results suggest that risk weight floor shift to Pillar 1 capital requirements has a relatively large and lasting positive effect on CDS spreads.”

“The observed reduction in capital ratios was not caused by changes in bank solvency or an increase in capital requirements but was instead triggered by a mere technical change in the implementation of a capital requirement”

V.????????????? Inadequate and infrequent Pillar-2 disclosures

In many countries, the banks are not required to disclose capital requirements quantified for Pillar-2 risks. Even if a regulator were to mandate the disclosure of Pillar-2 risks, diverse methods applied by banks to quantify Pillar-2 risks such as IRRBB or Credit Concentration risk reduces utility of such disclosures and investors & other stakeholder are likely to take them lightly as compared to disclosures of Pillar-1 ratios.

VI.??????????? How to capture capital charge for IRRBB- Case for capturing it under Pillar-1 ratio

Interest rate risk on Banking Book (IRRBB) had hogged the limelight after failure of 3 midsized banks in USA in March 2023. Failure primarily stemmed from poor liquidity and interest rate risk management practices. Under current norms, IRRBB is reckoned as a Pillar-2 risk and is covered under ICAAP.

Given the markets’ less sensitivity to capital requirements under Pillar-2 risks, shouldn’t we elevate IRRBB as a Pillar-1 risk and prescribe a homogenous methodology for computation of capital requirements against it?

In my view, given the lack of consensus amongst regulators on methods to measure capital charge on IRRBB and difference in IRR management capabilities of the banks, it is better to retain IRRBB as a Pillar-2 risk.

In this regard, the approach recommended by RBI in Annex-10 of Master Circular on Basel-III norms is worth reading and is quoted below

“The banks can decide, with the approval of the Board, on the appropriate level of interest rate risk in the banking book which they would like to carry keeping in view their capital level, interest rate management skills and the ability to re-balance the banking book portfolios quickly in case of adverse movement in the interest rates. In any case, a level of interest rate risk which generates a drop in the MVE of more than 20 per cent with an interest rate shock of 200 basis points, will be treated as excessive and such banks would normally be required by the RBI to hold additional capital against IRRBB as determined during the SREP.

The banks which have IRRBB exposure equivalent to less than 20 per cent drop in the MVE may also be required to hold additional capital if the level of interest rate risk is considered, by the RBI, to be high in relation to their capital level or the quality of interest rate risk management framework obtaining in the bank. While the banks may on their own decide to hold additional capital towards IRRBB keeping in view the potential drop in their MVE, the IRR management skills and the ability to re-balance the portfolios quickly in case of adverse movement in the interest rates, the amount of exact capital add-on, if considered necessary, will be decided by the RBI as part of the SREP, in consultation with the bank. “

VII.???????? Conclusion

In financial markets, the events tend to have unintended consequences. Nordea might not have anticipated the change in capital regulations, when it contemplated change in headquarters. As per press reports, it was a move executed to ensure level playing field with its Eurozone competitors. But this move had improved alignment between RWA computation methodology of Swedish banks and other banks in Eurozone. Interestingly, it offered a unique opportunity for researchers like Niklas to evaluate the relative change in efficacy of Pillar-1 disclosures on CDS spreads as compared to Pillar-2 capital requirements.