In recent weeks, Federal Reserve officials have led the charge, citing a swathe of unfinished regulatory business including, controversially, the need for a capital surcharge on foreign banks in the US. The latter move has sparked an EU-US spat amid fears over financial protectionism and the pro-cyclical entrapment of large European banks’ liquidity and capital in the US.
Against this backdrop, Deutsche Bank’s sale of €2.9 billion of stock at the end of April underscores the challenge for European banks, such as Barclays, as they wake up to new onerous regulatory requirements as well as diminishing organic routes to boost capital.
These challenges are especially daunting at a time when many analysts, investors and regulators fear large European banks are still under-capitalized on a common core tier 1 equity capital basis, despite protestations to the contrary by the European Banking Authority.
The sale – well received by markets – means DB has boosted its fully loaded Basel III common equity tier 1 capital position from 8.8% at the end of March to 9.5%. But DB’s equity issue came despite senior board members of the bank rejecting the need to raise capital in equity markets, in public comments made in January and, before the stock issue, in a recent meeting with Euromoney.
The stock sale reflects how alternative routes for capital accumulation are diminishing amid a shortfall of retained earnings to build the equity buffer in a timely fashion and regulatory curbs on optimizing the risk-weighting of assets to boost capital. Meanwhile, the oncoming US surcharge and a stricter leverage ratio also forced DB’s hand.
(Nevertheless, market fears over Deutsche’s capital position have not abated, with the stock still trading below book value. One core challenge: the bank still faces a battle to increase its leverage ratio – around 2.5% – to the current minimum Basel proposal of 3%, and it is possible that regulators in the US and UK, and investors, more generally, will soon demand a higher leverage benchmark. )
At the same time, Deutsche and Barclays Capital face challenges in meeting the US capital surcharge on foreign institutions. Nevertheless, at 9.5% Basel III tier 1, DB’s recent stock sale also shines an unfavourable light on Barclays with an 8.4% tier 1 capital ratio – the lowest Basel III ratio amongst the European investment banks.
This also compares unfavourably with its US peers on a reported basis, with JPMorgan at 8.9%, Citi at 9.3% and Bank of America at 9.4%.
Notes Chintan Joshi, European bank analyst at Nomura: “After a strong run in Q4-12 and Q1-13, Barclays could be vulnerable here as it now scans weak on capital at the same time as it is seeing negative earnings momentum, particularly on 2015 earnings potential.
“Management would now need to consider what options it has to close the gap relative to its IB peers, and this could lead to underperformance in the near term.”
As Euromoney has reported, the bank aims to cut legacy and other RWAs of £75 billion for a 2015 balance of £440 billion of RWAs after CRD IV implementation, with a common equity tier 1 ratio above 10.5% by 2015. It hopes this will allow a progressive dividend policy from 2014, eventually targeting, over an unspecified period of time, a 30% payout ratio. However, the perverse reaction of equity investors to Deutsche’s equity dilution – with the shares trading up by 6% – suggests investors place a premium on well-capitalized banks amid the bombardment of new regulation, which might force Barclays to speed up its capital plan.
What’s more, in addition to facing market demands to beef up its core tier 1 capital, Barclays faces a headache in boosting the capitalization of its US broker-dealer unit, which would need to be structured as an independently-regulated entity in the US.
While it’s not fully clear how foreign banking operations of European investment banks in the US will be treated in the final designation of the rule, the draft proposal envisages that the broker-deal unit will be subject to a US leverage ratio, which some analysts speculate could be in the region of 5%, possibly netted for derivatives, compared with the current unadjusted Basel III proposal of 3%.
In this case, while the independently regulated bank holding company meets the US capital requirement, Barclays’ broker-dealer unit in the US faces a severe capital shortfall with a 2.4% leverage ratio, implying an $8.2 billion shortfall in the event a 5% leverage ratio becomes binding, according to Nomura.
Says Joshi: “More than two thirds of the assets within the entity are collateralized agreements, and prima facie appear to be low-risk operations. If such a demand were to be made, Barclays would undoubtedly consider its options [say] to try to net off such operations or search for another solution.
“What impact this could have on earnings remains a key uncertainty, and there is always a risk that such reduction of activities could have friction costs as well. In addition, if funding would also be required to be ring-fenced, this would be an added cost.”
One European bank analyst strikes a more sanguine tone: “Barclays is already engaged in a strategic review but they now need to re-think their business structure in US. The board could consider down-streaming capital under the bank-holding company level to the broker-dealer unit.
“The structure and time-scale for this should be manageable but this new regulation clearly complicates Barclays’ international strategy.”
And there is the rub. After unveiling an ambitious turnaround strategy and ROE goals, the last thing CEO Antony Jenkins' needs is more risks to earnings, uncertainty over the direction of the bank's US investment banking arm – core to its global footprint - and market pressures to accelerate capital accumulation.