Banks' judgment leaves investors with alternative risk

Good judgment comes from experience, but experience is often earned through bad judgements.

Regulators are becoming more concerned about the ability of banks to judge risk well—and about investors' abilities to assess those judgements. The Basel Committee is considering whether to stop banks from treating government bonds as risk free, for example.

But it is the Basel Committee that has made banks' internal assessment of risks so important in the financial system and to investors. Now, as banks rebuild their balance sheets to meet the latest Basel capital rules, a troubling conundrum is emerging that equity investors should examine closely.

The issue is that the European banks that place greatest store in their own ability to judge risk when setting their capital requirements are also those shoring up their balance sheets with the biggest slugs of newfangled convertible bonds and other alternative capital.

The lower a bank's risk-weighted assets, the less old-fashioned equity capital it needs to hit its minimum core capital ratio, set at 10% for bigger banks in the euro zone. But the risk-weighted version of a bank's assets can be small compared with its total assets when it believes those assets are relatively safe. The safer the assets are judged to be, the lower the proportion of risk-weighted to total assets.

This creates a problem because regulators are also interested in a bank's leverage ratio — the relation between its capital base and its total assets. Banks that meet their core equity capital ratio through treating assets as lower risk will need to top up their capital to meet the simpler leverage ratio requirement.

But banks are loath to do so because issuing equity can dilute existing holders, or retaining more of it makes it difficult to generate higher returns. That, in turn, can lead to lower valuation multiples.

As a result, some European banks have turned to so-called alternative capital or what are known as Tier 1 securities—mainly contingent convertible bonds—that can be used to meet leverage ratios and are proving much cheaper than equity.

The top five issuers of Tier 1 instruments in Europe, including Deutsche Bank and Credit Suisse, all have ratios of risk-weighted to total assets of about 30% or less. That compares with an average of 42% for 48 listed European banks and about 69% for US banks. Put another way, the judgements the top issuers of alternative equity make about risk slash the size of their balance sheets to less than one-third the size of their total recorded assets.

The problems with alternative capital are many, though. For starters, it isn't real equity. And there is a worry that this capital, which is meant to convert into equity when a bank hits trouble, is being priced too cheaply. Regulators expected this capital to pay returns much closer to that of equity, of 10% or more. In fact, such bonds have yields much closer to debt securities.

The hunt for yield is depressing returns on many assets. But the real problem seems to be that investors don't really expect these contingent securities to be forced to take losses or to convert into equity, highlighting their limited use as capital.

A bank may never allow such bonds to be triggered because it would ruin its reputation in both the equity markets—where existing investors would be diluted — and in debt markets where investors would face hefty losses before equity investors did. Banks are more likely to tap existing investors for a pre-emptive rights issue at any signs of weakness. Similarly, a regulator might not let a bank get sufficiently weak to trigger conversion for fear of provoking a run on the institution.

Unlike actual equity, the ultimate loss-absorbing buffer, no one really knows how these new instruments will behave when it matters most. Equity investors in banks with the lowest ratios of risk-weighted to total assets that are using alternative capital as a prop should be concerned.

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This article was first published by The Wall Street Journal

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