Saturday 22 October 2016

New bank rules present threats and opportunities

Ronan Reid

Published 12/04/2015 | 02:30

AIB SUCCESSION: Allied Irish CFO Mark Bourke with outgoing CEO David Duffy walk ahead of chair Richard Pym and COO Stephen White. Photo: Mark Condren
AIB SUCCESSION: Allied Irish CFO Mark Bourke with outgoing CEO David Duffy walk ahead of chair Richard Pym and COO Stephen White. Photo: Mark Condren

Not enough people are thinking about Basel III - the new set of rules that imposes stringent capital and liquidity tests on banks.

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Implementation is targeted for early 2019 after a lot of false starts. Previous versions of the rules (known imaginatively as Basel I and II) focused on the reserves banks must hold but the new, and hopefully improved, version focuses on the risk of 'a run on the bank'. It essentially requires different reserves to be held for different types of bank deposits.

Basel III also allows an additional and discretionary buffer to be applied by local central banks.

More capital inevitably requires more margin, which increases the charges and interest spread a bank will charge for this extra security.

For me, the flaw is the extensive focus on deposits; there should be a greater focus on the credit and loan side - in particular the over-reliance on the credit risk assessments of the likes of Moody's and S&P which appear standardised and which have badly served investors in the past.

The lack of focus on derivatives and those selling derivatives for profit is an additional concern. The other consequence is that in Europe we may see more non-bank lenders similar to some of the non-bank lenders seen funding the purchase of loan books and property in Ireland.

Banks are not alone in facing regulatory change. Insurers face changes with the implementation of new rules courtesy of Solvency II to be implemented this January.

This requires greater asset liability matching for insurance companies, greater provision of capital and more protection at the local company level.

The consequence is seen as greater doomsday protection for the consumer but less efficient capital use for the insurer. Lower returns inevitably mean higher premiums.

Stockbrokers - in the area of finance where I work - also face greater regulation at the client and corporate level.

They require more capital than they did in the past and the new so-called MIFID II rules will increase client facing and operational compliance over the next few years. In Cantor, we additionally ensure client assets are held externally by Bank of New York and think this is a good principle, but it all comes at an operational and capital cost. The cost of operational compliance is not just the cost of compliance staff, but the cost of additional processes, technology and personnel to monitor and report on compliance.

Lastly, reading the recent Central Bank of Ireland paper on credit union compliance, the range of investment options remains limited, the ability to lend reduced and a related increase in reporting and other costs means lower dividends for deposit holders.

Also consider the impact of quantitative easing in Europe. Loose monetary policy is designed to help banks get stronger and lend, and it has certainly had the effect of creating negative interest rates in certain countries. It is cheaper, it is said, in Switzerland to pay a security firm to guard a decent hoard of gold than pay negative rates to the banks.

Consumers should adjust to negative rates. They will have to pay banks to hold their cash.

The merit of many of these changes is unquestionable, given the last decade's turmoil in markets and the threat of loss of capital to the consumer - but the cost is not fully appreciated. When costs rise, capital requirements increase and the return on capital falls - consumers face higher charges through the passing on of charges or through less competition as players merge.

Who wins? In part, those companies that adopt technology to mitigate rising costs and those that pursue a mergers or acquisitions with true synergy benefits.


As the Government moves to liquidate bailed-out assets, one of the largest remaining contingent assets is Allied Irish Banks. It is valued conservatively by Government at €11.7bn which is below Cantor's valuation of €13bn. The Government also owns €1.6bn in other convertible securities.

AIB's preference shares (€3.5b) are not Basel III compliant and account for too much of the capital of the bank, the convertible shares are expensive with a 10pc coupon and also non-Basel compliant. And lastly, there are simply too many shares (523 billion) which, along with the tiny free-float of 0.2pc, has resulted in the equity being persistently overvalued. As matters stand, these shares should not be purchased.

To remedy this state of affairs, the Government should convert €1.5bn preference shares into ordinary shares. They should repurchase the remaining €2bn of preference shares and the convertibles should be bought back with proceeds of a less expensive bond issue.

Then the resulting ordinary shares should be consolidated on the basis of one new share for every 10 in issue. Several steps have been passed including a court ruling to allow AIB reduce its share capital, the positive outcome to the European Central Bank's comprehensive stress test.

Probably the last remaining hurdle before a sale of a quarter of the Government's holding later this year or early next year is the appointment of out-going chief executive David Duffy's successor. Timing should be good. We have economic growth of more than 4pc in Ireland, a rebounding housing market and the positive backdrop of QE.


Another asset, though only recently, is IBRC. The special liquidators produced a statement of affairs in September 2013 suggesting a €150m deficit.

Now with the market transition, lower rates and improved outlook for Ireland, it appears a surplus is possible, assuming no significant additional litigation costs and that less clear items such as intra group liabilities net off against the carrying value of subsidiaries. In fact, the recently announced €1.8bn in cash, plus additional portfolio sales, suggests a significant return to the Government over and above its entitlement under the ELG and deposit guarantee schemes.

Those attending a recent briefing were told a first distribution to unsecured creditors is likely towards the end of the year - so the Government's coffers may be better than was certainly expected 18 months ago, thanks to AIB and IBRC.

When is capital not capital?

Banks in Europe racked up losses through difficult times and had tax losses going forward as a consequence.

But governments stepped in to bailout banks - a process which involved backstopping the losses. The world moves forward and profitability is on the horizon. This means tax losses may now be utilised.

Two interesting aspects are, firstly, these deferred tax assets are included in the estimate of equity of a number of European banks. Specifically for Greek, Italian, Spanish and Portuguese banks, they represent €40bn of equity.

Secondly, such treatment was intended to be addressed under Basel III - but the countries mentioned have maintained the current treatment. Now, European authorities are reviewing this treatment under state aid rules given normal government backstops to banks.

When looking at banks, investors should take such possible changes into consideration. All in all, the regulation coming down the tracks is worth considering carefully.

Ronan Reid is the chief executive of Cantor Fitzgerald Ireland.

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