Tag: Fitch

Revised Model-Based Market Risk Rules Costly for Banks – Fitch

The overhaul of the internal models approach – used by most banks with large trading books to calculate market risk capital requirements – will be costly, says Fitch Ratings. The Basel Committee on Banking Supervision’s revised market risk framework, published in January and effective from 2019, fundamentally changes the approach.

The model revisions should improve risk assessment capabilities, lead to higher capital charges for hard-to-model trading positions and make it easier to compare banks’ results. But the model approval process and governance are being thoroughly revised and implementing the changes will require considerable investment in technology and risk management.

Banks will need to obtain approval for internal models desk by desk, rather than bank-wide. This will make it easier for supervisors to decline approval for a particular trading desk, if, for example, the desk is unable to satisfy model validation criteria due to back-testing failures or an inability to properly attribute profits and losses across products. But Fitch thinks costs associated with building and running the more sophisticated models will be high.

Instead of running a single bank-wide model for a range of stressed and unstressed risk factors, multiple new models will need to be built, validated and run daily. This will multiply the number of model reviews and operational runs and add to subsequent data analysis and reporting procedures. Additional risk personnel will be required for review, oversight, and reporting purposes.

The amount of regulatory capital models-based banks will need to cover potential market risks following the revisions is uncertain. The Basel Committee’s latest studies show that, for a sample of 12 internationally active banks with large trading books, all of which provided high-quality data, market risk capital charges under the revised approach were 28% higher. But for a broader sample of 44 banks using internal models, the median market risk capital requirements fell by 3% under the revised models.

Fitch thinks the result for the 12 banks could reflect greater concentrations of less liquid credit positions that require more capital, or larger trading positions lacking observable transaction prices, which are subject to a stressed capital add-on. Banks facing higher charges under the regime may re-assess whether certain activities remain profitable.

The new internal models approach replaces value at risk (VaR) with an expected shortfall (ES) measure. VaR does not capture the tail risk of loss distribution, which can arise during significant market stress. The use of ES models for regulatory capital is positive for bank creditors because they could lead to better capitalisation of tail-risk loss events and might motivate risk managers to limit trading portfolios that could lead to outsized losses.

When calculating ES measures, banks will have to use variable market liquidity horizons – to a maximum of 120 days for complex credit products, against the current fixed 10-day period. We think model inputs will be more realistic, by acknowledging that some instruments take longer to sell or hedge without affecting prices. ES will also constrain recognition of diversification and hedging benefits, extensively used in VaR models to reduce capital charges. We think this will make model outputs more prudent and force banks to better capitalise potential trading losses.

Structural flaws in the way banks calculated capital charges for market risk were exposed during severe market stresses in 2008-2009. The Basel Committee subsequently undertook a fundamental review of the trading book. The original proposals were watered down, but we think the final revised minimum capital standards for model-driven market risk are positive for creditors because improved model standards and more prudent methods employed to capture risk should mean trading risks are more accurately capitalised.

Revised Market Risk Capital Rules Will Hit Smaller Banks – Fitch

Smaller banks are likely to have to set aside more Pillar 1 capital to cover potential market risks when the Basel Committee on Banking Supervision’s (Basel Committee) revised market risk framework comes into force in 2019, says Fitch Ratings. This is because banks using the standardised approach to calculate market risk capital requirements, including the bulk of second-tier, less sophisticated banks, will face steeper capital charges once they apply the revised approach.

Impact studies conducted by the Basel Committee show that, for a sample of 44 banks using the standardised approach for market risk, median market-risk capital requirements rise by 80% when the revised standardised guidelines are applied.

But on the whole, market risk is low as a proportion of overall risks faced by banks and the additional capital to be earmarked for market risk under the new rules should not be too onerous. The Basel Committee says that the revised framework produces market risk-weighted assets (RWA) that account for less than 10% of total RWAs, higher than the current framework’s 6%, but still low as a proportion of the total.

The standardised approach for market risk capital calculation is still widely used, especially by banks with limited trading activity or those lacking regulatory approval to use internal models. But some banks involved in straightforward commercial banking have sizeable derivative portfolios to hedge currency- and interest-rate risks.

For these banks, revised capital requirements could be more onerous, depending on the complexity of the instruments. Under the revised approach, capital charges will rise for interest rate, credit, FX and commodity derivatives. Exotic derivatives that cannot be broken down into vanilla constituents, or with complex underlyings, and instruments with embedded optionality will attract a residual risk add-on charge, ranging from 0.1%-1% of the gross notional value of the derivative.

Revisions to the standardised approach will overcome some shortcomings in the current framework, which was last amended in 1996. The new framework amends the assumption that all positions can be sold or hedged within 10 days and addresses both the inability to assign capital based on pricing model sensitivities and the failure to fully capture risks associated with credit products, such as credit spread and jump-to-default risks.

Under the new regime, the revised standardised approach will be the fall-back to the internal models-based approach, meaning that banks with internal model approval will still be required to compute capital under the revised standardised approach. The new framework harmonises key sensitivities and calibrations used under the revised standardised and revised models-based approaches. By sharing methodologies used for assessing tail-risks under stressed market conditions and variation in liquidity horizons, comparing results should become more straightforward. This should simplify the application of the revised standardised approach as a fallback if required.

Banks with large trading books use internal models to calculate market risk capital requirements and the Basel Committee’s new framework also overhauled the models-based approach.

Structural flaws in the way banks calculated capital charges for market risk were exposed during periods of severe market stress at the height of the 2008-2009 financial crisis. Post-crisis, the Basel Committee undertook a fundamental review of the trading book. The original proposals were watered down, but we think the final revised minimum capital requirements for market risk will be positive for creditors because traded market risks will be more rigorously capitalised, with banks using more risk-sensitive approaches, rather than the current simplistic and outdated approach.

Banks May Need More Capital to Cover Basel Step-In Risk

The Basel Committee on Banking Supervision’s proposals concerning step-in risk are most likely to have an impact on banks with large asset and wealth management, investment fund, and securitisation origination and sponsorship activities, says Fitch Ratings.

The Basel Committee launched a consultation on 17 December 2015 to assess whether banks should hold capital specifically to cover the risk that they may be required to step in and provide financial support to non-bank financial entities at a time of financial stress, even in the absence of clear contractual obligations to do so.

These additional capital requirements could prove onerous. This increases the likelihood that affected banks could lobby and resist the proposals.

Banks with discretion over the assets they manage in their wealth management units would incur a capital charge because they might encounter higher step-in risks. Under the proposals, a credit conversion factor, which could be as high as 100%, should be applied to the volume of discretionary assets under management. Large asset and wealth managers could potentially face high additional capital charges if the proposals are adopted, even if only a fraction of assets under management were classed as discretionary.

Fitch says this could reduce the attractiveness of asset and wealth management as a business line, especially if banks are unable to pass on additional capital costs by increasing fees. The Basel Committee also highlighted step-in risk arising from structured note special purpose vehicle platforms, such as the ones used by investment banks and wealth managers to create bespoke investment products for institutional and high net worth investors.

Step-in risk is not new. During the 2008 financial crisis, several banks supported entities which had been shifted off-balance sheet because they were heavily invested in the entities, were the entities’ sole source of liquidity or failure to provide support would lead to considerable reputation damage. Accounting consolidation standards were tightened and regulatory reforms, such as the Basel Committee’s Pillar 2 reputational and implicit support risk guidelines, have tried to tackle step-in risks. And on 14 December 2015, the European Banking Authority issued guidelines regarding limits on banks’ exposures to shadow banking entities.

But the Basel Committee is now proposing that banks should capture potential step-in risk using a quantitative approach either under Pillar 1 or 2 capital requirements. Regulatory drives to ensure banks hold sufficient capital in advance of a stress can be positive for ratings. But we think the proposed step-in capital charge could include an element of double counting.

The Basel Committee’s Liquidity Coverage Ratio already forces banks to determine the liquidity impact of non-contractual contingent funding obligations and asking banks to hold additional capital for step-in liquidity risks could prove too onerous. The proposed step-in risk capital charges could, however, add value when banks calculate their leverage ratios because step-in contingencies go beyond the off-balance sheet liabilities included in leverage calculations.

Fitch already considers potential step-in risks as part of its rating process. Highly opaque or complex organisational structures might be a negative ratings factor. Off-balance sheet risks are analysed when we assess a bank’s financial profile and reputational risks are closely reviewed, particularly when we assess a bank’s propensity to support subsidiaries and affiliates. Branding, entity sponsorship, liquidity provision and the ability to influence management, which the Basel Committee identifies as key potential step-in risk triggers, are factored into our bank ratings.

The Basel Committee’s consultation period on step-in risk closes in March 2016.

Tough Environment Raises Fiscal Risks in Australia, NZ

A challenging economic environment – particularly weaker external demand conditions – has affected the fiscal outlook for Australia and New Zealand, resulting in delays to budget consolidation and potentially higher credit risks over the medium term, says Fitch Ratings.

Mid-year budget updates, released yesterday, highlighted the trajectory of a gradual return towards budget surplus remains for both countries, but weaker-than expected economic performance has pushed back consolidation timelines. However, low public indebtedness continues to be a strength, helping to anchor ratings during a period of heightened economic uncertainty.

Slowing external demand has led directly to weaker terms of trade. This has in turn resulted in budget deterioration, owing mainly to weakness on the revenue side, with lower nominal GDP growth likely to weigh on tax receipts. Yet lower inflation should restrain nominal expenditure growth, and currency depreciation has helped to cushion the fall in commodity prices in local-currency terms. The lower currencies of both countries has also boosted export competitiveness, particularly in the services sector which accounts for one-third and one-fifth of New Zealand and Australian exports, respectively.

According to the latest mid-year budget updates between fiscal years 2016-2019, Australia’s underlying cash balance relative to GDP is now expected to be on average 0.4ppt lower each year, while New Zealand’s Operating Balance Excluding Gains and Losses (OBEGAL) is on average 0.3ppt lower.

Australia is now projected to achieve a surplus in FY21, a year later than previously planned. Fiscal balances have started to fall behind many of the 11 other ‘AAA’ rated sovereigns. A failure to rebalance the economy away from mining is a potential risk over the medium term, which could put pressure on public finances and Australia’s credit rating.

However, this risk is only likely to materialise over the long term; rebalancing is only in the early stages, while services exports and residential investment are making bigger contributions to growth. We expect Australia’s gross government debt/GDP ratio to remain firmly below the ‘AAA’ median, and this affords time for a more protracted return to fiscal surplus – in the absence of a severe economic shock.

In New Zealand, the OBEGAL is likely to fall back into deficit in FY16 after unexpectedly reaching a surplus for the first time since 2008 in FY15. Fitch had previously highlighted that a reduction in the general government deficit – leading to a steady reduction in public debt ratios – would be a trigger for positive rating action. But the Treasury now projects Net Core Crown Debt to peak at 27.7% of GDP in FY17, compared with a peak of 26.3% as forecast by the government in May. Nevertheless, New Zealand’s fiscal position still sits comfortably alongside its ‘AA’ peers despite the weaker outlook.

Higher-than-expected net migration inflows have been a boon for New Zealand’s medium-term fiscal outlook, limiting the downward revision to potential growth as a result of lower investment. Growth is now likely to increase from 2.5% to 2.6% in FY16 from a previous 2.8%. Net migration inflows have been due in part to fewer departures of New Zealand citizens to Australia. This has also contributed to a lower estimate of Australia’s medium-term potential growth rate, revised down from 3.5% to 3.0% by the Australian Treasury.

Both the Australian and New Zealand economies share vulnerabilities pertaining to high external indebtedness and commodity dependence, and run large current account deficits. Fiscal projections for both economies are highly sensitive to macroeconomic assumptions, including global demand and commodity prices. This may require the sovereigns to have a slightly larger buffer in public finances than similarly rated peers.

Asia Growth to Normalise, Not Collapse as Pressures Mount – Fitch

Fitch Ratings says that emerging Asia’s real GDP growth should slow to 6.3% in 2016 as regional economic pressures continue to add to a challenging outlook . That said, effective policy responses and sovereign buffers should provide a degree of protection, and the slowdown is better understood as a normalisation of growth rates and not an uncontrolled collapse. A hard landing in China is unlikely, and growth in India and in ASEAN should pick up. We forecast emerging Asia as remaining the fastest-growing emerging markets region in 2016.

Fitch’s latest Global Economic Outlook, published yesterday, forecasts global growth to pick up slightly in 2016. Issues linked to lacklustre trade and investment growth remain. But major advanced economies such as the US, Eurozone, UK and Japan seem to have emerged relatively unscathed from the slowdown in key emerging markets in 2015. We forecast global growth to accelerate to 2.6% in 2016 and 2.7% in 2017, from 2.3% in 2015.

In Asia-Pacific, the outlook remains challenging with added economic pressures from the continued slowdown in China’s growth, sluggish global trade growth, and an expected rise in US rates and resulting dollar strength. The expected slowdown in emerging Asia, however, is likely to be driven almost entirely by China. Fitch forecasts Indian growth to accelerate to 8% in the fiscal year ending March 2017, while emerging Asia excluding China and India should grow by 5.2% in 2016, up from 5% in 2015.

One potential downside risk to regional growth could come from high private-sector debt, which is still rising. Four Asian emerging markets have the highest ratios of bank private-sector credit to GDP of any Fitch-rated emerging markets – China, Malaysia, Thailand and Vietnam. Upward pressure on regional interest rates stemming from the US may weigh on domestic demand in more indebted economies.

Fitch maintains its view that the China slowdown is part of a broader structural adjustment necessary to achieve a more sustainable growth pattern. The data thus far from 2015 supports this picture, with weak exports and investments being offset by relatively robust consumption and a solid labour market. Importantly, the scenario of a very sharp slowdown in Chinese growth following the financial market volatility in the summer has not played out. This has reinforced the view that China is likely to muddle through during its structural-adjustment process – and avoid a hard landing.

The Chinese authorities maintain significant resources and capacity to avoid a disorderly deceleration. Fitch has raised its forecast 2017 growth rate for China to 6% from 5.5%, based on the latest Five-Year Plan which suggests a growth target of 6.5% for 2016-2020.

More broadly in Asia, sovereign rating outlooks are mostly stable despite the general outlook and mounting regional pressures. The risks of a financial crisis akin to 1997 are significantly mitigated. External balance sheets are stronger in the region; sovereigns rely less on foreign-currency funding than in 1996; and most countries now also benefit from flexible exchange-rate regimes.

Macroeconomic policy responses thus far have also helped to buffer credit profiles. This is especially the case in Indonesia and Malaysia, which stand out as relatively more exposed to external risk factors than other major economies in the region such as the Philippines and Vietnam.

No Change in UK Bank Capital Plans Following Stress Tests

Fitch Rating. says that after its latest stress tests, the Bank of England’s (BoE) assessment is that the UK banking sector is adequately capitalised and the results will not force any capital planning revisions. Further sector-wide capital step-ups are unlikely in future.

Capital ratios are likely to remain stable, held up by the BoE’s increased use of countercyclical buffers. These will be built up as lending growth accelerates and will be released when the cycle turns. The BoE’s intention is that banks’ capital planning should become more efficient and flexible. The BoE’s Financial Policy Committee indicated that it considers a Tier 1 capital adequacy ratio of 11% to be appropriate for the sector. Fitch expect banks to set their internal buffers relative to this level and plan their capital needs relative to the level of sensitivity to stress test inputs.

Results from yesterday’s stress test show that, under the baseline scenario, the seven participating banks are improving their capital positions. But the Royal Bank of Scotland Group (RBS; BBB+/Stable) and Standard Chartered (A+/Negative) did not meet the BoE’s capital requirements under the stress scenario. Both banks have taken, or are taking steps this year to address capitalisation.

The regulator will use future stress test results to assess individual banks’ capital requirements. Fitch expects the tests to become more sophisticated and more qualitative in nature. This is already the case in the US where the Federal Reserve’s annual Comprehensive Capital Analysis and Review plays an important role in how the country’s leading banks assess their capital planning exercises.

In the UK, annual cyclical tests will be run to capture risks from financial cycles, with the severity of scenarios increasing as risks build up. This should produce more rounded stressed results. Latent risks not captured by the annual cyclical scenario will be introduced every other year when the BoE will run a biannual stress test. Fitch thinks the banks should, over time, be able to anticipate broad movements in the annual cyclical scenario, making it easier for them to set internal buffers above minimum regulatory requirements, based on their expected sensitivity to the regulatory stress test.

The 2015 stress test hurdles – a 4.5% common equity tier 1 (CET1) ratio and a 3% leverage ratio – were not particularly onerous. All participating banks met these. But hurdle rates will evolve and banks will need to meet their Pillar 1 minimum CET1 ratios under stressed scenarios, plus any additional requirements set by the regulators under Pillar 2A and buffers for systemically important banks.

New Bank Operational Risk Method May Boost Comparability

Operational risks will rise as banks increasingly rely on technology, heightening exposure to systems failure and cyber attacks. Banks also face growing compliance and regulatory risks and the overhang of unresolved litigation is still considerable in some markets.

According to Fitch Ratings, the Basel Committee’s proposed overhaul of the way banks calculate how much capital they need to cover operational risk should result in simpler, more standardised charges, allowing for greater comparability.

Banks have been calculating operational risk capital requirements for over 10 years since the implementation of Basel II, but in many cases capital set aside proved inadequate to cover substantial losses arising from misconduct fines, controls failure or fraud, for example.

The Basel Committee’s update on post-crisis reforms, presented to the G20 leaders at the recent Antalya summit, confirms that it is considering eliminating the use of internal models to calculate operational risk capital charges. Basel II introduced several methods for calculating operational risks to reflect particular risk profiles across banks, variations in operating environment and management practices. But we believe flexibility has confused market participants and contributed to a lack of transparency.

The Basel Committee is considering replacing all current approaches with a single new standardised measurement approach (SMA), and will open a one-year consultation period by end-2015. SMA will borrow from the current advanced measurement approach (AMA) by incorporating a requirement for banks to continue to collect operational risk loss data, but internal modelling will not be used to determine appropriate capital levels. Comparing operational risk capital charges currently set aside by banks using AMA has proved difficult, largely because internal models are highly complex, methodologies vary from bank to bank and calculation outputs lack transparency.

Some Basel II methods for calculating operational risk charges are predetermined by regulators, such as the basic indicator and standardised approaches, both of which link capital charges to gross income (the standardised approach allows banks to vary multipliers across business lines and units). But operational risk capital charges can also be calculated using an internal measurement approach where banks draw on data from their internal operational loss experiences. The Basel Committee, which is already driving a trend to reduce reliance on complex models in other areas, says it will consult on removing the AMA. The AMA gave banks the greatest amount of freedom to set operational risk charges, as flexibility on the modelling approach meant risk charges would differ even when applied to the same base data.

Risk Concerns In USA and Europe

Two updates from Fitch have underscored emerging risks in both the USA and Europe.

First from Europe:

European credit investors have grown more bearish on emerging markets (EMs) and see them as the biggest risk to European credit markets, according to Fitch Ratings’ latest senior investor survey. But most investors see selective EM risk as acceptable in more stable countries and sectors.

Fifty-nine percent of respondents to the survey, which closed on 4 November, said the risk posed over the next 12 months by adverse developments in one or more emerging markets was high, up from 45% in our previous survey in July.

Investors again singled out EMs as most likely to experience deteriorating fundamental credit conditions in the coming year. Three-quarters of respondents think EM sovereign fundamentals will deteriorate, compared with two-thirds in July. For EM corporates the proportion increased nearly 20pp to 80%. Just 6% predict an improvement for either category.

A more pessimistic view among investors is consistent with the volatility in EM assets since mid-year. This has been driven by concerns about US monetary tightening, global growth, and commodity prices, as well as country-specific factors.

Survey responses reflect this range of related challenges, with no single risk factor notably outweighing others. 29% of respondents see low commodity prices as the main risk to EMs, followed by slower global growth (26%), a Fed rate rise (24%), and high debt levels (21%). The view that EM corporates face the greatest refinancing challenge has hardened, with 63% of respondents selecting this category, up from 46% in our previous survey.

Nevertheless, more than half of respondents described their view on EM debt as selective, looking to pick more stable countries and sectors to avoid high risk exposures. 14% think now is a good time to buy in an oversold market.

Concerns about EMs are not new, and Fitch’s European senior investor surveys have shown increasingly negative sentiment in recent years. US investors also saw EM contagion as the top risk to their market in our recent US survey. Our global growth forecast of 2.3% for 2015 factors in the impact of recessions in Brazil and Russia and a structural slowdown in China and other EMs.

Fed tightening can exacerbate credit pressures via its impact on EM rates, capital flows and currencies, but this will vary across regions and asset classes. Many sovereigns have large FX reserves and low public debt, while EM corporate debt has risen sharply in the last decade. Highly indebted corporates with large dollar exposure and unhedged FX risk profiles will face greater refinancing risk than those with good funding diversification. US rate rises may put pressure on some EM banking systems’ asset quality and increase refinancing challenges.

Fitch’s 4Q15 survey represents the views of managers of an estimated EUR7.5trn of fixed-income assets.

Next in the USA:

US banking regulators’ latest report on the Shared National Credits Program (SNC) noted an overall higher level of credit risk throughout the system in 2015, providing further evidence that overall asset quality is potentially trending weaker, says Fitch Ratings. This may lead to higher future loan-loss provisioning, which was already evidenced in third-quarter 2015 with energy-related loan-loss reserve builds.

SNC portfolio loan risk is not usually retained by US banks in its entirety. While US banks hold roughly 40% of the SNC’s outstanding commitments, the majority of the credit risk continues to reside in the nonbank sector. Of the $228.4 billion in loans classified as “weak” by regulators, nonbanks held $153.0 billion, while US-domiciled banks held just $40.7 billion, and foreign bank organizations held $34.8 billion. Compared with last year’s review, classified balances increased 19% while nonaccrual balances were 7% higher, with most of the deterioration attributed to the energy sector.

The credit issues highlighted in the report remain focused on leverage lending and, particularly this year, oil and energy exposures. The regulators noted that the banks are making progress in adhering to the leveraged lending guidance issued by regulators in 2013. However, there will still be weak structures cited by the regulators. While no specific grouping of US banks are identified, the sample of loans examined is skewed toward large syndicated loans originated by large banks.

The greatest impact on shared loan asset quality was oil price declines affecting exploration and production and oilfield services companies, which represent about 7% of the overall SNC portfolio. Classified oil and gas borrowers rose to $34.2 billion, representing 15.0% of total classified committed loans, up from $6.9 billion or 3.6% in 2014. The report noted that banks are taking “reasonable actions” during this stressed period.

Apart from the underlying credit picture, leveraged loan underwriting continues to reflect weaker capital structures and covenants that limit lenders’ abilities to manage risks. The SNC program continues to pay special attention to highly leveraged lending at US banks where debt/EBITDA exceeds 6x. Year-to-date 2015, 36% of leveraged transactions exhibited weak structures, up from 31% last year. Among the weaknesses cited are ineffective or no covenants, liberal repayment terms and allowances for incremental debt above leverage levels at the start of loans. The reported noted that 92.2% of leveraged loans originated after June 1, 2014 included incremental borrowing provisions, an area that was drawing attention.

Leverage lending has grown over the last few years and has contributed to US loan growth. Last year, leverage loans in the SNC review pool were up 31.8%, year over year, to $1.04 trillion. Healthcare, media and telecom, finance and insurance, and materials and commodities were the top four contributors to that growth. Banks have experienced a 13.7% CAGR in outstanding loan balances since year-end 2011, which compared to 8.5% since year-end 1989.

Beginning in 2016, the regulators will change the frequency of SNC exams. Previously, SNC exams were held once a year; but next year, the large banks will undergo two onsite SNC exams. The first review will begin in February, utilizing data as of Sept. 30, 2015. The target date for the SNC review results to be sent to the participating banks will be in March of the following year. The second review will begin in August, based on first-quarter 2016 data. Fitch does not expect the more frequent examinations to produce material changes in the exam findings.

UK Bank Ring-Fence Unlikely to Cause Material Rating Gaps

The Prudential Regulation Authority’s (PRA) ring-fencing policy proposals limit, but do not prevent, ring-fenced banks (RFB) to lend to non-ring-fenced sister banks (NRFB) and impose no added restrictions on dividend payments. This will allow some fungibility of funding and capital within group companies. Standalone Viability Ratings (VR) assigned to RFBs and NRFBs will therefore remain interdependent, reducing rating gaps between them, says Fitch Ratings.

The PRA has sought to eliminate the use of intra-group concessions across the ring-fence and now expects banks to apply third-party credit discipline to such exposures. This will improve analytical transparency which we view positively.

We envisage that UK banks subject to ring-fencing will adopt one of two models depending on the relative size of their non-ring-fenced activities, prior to the January 2019 deadline. Banks have to submit their plans by January 2016, according to the PRA’s consultation paper published on 15 October.

VRs assigned to RFBs are likely to be constrained by limited geographical and product diversification and, provided these remain largely focused on UK retail and SME lending, we do not expect to see much ratings differentiation between them. We already indicated in our September 2014 comment, accessed by clicking on the link below, that VRs for RFBs narrowly focused on domestic retail and SME business are likely to be capped in the ‘a’ range.

The UK ring-fencing rules apply to banks with more than GBP25bn of core deposits from SMEs and individuals. Most banks affected by ring-fencing have very limited (if any) wholesale and investment banking activities and therefore these groups will adopt models dominated by RFBs. This will be the case for Lloyds and RBS.

In these instances, the ability of the larger RFB to lend up to 25% of its regulatory capital to the smaller NRFB should be a significant positive ratings factor for the NRFB’s VR. This is because the NRFB will be able to benefit from ordinary support flowing from the larger RFB.

For groups whose non-retail, corporate and investment banking business is significant, as is the case for Barclays and HSBC, the importance of the NRFB within the restructured group is likely to be significant, or even dominant. The RFB’s ability to fund its NRFB sister will likely be less material simply because of the banks’ relative sizes. Under this model, we believe that management will seek to structure RFB and NRFB subsidiaries to ensure these remain robust on a standalone basis, maintaining strong and balanced funding and liquidity and meeting adequate capitalisation levels.

A clearer picture about the likely ratings outcome for RFBs and NRFBs will emerge once further details of group restructuring are available. Much will depend on exactly what activities are kept in or out of the fence. Resolution strategies (‘single point of entry’ or ‘multiple point of entry’), depending in particular on the volumes, form and source of ‘loss absorbing’ debt, will also be relevant for ratings and will add a separate layer of uncertainty to ratings within a UK banking group until more clarity emerges.

But, as far as regulations are concerned, our opinion is that the PRA proposals will not create a particularly ‘high’ fence, reducing intra-group rating differentials. By preserving the ability to share capital and funding across RFBs and NRFBs, the PRA is demonstrating that it is keen for RFBs to continue to enjoy the benefits of remaining part of broader banking groups.

Government’s FSI Support Will Strengthen Aussie Banks

The Australian government’s acceptance of almost all of the recommendations of the Financial System Inquiry (FSI) will lead to a strengthening of the banking system with improved resiliency to shocks, says Fitch Ratings. The decision to back the recommendations reinforces Fitch’s view that bank capital requirements will rise in line with regulatory changes over the medium term.

The Australian government released its response to the FSI on 20 October, agreeing with all of the inquiry’s recommendations pertaining to banking system resilience and regulation. The government stated that the Australian Prudential Regulation Authority (APRA) would implement key recommendations related to banking system stability.

This reinforces earlier policy announcements and bank capital issuance trends since the original announcement of the FSI recommendations in December 2014. Since then, APRA announced an increase in minimum mortgage risk-weights for internal ratings-based (IRB) banks in July, while each of the “Big 4” Australian banks have undertaken multi-billion dollar capital raises totaling an aggregate AUD17bn this year.

The government has also committed to APRA ensuring banks have an “appropriate” total loss-absorbing capacity (TLAC) in place at some point beyond 2016. A TLAC framework has been proposed by the Financial Stability Board for global systemically important banks, but this does not apply directly to Australia. Australia’s commitment to implementing a TLAC requirement would be credit positive for bank Viability Ratings, and is likely to reinforce the trends towards higher capital levels.

Implementation of the FSI recommendations will include reducing implicit government guarantees and implementing a bank resolution regime in line with evolving international practice. Fitch maintains that developing a stronger resolution framework would be likely to result in the removal of the sovereign Support Rating Floor for the banking system. Support Ratings for the largest Australian banks are at ‘1’, indicating a high level of government support. But, as a resolution regime is implemented, Fitch would expect Support Ratings and Support Rating Floors to migrate to ‘5’ and ‘No Floor’, respectively.

It is important to note that this should not have an effect on Australian banks’ Issuer Default Ratings (IDRs), as none of the banks’ ratings are at their Support Rating Floors.