Read our analysis of the impact of Basel III elsewhere in the world.
Canada and Basel III
Canada's economy performed relatively well during the global financial crisis. It never experienced the shock to employment and real estate prices that afflicted the U.S. Consequently, its banks outperformed their global counterparts and its banking system's capital levels remained healthy throughout the crisis. While large Canadian banks faced challenging environments in their capital markets operations, only CIBC reported a yearly loss during the financial crisis.
Basel III will lower the capital ratios of the large Canadian banks. The top six banks in Canada all have substantial capital markets operations. Basel III will boost risk-weighted assets by attaching higher capital requirements to counterparty risk, inter-financial exposures, and trading and derivatives activities. Moreover, investments in other financial institutions will receive harsher treatment under Basel III than Basel II, resulting in lower levels of Tier 1 common equity.
While the large Canadian banks are systemically important to the Canadian economy, we do not believe any of them will be treated as systemically important financial institutions.
Four of the six largest Canadian banks--Royal Bank of Canada (RY), CIBC (CM), National Bank of Canada (NA) and Bank of Montreal (BMO)--already meet the Tier 1 common equity requirements under Basel III. However, Bank of Montreal will likely dip below the 7% Tier 1 common equity requirement when its acquisition of internal capital generation. Bank of Nova Scotia (BNS) has not disclosed its pro forma Basel III Tier 1 common equity ratio, but we believe it should easily meet the 7% requirement by 2013.
The US and Basel III
Prior to the credit crisis, the United States found several reasons to delay its Basel II adoption. Consequently, the United States' timeline adds in the adoption of Basel II at the end of 2011 to the worldwide implementation timeline. Overall, due to the massive amounts of capital raising required by the government's two sets of stress tests, most U.S. banks are in a fairly good position to meet the basic Basel III capital requirements. We believe Bank of America (BAC), Citigroup (C) and J.P. Morgan (JPM) will all meet the definition of systemically important. Wells Fargo, as we mentioned previously, is still up in the air. However, we decided it was a good idea to look at all four big banks, and attempt to estimate the gap between current capital levels, and their requirements as a SIFI under Basel III. We assumed that the U.S. regulators would add an additional 1% - 1.5% common equity capital requirement to its SIFIs -- and that each bank would want a 50 basis point cushion over the minimum. This means in this scenario that all four banks would target a 9% Tier 1 Common Ratio -- which is at the top of most bank ranges currently published.
Bank of America (BAC)
Despite its recent rejection for an increase in its dividend payments in the second half of 2011, Bank of America is in a fairly good position to meet Basel III's capital requirements. The company's current Tier 1 Common ratio (measured under Basel I) was 8.6% at March 31. A very rough estimate of that same number under Basel III requirements would be closer to 6.1%, putting it slightly under the 7% minimum ratio. However, the bank has a plan to reduce risk-weighted assets by about $400 million through mitigation efforts by the time Basel III begins to be phased in 2013. Assuming the company can reduce its risk-weighted assets by the $400 million, we estimate Bank of America will need to hold an additional $28 billion of common equity to reach the 9% Tier 1 Common ratio required. That is equal to 4.5 years of net income at the current earnings level. However, we believe Bank of America has a lot more earnings power than the first quarter shows, meaning that without dividends, the bank could make up the entire difference between now and 2013.
Citigroup (C)
While Citigroup's announcement will have no effect on capital ratios, it is important to note the firm's stock will go through a reverse split at the beginning of May. Citigroup was – outside of AIG – the largest recipient of U.S. bailout funds during the crisis. At one point, the U.S. government owned more than 30% of the worldwide giant. The government has sold all of its common stock and redeemed most of its trust preferred stock, leaving Citigroup with massive quantities of common equity. Citigroup's Tier 1 Common ratio at March 31 was 11.3% as measured under Basel I. The bank has not given estimates based on Basel III, but stated it is "confident, based on what we know today, that we will be well above the Basel III capital requirements and above 8% to 9% on a Tier 1 Common basis in 2012." The company stated that it's unlikely to give additional details in the near future. Due the changes in risk weightings, it is very hard to guess where Citigroup stands currently in relation to Basel III. But with an already high level of capital and quarterly profits likely to be the norm once again, we have little doubts that Citigroup will be able to reach the 9% level without a capital raise.
J.P. Morgan Chase (JPM)
J.P. Morgan's Jamie Dimon has been one of the most vocal CEOs about the Basel III rules. It seems that while he thinks higher standards were needed, they have definitely gone far enough. Under Basel III standards, the bank's March 31st Tier 1 Common ratio would measure out to 7.3%, 30 basis points higher than just three months before, despite the higher dividend rate the company announced for the second quarter. With earnings projected to increase, rather than decline, the 170 basis-point gap could be closed in just under a year and half, months before the Basel III rules even begin to get phased in.
Wells Fargo (WFC)
Wells Fargo remained profitable during the recent recession, but also more than doubled in size through the purchase of Wachovia. Through its tremendous earnings power, and some capital raises, the bank's Tier 1 Common Equity ratio increased to 8.9% at March 31, 2011, up from just 3.1% in the first quarter of 2009. Under Basel III rules, the bank estimates its Tier 1 Common ratio would be 7.2%. Primarily a retail bank within the Untied States, it is hard to see who the bank will become systemically important to in the global banking industry. However, if the rules are applied country by country, we believe Wells could get entangled. We estimate the 180 basis-point gap between the current Tier 1 common ratio and our estimated goal of 9% to be about $21 billion. After its newly established $0.12 quarterly dividend rate, Wells Fargo could add more than $3 billion each quarter to common equity, if it decides to forego share buybacks. This would put the bank in line to meet the 9% goal before the 2013 phase-in period. Assuming an increased dividend rate and share buybacks, the bank would still be able to meet the 9% guidelines well before their 2019 deadline.
Chile and Basel
Chilean banks' capital is generally of quite good quality. With more than 65% of Tier 1 being share capital (which is further strengthened with retained earnings), new capital standards will not be terribly onerous for most banks. Already firms' capital metrics--core and total capital ratios--are above the 2019 minima. Moreover, Chilean law introduced a leverage ratio in 1997, which has not dipped below 6% in the past decade for the system average. In terms of liquidity, the Chilean banking system's levels have exceeded the minimum set by Basel III since early 2009 and have shown a growing trend.
Banco Santander Chile (SAN) will have no trouble meeting the new capital regulations, in our view. As of Dec. 31, 2010, the bank's core capital and total capital ratios were 10.6% and 14.5%, respectively, already exceeding the new minima. To be sure, we think the bank has a stout ability to generate capital internally with its strong earnings power (ROEs well-above 20%) and not overly burdensome dividend payout of around 50%. As a result, we anticipate Santander Chile will neither have to raise fresh equity nor cut its dividend in order to comply with new regulations and fund its future growth.
Brazil and Basel
As with Chile, for many years Brazil's banking rules have been more conservative than what international regulations command. Hence, the Central Bank of Brazil expects that although there will be a need to strengthen some of Brazil's banks' capital base, by and large Brazilian banks are at a more comfortable position to implement Basel III reforms that most financial firms in other countries. To be sure, the capital measures that Basel III calls for early implementation are already met. In addition, the central bank is studying the possibility of setting an accelerated schedule, in which the regulatory adjustments would be in place by July 2012--two years ahead of Basel III's proposed timeline.
We think that all three Brazilian banks under our coverage--Banco Bradesco (BBD), Itau Unibanco (ITUB), and Banco Santander Brasil (BSBR)--will have no major issues complying with the new stricter capital minima. Even though the banks have not released updated measures of core capital, by our estimates most of their Tier 1 capital is made up of common equity and looks sturdy at 13.1%, 11.8%, and 19.0%, respectively. In our view, not only are their current capital ratios adequate, but their NPLs are manageable (around 4% of their loan books), especially with the healthy reserves each institution has (over 100% in all three cases). Thus, we think their internally generated equity should suffice to take advantage of Brazil's economic growth by deploying capital while maintaining strong capital ratios.
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