December 28, 2018 / 10:13 AM / 6 months ago

Breakingviews - EU investment banks face the regulatory microscope

The euro sign in front of the former headquarters of the European Central Bank (ECB) is photographed with long exposure in Frankfurt, Germany, November 20, 2017.

LONDON (Reuters Breakingviews) - Europe’s careworn investment banks have something new to worry about in 2019: a close-up examination by regulators. As five years of benign credit and abundant liquidity comes to an end, watchdogs are probing lenders’ internal models to test their resilience to turbulent markets. For banks which hitherto relied on their own guesstimates, that could eat into capital. The Single Supervisory Mechanism – the European Central Bank’s top bank cop - has spent much of its short life focusing on the bad debts that were the legacy of the euro zone crisis. In 2019, however, it is expected to shift its focus to scrutinising investment bank balance sheets. One component is finalising its “targeted review of internal models” (TRIM), which began in 2017. Lenders such as BNP Paribas, Deutsche Bank and Société Générale are all heavy users of bespoke models to help calculate risk-weighted assets (RWAs) and, by extension, their common equity Tier 1 capital ratio (CET1) requirements. Regulators have long suspected that this approach allows big banks to shrink the amount of capital they would otherwise have to hold compared with standardised models mostly used by smaller lenders. They are now phasing in new rules which requires the outputs of banks’ own calculations to be no lower than 72.5 percent of the standardised version. Yet ECB supervisors are still concerned by what they say are large inconsistencies in the way banks measure similar RWAs – with some lenders relying on overly “optimistic” assumptions, according to a person familiar with the discussions. The ECB’s other priority will be examining the assets on bank balance sheets - including credit default swaps, long-dated derivatives and private equity investments – whose value cannot be determined by market prices and thus relies on banks’ internal assumptions. For European Union banks these “Level 3” assets have collectively shrunk from 188 billion euros to 132 billion euros over the past three years, according to ECB data, and account for less than 1 percent of total bank assets. Yet their significance is substantial for a few investment banks. At Deutsche Bank, BNP and SocGen, Level 3 assets are equivalent to 47 percent, 14 percent and 18 percent of CET1 capital respectively. A small change in valuation assumptions could therefore have large consequences. Following years of poor returns, rising rates and increased market volatility could boost investment banks’ trading revenue, while the effects of past cost-cutting should also begin to pay off. But a spell under the regulatory microscope will dent that enthusiasm.

- This is a Breakingviews prediction for 2019. To see more of our predictions, click reut.rs/2R6H5pG

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