TEXT-Fitch: move to Basel III sharpens focus on risk return tradeoffs

June 12 - Banks preparing to meet tougher Basel III capital standards by
2019 will face increasingly difficult tradeoffs if they hope to boost return on
equity (ROE) performance while adhering to increasingly stringent regulatory
capital guidelines. Although credit investors will generally benefit from a
derisking of bank balance sheets over the next few years, Fitch Ratings expects
bank management teams to remain focused on the need to counteract ROE pressure,
potentially pushing them into riskier activities that maximize returns on a
given unit of Basel III capital.

Our analysis suggests that median ROEs for 29 global systemically important
financial institutions (G-SIFIs) will likely remain constrained over the next
few years as higher equity capital requirements, in addition to other regulatory
costs and revenue pressure, will challenge bank profitability. In contrast to
median ROEs of roughly 11% for these 29 institutions in 2005-2011, future equity
returns might fall to the high single-digit range due to the Basel III increase
in minimum capital requirements, absent changes in earnings dynamics.

In addition to the Basel III requirements, which will be phased in over the next
six years, banks are facing other challenges that are contributing to near-term
ROE compression. The median ROE for the 29 G-SIFIs weakened to 7.5% in 2011,
highlighting the difficulties large banks are already facing in adapting to a
more difficult operating environment driven by lacklustre economic growth, the
effects of historically low interest rates on bank margins, and rising
regulatory costs.

Although some investors might accept lower returns in exchange for greater
stability, banks reporting high single-digit returns in a more stringent global
regulatory framework will potentially face pressure from equity holders to seek
ways to avoid the constraints of new capital requirements by shifting their
business mix over time.

This may lead some banks to de-emphasize lending activities requiring increased
capital charges under Basel III. Banks are likely to focus on opportunities to
trim some loan portfolios that offer weaker returns on risk-weighted assets
(RWA) in favor of other fee-based revenue streams where the lower regulatory
capital charges can help boost ROE.

Many of the largest banks have already begun the process of reducing RWA, in
part to begin the transition to Basel III compliance, but also in an effort to
boost ROEs at a time when many banks have seen their equity market values fall
below tangible book value. Since it is impossible for regulators to perfectly
align capital requirements with risk exposure, some banks may seek to increase
ROE by favoring higher yielding, riskier activities not fully captured by the
Basel III rules, including new forms of regulatory arbitrage.

For a closer look at Basel III capital requirements and their potential impact
on G-SIFI capitalization and returns, see "Basel III: Return and Deleveraging
Pressures," dated May 17, 2012, at www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market
commentary page. The original article can be accessed at www.fitchratings.com.
All opinions expressed are those of Fitch Ratings.

Applicable Criteria and Related Research:
Basel III: Return and Deleveraging Pressures