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June 21 (Reuters) - (The following statement was released by the rating agency)
An "adjusted" 3% minimum common equity Tier 1 (CET1) leverage ratio for UK banks is the most challenging aspect of the Prudential Regulatory Authority's capital shortfall exercise, Fitch Ratings says. A shorter implementation timetable naturally leads to less execution flexibility for the lenders.
The date by which these lenders have to reach the 3% PRA-leverage requirement has not been disclosed yet, but it could be significantly earlier than the 2018 start date for the Basel III leverage ratio. The PRA estimates that two lenders - Barclays and Nationwide - will fall short of the leverage requirement even after taking actions to reach the 7% PRA-calculated CET1 benchmark.
Addressing the leverage shortfall in a short period could be challenging as organic reduction in leverage takes time for some asset classes. It is easier to reduce liquid and tradeable assets, so a short timetable would encourage banks to reduce excess liquid assets. The main challenge lies in the PRA's requirement that the target is met without reducing lending to the real economy, as the government continues to press for wider access and more affordable lending.
For a bank with a less flexible asset structure, a short timetable for implementation of the leverage requirement could spur issuance of core capital instruments and encourage lenders to look for debt buyback opportunities to boost CET1. Nationwide may issue a new form of mutual CET1 instrument called core capital deferred shares. A move towards higher-yielding, higher-risk mortgages and increased lending rates is also possible. The lenders' plans to address the leverage ratio shortfall will be agreed with the PRA no later than end-July.
If the capital exercise is extended to other banks and building societies, we would expect those involved in prime residential mortgages, which set aside capital using the internal rating-based approach to credit risk to have to improve their leverage ratio. A healthy and well-performing portfolio of UK prime residential mortgages currently leads to risk weightings under the IRB approach of 8%-10%, which means leverage can remain high.
We expect the capital exercise to reduce the variation in UK banks' reported fully loaded Basel III ratios and to push the average higher by end-2013. This should leave the banks well placed for the European Banking Authority stress test in 2014 and increase the resilience of the sector. However, it has created some short-term uncertainty during the process as there is limited detail on the PRA adjustments and on when leverage shortfalls must be closed.
We believe the PRA has been conservative in making adjustments to capital and risk weights. For example, the asset valuation adjustments were based on three years of expected losses with no credit given for future income from the portfolio. Fitch's credit analysis uses various stress scenarios, which may differ to those of the PRA.
The PRA announced the completion of its capital shortfall exercise yesterday. This involved eight major UK banks and building societies. The PRA made adjustments to reflect a more prudent assessment of asset valuation, future costs of conduct redress and risk weights.