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The turmoil in banking has left investors swimming in an alphabet soup of acronyms. They rightly question how useful it is to cling to such straws as capital ratios. After all, banks with irreproachable metrics unravelled anyway.
Deposit flight toppled Silicon Valley Bank, Signature and Silvergate in the US. In Switzerland, Credit Suisse was rescued by UBS.
Some of these banks had good profitability, allowing them to generate excess capital. Others such as Credit Suisse had losses but apparently strong capital ratios. We will explain the various capital terms and their relevance.
For years, bank bosses, brokers and analysts have fetishised CET1. The acronym stands either for “common (or core) equity tier one” capital. This buffer consists of the most dispensable capital of the bank, shareholders’ equity and retained earnings.
CET1 capital is the first line of defence wiped out in a crisis. After common equity evaporates the next buffer is additional tier one bonds (AT1 capital). These rank higher than equity in any bankruptcy or dissolution of the bank, though below more senior debt.
When they forced UBS to absorb Credit Suisse, the Swiss authorities stoked controversy by inverting that precedence, wiping out AT1 bondholders but not Credit Suisse shareholders.
After AT1s comes tier two capital — bonds more senior than CET1 and AT1.
The whole layer cake is meant to shield taxpayers from the cost of bank bailouts. After 2008, financial regulators recognised that lenders had too many assets, primarily loans, sitting atop too little equity. In 2007, Barclays held assets worth 38 times its shareholders’ equity. By last year that leverage had fallen by almost half, on S&P Capital IQ data.
Regulators aimed to force leverage down by requiring banks to hold higher capital buffers to protect against the effects of loan losses. Using a weighting system developed with the Basel Committee on Banking Supervision, banks had to report their risk weighted assets, or RWAs.
In theory holding CET1 capital buffers against these RWAs (expressed as a percentage) is healthy. However, when depositor sentiment deteriorates badly, and an online exodus of funds occurs, capital buffers offer little protection from a liquidity shock.
So, deposit flight has turned the spotlight on the liquidity coverage ratio (LCR). This measures the proportion of highly-liquid assets available compared to a month’s worth of cash outflows in regulator’s stress tests.
The focus has also shifted from a bank’s asset quality to what keeps depositors’ money at a bank. That in turn hinges on what proportion of these accounts are insured by governments. In the US, SVB had about 12 per cent of its deposits insured last year. JPMorgan had over 40 per cent.
Last week, Lex dismissed the frenzied sell-off in the shares of Germany’s leading lender Deutsche Bank. The bank holds plenty of capital and has sufficient profitability to replenish its capital buffers, unlike Credit Suisse which had racked up losses. Deutsche has built up cash reserves over the decade as well.
Also, compare Credit Suisse’s CET1 ratio with, say, Barclays. Not long before its forced sale to local rival UBS this month, the Swiss wealth manager reported a very respectable CET1 ratio of 14.1 per cent. Barclays is at 13.9 per cent.
But like Deutsche, Barclays has diversified its liability base and steadied its ship over the past decade. A substantial CET1 ratio did not prevent the collapse of Credit Suisse.
One lesson from this month’s crisis is that scale matters. Smaller banks will receive much more scrutiny from regulators everywhere. Another is that higher capital buffers may only offer comfort in normal periods. But bank capital requirements will be more not less onerous in the near term.
United Utilities: Great Stink II may land water groups with £56bn bill
Picturesque Windermere is a favourite haunt of wild swimmers. Reports of sewage pouring into the lake’s waters sends them off the deep end. The problem riles investors too. United Utilities, the rainy north-west England water authority, has a quarter more sewer overflows than average. The government has demanded more than £14bn of investment from the company to address the problem.
Water pollution is a big issue in the UK, as it was during London’s Great Stink in 1858. Sewage discharges now head a list of complaints also including high leakage rates and opaque finances. Campaigners, politicians and media are increasingly hostile.
Regulated monopolies such as United Utilities tend to be steady earners. True to form, the company said revenues would be only 1 per cent lower than guided. Inflation will take a toll despite inflation-linked revenues. The utility is a heavy user of index-linked debt. Its net finance costs will be 6 per cent, or £10mn, higher than last year.
The valuation of water utilities is in line with the historical average, at a premium of 15 per cent to adjusted regulatory capital value. Yet the political risks of investing are rising. Politicians have responded to public anger by threatening fines of up to £250mn, a 1,000-fold increase. Water companies will have to prepare better for droughts. They need to spend an estimated £20bn on cutting leaks and reducing usage.
Water meters are part of that drive. About half of households have switched, in some cases compulsorily. But meters make it harder for water companies to increase bills to pay for necessary investment. The average bill per household would need to rise by a daunting 60 per cent in real terms, to £700 a year, to cover the £100bn of capital expenditure required across the industry, according to Barclays.
The cost of curbing sewage spills comprises £56bn of that figure. The Great Stink was remedied with new sewers that still serve that purpose today.
Water companies may need to raise new equity and splurge retained earnings. That will focus attention on dividends. Payouts extracted via expensive loans from shareholders will receive unwonted scrutiny.
As bond proxies, utilities have attractions. But amid a second Great Stink, investors should weigh up growing political risks before taking the plunge.
Lex is the FT’s concise daily investment column. Expert writers in four global financial centres provide informed, timely opinions on capital trends and big businesses. Click to explore
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