Large banks across the globe routinely compete head-to-head. As an example, we have recently shown how large banks in the U.S. compete directly with large European banks to provide underwriting and derivative services to large U.S. corporations. The ability to compete in the global market for banking services depends importantly on costs: a bank with lower costs can offer its services at lower prices and win business. For banks, capital is a significant cost driver. A bank that is required to issue more equity to build capital will incur higher costs since equity financing is expensive. More specifically, these days a bank pays depositors around one to two percent per year in interest on a deposit account but generally pays equity investors a rate of return closer to ten percent per year.
In this post, we review the differences between required capital levels for U.S. and European banks and discuss the implications for competitive equality.
The amount of capital that a large, internationally active bank is required to maintain is determined according to the formula,
$ Capital = $ RWA X % Capital Requirement.
The term $ RWA is the value of risk-weighted assets held by the bank and reflects the risk-adjusted size of the bank’s balance sheet. The term % Capital Requirement refers to the amount of capital that is required to support each dollar of risk-weighted assets. As we will show, both $ RWA and % Capital Requirement are higher for large U.S. banks than for large European banks.
Differences in Risk-Weighted Assets: U.S. vs. Europe
Risk-weighted assets provide a risk-adjusted measure of overall bank size. As an example, a $100 U.S. Treasury bond has an accounting value of $100 but a risk-weighted value of $0 reflecting its low risk. A bank that is larger and holds more loans and securities is required to issue more capital. Data produced by former FDIC Vice Chairman Thomas Hoenig in his Global Capital Index show that large U.S. banks that are members of the Financial Services Forum have a total amount of risk-weighted assets of roughly $6.6 trillion. Using the same data, correspondingly large European banks have a total amount of risk-weighted assets of roughly $6.0 trillion.
Despite the apparent similarity between the risk-weighted asset values of large U.S. and European banks, the reality is more complex. Specifically, European banks tend to show significantly smaller risk-weighted assets relative to the accounting value of assets. This difference arises, in part, from the fact that European banks have greater regulatory approval to use risk-sensitive internal models to calculate risk-weighted assets. In addition, even when European banks are required to use standardized approaches to calculate risk-weighted assets, these approaches are generally more risk sensitive than U.S. standardized approaches. As a specific example, in the U.S. all corporate loans attract a standardized risk-weight of 100% while in Europe a loan to a high-quality corporate borrower is risk-weighted at 20%. As a result, a U.S. bank that makes a loan to a high-quality and low-risk company reflects a risk-weighted asset value of $100 while a European bank making a loan to the very same company reflects a risk-weighted asset value of only $20. These kinds of differences result in higher levels of $ RWA for large U.S. banks relative to large European banks.
Table 1 below shows the total accounting value of assets and the risk-weighted value of assets for large, internationally active U.S. and European banks.
Table 1: U.S. and European Total Assets and Risk-Weighted Assets
|U.S. Banks||European Banks|
|Accounting Value of Assets (TA)||$12.9 Trillion||$18.1 Trillion|
|Risk-Weighted Assets (RWA)||$6.6 Trillion||$5.9 Trillion|
Source: Global Capital Index
Table 1 clearly shows that large U.S. banks have substantially higher risk-weighted assets relative to the accounting value of assets than similar European banks. In particular, note that the accounting value of assets is larger for European banks (18.1 vs. 12.9), but that the risk-weighted value of assets for European banks is smaller (5.9 vs. 6.6). This difference in risk-weighted assets relative to accounting assets means that a large U.S. bank would be required to issue more capital than a European bank with similar assets and risks. Of course, the difference shown in Table 1 may be driven by other factors. If, for example, European banks hold more low-risk assets than U.S. banks this would also reduce European risk-weighted assets relative to the accounting value of assets. In any event, some of the difference reflected in Table 1 is driven by the more conservative and less risk-sensitive, risk-weighted asset requirements that apply to large U.S. banks.
Differences in Percentages Capital Requirements: U.S. vs. Europe
The term % Capital Requirement refers to the amount of capital that is required to support one dollar in risk-weighted assets. A % Capital Requirement of 10% means that for every $1 in risk-weighted assets, a bank must issue $0.10 in equity. The % Capital Requirement that applies to large, internationally active banks in the U.S. and Europe is determined according to the following formula,
% Capital Requirement = 4.5% +GSIB% + CCB% + CCyB%,
where the amount 4.5% represents the minimum amount of required capital. The other terms that determine the overall level of % Capital Requirement are the GSIB capital buffer (GSIB), the capital conservation buffer (CCB) and the countercyclical capital buffer (CCyB). The specific value of each of these buffers varies across the U.S. and Europe, varies across banks, and also varies over time. Figure 1 shows how each of these components of % Capital Requirement varies across large U.S. and European banks.
The GSIB capital charge is calculated differently in the U.S. and Europe because the U.S. unilaterally decided to depart from the internationally agreed upon standard for computing the GSIB surcharge and imposed a higher surcharge. As shown in Figure 1, the average GSIB surcharge in effect in the U.S. for Financial Services Forum members is 2.7%. The corresponding surcharge for large, European banks is 1.3%.
The capital conservation buffer (CCB) is an extra amount of capital that large banks maintain to ensure that they have an adequate amount of capital over and above minimum requirements as investors, depositors, and regulators may become concerned about a bank’s viability if its capital level falls too close to its minimum requirement. And here again, the U.S. unilaterally departed from the internationally agreed upon standard that set the CCB at 2.5% of risk-weighted assets. Under a recent proposal by the Federal Reserve, the CCB would be replaced by the stress capital buffer or “SCB” that is based on the outcome of the Federal Reserve’s stress tests. Recent research suggests that the SCB for Financial Services Forum members would be roughly 3.6%, or over 1% higher than the CCB that applies in Europe.
Finally, the countercyclical capital buffer (CCyB) is yet another capital buffer that is intended to be time-varying over the business cycle. The CCyB is set by bank regulators within each individual jurisdiction based on their assessment of risk in its jurisdiction. In the U.S., the CCyB is currently 0%. In Europe, the CCyB ranges between 0% (in many countries) to 1.0% (in the UK). The average CCyB that applies to large European banks reflected in Figure 1 is 0.3%.
Taken together, the results in Figure 1 indicate that large U.S. banks are, on average, subject to a % Capital Requirement of 10.8% (4.5%+2.7%+3.6%+0%). Large European banks, on the other hand, are subject to a % Capital Requirement of only 8.6% (4.5%+1.3%+2.5%+0.3%). As a result, large U.S. banks are required to maintain a capital ratio that is more than two percentage points higher than their European counterparts.
In this post we have shown that U.S. banks are subject to more stringent and less risk-sensitive RWA requirements and higher percentage capital requirements. Both of these factors increase required capital levels for large U.S. banks relative to their European counterparts. Taken together, the estimates in Table 1 and Figure 1 suggest that Financial Services Forum members are required to maintain between $130 billion and $350 billion more capital than similar European banks.
These amounts of additional capital are significant. Of course, strong capital is necessary for a safe-and-sound banking system. Financial Services Forum members are committed to robust capital levels and maintain over $821 billion in common equity capital, which represents an 122% increase over the past decade.
At the same time, the competitive effects of higher capital requirements should not be overlooked. Banks with significantly higher capital requirements have a higher cost structure and are less competitive. Strongly divergent capital regimes in the U.S. and Europe put large U.S. banks at a competitive disadvantage in the global marketplace.
A healthy and robust banking sector requires healthy competition between banks operating on a level playing field. Capital requirements that confer a significant advantage to one group risk reducing competition and the vibrancy of the global financial system.