Fitch: Banks May Need More Capital to Cover Basel Step-In Risk

The Basel Committee on Banking Supervision's proposals concerning step-in risk are most likely to have an impact on banks with large asset and wealth management, investment fund, and securitisation origination and sponsorship activities, says Fitch Ratings.

The Basel Committee launched a consultation on 17 December 2015 to assess whether banks should hold capital specifically to cover the risk that they may be required to step in and provide financial support to non-bank financial entities at a time of financial stress, even in the absence of clear contractual obligations to do so.

These additional capital requirements could prove onerous. This increases the likelihood that affected banks could lobby and resist the proposals.

Banks with discretion over the assets they manage in their wealth management units would incur a capital charge because they might encounter higher step-in risks. Under the proposals, a credit conversion factor, which could be as high as 100%, should be applied to the volume of discretionary assets under management. Large asset and wealth managers could potentially face high additional capital charges if the proposals are adopted, even if only a fraction of assets under management were classed as discretionary.

In our view, this could reduce the attractiveness of asset and wealth management as a business line, especially if banks are unable to pass on additional capital costs by increasing fees. The Basel Committee also highlighted step-in risk arising from structured note special purpose vehicle platforms, such as the ones used by investment banks and wealth managers to create bespoke investment products for institutional and high net worth investors.

Step-in risk is not new. During the 2008 financial crisis, several banks supported entities which had been shifted off-balance sheet because they were heavily invested in the entities, were the entities' sole source of liquidity or failure to provide support would lead to considerable reputation damage. Accounting consolidation standards were tightened and regulatory reforms, such as the Basel Committee's Pillar 2 reputational and implicit support risk guidelines, have tried to tackle step-in risks. And on 14 December 2015, the European Banking Authority issued guidelines regarding limits on banks' exposures to shadow banking entities.

But the Basel Committee is now proposing that banks should capture potential step-in risk using a quantitative approach either under Pillar 1 or 2 capital requirements. Regulatory drives to ensure banks hold sufficient capital in advance of a stress can be positive for ratings. But we think the proposed step-in capital charge could include an element of double counting.

The Basel Committee's Liquidity Coverage Ratio already forces banks to determine the liquidity impact of non-contractual contingent funding obligations and asking banks to hold additional capital for step-in liquidity risks could prove too onerous. The proposed step-in risk capital charges could, however, add value when banks calculate their leverage ratios because step-in contingencies go beyond the off-balance sheet liabilities included in leverage calculations.

Fitch already considers potential step-in risks as part of its rating process. Highly opaque or complex organisational structures might be a negative ratings factor. Off-balance sheet risks are analysed when we assess a bank's financial profile and reputational risks are closely reviewed, particularly when we assess a bank's propensity to support subsidiaries and affiliates. Branding, entity sponsorship, liquidity provision and the ability to influence management, which the Basel Committee identifies as key potential step-in risk triggers, are factored into our bank ratings.

The Basel Committee's consultation period on step-in risk closes in March 2016.

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