# Presentation: 079125

## Competitive Effects of Basel II on U.S. Bank Credit Card Lending

- William W. Lang
-  Loretta J. Mester
- Todd A. Vermilyea
- Federal Reserve Bank of Philadelphia

- 2006 FDIC/JFSR Conference** **
- Arlington, Virginia
- September 13 ,2006

**Notes:**
Good Afternoon
Acknowledge co authors
Invite questions comments through out

## Purpose

Basel II creates a more risk sensitive capital requirement to reduce market distortions created by capital regulations

However, different banks will operate under different regulatory capital rules

Different regulatory requirements could create competitive inequities

Analyze this issue for credit card portfolios

- Basel II creates a more risk sensitive capital requirement to reduce market distortions created by capital regulations
- However, different banks will operate under different regulatory capital rules
- Different regulatory requirements could create competitive inequities
- Analyze this issue for credit card portfolios

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Outline of presentation

Structure of U.S. credit card (CC) market

Conceptual Framework

 Are Basel I requirements “binding”?

 Basel II affect on regulatory capital 

 Will Basel II Changes Matter?

- Structure of U.S. credit card (CC) market
- Conceptual Framework
-  Are Basel I requirements “binding”?
-  Basel II affect on regulatory capital
-  Will Basel II Changes Matter?

**Notes:**
Purpose of the paper is to analysis the potential compedive effects of the bifurcated application of proposed Basel II capital regime on Credit card lending

All in capital requirements
	Receivables
	Open to buy
	Securitizations (off balance sheet)

Caveats/Limitation
Current Basel II proposal (ANPR august 2003)  current Basel I based RBC rules
US only – no attempt to analyze international credit card markets
Data as of June 2004 unless otherwise noted

## Summary of findings and main implications

CC markets are highly concentrated; only a few banks significantly affected by CC rules
Community banks and most regional banks not affected
Basel I capital requirements on CCs are not binding 
Basel II substantially raises requirements for CC lending
Most of the increase is in tier 2 capital
Capital requirements for CC may be extremely procyclical
Basel II increases incentives to securitize CCs
CC lenders not subject to Basel II may receive a modest competitive advantage 

- CC markets are highly concentrated; only a few banks significantly affected by CC rules
- Community banks and most regional banks not affected
- Basel I capital requirements on CCs are not binding
- Basel II substantially _*raises*_ requirements for CC* *lending
- Most of the increase is in tier 2 capital
- Capital requirements for CC may be extremely procyclical
- Basel II increases incentives to securitize CCs
- CC lenders not subject to Basel II may receive a modest competitive advantage

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Credit Card Market is Highly Concentrated     

**% of total industry outstandings**

**Source:  The Nilson Report, 1998-2005.**

**Notes:**
Important slide – shows consolidation over time (as of 1990 top 10= 55%)

Consolidation has continued mkt share of A-IRB banks continued to grow even as shape of Basel II has come into focus

Although we believe Basel II capital reguarlemt will exceed Basel I requirement – consideration suggests no trend toward assets moving out of A-IRB banks. 

## Other Structural Elements of the U.S. 
Credit Card Market

Credit Card Specialty Banks (CCSB)
Monolines
Credit Card operations of large banks often placed in a separate charter 

Nonbanks issue CCs through bank subsidiaries

CCs largely funded through wholesale market  
 60% funded through securitization

- Credit Card Market
- Credit Card Specialty Banks (CCSB)
- Monolines
- Credit Card operations of large banks often placed in a separate charter
- Nonbanks issue CCs through bank subsidiaries
- CCs largely funded through wholesale market
-  60% funded through securitization

**Notes:**
Credit cards are important
 600 billion managed (on bs = 290 securitized = 340) 3 trillion in cc commitments
Contrast with C&I 875 billion on bs and 2 trillion in non cc loan commitment and 400 billion in stand by letters of credit)
Highly concentrated
Top ten 93% of market (of commercial banks not all credit card issuers)
Contrast with lt 50 percent of assets for top 10 overall
Not important for most community and regional banks
Community banks
Most banks (about 4500) do not have any credit card 
Among community banks w credit card median share of cc to total loan is .36 
Non CCSB under 1 billion account for .2 percent of managed loans
Regional banks have largely existed
Non A-IRB mandatory, non CCSB, over 1 b 2.6 percent of managed cc loans
The are exceptions (BBT, Lauritzen Corp (FNB Omaha)) 

## Capital concepts

Economic capital: capital that banks would choose if there is no regulatory minimum
Regulatory capital: refers to “pillar 1” capital requirements
Binding regulatory capital: 
bank capital > economic capital
can occur even if: 
	bank capital > regulatory capital 
	economic capital > regulatory capital

- _Economic capital_: capital that banks would choose if there is no regulatory minimum
- _Regulatory capital:_ refers to “pillar 1” capital requirements
- _Binding regulatory capital_:
- bank capital > economic capital
- can occur even if:
- 	bank capital > regulatory capital
- 	economic capital > regulatory capital

**Notes:**
To answer this question we need a definition of binding

Note regulatory capital is typically set below economic capital (but it still is binding since bank may desire buffer stock)

Make three arguments: 
	Look at actual capital levels held by CCSB
	Look at trends over time

	A bit more formal anyiisis using a regression 

## Actual

**Actual**
**Capital**

**Regulatory Capital**

**45°**

**Economic**
**Capital**

- kb

- kb is point of binding capital requirement

**Buffer Capital**

## Capital Levels at Credit Card Banks Are Far Higher Than Regulatory Requirements

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Securitization Rates and Capital Demand at Credit Card Banks

Securitization rate for CC loans has risen over time

Higher securitization rate lowers regulatory capital requirements relative to managed assets

Capital to assets ratio has risen in response, while capital to managed assets ratio has been stable

- Securitization rate for CC loans has risen over time
- Higher securitization rate lowers regulatory capital requirements relative to managed assets
- Capital to assets ratio has risen in response, while capital to _managed assets_ ratio has been stable

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Capital levels and securitization rates over time

**Equity Capital/Assets (left axis)**

**Securitization Rate (bars, right axis)**

**Equity Capital/Managed Assets (left axis)**

- Percent

- Percent

**Notes:**
Looking at trends over time
Equity to assets has been steadily increasing over time (at same time securitizing credit card receivables has taken off)
Equity to managed assets has been relatively stable at around 7%

This is constant with the idea that CCSB hold capital to support their managed book rather than their balance sheet.

We explore that idea a bit more formally with regreion anayisis 

## Regression Analysis of Capital Demand at Credit Card Banks

- Regression models:
- Dependent variables:  different bank capital ratios
- Controls for growth and risk
- Sample of banks with:
- Over $1 billion in assets
- Managed loans to managed assets ≥ 60 percent
- Equity to assets ≤ 25 percent
- Contrast managed assets to balance sheet assets

**Notes:**
Series of regressions with various capital rations (equity to various measures of assets, similar for total capital and tier I capital) as a function of 
measure earning volitly, 
size, 
growth, and 
credit card specialty bank indicator.

Sample is banks over 1 billion with some filter to eliminate non lenders and
275 banks

Purpose is to compare differing concepts of assets (managed vs. on bs)

## Equity capital ratio regressions 

***** Significantly different from zero at the 99% level ** significantly different from zero at the 95%, level **
*** significantly different from zero at the 90% level**

## Are Basel I requirements binding for bank credit card activities?  No.

- CCSBs’ high capital buffers cannot be explained by growth or risk
- CCSBs’ demand for capital is more in line with their managed portfolio rather than their on-balance-sheet credit card assets
- Model indicates that CCSBs’ demand for capital is similar to peer banks when CCSB assets are measured as managed assets rather than on-balance-sheet assets
- Conclusion supported by prior research and views of credit rating agencies

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Basel I vs Basel II: Risk Weighted Assets   	
On Balance Sheet CC Loans 

Basel I – 100% risk weight

Basel II – risk sensitive risk-weight for loans and unused lines 
Depends on PD, LGD, EAD
Regulators set asset value correlation to 8%

- On Balance Sheet CC Loans
- Basel I – 100% risk weight
- Basel II – risk sensitive risk-weight for loans and _*unused lines*_
- Depends on PD, LGD, EAD
- Regulators set asset value correlation to 8%

**Notes:**
To answer this question we need a definition of binding

Note regulatory capital is typically set below economic capital (but it still is binding since bank may desire buffer stock)

Make three arguments: 
	Look at actual capital levels held by CCSB
	Look at trends over time

	A bit more formal anyiisis using a regression 

## Basel I vs Basel II: Risk Weighted Assets   	
Securitized CC:  normal times
Approximately the same for total capital with slightly higher effective tier 1 requirements

Securitized CC Loans:  stressed times 
Much higher regulatory capital requirements under Basel II

- Securitized CC:  normal times
- Approximately the same for total capital with slightly higher effective tier 1 requirements
- Securitized CC Loans:  stressed times
- Much higher regulatory capital requirements under Basel II

**Notes:**
To answer this question we need a definition of binding

Note regulatory capital is typically set below economic capital (but it still is binding since bank may desire buffer stock)

Make three arguments: 
	Look at actual capital levels held by CCSB
	Look at trends over time

	A bit more formal anyiisis using a regression 

## 	Basel I vs Basel II:  Definition of Capital

Total Capital
Basel I:  reserves are a component of capital
Basel II: reserves minus EL a component of capital  		  (UL only) 

Tier 1 Capital
Basel II: deduction if EL > reserves (typically true  		  for CC lenders)

- Total Capital
- Basel I:  reserves are a component of capital
- Basel II: reserves minus EL a component of capital  		  (UL only)
- Tier 1 Capital
- Basel II: deduction if EL > reserves (typically true  		  for CC lenders)

**Notes:**
To answer this question we need a definition of binding

Note regulatory capital is typically set below economic capital (but it still is binding since bank may desire buffer stock)

Make three arguments: 
	Look at actual capital levels held by CCSB
	Look at trends over time

	A bit more formal anyiisis using a regression 

## Formula for Basel II total capital requirement

- T − D − EL = 0.08 × RWA

- RWA = RWAON + (CCFSEC x RWASEC)
- =>
- T = 0.08 x [RWAON + (CCFSEC x RWASEC)]+ EL + D

**Gross total regulatory capital**

**Deductions**

**Expected losses**

**Risk-weighted assets**

## Estimated impact of Basel II on “typical” CC bank’s required capital in normal times

|  |  |  |
| --- | --- | --- |
|  | No Adjustment for Eligible Reserves | Adjustment for Eligible Reserves
(Monoline CC Bank Assumption) |
| Average | 	44.3% | 	23.6% |
| Min | 	19.1% |   	6.7% |
| Max | 	67.0%	 | 	32.2% |
| Percentage Change in Required Tier 1 Capital
(Assuming Securitized Assets Are Healthy) |  |  |
|  | No adjustment for shortfall of reserves from expected losses
(Diversified Bank Assumption) | Deduction of half of shortfall of reserves from expected losses
(Monoline CC Bank Assumption) |
| Average |   	2.2% | 	13.2% |
| Min | 	-5.4% | 	-1.7% |
| Max | 	14.8% | 	25.8% |

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Estimated impact of Basel II on “typical” CC bank’s capital ratios in Normal and Stressed Times

| Total Capital to Risk-Weighted Assets |  |  |  |
| --- | --- | --- | --- |
|  | No Adjustment for Eligible Reserves
(Diversified Bank Assumption) |  | Adjustment for Eligible Reserves
(Monoline CC Bank Assumption) |
| Basel I | 	18.5% |  | 	18.5% |
| Basel II, healthy portfolio | 	12.8% |  | 	14.9% |
| Basel II, stressed portfolio | 	10.4% |  | 	12.1% |
|  Tier 1 Capital to Risk-Weighted Assets |  |  |  |
|  | No adjustment for shortfall of reserves from expected losses
(Diversified Bank Assumption) | Deduction of half of shortfall of reserves from expected losses
(Monoline CC Bank Assumption) |  |
| Basel I | 	15.0% | 	15.0% |  |
| Basel II, healthy portfolio | 	14.7% | 	13.3% |  |
| Basel II, stressed portfolio | 	11.9% | 	10.8% |  |

**Notes:**
Read slide

Importantly credit rating agencies are on record as saying they evaluate a bank on their managed book (or a very similar concept0 when they evaluate an institution.

Due to the prevalence of securitization and the lack of a capital charge on investors interest, combined with market pressures to hold capital on managed book we conclude that Basel I regulatory reguments are not binding.

Turn over to Bill
(intro)???

## Summary of estimates for typical large CC lender in “normal times”

- Substantial rise in total capital requirements for CC activities; total capital requirements might become binding
- Modest rise in tier 1 requirements; unlikely to feel significant impacts on actual tier 1 capital
**However, some CCSBs may see a substantial tier 1 impact.**

## Summary of estimates for typical large CC lender in “stress periods”

- If stress is sufficient to trigger a 15% CCF for securitized CCs, then increase in capital requirement  significant for total and tier 1 capital
- If stress is sufficient to trigger a 50% CCF for securitized CCs, then severe capital pressures
- Note that Basel I banks might also face substantial pressure from supervisors and the market to increase capital under these circumstances

## Implications of our findings

- There may be a cost advantage for large CC lenders that are not subject to the Basel II capital requirements
- Disincentives for independent monoline CC banks to adopt Basel II
- Any cost advantage would likely be modest since Basel II banks may be able to meet additional capital needs through additional tier 2 capital (rather than more expensive tier 1 capital)
- There will be no substantial competitive effect on community banks and most regional banks, as credit cards are not a major product line

## Implications of our findings (cont’d)

- Basel II could generate extremely large increases in required capital for CCs during stress periods
- This might result in CC lenders holding higher capital even in normal times
- Differential in “pillar 1” capital requirements may overstate the effects of Basel II since Basel I banks in financial distress will face increased supervisory and market demands for higher capital Basel II likely raises incentives to securitize credit cards and possibly mitigate the increase in required capital for on-balance sheet exposures
- Basel II likely raises incentives to securitize credit cards and possibly mitigate the increase in required capital for on-balance sheet exposures