1. So, as promised. Let's start with the basics and apologies to those who know all about it. It's generally accepted that having well capitalized banks is important & good for the economy because they can lend and help transmit monetary policy.
2. But what does it mean for a bank to be well capitalized? The amount of capital is not hugely relevant, it's the capital ratio which is, i.e. a metric entirely determined by a set of very complex rules.
3. Going into more detail now: the basic ratio is this Capital/RiskExposureAmount. The bulk of RiskExposureAmount is credit risk (& I'll only talk about that) which is basically the risk you are taking from your lending activity.
4. Because lending to the baker down the street & the German government is not the same, regulations have introduced a so-called risk-weight which is basically another way of saying how much capital you need for a loan or a credit exposure.
5. The formulas to calculate this can be a bit tedious, but the key thing to know is that it works like this: REA=RW*EAD, where EAD is your exposure at risk (what's the maximum you can lose in theory) and RW is the risk weight.
6. The risk weight is basically LGD*f(PD), in other terms it's how much you expect to lose if the loan is in default (Loss Given Default) multiplied by a complex function of the probability that the loan is in default (Probability of Default).
7. They key here is that f is a complicated function, it's not even an increasing function (yes if the probability of default goes up, in some cases you need *less* capital) but the link between LGD and the capital you need is completely linear.
So let me give you an example. Bank A has capital ratio of 12%. Great. It's using an average LGD of 45% and has 100 of capital. So its REA is 100/12%=833. Suppose for some reason the LGD goes up 10pp to 55%, then wow its capital ratio is now only 9.8%.
9. That bank was very well capitalised, now it's clearly short of capital. Nothing has changed except its estimate of the LGD. So what is the new proposal on LGD about ?
10. Banks with high NPLs have been forced by the SSM to sell their NPL books, at prices sometimes in the 25% area. But in their calculations above they use LGD (based on their historical experiences) in the 45% area. So yes, the SSM has forced them to reduce drastically recovery
11. Some have made large losses because of this & have recapitalised as a consequence, but they fear much worse could happen. If those NPL sales are used in their statistical data to compute how much they have lost in the past on NPLs, their estimated LGD could get closer to 25
(Closer to 75% sorry.) And this is not about what happens to the NPL book, it is about what happens to capital requirement for the entire loan book ! And if you've followed the maths, in our example above going from 45 to 75 will get your capital ratio from 12 to...7.2%...
13. Creepy - we've seen banks put into resolution with ratios above 7.2%. And remember, all this the consequence of changing the statistical dataset which we use to estimate your future losses on future NPLs.
14. So that's what this is all about: banks are lobbying to get a waiver, i.e. the right not to include those NPL sales in their historical data. EBA has said it is against those waivers, SSM has been more flexible... but it is now time for lawmakers to say what they want.
15. And the implications are potentially huge. End/
