I am investigating which banks are sensitive to the #Covid crisis & I thought I’d share a very specific situation as it illustrates how tricky it is to analyse a bank’s balance sheet and risks – and the weirdness of some capital regulations.
Let’s talk about Barclays. (You know the rules: this is NOT investment advice.) People always say "banks’ internal models are a black box and are “gamed”", so let’s look at Barclay’s book which is NOT using internal models.
For Barclays, that’s a 270bn£ book, in terms of exposures at default : the metric you multiply by the “risk weight”, which measures the risk of the exposure, to get the Risk Weighted Assets (RWA) ; capital required is approximately 12% of RWA
But wait, 166bn£ of this is just sovereign risk (government bonds etc.) and let’s not focus on that today. (In case you wonder why there is no internal model for sovereign risk, that’s because it leads to almost 0 capital required 😊)
So the rest is tiny, why would I care about that? I mean 100bn£ is a lot of money, but not in Barclays’s balance sheet. The total capital required is approx. 6.8bn£, not huge for Barclays.
But wait (again!) – we are still far away from the end of the story. Because if you stop there, you basically missed the biggest risk (imho) in Barclay’s balance sheet. And what is that risk?
Let’s forget the EAD and look at the gross exposures: there is little line called “Retail” (SA) with a total gross exposure of 105bn£! How come one line of exposure is bigger than the total EAD? Well, meet the “Credit Conversion Factor”.
This has been discussed quite a lot about corporate lending: when you give a loan facility to a company, the amount they actually borrow is on the bank's balance sheet, the amount they have the right to borrow is off balance sheet.
With the crisis, everyone has been monitoring how much companies use this capacity to borrow (in a nutshell: they have used it a lot as the crisis develops and they run for cash.) But until they actually borrow the money, bank regulations say it works like this:
The EAD is the sum of the "on balance sheet exposure" (how much they borrowed) and the "off balance sheet exposure" (how much they have the right to borrow) multiplied by a “credit conversion factor”, CCF, i.e. EAD = BS+ OBS x CCF%
And believe it or not, some CCF are VERY low even if the risk that the client uses the facility is high!
So back to Barclays and that weird line called “Retail” (SA): the on-balance sheet amount is 29.7bn£, the off-balance sheet amount is… 75.8bn£ (!!!) and the EAD is 29.4bn£, which means you need a microscope to calculate the CCF!
Also the capital required for this line of business is 12% x 22.1bn£ = 2.6bn£ - again, tiny in Barclay’s balance sheet.
But what is in that line exactly ? Well out of 105bn£, 87bn£ is in the US and 105bn£ is not a business sector – so households. It doesn’t take a genius to realise what we have here are good old overdraft facilities, revolving credit, etc., for individuals.
And the capital charge for this, remember, was 2.6bn£ - whereas credit provisions are 2.7bn£! This is almost a 10% cost of risk on the EAD number, but of course, that’s because the EAD number is meaningless. And so is the capital required.
On the real exposure number, it’s a 2.6% cost of risk, still high, but more realistic.
So what is the bottom line? If you assume Covid makes the cost of risk 3x worse (not absurd), we’re talking 8.1bn£ of provisions here ! No way you could see it by looking at the minuscule EAD number or capital required!
