Thursday, 11 June 2015

The Too Big To Fail Subsidy in UK Banking: a concrete example

From the CMA inquiry into retail and SME banking, here is a case study from a new entrant, Metro Bank:

Capital requirements
Metro stated that it was currently required to hold around six to ten times more
capital than the big banks and building societies when securing a mortgage
for a customer, even if it was for the same customer, with the same deposit,
on the same property – a situation which did not reflect a level playing field.
To elaborate this point, Metro told us that as a new entrant to the market, it
had to use the standardised approach (SA) to credit risk when calculating
capital requirements, while the larger banks were permitted to use an internal
ratings based approach (IRB). Metro indicated that the IRB approach was
based on many years of data, and enabled certain institutions to significantly
reduce the value of their risk-weighted assets.

Note that  the IRB is a calculation done by the banks themselves.  

Metro pointed out to the CMA the difference between the SA and IRB by
using an example of
a low loan- to -value residential mortgage.Metro stated
that such a mortgage carried the same risk profile regardless of the lending
institution but the challenger banks risk weight these particular assets at 35%
compared with 3 to 6% for the larger banks.

And here's the answer from the regulators

In March 2013, the FSA and the BoE announced a shift in approach to the
prudential regulation of banking start-ups whereby the additional requirements
(known as ‘add-ons and scalars’) previously applied to reflect the
uncertainties inherent in start-ups were no longer to be applied. These
requirements according to the two regulators often resulted in capital and
liquidity requirements for start-ups being higher than for existing banks.

In a follow-up review, the PRA and FCA referred to the IRB approach to
calculating credit risk versus the SA (the default position) for all new and
existing banks and noted that ‘The PRA has taken steps to address
underestimation of risks that can result from applying the IRB approach to
certain types of exposures.’ According to this review, the PRA was to
continue to consider the impact of its policies on competition as required by its
competitive objective with a caveat that the regulatory capital requirements
were to a large extent determined by the relevant EU legislation over which
PRA had little or no discretion