The Bank of England is expected to refuse to follow the European Union's loosening of bank capital rules in its first significant post-Brexit divergence, but this could put an extra burden on U.K. banks, according to analysts.
The European Banking Authority said in December 2020 that it would allow software assets to count as bank capital. This means banks can count investment in software toward their core capital levels without the deduction requirement that normally applies to intangible assets in common equity Tier 1.
The EBA has said that, based on a sample of 64 banks, ceasing deduction would have about a £20 billion aggregate capital uplift across all banks. Based on applying a 100% risk weighting to software that is expected to preserve its value even if the bank collapses, the increase in the CET1 ratio of the institutions in the EBA's sample would range from 0.1 basis point to 18.7 basis points.
Since the EU issued this rule just before the U.K. left the bloc under Brexit, it would have to be "onshored" into U.K. regulations under the U.K.'s post-Brexit plans.
However, the BoE has now said, forcefully, that it does not agree, noting that it had "found no credible evidence" that software assets can absorb losses effectively in turbulent times.
BoE Governor Andrew Bailey went further, noting that the Basel standards do not include intangible assets in bank capital and so the new rules could be dangerously misleading.
"We have not identified any evidence to support the notion that software assets have value in stress. On that basis, including them in bank capital would give a false picture of a bank's loss-absorbing capacity," he said in a speech on open markets.
Unusually, the BoE has said it is consulting to maintain the earlier position whereby all software continues to be fully deducted from CET1 capital and the expectation is that it will be maintained, according to Fahed Kunwar, an analyst at U.K. broker Redburn.
"I think it's clear the BoE will diverge from the EU over this," he told S&P Global Market Intelligence. "It's a reasonable amount — for the three or so biggest banks it's between 30 basis points and 50 basis points that they would have been able to deduct and which they now can't, so it's meaningful."
The BoE's expected refusal to follow the EBA on this issue does result in the risk that U.K. banks might be less competitive, Kunwar said. The biggest implications are for Barclays PLC, he said.
"[Barclays has] a more global business, so is at a slight disadvantage because of its investment banking business which is all about allocating capital, and it was set to get about 30 basis points [of core capital] because of the EBA's move," Kunwar said. "NatWest Group PLC and Lloyds Banking Group PLC are competing within the U.K., so as long as in the U.K. they are on an even playing field, it shouldn't make too much difference."
Strong capital position
The EBA's ruling comes at a time when U.K. banks are flush with capital. The BoE has noted that the average CET1 ratio was three times stronger than it was during the financial crisis.
The banks' "huge excesses of capital" means they are well-placed to handle any split between the BoE and EBA on the software issue, according to Ian Gordon, an analyst at banking and wealth management group Investec.
But he said if U.K. banks are required to carry more capital for the same sort of risks than foreign competitors as a result of the EBA's rules, they would be at an economic disadvantage.
Gordon said that, with the singular exception of Metro Bank, there is no U.K. bank where capital adequacy is a particular focus of attention.
Metro Bank PLC, a retail and commercial bank founded in 2010, reported a bigger-than-expected annual loss of £310 million for 2020. It has been struggling to boost its capital and improve profitability.
Metro Bank told S&P Global Market Intelligence that the current benefit of the EBA's rule to its CET1 ratio is 0.8%, but it had already recognized that software will return to being fully deducted prior to Jan. 1, 2022.
"We are therefore not considering the benefit when making capital decisions today or in our longer-term strategic planning," a spokesman said via email.
Metro and Virgin Money UK PLC are among banks which have recently invested heavily in IT systems, and under the BoE's likely break from the EBA they would not be able to get a capital boost.
Virgin Money, too, said it had accounted for software being fully deducted.
"This is entirely in line with what we expected, which is why we excluded the benefit from our full-year guidance when we released our [first-quarter] trading statement last month," a spokesman said.
Virgin Money's CET1 ratio stood at 13.9% at the end of 2020, with about 40 basis points of that from software intangible changes. Following the expected BoE changes, it now expects a CET1 ratio of about 13% by September 2021.
The EBA's move has been supported by the European Banking Federation., however, as Gonzalo Gasós, EBF senior director of prudential policy and supervision, told S&P Global Market Intelligence via email.
"Nonfinancial assets are weighted upon assumptions set a long time ago," he said.
"The adjustment made to EU legislation has partially compensated that disproportionate historical difference, so now software requires around 4x more capital than furniture and equipment, which still seems to be a quite conservative assumption for software compared to other assets."