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Mortgage-heavy Volksbank 'comfortable' with Basel III capital hit

Dutch lender Volksbank NV has estimated that adjusting to the new Basel III capital requirements will effectively shave about 800 basis points off its common equity Tier 1 capital ratio but feels it is in a "comfortable position" to absorb the hit.

The bank's fully phased-in CET1 ratio was 34.3% at 2017-end, up from 29.6% at 2016-end. This is considerably higher than the 10.5% fully phased-in CET1 ratio minimum required of Volksbank under the Supervisory Review and Evaluation Process, or SREP, of the European Banking Authority and the lender's own medium-term target of 15%.

However, applying the new Basel III rules will result in an increase in Volksbank's risk-weighted assets, or RWAs, of around 35%, which corresponds to a CET1 ratio drop of 8 percentage points, the bank said. The CET1 ratio will also be affected by the first-year implementation of the International Financial Reporting Standard, IFRS 9, in effect since Jan. 1.

The bank has estimated that due to a reassessment of risks in its existing asset portfolio and an increase in loan loss provisions under IFRS 9, the CET1 ratio will be 2 percentage points lower. This means that the pro forma, fully phased-in CET1 ratio for 2017 would drop to about 24% if both the Basel III and the IFRS 9 impact are taken into account.

Volksbank aims to hold more excess capital than other Dutch lenders because it sees itself more exposed to regulatory requirements, according to CFO Annemiek van Melick. "We realize that we have a relatively high management buffer but that is also related to the way that a bank with a profile we have is impacted in stress testing ... We will always have a relatively larger buffer or a somewhat higher core Tier 1 target than our peers," she told analysts Feb. 22 at the presentation of Volksbank's 2017 earnings.

Internal target

Volksbank's internal 15% CET1 ratio target includes a Pillar 2 guidance component and a management buffer, both accounting for 4.5 percentage points of the total target. The Pillar 2 capital requirements are applied to banks on an individual basis. Those requirements are meant to make sure that risks, which are specific to a certain institution, are not overlooked and each bank has sufficient capital cover.

The management buffer is a further component which could be added to the capital reserves by the bank itself to reflect additional risks that the bank's management believes are prudent to cover.

Volksbank was always considered more vulnerable to the final Basel III capital requirements announced in December 2017 than other Dutch banks such as ABN AMRO Group NV, Rabobank Research credit analysts said in a note Feb. 22.

That expectation was based on the fact that over 70% of Volksbank's balance sheet comprises mortgages that also have a very high loan-to-value level, averaging at 80% LTV for the whole mortgage book, according to the analysts.

However, Volksbank's current Basel III guidance is much more positive than that expected by Rabobank credit analysts. The 800-basis-point hit "is still significant but in the context of a CET1 ratio starting point of over 34% they can easily absorb this impact and it is much less than we expected," they noted.

Higher RWAs expected

Dutch banks in general were expecting a big increase in RWAs due to the Basel III output floor of 72.5% — the percentage at which banks' internal risk assessment models should match the standardized model devised by regulators — as they have big mortgage books with low risk covers because of the historically low default rates in the Netherlands.

Adhering to the new output floor means the banks will have to recognize a bigger part of their assets as more risky than they previously did and hold more capital against those assets. RWAs are a key component in calculating the CET1 ratio, which is a measure of a bank's capital strength.

Volksbank's RWAs amounted to €9.8 billion at the end of 2017, down from €10.8 billion at 2016-end.

While an RWA inflation of 35% is large, it is positive guidance coming from Volksbank as the lender had managed to bring down RWA inflation to the same level as peer ABN AMRO, the Rabobank analysts said. This is probably because Volksbank had benefited from the Basel III framework allowing the use of loan splitting, they said.

Under the loan-splitting approach, banks can divide assets in a loan portfolio by their risk level. This allows banks to raise the cover just for high-risk loans and reduce the overall RWA inflation.

"Another explanation is that [the Basel rules] will have a significant impact on nonmortgage loan portfolios (such as specialized lending and clearing) to which Volksbank is less or not exposed," the analysts wrote.

ABN AMRO has estimated the Basel III-related effect on its CET1 ratio at some 450 basis points and sees RWA inflation at about 35%.