RAC and ruin

Philip Bayley
Early last week, Standard & Poor's released a report entitled "S&P Ratio Highlights Disparate Capital Strength Among The World's Biggest Banks" and sparked a bit of local controversy with many thinking that Australia's high quality banks had been unfairly treated by a comparison that showed them to be only slightly better than their global peer average, in terms of S&P's new risk adjusted capital measure (RAC).
 
Any reasonable reading of the report should dispel such views but it is likely that many have not read it.

If anything, this highlights a problem with S&P's selective disclosure of information, rather than the RAC methodology or application of the new RAC framework by S&P.

Strictly speaking, the report is available only to subscribers to S&P's RatingsDirect service. But for reports like this, where just a media release stirs up controversy, which wasn't really assuaged by a subsequent press release, it may be better simply to make the report freely available from the start.

S&P's methodology and criteria are freely available and reports that deal with the application of such, like this one, should probably be treated the same way.  

In any event, S&P has spent four years developing its new risk-adjusted capital framework in anticipation of the implementation of Basel II.

The RAC framework is intended to provide a measure independent of national regulations, Basel II methodological options, and banks' own internal risk measurement systems. Moreover, the framework is intended to be consistent across all banks as an industry sector, and across national and geographic boundaries.

The report took a sample of 45 banks and applied the RAC framework to give an indication of how it would work and what the results may show. S&P acknowledged that it had less than perfect information for some of the sample members but had endeavoured to compensate for this.

The methodology is conservative and applies a much tougher definition of Tier 1 capital and risk weighted assets than that used under Basel II. S&P uses its measure of Total Adjusted Capital that excludes many of the hybrid securities that are included in the Tier 1 measure.

For example, TAC allows for hybrid inclusion up to 25 per cent but hybrid securities comprise 81 per cent of UBS' Tier 1 capital.

S&P's measure of risk-weighted assets, which is applied as the denominator to TAC, includes higher charges (than under Basel II) for market risk, capital tied up in subsidiaries, insurance risk and credit risk. In the case of the latter, S&P applies higher risk ratings for unrated exposures than just the standard 100 per cent applied under Basel II.

The result of these adjustments was such that for the sample group, risk-weighted assets were on average 70 per cent higher than under the Basel II measure.

The important point here is S&P has determined a conservative and consistent measure of a bank's real capital adequacy - a measure that can be applied across the industry sector and globally. No CRA can be criticised for doing this.

Even more important though is S&P's statement that the RAC ratio is just the starting point of its capital analysis, which is complemented by qualitative factors, as well as other quantitative measures used by the market. Indeed, when it comes to determining a bank's overall credit ratings it is only one consideration among many, including the economic and regulatory framework in which the bank operates, its competitive position, earnings, asset quality, funding and liquidity, and the availability of external support mechanisms such as government support.

S&P included only three of the four major banks in Australia in its sample group (ANZ, CBA and NAB). While the RAC scores for this trio came out only slightly better than the sample average of 6.7 per cent, it is worth noting that Citigroup was awarded the second lowest score at 2.1 per cent, followed by UBS at 2.2 per cent and Bank of America came in at 5.8 per cent followed by Deutsche Bank at 6.1 per cent.
       
S&P will apply the RAC framework to all rated banking groups worldwide by the end of 2010 and will publish detailed ratio analysis in individual bank reports as the framework is applied.