Financial Institutions Business Strategy | General financial discussion | Discussion forum

Hi Greg,

I'm not sure if this is exactly the answer you may be looking for, and I should note that my eyes tend to glaze over when organizations such as the Bank of International Settlements (a sort of "central bank" for central bankers, if you will) Basel Committee on Banking Supervision talks about revising its "Tier 1", Tier 2" and so on capital ratios, but from a layperson's perspective (and I still consider myself to be a "layperson", even though my understanding of such matters may be somewhat higher than "Mike" from Canmore), there are a number of other factors that determine an institution's so-called "Tier 1" capital ratios.

I think it would be simplistic to state that deposit-taking institutions (even I didn't know that there was a "DTI" abbreviation for that - or that internal capital adequacy assessment had its own ICAAP abbreviation!) would simply have to raise their deposit rates to attract additional capital to fund their mortgage, auto lending, consumer financing or credit card activities. The reality is, there's a myriad number of ways they can accomplish this. They can go to the bond markets, with their ultra-low rates right now but also because the banks operate their own large capital markets businesses, they've got established businesses on which to "go to market" and attract additional funds through that "wholesale funding" model (as it's called). They can issue preferred stock that pays a fixed dividend and may be callable at certain times or have its dividend rate "reset" in line with the current market rates (presumably, determined by the current central bank's interest rate or LIBOR). That's partially why, at least in my opinion, you'll often find credit unions more likely having to raise their deposit and GIC rates, because it's difficult and perhaps more expensive for them, to utilize the "wholesale funding" model (potentially because they'd have to go through their provincial Credit Union Central, which only does new issues at certain timeframes and they may carry a somewhat lower credit risk rating from the ratings agencies).

There's other ways banks and credit unions can improve their capital adequacy. They can look at reducing or removing clients' undrawn, or partially drawn, unsecured or even secured line of credit limits. For instance, and this is a curious anomaly since banks have tried so much to cross-sell multiple products to every client they see (and I'm talking personal clients only in this example, but certainly it would apply to commercial clients as well, perhaps to a somewhat lesser extent since most banks charge monthly & annual fees for the privilege of having each commercial lending facility which adds significantly to their "fee income"), a bank may end up with a number of clients with undrawn (industry parlance for a non-utilized) line of credit limits that the bank has to hold an equivalent amount of capital against. Even though they aren't being used, because they are a revolving facility, they could essentially be drawn tomorrow. That's why, particularly in 2008 and 2009, you saw some institutions (I think TD Canada Trust and perhaps Vancity, Coast Capital Savings and I know HSBC Bank Canada) sent letters to their clients that they would be raising the "spread modifier" (sorry, can't think of a better term at this point, but essentially, if your rate changes with the bank's Prime rate and your LOC rate was Prime+1%, it may have sent you a letter that your rate would now be Prime+2% for secured and Prime+4 or 5% for unsecured) on various customer line of credits. Secured LOCs at Prime are almost unheard of, reserved only for their best clients, if at all. More common is a Prime+0.5 or Prime+0.75. More recently, I know some banks (including HSBC) started going through their portfolios and where, let's use HSBC as an example, in the past they gave every Premier client a pre-approved $25,000 unsecured LOC as part of the offering (regardless of credit rating, the thinking being that person would be holding $100,000 on deposit to qualify for that Premier proposition), found a lot of clients weren't using those LOCs so why continue to mandate every customer take one, just because it's part of the package? So, they removed that from the offering, making them available only subject to credit approval and not by default to everyone and sent letters, in some cases, explaining their reasons for removing those limits in some cases. Other banks made similar moves, I believe.

To take that a step further, if a bank is really going through their book with a "finely-toothed comb", they could even look at reducing their maximum limits for physical holdings of cash by branch and encouraging their branches to not fully utilize those reduced maximum limits, to increase their margins. The reason being, physical cash is essentially "trapped capital" that they cannot lend and, if they can reduce those maximum limits, that frees up their availability to lend without having to add additional capital. Granted, this would probably have the least effect, but if you have a CFO and his or her Finance Department that is going through everything in extreme detail to maximum use of capital and, by extension, grow their "bottom line" with tepid revenue growth, that's yet another way they could do it.

At first, from a consumer standpoint, I thought it was a case of the "big bank" taking away a product from a client for the bottom line. And it is, albeit indirectly, since by reducing the amount of capital you have to hold, you "release" those assets and that leads to your common share dividends (without actually growing the "top line") being increased, shares being bought back, preferred shares being "called" (i.e., bought back), etc. However, working in a bank, you realize it's also prudent risk management through the "pruning" of your portfolio and the ability to "unlock" value from that existing portfolio. Does that kind of make sense?

You can take it a step further and this doesn't just apply to line of credits but all of the letters of credit issued by banks to commercial enterprises (essentially, Bank A issues Letter of Credit to Corporation A and Corporation A uses that to secure financing for, let's say, buying inventory from overseas from Corporation B - if Bank A has to fund that obligation, maybe because that Corporation A is having an unforeseen cash flow problem, it now has to put a loan on its books and honour its commitment to Corporation B). Granted, banks do collect annual fees for guaranteeing these Letter of Credits and that all adds to their fee income and, in many cases, do require the corporation to put up at least some capital but is generally not at a 1:1 or 2:1 ratio (more like a 1:2, 1:3, 1:4 or 1:5 or more ratio).

Similarly, and this gets pretty complex even I only have only a basic understanding, but the term is "return on risk-weighted assets" or RoRWA. Essentially, what that is, from my limited understanding, is the ability to earn a certain for every dollar that a bank or financial institution lends, based on a sort of "sliding scale" depending on the risk profile. So, by extension, "risk-weighted assets" is just that: the assets (i.e., loans and credit facilities) on a bank's books that are assigned a "risk rating" based on complex mathematical formulas. I don't pretend to know what these formulas or even "risk ratings" are, so I may not be accurate or am over-simplifying the concept, but let's assume a mortgage to a "prime" borrower carries a rating of 1. An auto finance loan, though secured, to a B borrower carries a risk rating of 2. An unsecured LOC carries as a risk rating of 3. An auto finance loan, secured also, to a D borrower carries a risk rating of 4. The higher the rating assigned, the more capital they must hold.

And, then, they separate those risk ratings and formulas for "banks and credit unions" and SIFIs (systemically-important financial institutions), designated by their countries' regulators or as global SIFIs by the Basel Committee, that have altogether different requirements.

Not sure if that exactly answered your question, but I think it covers "capital adequacy" from a general sense, at the very least. And, banks and financial institutions have various "capital adequacy" reports that regularly reviewed (in varying degrees of intensity) from the branch level, to the district level, to the head office level and, ultimately, by the Board of Directors and regulators.

So, if the banks are going to be forced to hold more capital for certain assets, would that push deposit rates up? It may factor into the decision, sure, but there's a whole number of other reasons, not least of which is lending demand and mortgage lending growth (in most markets) is anemic at best. And, the growing area, auto finance, rates are typically significantly higher than mortgage rates, therefore, although they may have to hold more capital (in its various forms), they're earning a higher return already in the form of the higher lending rates.

Cheers,
Doug

I must have nerves of steel to dare to comment here, but here goes...
I really appreciate having all these ideas to wrestle with, even if I don't understand a lot of them.

However, on the question of credit unions, it seemed to my unlearned eye that a piece of the puzzle has to be that credit unions are member-owned organizations. There are no dividends to be paid to investors, no fees to belong to the stock exchange or whatever, and I haven't noticed that they have expensive real estate on Bay St (although maybe someone can correct me) or huge international investments to worry about (which sometimes default spectacularly). Whatever might have become dividends is returned to the members in better rates whenever possible. This is the whole principle of credit unions in the first place, and it is a worthy one for those of us who feel ripped off by the banks to consider. Some have better rates than others; local variables no doubt are a factor.
Similarly, it would appear, from my vantage point in Ontario, that credit unions don't spend nearly as much money on promotion and advertising as the BigBanks. I don't know how that works out as a percentage of assets, but my computer screen is constantly littered with ads from the BigBanks, and none from the credit unions, even though I visit all of these sites frequently. Advertising is paid for with OUR money, just like the big CEO salaries and so on.

I realize the question was not directed to me. However, it's a public forum, so there's my 2cents.

Methinks that only in Canada would a town of 10,000 support 4 banks!

I'm sure the history of the CUs in various areas would make an interesting read. Indeed, many have been started by people who were denied credit by banks who couldn't be bothered dealing with them. I read on one of the MB sites that they were founded because the banks considered, in the 1940s, that Mennonite farmers were a bad risk. Ha! MB credit unions, full of Mennonites, are still chugging along successfully.
Realistically, it's harder to fool your neighbour about your financial prospects than it is to fool a bank with HQ in Toronto, if you're a farmer. If your neighbour who sits on the loans committee of your credit union will give you a loan, he's going to care a lot more about a lot of things than the exec in TO, including the vitality of the community, and he's going to know if you spend your time partying rather than working hard.

I may be wrong but my understanding is that in QC, the caisses populaires were typically started by French RC parishes, which is why they really only took off among francophones. I wouldn't be at all surprised if that too had something to do with a certain lack of interest in them by BMO. The Anglo Montreal merchant class didn't have much use for the French in the early days, and there may not have even been any banks in the small villages around the province.

I inherited a few pages of accounting ledgers from my greatgrandfather, a southern Ontario farmer, from the 1880s. I was fascinated to see that it included many private loans, back and forth. Similarly, early land records on the property do not show bank mortgages, but private loans. It was a hard slog, and took 3 generations and almost a hundred years before the property was finally free and clear. Hard to imagine a bank extending a mortgage that long! It seems to me that this was the way things were done then, and that credit unions would be a logical development from this in the absence of banks.
Small but mighty!

But I digress...