28 July 2010

Basel Tone Improves - Positive for Canadian Banks

Scotia Capital, 28 July 2010

• The Basel Committee on Banking Supervision reached broad agreement July 26, 2010 on the overall design of the capital and liquidity reform package including definition of capital, the treatment of counterparty credit risk, the leverage ratio, and the global liquidity standard.

• In general, the agreement seems to provide a more balanced and constructive approach to capital and liquidity. Capital definitions have been eased and liquidity design softened with transition time frames extended. It seems the increase in systemic risk (Euro crisis) and broad consultation may have caused Basel to moderate its very aggressive stance on bank regulation. Adopting more of a going concern approach along with effective regulation (accountability) will likely have a better outcome for economic growth and the health of the banking system.

• The tone is improving, however calibration risk and uncertainty still persists until the detailed rules are released later this year. Basel is expected to issue the details of the capital and liquidity reforms later this year together with the Quantitative Impact Study. Basel is expected to issue its economic impact assessment in August. Basel is expected to finalize the calibration and phase in arrangements at their meeting in September and finalize the regulatory buffers by year-end.

• In reaching the broad agreement July 26, 2010, Basel has made a number of amendments to the December 2009 consultative document. It concluded that certain deductions could have potentially adverse consequences for particular business models and provisioning practices, and may not appropriately take into account evidence of realizable valuations during periods of extreme stress.

• The July 26 agreement, we estimate, improves Canadian banks' Tier 1 common ratio by 100 BP versus the December 2009 proposal. If we adjust for the July 26 agreement and continue with conservative assumptions on market at risk and off balance sheet consolidation, our pro forma 2012 Tier 1 common for Canadian banks is 8.0%, which we estimate to be at the high end of the range that will be calibrated by year-end; perhaps providing some flexibility for Canadian banks to increase dividends.

Definition of Capital - Eased - Canadian Banks Capital Pick Up Est. 100 bp

• The most significant amendment certainly for Canadian banks is the definition of capital, particularly the treatment of significant investments in unconsolidated financial institutions, mortgage servicing rights, and deferred tax assets from timing differences. Instead of full deductions, each may receive limited recognition capped at 10% of banks' Tier 1 common equity with aggregate 15% limit.

• This amendment, we estimate, would increase Tier 1 common ratios for the Canadian banks by 100 BP (Exhibit 2, row #12) versus the Basel December 2009 Consultative Documents.

The Tier 1 common impact for BMO, BNS, CM, NA, RY and TD is estimated at 70 BP, 100, 110, 30, 130, and 100, respectively.

• Our pro forma 2012 Tier 1 common ratio for bank group has improved to 8.0% (Exhibit 5, row # 11) with BMO, RY, and TD a high of 8.5% with NA at 8.0%, CM 7.7% and BNS at 6.6%.

Leverage Ratio - Design/Calibration - Business Model Appropriate - 2018

• In terms of the leverage ratio, the committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run. The transition period is expected to be used to assess whether the proposed design and calibration is appropriate over a full credit cycle for different types of business models (e.g., originate to hold versus sell models).

• The supervisory monitoring period begins January 1, 2011 with parallel run commencing January 1, 2013 until January 2017. Bank disclosure of the leverage ratio and its components will start January 1, 2015. The view is to migrate to a Pillar 1 treatment January 1, 2018 based on appropriate review and calibration.

Regulatory Buffers, Provisions, and Cyclicality - Consultation Pending

A consultative document has been issued with comments due by September 2010. Buffers could be run down to absorb losses during a period of stress.

Systemic Risk, Contingent Capital, and a Capital Surcharge - Further Discussion

• The Committee will review a fleshed-out proposal for the treatment of 'going concern' contingent capital in December 2010.

Global Liquidity Standards - LCR Softened - NSFR - Time Frame Extended

A. Liquidity Coverage Ratio (LCR)

• The Committee made revisions to the definition of qualifying liquid assets, easing some of the liquidity requirements.

B. Net Stable Funding Ratio (NSFR) - Introduction 2018

• The Committee is committed to the introduction of NSFR as a longer term structural complement to LCR. However, the Committee acknowledges the calibration as set out in December 2009 proposals needs to be modified. A number of adjustments are under consideration and with a long transition and observation phase with introduction by January 1, 2018.