1 Competitive Effects of Basel II on U.S. Bank Credit Card Lending William W. Lang Loretta J. Mester Todd A. Vermilyea Federal Reserve Bank of Philadelphia 2006 FDIC/JFSR Conference Arlington, Virginia September 13,2006

2 Purpose  Basel II creates a more risk sensitive capital requirement to reduce market distortions created by capital regulations  However, different banks will operate under different regulatory capital rules  Different regulatory requirements could create competitive inequities  Analyze this issue for credit card portfolios

3 Outline of presentation  Structure of U.S. credit card (CC) market  Conceptual Framework  Are Basel I requirements “binding”?  Basel II affect on regulatory capital  Will Basel II Changes Matter?

4 Summary of findings and main implications  CC markets are highly concentrated; only a few banks significantly affected by CC rules  Community banks and most regional banks not affected  Basel I capital requirements on CCs are not binding  Basel II substantially raises requirements for CC lending  Most of the increase is in tier 2 capital  Capital requirements for CC may be extremely procyclical  Basel II increases incentives to securitize CCs  CC lenders not subject to Basel II may receive a modest competitive advantage

5 Credit Card Market is Highly Concentrated % of total industry outstandings Source: The Nilson Report,

6 Other Structural Elements of the U.S. Credit Card Market  Credit Card Specialty Banks (CCSB)  Monolines  Credit Card operations of large banks often placed in a separate charter  Nonbanks issue CCs through bank subsidiaries  CCs largely funded through wholesale market  60% funded through securitization

7 Capital concepts  Economic capital: capital that banks would choose if there is no regulatory minimum  Regulatory capital: refers to “pillar 1” capital requirements  Binding regulatory capital:  bank capital > economic capital  can occur even if: bank capital > regulatory capital economic capital > regulatory capital

8 Actual Capital Regulatory Capital 45° Economic Capital kbkb k b is point of binding capital requirement Buffer Capital

9 Capital Levels at Credit Card Banks Are Far Higher Than Regulatory Requirements

10 Securitization Rates and Capital Demand at Credit Card Banks  Securitization rate for CC loans has risen over time  Higher securitization rate lowers regulatory capital requirements relative to managed assets  Capital to assets ratio has risen in response, while capital to managed assets ratio has been stable

11 Capital levels and securitization rates over time Equity Capital/Assets (left axis) Securitization Rate (bars, right axis) Equity Capital/Managed Assets (left axis) Percent

12 Regression Analysis of Capital Demand at Credit Card Banks  Regression models:  Dependent variables: different bank capital ratios  Controls for growth and risk  Sample of banks with:  Over $1 billion in assets  Managed loans to managed assets ≥ 60 percent  Equity to assets ≤ 25 percent  Contrast managed assets to balance sheet assets

13 Equity capital ratio regressions *** Significantly different from zero at the 99% level ** significantly different from zero at the 95%, level * significantly different from zero at the 90% level

14 Are Basel I requirements binding for bank credit card activities? No.  CCSBs’ high capital buffers cannot be explained by growth or risk  CCSBs’ demand for capital is more in line with their managed portfolio rather than their on-balance-sheet credit card assets  Model indicates that CCSBs’ demand for capital is similar to peer banks when CCSB assets are measured as managed assets rather than on-balance-sheet assets  Conclusion supported by prior research and views of credit rating agencies

15 Basel I vs Basel II: Risk Weighted Assets  On Balance Sheet CC Loans  Basel I – 100% risk weight  Basel II – risk sensitive risk-weight for loans and unused lines  Depends on PD, LGD, EAD  Regulators set asset value correlation to 8%

16 Basel I vs Basel II: Risk Weighted Assets  Securitized CC: normal times  Approximately the same for total capital with slightly higher effective tier 1 requirements  Securitized CC Loans: stressed times  Much higher regulatory capital requirements under Basel II

17 Basel I vs Basel II: Definition of Capital  Total Capital  Basel I: reserves are a component of capital  Basel II: reserves minus EL a component of capital (UL only)  Tier 1 Capital  Basel II: deduction if EL > reserves (typically true for CC lenders)

18 Formula for Basel II total capital requirement T − D − EL = 0.08 × RWA RWA = RWA ON + (CCF SEC x RWA SEC ) => T = 0.08 x [RWA ON + (CCF SEC x RWA SEC )]+ EL + D Gross total regulatory capital DeductionsExpected losses Risk-weighted assets

19 Estimated impact of Basel II on “typical” CC bank’s required capital in normal times No Adjustment for Eligible ReservesAdjustment for Eligible Reserves (Monoline CC Bank Assumption) Average44.3%23.6% Min19.1% 6.7% Max67.0%32.2% Percentage Change in Required Tier 1 Capital (Assuming Securitized Assets Are Healthy) No adjustment for shortfall of reserves from expected losses (Diversified Bank Assumption) Deduction of half of shortfall of reserves from expected losses (Monoline CC Bank Assumption) Average 2.2%13.2% Min-5.4%-1.7% Max14.8%25.8%

20 Estimated impact of Basel II on “typical” CC bank’s capital ratios in Normal and Stressed Times Total Capital to Risk-Weighted Assets No Adjustment for Eligible Reserves (Diversified Bank Assumption) Adjustment for Eligible Reserves (Monoline CC Bank Assumption) Basel I18.5% Basel II, healthy portfolio12.8%14.9% Basel II, stressed portfolio10.4%12.1% Tier 1 Capital to Risk-Weighted Assets No adjustment for shortfall of reserves from expected losses (Diversified Bank Assumption) Deduction of half of shortfall of reserves from expected losses (Monoline CC Bank Assumption) Basel I15.0% Basel II, healthy portfolio14.7%13.3% Basel II, stressed portfolio11.9%10.8%

21 Summary of estimates for typical large CC lender in “normal times”  Substantial rise in total capital requirements for CC activities; total capital requirements might become binding  Modest rise in tier 1 requirements; unlikely to feel significant impacts on actual tier 1 capital  However, some CCSBs may see a substantial tier 1 impact.

22 Summary of estimates for typical large CC lender in “stress periods”  If stress is sufficient to trigger a 15% CCF for securitized CCs, then increase in capital requirement significant for total and tier 1 capital  If stress is sufficient to trigger a 50% CCF for securitized CCs, then severe capital pressures  Note that Basel I banks might also face substantial pressure from supervisors and the market to increase capital under these circumstances

23 Implications of our findings  There may be a cost advantage for large CC lenders that are not subject to the Basel II capital requirements  Disincentives for independent monoline CC banks to adopt Basel II  Any cost advantage would likely be modest since Basel II banks may be able to meet additional capital needs through additional tier 2 capital (rather than more expensive tier 1 capital)  There will be no substantial competitive effect on community banks and most regional banks, as credit cards are not a major product line

24 Implications of our findings (cont’d)  Basel II could generate extremely large increases in required capital for CCs during stress periods  This might result in CC lenders holding higher capital even in normal times  Differential in “pillar 1” capital requirements may overstate the effects of Basel II since Basel I banks in financial distress will face increased supervisory and market demands for higher capital Basel II likely raises incentives to securitize credit cards and possibly mitigate the increase in required capital for on-balance sheet exposures  Basel II likely raises incentives to securitize credit cards and possibly mitigate the increase in required capital for on-balance sheet exposures