FT Alphaville " Retail lending, mitigate thyself European retail lending as a dying bank business model walking - charts via McKinsey, in this new report by the consultants: Those are plummeting returns on equity for mortgages, credit cards and other basic business lines across the region, all holed below the waterline by the new generation of bank capital and liquidity regulations. "We estimate that for the four largest markets as a whole, retail ROE will fall from about 10 percent to 6 percent, a drop of 41 percent," McKinsey's analysts say. It's mostly because of the extra capital which Basel III will require these assets to be backed up with. This is the coal-face of the new, increasingly standardised, risk-weightings facing banks. There's a certain irony here - European retail lenders have lived with the concept of risk-weighted assets much longer than US banks, after adopting earlier versions of Basel sooner. So it's maybe not surprising... but also a little eyebrow-raising... that McKinsey suggests tinkering with risk-weightings as one of the most effective methods of reviving return on equity: Technical Mitigation By improving the efficiency of capital and funding (through improved data quality, better risk processes, and refined risk models) banks can increase RoE by between 30 and 160 basis points... our estimate for technical optimization consists mainly of risk-weighted assets (RWA) optimization levers. Capital-and funding-light operating models Banks can further improve funding efficiency and reduce RWAs by, for example, changing their product mix and characteristics, pursuing collateral more vigorously, and improving their ability to outplace risks (by issuing covered bonds for mortgage portfolios, for instance). These changes can also help boost revenues, and improve ROEs by between 10 and 80 basis points... Now, McKinsey is also talking here about banks simply gaining more control of their own data on customers, or having better records of things like loss given default, a key element of risk-weighting calculations. But other suggested bits of RWA "optimisation" ring familiar: Finally, leading banks are exploring methodological improvements. These include refinements to risk models, to better estimate risk parameters. Many banks don't use sufficiently granular risk models; instead they treat customers and products that have very different characteristics with one model. For example they do not differentiate sufficiently among retail, small, and medium- size businesses in their models. Separate and fine-tuned models for each segment can reduce overall RWAs. Even within retail segments, banks will find that further subsegmenting by exposure and customer characteristics can improve the risk assessment and reduce RWAs. Clearly the incentive is there for retail banks. At the high end, "technical mitigation" would account for up to 40 per cent of recouped losses* due to regulation, on average across countries in Europe, says McKinsey. Related link: Banks turn to financial alchemy in search for capital - FT This entry was posted by Rahul Wagh on Thursday, July 19th, 2012 at 9:58 and is filed under Capital markets. Tagged with Basel III, Regulation, RWA.