S&P Global Ratings has updated its risk-adjusted capital (RAC) ratios in its annual capital review for the world's top 100 rated banks. This year's review indicates that the RAC ratios of the top 100 banks have improved slightly in 2019 compared with those in 2018. The average RAC ratio ticked up to 9.0% in 2019 from 8.8% for the prior year. However, the asset quality and revenue deterioration stemming from COVID-19 will hit internal capital generation. At the same time, banking regulators across the globe have encouraged banks to continue to lend to their customers by loosening capital requirements and minimum buffers. As such, we expect the average RAC ratio to weaken in 2020 to about 8.7% and stabilize in 2021. The marginal degree of the projected decrease leaves our view of the capital strength among these banks largely unchanged, and we continue to consider it as neutral to slightly positive.

However, we believe there are material downside risks to our base-case assumptions, and consequently, to our RAC projections. This constitutes one of the factors behind the large proportion of negative outlooks we have assigned to banks (30% of the top 100).

Banks' RAC and regulatory capital ratios continued to increase amid the ongoing implementation of Basel III standards across the globe through 2019. This came to an abrupt stop in 2020, as economies, regulators, and banks across the globe grappled with the implications of the COVID-19 shock. We believe the overall increase in capital levels will be on hold for the next two years. The delay by one year of the implementation of the finalization of Basel III announced this year is one example of the various regulatory relief measures announced (see "Bank Regulatory Buffers Face Their First Usability Test," published June 11, 2020). These measures aim to provide more operational capacity for banks and regulators to respond to the impact of COVID-19 on the banking systems worldwide, and to boost the capacity of banks to maneuver through the worst part of the economic stress while supporting their clients.

In our view, the regulatory capital ratios' consistency has also improved among banks in Basel III jurisdictions. Yet, various levels of national discretion and differences in banks' internal models still influence regulatory capital ratios. As a result, RAC ratios remain the cornerstone of our capital analysis as part of our bank ratings evaluation, and continue to provide stronger risk differentiation particularly in the currently difficult operating environment.

We've selected the top 100 global banks based on their total adjusted capital, which we base on our risk-adjusted capital framework methodology, as opposed to the Tier 1 capital that we used in previous years. Starting in 2016, the RAC ratios reflect our revised methodology for assessing the capital adequacy of banks.

Table 1

S&P's RAC Ratios Continue To Provide Strong Risk Differentiation

We observe significant regional differences in the RAC ratios among the world's top 100 rated banks (see chart 1). Banks in Switzerland, Germany, and the Nordic countries have the strongest capital ratios; while the weakest ratios among the top 100 banks remain in Brazil, China, Italy, and Spain. This is mostly due to these countries' weaker economies, resulting in higher risk weights on domestic banks' assets than those of their peers in the sample. Although Spain's economic growth has been improving until the recent economic shock caused by the pandemic, the country's economy was severely damaged during the 2008 crisis and has yet to fully recover from it.

We base the risk weights we apply to banks' exposures on our assessment of each country's economic risk, a component of our Banking Industry Country Risk Assessment (BICRA), and on the risk weights applied to sovereign exposures, which are based on the sovereign ratings. The higher the risk, the higher the risk weights, which result in weaker ratios, while all other credit fundamental remain unchanged. Consequently, changes in our view of a country's economic conditions result in changes in the domestic banks' RAC ratios.

We saw improvements in economic risk in Spain, Australia, and Denmark during 2019, which partly explain the rise in the respective banks' RAC ratios for that year. We saw deterioration in India, which partly explains the erosion in its banks' 2020 forecasts.

We see significant variations in RAC ratios in some regions, which is why we present a range of minimum and maximum ratios across regions in chart 1. Those among Canadian and Japanese banks were the widest. The significant variation occurred in the following world regions:

• China and Hong Kong: China CITIC Bank Corporation Limited had a RAC ratio of 4.2% while Agricultural Bank of China Limited had 8.2% in 2019.
• Canada: Federation des caisses Desjardins du Quebec, the core issuing entity associated with Canada's leading cooperative, the Desjardins Group, had a RAC ratio of 14.8%, compared with The Bank of Nova Scotia's 7.8%.
• CEEMEA: Russia's VTB Bank JSC had a ratio of 4.7% compared with United Arab Emirate-based First Abu Dhabi Bank's 14.1%.

Chart 1

After The 2019 Peak, We Expect RAC Ratios To Dip, Then Broadly Stabilize

Our survey indicates that 59 banks have improved their RAC ratios as of the end of 2019 compared with those in 2018. The biggest improvements were in Switzerland (UBS Group AG and Credit Suisse Group AG) driven by internal capital generation due to supportive 2019 results and AT1 issuances, but also to a lesser extent, to RWA reduction in particular on the market risk front for UBS. In addition, the sharp strengthening occurred in Australia (mainly due to the improvement in our economic assessment explained above), and the Nordic countries (Danske Bank A/S and Svenska Handelsbanken AB). While Svenska Handelsbanken has strengthened its capitalization almost entirely through earnings retention and conversion of some subordinated loans into core capital, Danske Bank'scapital increase also resulted from a reduction of our calculated RWA.

We expect RAC ratios to decrease, because banking regulators have loosened capital requirements and minimum buffers in various regions in order to support additional lending or absorb potentially significant loan-loss provisions. We believe banks will have to absorb wider credit losses in 2020 and 2021 due to the impact of COVID-19. Both International Financial Reporting Standards (IFRS; the financial reporting rules applicable across much of the world outside of the U.S.) and U.S. Generally Accepted Accounting Principles (U.S. GAAP) require banks to take a more forward-looking approach when estimating credit losses on their loan portfolios. These rules mean that because of expectations of credit losses, banks may have to increase reserves markedly. Moreover, the low interest rates, combined with the thin margins on guaranteed loans and lower fees, have contributed to constrain banks' internal capital generation capability.

We expect the recovery of banks' profitability to pre-pandemic to be slow, uncertain, and highly variable across sectors and geographies. In our view, the performance of many prominent banking systems may not recover fully until 2023 (see "Global Banking: Recovery Will Stretch to 2023 And Beyond," published Sept. 23, 2020). In addition, we expect widespread restrictions on dividends to only be temporary in nature. Therefore, distributions could resume during our projection horizon for certain banking systems.

In contrast, one of the few systems where we don't expect a weakening in the major banks' RAC ratios in 2020 and beyond is Australia, because the institutions retain in our view sizeable headroom in their earnings to absorb the likely increase in credit losses and contraction in interest spreads and fee income. Furthermore, we expect that they would take actions to increase the absolute amount of capital they hold--by cutting dividend payments and issuing new capital--to maintain their regulatory capital ratios.

Chart 2

Capital Strength Impact

Similar to what we saw in our previous surveys, the capital strength impact on stand-alone credit profiles (SACPs) of the world's top 100 rated banks ranges from minus 3 notches to plus 2 notches (see chart 3 and refer to appendix for further clarification). The capital strength impact is neutral or positive to the SACPs of 82 banks in our current review, the same trend as in our last survey.

The current distribution of the combined impact remains significantly stronger than five years ago, when only 62 banks had a neutral or positive impact and reflects the capital build-up among the top 100 banks during this period. Additionally, we now consider capital adequacy (capital combined with risk position) a ratings strength for 31 of the top 100 banks (the same as last year), up from 19 five years ago. Any expected improvements or deteriorations in RAC ratios are already captured in this combined assessment, because we base the capital assessment on our capital projections, rather than actual values, and have incorporated the expected improvements for the next two years.

Chart 3

Our RAC Ratios Provide Stronger Risk Differentiation Than Regulatory Tier 1 Ratios

Our RAC ratios continue to be typically lower than regulatory Tier 1 ratios, reflecting the various levels of national discretion on regulatory ratios and differences in banks' internal models that still influence regulatory ratios to a large extent. However, some of the features in the Basel III framework, which regulators around the world are currently implementing, help diminish the gap, given that these features were already part of our capital methodology. For example, we've deducted tax loss carry forward and goodwill from our measure of TAC since we introduced our RAC framework in 2010.

We continue to observe the widest difference between the RAC and regulatory ratios for banks in countries whose sovereign ratings and economic risk scores are lower, reflecting the higher charges we apply to their exposures versus regulatory risk weights (see chart 4). That includes the risk weights we apply to sovereign exposures, which we base on our sovereign ratings, versus the risk weights applied by the regulators, which are subject to national discretion and usually very low or nonexistent. The biggest gap between the two metrics remains among banks in Brazil, the Nordic countries, the U.K., and Italy, as we observed in our previous surveys. The large gap among Brazilian and Italian banks is mainly due to both countries' weaker economic risk score; the higher risk weights we apply to deferred tax assets (DTAs) because of temporary differences from what the regulator applies; and the relatively higher risk weights we apply to the sovereign exposures based on our sovereign rating, while the regulator applies no risk weight. In contrast, the gap in some other countries results from the extensive use of internal models. Internal models tend to produce lower risk weights than the standardized approach and what our core RAC assumptions indicate. For example, this is the case for banks in the U.K., France, and the Benelux and Nordic countries that have large gaps, because although their economic risk is stronger, the banks have insurance operations and use internal models.

Chart 4

Appendix: The Capital Strength Impact On Banks' SACPs

To evaluate a bank's capital strength, we primarily look at capital and earnings and the risk position. These two factors are part of the four components of our rating analysis of banks. We assess these factors on a six-point scale: very weak, weak, moderate, adequate, strong, and very strong. The assessment of the risk position incorporates other factors not captured in our RAC ratios, such as differences in underwriting standards across banks and their credit losses.

In general, as long as the banks' anchor SACP--derived from our BICRA methodology--is investment-grade, an adequate assessment is neutral to a bank's SACP. All else being equal, a moderate assessment would lower the SACP by one notch, a weak assessment by two or three notches, and a very weak one by five notches. On the other hand, a strong assessment would raise the SACP by one notch, and the very strong one by two notches.

Related Criteria

• Guidance: Applying The Risk-Adjusted Capital Framework Methodology, Sept. 13, 2018
• General: Risk-Adjusted Capital Framework Methodology, July 20, 2017
• Bank Rating Methodology And Assumptions: Additional Loss-Absorbing Capacity, April 27, 2015
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011
• Banks: Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research

• Global Banking: Recovery Will Stretch To 2023 And Beyond, Sept. 23, 2020
• Nordic Banks' Strong Capital Deflects COVID-19 Impact, Sept. 8, 2020
• Bank Regulatory Buffers Face Their First Usability Test, June 11, 2020
• How U.S. Bank Dividend Cuts Could Affect Ratings, June 3, 2020
• North American Financial Institutions Monitor 2Q 2020: COVID-19 Weighs On Earnings And Ratings, May 15, 2020
• EMEA Financial Institutions Monitor 2Q2020: Resilient But Not Immune To COVID-19, May 14, 2020
• LatAm Financial Institutions Monitor 2Q2020: COVID-19 Hits Banks' Bottom Lines, May 14, 2020
• Asia-Pacific Financial Institutions Monitor 2Q2020: COVID-19 Crisis Could Add US$440 Billion To Credit Costs, May 14, 2020
• Europe’s AT1 Market Faces The COVID-19 Test: Bend, Not Break, April 22, 2020