PwC's Managing upstream risk: Regulatory reform review - An asian perspective December 2013

6. Even in the short run, we believe too much is made of the dilutive effects of raising additional capital (whether in response to RWA, LR, ECB or national supervisory pressure). The crisis has revealed that performance enhancement through financial leverage, as well as being potentially calamitous, is substantially an illusion for equity investors. This is because the higher equity returns come hand-in-hand with higher equity risks and therefore higher equity costs. It follows that the supposed costs of financial de-leverage, in terms of RoE dilution, are also largely illusory. 7. Nevertheless, we expect that banks faced with a capital shortfall will again work through the usual balance sheet restructuring menu of technical mitigation (‘paper’ changes), business/operational mitigation (e.g. netting and other forms of balance sheet compression), asset restructuring (sale or runoff) and liability restructuring (capital raising/restructuring). 8. Of these, we believe the usual last resort of liability restructuring will prove to be the dominant response because other measures will not go nearly far enough. We see up to two-thirds of the Tier 1 capital shortfall (c. €180bn for European banks) being met by capital raising or restructuring, partly out of necessity, but also on merit: We believe there is growing investor acceptance of the new lower risk – lower cost – lower return paradigm; a gradually improving confidence in the nascent economic upturn; and a growing recognition of the value of having the balance sheet capacity to invest into this upturn. In this environment, the frictional costs of being under capitalised far outweigh the frictional costs of being over capitalised (to the extent that the latter exist at all). 9. Liability restructuring will take many forms including ordinary equity issuance, AT1 securities issuance, internal capital restructuring, asset backed structured finance/securitisation transactions and more radical holistic balance sheet restructures. 12 Regulatory Reform Review | Banking 10. For banks in scope of the ECB Comprehensive Assessment, although the process will not conclude until late 2014, there is little merit in deferring action until then. The ECB announcement gave pointed encouragement to taking action sooner rather than later, presumably to mitigate the risk of market disruption/ v

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