25 July 2016
Financial Institutions
Level 3 Assets:
Than Meets the Eye
Level 3 Less
Assets:
Less Than Meets the Eye
This report zooms in on European banks’ Level 3 assets – which still seem to carry
a bad reputation with some market participants and are sometimes cited as an
element of concern by investors. Based on the data and trends presented in this
report, some concerns may appear excessive.
Analysts
Our analysis shows that, for most banks, Level 3 assets are a small portion of the total
balance sheet and can be seen as immaterial. For the European banks rated by Scope,
Level 3 assets represent on average just over 1% of total assets. We also note that in
recent years Level 3 assets have been declining faster than total assets, while capital
bases have been increasing across the board. As a percentage of core capital, on
aggregate Level 3 assets have gone from 43% in 2010 to 26% in 2015.
Pauline Lambert
+44 20 3457 0444
[email protected]
Marco Troiano, CFA
+44 20 3457 0452
[email protected]
However, Level 3 assets are not uniformly distributed and are indeed concentrated in a
few names in Europe. For example, as a percentage of total assets as of end-2015 they
represented 4.5% for DNB, 4% for Credit Suisse and 3.3% for Barclays. For these banks,
they also represent a higher-than-average proportion of CET1 capital (see Figure 1).
Figure 1: Level 3 assets/CET1 capital (%)
Scope Ratings AG
Source: SNL, Scope Ratings
We see the presence of Level 3 assets as being closely related to the respective banks’
business models. In particular, banks with a more significant wholesale and investment
banking profile tend to have more Level 3 assets compared to banks with a more retailoriented business model.
Overall, we consider that the presence of Level 3 assets in banks’ balance sheets is
generally not a concern, as these are justified in the context of the banks’ normal
operations. For the banks we rate, they are not a rating driver. It is also important to
stress that the classification of assets into Level 3 does not necessarily carry informative
value as to the quality of the assets, but only informs on their illiquidity and on the
observability of valuation parameters. Hence we caution against simplistic conclusions
drawn by comparing different banks on this particular metric: The mix of Level 3 portfolios
varies materially among banks. In the remainder of this report we comment on the Level
3 portfolios of the five rated banking groups ranking highest in Figure 1: Barclays, Credit
Suisse, DNB, Deutsche Bank, and Nordea.
25 July 2016
Suite 407
2 Angel Square
London EC1V 1NY
Phone
+44 20 3457 0452
Headquarters
Lennéstraße 5
10785 Berlin
Phone +49 30 27891 0
Fax
+49 30 27891 100
Service +49 30 27891 300
[email protected]
www.scoperatings.com
Bloomberg: SCOP
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Level 3 Assets:
Less Than Meets the Eye
Not all Level 3 assets are created equal
Barclays
As of end-2015, Barclays had GBP 36.6bn in Level 3 assets – 3.3% of total assets and
nearly 90% of CET1 capital. The amount has fluctuated in recent years due to the group’s
strategy to exit non-core businesses. The two largest components of Level 3 assets are
GBP 16.8bn in non-asset backed loans and GBP 7.4bn in non-current assets held for sale.
Non-asset backed loans are largely comprised of the non-core GBP 16.2bn Education,
Social Housing and Local Authority (ESHLA) portfolio – primarily long-dated fixed-rate
loans extended to low credit risk counterparties in the UK Education, Social Housing and
Local Authority sectors. Since 2013, the loans have been categorised as Level 3 due to
their illiquid nature and the significance of unobservable loan spreads to their valuation.
As at end-2014, a revised valuation methodology was adopted; this led to an income
statement charge and corresponding fair value reduction in the loan portfolio of
GBP 935m in 2014 results. The change had no impact on CET1 capital.
Other Level 3 assets include GBP 2.9bn in corporate bonds, GBP 2.7bn in interest rate
derivatives and GBP 1.9bn in FX derivatives.
Per Barclays, the effect of stressing unobservable inputs to a range of “reasonably
possible alternatives, alongside considering the impact of using alternative models” on
total Level 3 assets could potentially have a negative profit-and-loss impact of GBP 2.2bn
and a negative equity impact of GBP 71m.
Credit Suisse
As of end-2015, Credit Suisse had CHF 35.7bn in Level 3 assets – 4% of total assets or
c. 78% of CET1 capital. They have materially declined over the last five years; in 2011
they were over 150% of CET1 capital. At end-March 2016, Level 3 assets had declined
further to CHF 28.7bn, in line with the group’s strategic plan to reduce risk exposures.
The majority of Level 3 assets stems from the investment banking businesses and
includes:
 CHF 14.4bn in trading assets, including CHF 4.4bn in debt (e.g. corporate debt, CDO,
RMBS), CHF 4.7bn in derivatives (e.g. equity/index-related, credit, interest rate) and
CHF 4.5bn in other trading assets (primarily RMBS loans and life settlement and
premium finance instruments)
 CHF 8.8bn in loans. The group has elected to account for substantially all commercial
loans and certain emerging market loans from the investment banking businesses at
fair value as these activities are managed on a fair value basis
 CHF 3.1bn in other assets, mainly loans held for sale
 CHF 2.0bn in other investments, mainly life finance instruments
DNB
As of end-2015, DNB had NOK 117bn in Level 3 assets – 4.5% of total assets or nearly
72% of CET1 capital. The majority of Level 3 assets are loans to customers (NOK
108bn); primarily NOK fixed-rate loans (NOK 88bn) and margin loans carried at fair value
(NOK 21bn). According to DNB, if the discount rate on fixed-rate loans and the margin
requirement on margin-based loans were reduced by 10bps, this would change the
carrying value of the loan portfolio by a negative NOK 235m. The remaining Level 3
assets are primarily NOK 6bn in shareholdings (e.g. private equity funds and unquoted
equities) held in the group’s life insurance company.
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Level 3 Assets:
Less Than Meets the Eye
Deutsche Bank
In the case of Deutsche Bank, Level 3 assets stood at EUR 31.5bn – 1.9% of total assets
or 60% of CET1 capital. They have materially declined in the past five years (EUR 48bn
in 2011). Level 3 assets include:
 EUR 6.7bn in trading securities (including highly structured corporate bonds and
certain illiquid emerging market corporate bonds, as well as structured securitisation
notes)
 Level 3 derivatives (EUR 9.4bn) consist of derivatives valued on the basis of one or
more unobservable parameters. These include customised CDO derivatives, credit
derivatives, multicurrency FX derivatives, options and CDS for which the credit spread
is not observable
 EUR 6.1bn in other trading assets, consisting of illiquid leveraged loans, illiquid
residential and commercial mortgage loans
 Available-for-sale financial assets (EUR 4.8bn), mainly NPLs and real estate assets
 Other fair value assets (EUR 4.5bn) include certain corporate loan facilities with
unobservable utilisation rate parameters
Nordea
At c. EUR 10bn, Level 3 assets represent 1.54% of assets and 42% of CET1 capital at
Nordea. These consists primarily of investments in unlisted shares and properties of the
life insurance business (over 70% of the total), as well as other shares and property
investments in the group (c.10%). Derivatives and other illiquid interest bearing securities
account for the balance.
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Level 3 Assets:
Less Than Meets the Eye
Scope Ratings AG
Headquarters Berlin
Lennéstraße 5
D-10785 Berlin
Frankfurt am Main
Rüsterstraße 1
D-60325 Frankfurt
Paris
21, Boulevard Haussmann
F-75009 Paris
Phone +49 30 27891 0
Phone +49 69 97944 754
Phone +33 1 53 43 29 89
London
Suite 407
2 Angel Square
London EC1V 1NY
Madrid
Paseo de la Castellana 95
Edificio Torre Europa
E-28046 Madrid
Phone +44 20 3457 0452
Phone +34 914 186 973
[email protected]
www.scoperatings.com
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