Keep bank regulation as simple as possible, but no simpler

Reading Andrew Bailey’s summary of what the Bank of England has learned about bank capital adequacy over the last decade, it strikes me that there are four major issues facing regulators.

Firstly, simple capital ratios as applied by Basel I encourage banks to increase the average risk-weighting of their assets in order to maximize their return on capital. The same problem applies to the Leverage Ratio introduced in Basel III, which ignores risk-weighting of underlying assets. While useful as an overall measure of capital adequacy, exposing any inadequacies in risk-weighted models, it should not be used on its own.

Risk-weighted capital ratios, however, where bank assets are risk-weighted prior to determining required capital, create incentives for banks to concentrate investment in low-risk-weighted assets such as home mortgages and sovereign debt. Consequent over-exposure to these areas increases risks relative to historic norms, creating a trap for the unwary.

A third pitfall is the use of hybrid debt instruments as part of bank capital. Andrew Bailey explains:

Basel I allowed hybrid debt instruments to count as Tier 1 capital even though they had no principal loss absorbency mechanism on a going concern basis. They only absorbed losses after reserves (equity) were exhausted or in insolvency. It was possible to operate with no more than two per cent of risk-weighted assets in the form of equity. The fundamental problem with this arrangement was that these hybrid debt instruments often only absorbed losses when the bank entered either a formal resolution or insolvency process. It was more often the latter in many countries, including the UK, since there was no special resolution regime for banks (unlike today). But the insolvency procedure could not in fact be used because the essence of too big or important to fail was that large banks could not enter insolvency as the consequences were too damaging for customers, financial systems and economies more broadly. There were other flaws in the construction of these capital instruments. They often included incentives to redeem which undermined their permanence. They were supposed to have full discretion not to pay coupons and not to be redeemed in the event of a shock to the bank’s condition. But banks argued that the exercise of such discretion would create an adverse market reaction which would be disproportionate to the benefits, thus undermining the quality of the capital. More broadly, these so-called innovative instruments introduced complexity into banks’ capital structures which resulted from the endeavour by banks to optimise across tax, accounting and prudential standards.

But even use of contingent convertible capital instruments “with a trigger point that is safely above the point at which there is likely to be a question mark as to whether the bank remains a going concern” could cause upheaval in capital markets if they become a popular form of bank financing. Triggering capital conversions could inject further instability. The only way, it seems, to avoid this would be to break the single trigger point down into a series of small incremental steps — or to exclude these instruments from the definition of capital.

I agree that “there is no single ‘right’ approach to assessing capital adequacy.” What is needed is a combination of both a simple leverage ratio and a risk-weighted capital adequacy ratio to avoid creating incentives that may harm overall stability. This implies a more pro-active approach by regulators to assess the adequacy of risk weightings and a healthy margin of safety to protect against errors in risk assessment.

Lastly, banks are likely to resist efforts to increase capital adequacy, largely because of bonus structures based on return on capital which conflict with the long-term interest of shareholders. Higher capital ratios are likely to lead to lower cost of funding and greater stability.

I do however accept that there remains a perception in some quarters that higher capital standards are bad for lending and thus for a sustained economic recovery…… Looking at the broader picture, the post-crisis adjustment of the capital adequacy standard is a welcome and necessary correction of the excessively lax underwriting and pricing of risk which caused the build up of fragility in the banking system and led to the crisis. I do not however accept the view that raising capital standards damages lending. There are few, if any, banks that have been weakened as a result of raising capital.

Analysis by the Bank for International Settlements indicates that in the post crisis period banks with higher capital ratios have experienced higher asset and loan growth. Other work by the BIS also shows a positive relationship between bank capitalisation and lending growth, and that the impact of higher capital levels on lending may be especially significant during a stress period. IMF analysis indicates that banks with stronger core capital are less likely to reduce certain types of lending when impacted by an adverse funding shock. And our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements. These banks are less likely to cut lending aggressively in response to a shock. These empirical results are intuitive and accord with our supervisory experience, namely that a weakly capitalised bank is not in a position to expand its lending. Higher quality capital and larger capital buffers are critical to bank resilience – delivering a more stable system both through lower sensitivity of lending behaviour to shocks and reducing the probability of failure and with it the risk of dramatic shifts in lending behaviour.

Read more at Andrew Bailey: The capital adequacy of banks – today’s issues and what we have learned from the past | BIS.