Capital Adequacy for Banks: Why the New Standard Falls Short

November 19, 2015 11:45 AM

Can systemically important banks now fail without placing the rest of the financial system or public funds at risk? Has "too-big-to-fail" been dealt with? "Yes" was the courageous judgment of the Financial Stability Board (FSB) when it unveiled its new capital adequacy regime on November 9 for the 30 banks identified as global systemically important banks (G-SIBs). But both history and scrutiny would advise greater caution on the part of the FSB, especially as their new capital adequacy regime is built on the flawed foundations of the last.

Under the new regime, G-SIBs, seven of which are headquartered in the United States, would be required to hold total loss absorbing capital (TLAC) of no less than 16 percent of their risk-weighted assets by January 1, 2019, and 18 percent by 2022. TLAC is a new categorization of regulatory capital, and so the level is not easily comparable to previous regulatory ratios. It includes equity, retained earnings, and instruments that can be written down or converted into equity, such as "bail-in securities." These globally systemic banks would require an additional estimated $1.2 trillion of TLAC from where they are today.

The idea that the amount of bank capital, be it TLAC or otherwise, should be sensitive to the amount of risky assets a bank holds sounds sensible but suffers from the post hoc ergo propter hoc fallacy. Banks don't topple over from doing things they know are risky but from doing things they were convinced were safe before they turned risky. Against loans they think are risky, banks demand extra guarantees, collateral, interest, and repayment reserves. Against their reported risk-weighted assets, they were never as well capitalized as just before the crisis that brought them down. Under the risk-sensitive approach, they had and will have the least capital against those assets they thought were safe, just before they turn bad. It is not the things you know are dangerous that kill you.

Previously considered safe assets turning bad—like AAA-rated structured products, euro-denominated sovereign debt, or residential mortgages—is what causes the financial crises that bring down the big banks and forces taxpayers to bail them out. It is the critical problem that regulators should be trying to solve. One partial solution is to set a leverage ratio—an amount of capital that is no less than some percentage of all of the bank's assets, however risky or safe they are. The FSB's proposed 6.75 percent leverage ratio is a very small step in the right direction given that 6 percent is already the leverage ratio of the deposit-insured subsidiaries of large bank holding companies in the United States.

On top of this old problem, regulators have created a new one by putting too much faith in market instruments. Regulators have a history of being mesmerized by new financial instruments. At the turn of the century, they were warned that Basel II's encouragement of the use of securitized credit instruments, market-sensitive risk models, public datasets, and public ratings would not diversify risks but concentrate them. This time around they are putting their faith in the "bail-in security": debt instruments that automatically convert into ordinary shares if the issuer breaches its regulatory requirements. Bail-in securities will likely make up most of the new capital that the G-SIBs will raise, as bankers consider it cheaper to issue than equity.

However, in the circumstances of where bank assets turn bad, bail-in securities will make matters worse. To see this, it is useful to ask who will buy the new bail-in securities. The risk that some event occurs that forces the bail in of these securities is greater the longer they are held. Consequently, they are not appropriate for buy-and-hold investors like life insurers and pension funds who are looking for long-term assets to match their long-term liabilities. Banks will not be allowed to buy them, as doing so would create systemic risk if they got bailed in when their counterparties got into trouble. Bail-in securities have been and will be purchased by credit hedge funds or similar institutions.

The demands of liquidity and leverage mean that these institutions have a short-term horizon and no capacity to end up holding bank equity. They will buy bail-ins when they are considered safe, and each will plan to exit before anyone else. In the booms when risk is unseen, they will buy more bail-in securities, which will lead to more bank lending—the opposite of what is required. In the good times investors will use them as safe assets that could act as collateral for other activities—which will add to their systemic quality. When the veil of the boom slips, these investors will head for the door at the same time. The spike in bail-in yields will be viewed as the market's best guess of the likelihood of bank failures, and so the markets that the banks dominate will freeze and bank liquidity will disappear, just as in the winter of 2008−09. In such an environment only 100 percent of capital or liquidity would save a bank, and taxpayers will be dragged in once more.

See Policy Brief 14-23: Why Bail-in Securities Are Fool's Gold, by Avinash D. Persaud.