Sifting through the alphabet soup of bank capital requirements

Less is more, as any good designer knows. With regard to the Banking Capital Master Plan, the main supervisor of UK lenders suggested back to the drawing board. It’s a seductive concept: complexity can incur costs, inhibit scrutiny, and make the system easier to play. Sam Woods, Deputy Governor of the Bank of England, instead wants simplified but higher capital requirements for big banks around the world. His ideas are kites rather than formal proposals. Or as he put it, like a concept car designed to spark conversation rather than be roadworthy. Still, they are worth looking into.

A plethora of security measures were introduced by governments around the world following the financial crisis 14 years ago. In addition to the minimum capital requirements that banks must comply with, a series of buffers have been added by the Basel Committee to allow banks to absorb losses and continue to lend in times of crisis. The idea was to protect the economy from the banks and the banks from the economy, thereby reducing the likelihood of future taxpayer bailouts. Each cushion has been designed to target a particular risk. But some supervisors are now concerned that the different buffers don’t fit together well, and sometimes even conflict.

Woods suggests replacing the alphabet soup of buffers – with abbreviations like CCyB, CCoB and Sifi – with a single, more brutal one. Basically, it would require banks to build this with purer equity and cash capital rather than currently permitted hybrid instruments. He also wants to keep the current mix of asset weightings based on their degree of risk, as well as the leverage ratio that measures equity to total assets.

There should be no move to reduce the overall amount of bank capital; some argue that it is not high enough. But consolidating tampons, which could amplify their positive effects once released, is an idea with some merit.

The caveat is that his vision, if it is to work safely, would require intense regulatory scrutiny and intervention; probably much more than today. The BoE traditionally favors simplicity coupled with discretion – the famous governor’s raised eyebrow – but the system is only as good as its supervisors. Woods acknowledges that his view is that the intensity of balance sheet stress testing would likely increase. This is already a time-consuming exercise which, in the UK, is done once a year (and which all lenders have adopted recently).

Woods’ plan has some shortcomings. The first is that the proposed buffer release, to help maintain lending in times of crisis, would leave only a “low level” of minimum capital. But what if a second stress occurs immediately after a first: a war, for example, right after a pandemic? Another flaw is that it is market forces rather than regulatory pressure that banks feel most intensely. This will not be easily solved by favoring a brutalist capital stack over a baroque one. Banks fear the stigma of running out of buffers because of what it could signal to the wider market. No bank wants to raise a red flag.

There are no easy solutions. One possible remedy is to better strengthen resolution regimes. Since the crisis, efforts have been made to establish how to safely resolve or let the big banks fail. They must have “participating” capital alongside going concern reserves. This aims to put creditors on their backs by “bailing out” the debt rather than calling for a government bailout. But the appetite for bail-in, which could bring its own economic maelstrom, has not been tested.

Simplification ideas are welcome. But with strong economic headwinds blowing, now is not the time for this kind of reform. Which means banks and their supervisors will continue to stir their alphabet soup for quite some time.

Comments are closed.