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Calibrating Capital

Banks say regulators demand too much capital. Critics say that banks have too little. Some contend that banks have about enough, thanks to regulatory reform. Who’s right?

By Dr. Thomas F. Huertas

The Clearing House(Note: The author is a partner in the Financial Services Risk Practice at Ernst & Young and chairs the firm’s Global Regulatory Network. The paper represents the author’s personal views, and he is responsible for any errors. A full version of the paper, including footnotes and references, is available here). 

Capital is controversial. Banks complain that regulators demand too much. Critics complain that banks have too little. A few lone voices contend that banks have just about enough, thanks to the regulatory reform measures taken over the past decade in the wake of the financial crisis. Who’s right? 

To determine the answer, we need a standard against which to measure the responses. Although all agree that capital reduces the risk that a bank will fail and the possibility that this will result in a loss to depositors and trigger a banking crisis, there is no explicit agreement on the level of risk that a bank should be allowed to assume or on the minimum credit rating that deposits should have.

That used to not matter. In a world of deposit insurance and “too big to fail,” there was an implicit agreement that the rating for bank liabilities, especially bank deposits, was effectively linked to the sovereign rating of the government in the bank’s home country. In this situation, capital requirements could be understood as being akin to the type of covenants that a creditor or guarantor would impose upon a borrower.

Resolution reform puts investors and uninsured depositors at risk if a bank reaches the point of nonviability. The loss if a bank fails can no longer be assumed to be zero.

Today, this rationale no longer holds. Resolution reform puts investors and uninsured depositors at risk if a bank reaches the point of nonviability. The loss if a bank fails can no longer be assumed to be zero. More specifically, the risk of a particular bank liability (such as senior non-preferred debt) is the product of two factors:

  • The probability that the bank will reach the point of nonviability; and
  • The loss the liability holder will suffer, if the bank were to reach such a point.

The former depends primarily on the risk the bank assumes. The latter depends not only on the liability’s position within the creditor hierarchy but also on when and how the authorities initiate and execute resolution. That significantly affects loss if there is a failure.

Hence, we need to view capital requirements from a different perspective, one that takes into account the probability that depositors would suffer a loss of principal and the possibility that access to that principal might be suspended.

This paper argues that current regulation minimizes the first possibility. If authorities initiate resolution in a timely manner, requirements that banks maintain a minimum total loss absorbing capacity (TLAC) – together with depositor preference – make deposits practically immune from loss of principal. However, this will not make deposits also exempt from suspension.

To avoid suspension, resolution reform needs completion. Two areas are vital: valuation, so that the authorities avoid forbearance and intervene promptly, and liquidity, so that the recapitalized bank in resolution can meet demands for withdrawal when it reopens for business. Together, these steps can make deposits not only immune from loss but also exempt from suspension. If deposits meet that standard, the bank surely has enough capital.

How safe should deposits be?
The distinguishing feature of deposits, particularly demand deposits or current accounts, is that they enable the holder to transact – to buy and sell goods, services, and assets. Without deposits, customers would find it difficult to receive their wages or pay their bills. Therefore, deposits perform a critical economic function. To this end, deposits should be a store of value. They should be continuously convertible into cash or central bank money at par. Deposits should also function as a medium of exchange. They should be continuously available for use. This suggests that deposits should not only be immune from loss but also exempt from suspension in the event a bank fails.

The Pre-Crisis Regime
Before the crisis, deposits came close to that standard, at least in jurisdictions where the government’s finances were strong enough (and the political opposition to bailouts weak enough) to enable it to provide support. In such jurisdictions, strong governments stood behind weak banks. As far as creditors were concerned, big banks were akin to government agencies. Big banks were considered “too big to fail” and therefore enjoyed an implicit government guarantee. The presence of such an implicit guarantee created moral hazard. By granting the guarantee, governments gave banks the incentive to maximize return by taking on more risk. If things turned out well, all the reward would accrue to shareholders. If things turned out very badly, taxpayers would absorb any losses in excess of the limited amount invested by shareholders.

Thus, the risk to a creditor holding a bank liability such as an uninsured deposit or senior debt depended on two factors:

  • The probability that the bank would reach the point of nonviability (PONV); and
  • If it did, the probability that the authorities would support either the bank itself or the liability in question.

Indeed, rating agencies analyzed the two factors separately. They first assigned banks a stand-alone rating based on their assessment of the bank’s business model, income forecast, and balance sheet. The rating agencies then estimated the probability that the bank in question would receive government support if the bank were to reach the PONV. This estimate was then translated into an uplift to the stand-alone rating to arrive at the bank’s overall rating (see Figure 1).

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In such an environment, capital regulation limits risk to the guarantor. It ensures that the owners of the bank have a minimum amount of their own funds at risk that they can and will lose if the bank fails. To ensure that the bank actually holds the capital it is supposed to maintain, banks must meet frequent reporting requirements and are subject to ongoing prudential supervision.

The crisis exposed the flaws in this regime. Although banks met or exceeded minimum regulatory requirements, they did not have enough capital to absorb the losses that occurred in 2007 and 2008. Although markets and banks seemed awash in liquidity in early 2007, liquidity evaporated during the second half of that year and into 2008, culminating in a complete stop following the bankruptcy of Lehman Brothers in September 2008.

Together, more rigorous regulation and stricter supervision greatly reduce the probability that a bank will reach the point of nonviability.

Faced with the utter collapse in the banking system and the economic havoc that such a collapse would have caused, governments around the world elected to support troubled institutions, particularly banks, and to provide liquidity to markets generally. Together with massive fiscal stimulus and significant reductions in interest rates, this support for the financial system prevented the implosion of the global economy. As a result, economists now characterize 2008–2009 as the Great Recession, not the Great(er) Depression.

Response to the Great Recession
In response to the crisis, G20 leaders mandated regulators devise and implement measures to do the following:

  • Reduce the risk that banks, particularly systemically important banks, would fail; and
  • If such an institution were nonetheless to fail, reduce the impact that such a failure would have on the government’s finances, financial markets, and the economy at large.

Basel III Reduces Likelihood of Bank Failure
Reforms to capital regulation were at the heart of the first endeavor. Under the Basel III accord, policymakers adopted stricter definitions of what would qualify as capital, raised risk-weighted capital requirements substantially (see Figure 2), and introduced a leverage ratio as a backstop to the risk-weighted regime. In conjunction with resolution reform (see below), regulators set standards for TLAC and required that a minimum amount of this be held in the form of “gone-concern” capital (Additional Tier 1 and Tier 2 capital plus qualifying senior nonpreferred debt).

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Supervisors strengthened the capital regime further via the introduction of stress tests. These introduce a forward-looking dimension into capital requirements. The tests enable the supervisor to determine whether banks will be able to continue to comply with regulatory capital requirements, even if macroeconomic and market conditions deteriorate markedly. If the bank is unlikely to be able to do so, the supervisor will require the bank to submit a remediation plan and may require the bank cease paying dividends or making distributions to shareholders. For extreme shortfalls, the supervisor may require the bank to raise more capital immediately. Together, more rigorous regulation and stricter supervision greatly reduce the probability that a bank will reach the point of nonviability.

Resolution reform attempts to reduce the impact of bank failure. But such reforms cannot make banks fail-safe. There remains the possibility that the bank could deplete its equity capital and lose access to market funding (i.e., reach the PONV). Hence, banks had to be made “safe to fail,” so that a bank could fail without cost to taxpayers and without significant disruption to financial markets or the economy at large.

To achieve these ends, resolution reform attempts to ensure that investors, not taxpayers, bear the cost of bank failures and that, even in resolution, banks continue to perform their critical economic functions.

Resolution reform has done a much better job in achieving the first objective than the second. Reform ensures investors bear the cost of bank failures. In major jurisdictions, reform has revised or clarified the creditor hierarchy at banks to give deposits preference and to introduce one or more tranches of liabilities between deposits and common equity (see Figure 3).

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In addition, reform requires that banks fill the junior-most of those tranches with so-called gone-concern capital in an amount sufficient to recapitalize the bank if its common equity becomes exhausted. This “gone-concern capital” is subject to bail-in (write-down or conversion into common equity) if the bank reaches the point of nonviability. In this manner, investors, not taxpayers, bear the cost of bank failures.

Together, the introduction of depositor preference and the requirement that banks issue “gone-concern capital” reduces the risk that depositors will suffer a loss of principal in the event the bank reaches the PONV. The capital backing deposits is not just CET1 capital, or even TLAC as a whole, but all liabilities junior to deposits (see Figure 4). As long as the authorities initiate resolution while losses are less than the amount of TLAC outstanding, the bank’s assets should have a value in excess of its deposits, and depositors are highly likely to recover their principal in full. In other words, for deposits (and the deposit insurance fund) the loss given failure is likely to be zero.

Resolution reform aims to ensure continuity of critical economic functions. Although resolution reform has practically made deposits immune from loss, it has not as yet made them exempt from suspension.

This is because the traditional bankruptcy tactic of temporarily suspending payment obligations to creditors doesn’t work for banks. When a non-financial firm enters bankruptcy, it can put a stay on payment to creditors while continuing to operate the business. But for banks, issuing claims (deposits, funding commitments, derivatives, etc.) to “customer-creditors” is the very essence of banking, and precisely the critical economic function whose continuity resolution reform aims to ensure.

Putting a stay on payments to creditors effectively puts the bank out of business, interrupts its critical economic functions, and forces the bank into liquidation, augmenting losses to creditors of the bank. Moreover, the possibility that resolution would bar customers from accessing deposits, even temporarily, makes it rational for depositors to run at the first sign of trouble. That could accelerate bank failures.

Resolution reform therefore seeks a means to keep the bank in resolution in operation so that customers can continue to exercise their claims against the bank and the bank can continue to issue new deposits, derivatives, and funding commitments. To this end, resolution reform has put together a framework analogous to a special “pre-pack” bankruptcy that can be executed immediately when the bank reaches the point of nonviability.

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The resolution plan encompasses the following:

  • Immediate recapitalization of the bank via bail-in of “gone concern” capital
  • Stay on immediate termination of “qualified financial contracts”
  • Continued provision of services by affiliates and third-party providers
  • Preservation of access to financial market infrastructures
  • Access to funding liquidity upon reopening for business the next business day

In concept, these resolution plans can succeed. In practice, however, they may not. That’s because each component of the plan must work, and all must work together and within a very short time frame, if a bank is to reopen for business the business day following its entry into resolution. Although authorities and banks have made significant progress on each of the components, none is as yet perfect. Moreover, there is not yet certainty that they would all function simultaneously and seamlessly within the very tight timetable. For all these reasons, deposits cannot yet be characterized as exempt from suspension.

Completing resolution reform. To make them so, banks and the authorities need to complete resolution reform, primarily in two areas: valuation and access to liquidity.

The Importance of Valuation
Valuation is critical to implementing resolution reform. It serves as a key input into the authorities’ decision to place the bank into resolution, as well as into their determination of the resolution tool(s) to use. In the case of bail-in, valuation also factors into the authorities’ decisions regarding how far up the creditor hierarchy bail-in should go, the amount of any writedowns that should be made, the amount of any equity the liability holder should receive as a result of conversion, and the amount, if any, that a liability holder should receive under any “no creditor worse off” provision. In addition, valuation serves as an input into the central bank’s determination of whether the bank in resolution should be able to access liquidity facilities as well as into authorities’ decisions regarding restructuring.

However, current valuation practices hinder effective resolution. Banks tend to value their balance sheets infrequently with a significant interval between the balance sheet date and the date the valuation is finalized, and there may be a further interval before the results are reported to the supervisor and/or disclosed to investors and the public.

Such delays may foster regulatory forbearance (in other words, the authorities allow the bank to continue to operate, even though it fails to meet minimum requirements and may actually be insolvent). Forbearance reduces the likelihood that the bail-in of gone-concern capital will be sufficient to recapitalize the bank, once it does enter resolution. This in turn complicates restructuring and increases the risk that bail-in will have to extend to the bank’s operating liabilities, possibly even to deposits.

Together with prompt intervention, access to liquidity should go a very long way to ensuring that the bank in resolution can continue to perform its critical economic functions.

In contrast, if the authorities intervene (as they should) no later than the point at which the bank breaches its minimum capital requirement, the failing bank is likely to enter resolution while it still has positive net worth. That enhances the prospect that the writedown or conversion of the bank’s gone concern capital will be sufficient to recapitalize the bank so that it may be restructured as a going concern. Prompt intervention also significantly reduces the risk that the bank’s operating liabilities will be exposed to loss. Finally, prompt intervention also facilitates restructuring.

The key to prompt intervention is prompt valuation. Accuracy is important, but so is speed. Taking an extra few weeks to ensure that the capital ratio is accurate down to the last basis point is pointless. What matters is prompt valuation – knowing immediately and frequently the bank’s capital ratio down to the last percentage point. That is far more likely to be “fit for purpose” – namely, to help the authorities decide to intervene promptly.

Improvements in data management and analytics potentially bring such “fit for purpose” valuation within reach. They make it possible to value the balance sheet much more frequently. Indeed, banks are required to do so on a daily basis for assets in the trading book, and banks have a greater capacity to do so for key elements in the banking book, especially loans, thanks in part to the efforts they have already made to comply with data management and modeling requirements overall as well as with respect to stress testing, liquidity reporting, and the introduction of provisioning on the basis of expected loss.

Access to Liquidity
If the bank in resolution is to maintain continuity in its critical economic functions, it will need access to liquidity. The acid test is likely to occur as soon as the bank reopens. At that point, any creditor with a claim that is due and payable can and probably will seek to get its money back. The bank in resolution must meet these claims. If it does not, the authorities’ resolution plan will fail, and the authorities will again face the choice between these options:

  • Putting the bank into liquidation. This action will interrupt critical economic functions, disrupt financial markets, and harm the economy at large.
  • Bailing out the bank. This action will avert immediate disruption, but distort competition, foster excessive risk taking and undermine the government’s finances.

If the authorities want to avoid having to make such a choice, their resolution plan will have to determine how the bank in resolution can meet the demands on its liquidity at its branches and affiliates around the world as soon as it reopens for business.

In making this determination, the bank itself can only go so far. The bank can and should provide the information on which the resolution authority can base its plan, but it is the resolution authority, not the bank, that has to develop and implement the plan.

To do so, the resolution authority will have to know whether the bank in resolution, once recapitalized, will have access to ordinary central bank liquidity facilities. Central banks have refrained from making an explicit statement on this, on the theory that such ambiguity is constructive.

It is not. If the central bank creates the impression that it may refuse to grant the recapitalized bank access to ordinary central bank facilities, this would undermine practically any resolution plan that the resolution authority might devise. If the central bank has no confidence in the authorities’ resolution plan, why should market participants? The time and place for ambiguity is prior to resolution with respect to the decision as to whether or not the bank should receive emergency liquidity or be placed into resolution. Once in resolution, it is certainty that is constructive, not ambiguity.

In sum, to the extent that the bank in resolution has assets eligible to serve as collateral for normal central bank liquidity facilities, the bank in resolution should have the right to obtain and the central bank the obligation to provide the bank in resolution access to such liquidity facilities, once it has been recapitalized. Together with prompt intervention (on the basis of prompt valuation), access to liquidity should go a very long way to ensuring that the bank in resolution can continue to perform its critical economic functions.

Conclusion
In sum, existing capital requirements – if monitored frequently and enforced promptly – should be adequate to make deposits immune from loss. But they cannot make deposits exempt from suspension. That requires the completion of resolution reform. Two areas stand out: ensuring that the authorities intervene promptly and ensuring that the bank in resolution – once recapitalized via bail-in – has access to adequate liquidity. Prompt valuation supports both of these objectives.

Here, banks can make significant further progress. But banks can only go so far on their own. The authorities own the resolution plan, not the bank. The authorities should pull the trigger on resolution as soon as the bank reaches the point of nonviability, and the authorities should make clear that the recapitalized bank in resolution will have access to ordinary central bank liquidity facilities. Taken together, these measures would go a very long way to enable the bank in resolution to continue to perform critical economic functions, including the most critical of all: the deposit function. That would ensure deposits are not only immune from loss but also exempt from suspension in the event a bank fails. Provided the authorities act to implement their own resolution plans correctly, current regulation ensures that banks have enough capital.