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How much capital?

Almost a decade after the global financial crisis, most regulators and commentators would agree that the banking industry is far more strongly capitalized than it was in the run-up to the crisis. Looking forward, there is less consensus as to how much capital banks should hold. Neel Kashkari, head of the Minneapolis Federal Reserve, attracted attention recently by calling for huge increases in minimum capital requirements for banks. At the other extreme, the election victory of Donald Trump has raised hopes on Wall Street of a significant relaxation of financial regulation.

A bank’s capital is the difference between the value of its assets and its liabilities. Capital acts as a buffer, enabling banks to absorb unforeseen losses in the value of their assets. Examples of unforeseen losses include a borrower defaulting on a loan, or a sudden decline in the value of an investment. The more capital a bank holds relative to its assets, the lower the risk of the bank becoming insolvent because its assets have dipped in value below its liabilities. However, the need to maintain a target ratio of capital to assets constrains the bank’s ability to write new profit-earning business, through additional lending or investment. A bank’s senior management team faces a conflict between profitability and minimizing the risk of becoming insolvent.

Over the past 30 years regulators have cooperated to develop a set of rules to ensure that banks hold sufficient capital, under the auspices of the Basel Committee at the Bank of International Settlements in Basel, Switzerland. Capital regulation for banks was introduced in 1988 under the Basel I Accord, which required internationally-active banks to maintain a capital ratio of at least 8% of assets adjusted for risk. Basel I was easy to understand and transparent, but focused solely on credit risk: the risk associated with borrowers defaulting on loan repayments. Several other sources of risk to the solvency of banks were completely ignored.

The assessment of risk was extended by Basel II, launched in 2006, to include market risk: the risk of losses on bank’s investments in securities and other assets; and operational risk: the risk of losses arising from failure on the part of a bank’s staff (‘rogue trader’ syndrome) or internal processes and systems. The focus was on capital as a proportion of risk-weighted assets, where different classes of asset used in the denominator of the capital-to-assets ratio would be weighted in accordance with the risk they carried. Basel II was overtaken by the global financial crisis and was never fully implemented. In response to the crisis Basel III introduced further modifications, including new capital and liquidity standards to be phased in between 2013 and 2019. Definitions of capital have been overhauled, to strengthen the banks’ loss-absorbing capacities. Banks and other financial institutions deemed to be ‘systemically important’ are required to hold additional capital.

Pound by stux. Public Domain via Pixabay.
Pound coins currency by stux. Public Domain via Pixabay.

During the phase-in period of Basel III, all major banks have significantly increased their risk-weighted capital-to-assets ratios. However, regulators worry that the current framework allows banks too much discretion in measuring the riskiness of their own assets. A number of proposals for change have emerged, dubbed unofficially by some commentators as ‘Basel IV’. These proposals suggest revisions to the measurement and management of risk, and restrictions on the use of banks’ internal models to quantify risk. For example, internal models might be required to adopt minimum default probabilities for loans. Standardized risk-weightings might be applied to assets in a given category, such as mortgages, regardless of local market conditions.

European and Japanese banks, among the heaviest users of internal models for risk assessment, have been among the most vocal in lobbying against these proposals. It has been argued that, perversely, by increasing the risk weightings attached to lower-risk assets such as mortgages, and thereby reducing the sensitivity of capital requirements to risk, the proposals may encourage banks to shift towards riskier lending in search of higher returns.

If implemented, the impact of the proposals may differ widely between banks in different countries. In the US mortgage defaults are common, but many residential mortgages are sold by the banks to the government-sponsored enterprises Fannie Mae and Freddie Mac. This suggests US banks would not be greatly affected by the proposed changes to risk weightings. In any case, US banks argue that they were faster on their feet than others in putting their house in order after the global financial crisis, by recapitalizing, reducing lending, and eliminating non-performing loans from their books.

In many European countries, by contrast, residential mortgage defaults are rare, and the adoption of standardized risk weightings in the calculation of risk-weighted assets may increase significantly the amounts of capital some European banks would need to hold. The prospect is alarming for several banks, such as RBS, already struggling to pass stress tests conducted by national or international supervisors to demonstrate their resilience in the face of hypothetical unforeseen losses. Negotiations around the proposals have been tough and seem likely to continue throughout the year, missing a self-imposed target of the Basel Committee on Banking Supervision to sign off on the new standards by the end of 2016.

Featured image credit: rainbow of credit by frankleleon. CC-BY-2.0 via Flickr.

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