Summary:
The FT reports that due to “modest but rising credit growth”, the Bank of England’s Financial Policy Committee (FPC) considered raising banks’ countercyclical capital buffer. According to the FT's Caroline Bingham:
This measure requires lenders to build up capital in good times to draw down in more challenging times.
And she goes on to say this:
The prospect of yet more capital that banks must set aside would come on top of capital rules on a European and global basis that lenders must implement. They complain that these ever-increasing buffers weigh on their profits and therefore lending ability.
No, Caroline, no. Banks do not "build up" or “set aside” capital. Capital is an integral part of the balance sheet structure. As the Bank of England explains, it is a form of funding:
It can be misleading to think of capital as ‘held’ or ‘set aside’ by banks; capital is not an asset. Rather, it is a form of funding — one that can absorb losses that could otherwise threaten a bank’s solvency.
And you really shouldn't listen to the complaints of banks. They talk their books.
Like any corporation, a bank’s balance sheet is made up of assets, which are principally but not exclusively loans, and liabilities (debt), which are principally but not exclusively deposits. The equity of the bank (shareholders’ capital) is the difference between assets and liabilities.
Topics:
Frances Coppola considers the following as important:
banks,
Capital,
Financial Crisis,
financial stability,
liquidity,
regulators
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The FT
reports that due to “modest but rising credit growth”, the Bank of England’s Financial Policy Committee (FPC) considered raising banks’ countercyclical capital buffer. According to the FT's Caroline Bingham:
This measure requires lenders to build up capital in good times to draw down in more challenging times.
And she goes on to say this:
The prospect of yet more capital that banks must set aside would come on top of capital rules on a European and global basis that lenders must implement. They complain that these ever-increasing buffers weigh on their profits and therefore lending ability.
No, Caroline, no. Banks do not "build up" or “set aside” capital. Capital is an integral part of the balance sheet structure. As the Bank of England
explains, it is a form of funding:
It can be misleading to think of capital as ‘held’ or ‘set aside’ by banks; capital is not an asset. Rather, it is a form of funding — one that can absorb losses that could otherwise threaten a bank’s solvency.
And you really shouldn't listen to the complaints of banks. They talk their books.
Like any corporation, a bank’s balance sheet is made up of assets, which are principally but not exclusively loans, and liabilities (debt), which are principally but not exclusively deposits. The equity of the bank (shareholders’ capital) is the difference between assets and liabilities. The bank is solvent if total liabilities are less than total assets. It is insolvent if total liabilities exceed total assets. This can happen if asset values collapse rapidly, as they did in the 2008 financial crisis. Note that a bank run, in which deposits rapidly leave the bank, does not by itself cause insolvency. It is the associated asset value collapse as the bank is forced to sell assets at fire sale prices to raise cash to fund the run that causes insolvency. I’ve explained this previously – see links at the foot of the post.
What we call “capital” for banks is actually various forms of equity and near-equity. It comes in two flavours: Tier1 capital, which is shareholders' funds, and Tier2 capital, which is debt that can be converted to equity (so-called “convergent contingent” bonds (Co-Cos) and other forms of subordinated debt) and various forms of capital reserve.
Tier1 capital is split into two parts. The largest portion is "Common Equity Tier1", which as the name suggests is entirely equity. The smaller portion, "Additional Tier1", may include perpetual preferred stock.
In the event of the bank suffering losses due to bad loans, it is Tier1 capital that is wiped out first. Shareholders of the bank always lose their money before anyone else. If the bank’s losses are so severe that Tier1 capital is entirely wiped, Tier2 capital is next in line.
Tier1 and Tier2 capital therefore protect creditors from losses. A bank’s creditors are unsecured bondholders, unsecured depositors, insured depositors, secured bondholders (including repo funding from other banks) and the central bank. In the event of a major bank failure, they are wiped in that order.
Clearly, the greater the proportion of capital to debt that a bank has – or, if you like, the greater the “gap” between assets and liabilities - the more losses it can absorb before creditors are affected.
Capital and leverage ratios define the minimum size of the gap between assets and liabilities that is consistent with providing reasonable protection to creditors against losses. They do so in slightly different ways: the capital ratio (capital/risk weighted assets) uses a view of the asset side of the balance sheet that takes into account the risk of each asset, while the leverage ratio (capital/total assets) ignores risk.
But why not protect creditors completely? Why not force banks to keep the gap between assets and liabilities sufficiently wide to absorb all potential losses from risky lending?
Some people argue that banks should do exactly this. Advocates of “full reserve banking”, in its strictest form, want bank lending to be funded only from banks’ own capital, not from deposits. Their view is that deposits should not be placed at risk. So they want banks to match their stocks of deposits with equally large stocks of risk-free assets – cash “reserves” or government bonds.
Cash reserves are not capital. They are cash deposits at the central bank which are maintained by banks to enable depositors to withdraw funds. Since, generally speaking, depositors don’t all withdraw their funds at the same time, the amount of ready cash that banks keep on deposit at the central bank is usually well under 100% of customer deposit value. In the USA banks are required to keep reserves equivalent to 10% of eligible customer deposits - this is the "reserve requirement ratio" (RRR) . But in Canada and Denmark, the RRR is zero, and banks borrow reserves as needed to settle deposit withdrawal. In the UK, prior to the advent of QE, the required reserve ratio (RRR) was tailored for each bank individually: however, since QE forces banks to maintain much larger cash deposits at the central bank than they need, the UK’s RRR is currently also zero.
Gold and government bonds are not capital either. They are safe liquid assets. They can be sold quickly and easily to meet depositor demands for withdrawals, reducing the likelihood of the bank needing to borrow emergency funds either from markets or from the central bank.
The “Liquidity Coverage Ratio” defines the proportion of safe liquid assets that banks must hold (in this case “hold” is the correct terminology, whereas it is incorrect for capital) to cover short-term outflows. This is how the Basel Committee
explains it:
The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
So, to summarise: capital requirements influence the overall structure of the balance sheet, and in particular the gap between assets and liabilities, while liquidity requirements influence the structure of the asset side only.
Now, about that countercyclical capital buffer (CCB). The CCB and the RRR serve similar purposes, but on opposite sides of the balance sheet: the RRR affects the asset side of the balance sheet, while the CCB affects the liability side.
Raising the RRR forces banks to hold more of their assets in the form of reserves, reducing their lending capacity. It does NOT mean they have less money to “lend out”. Banks create deposits when they lend: every time a bank lends, therefore, the RRR forces it to increase cash reserves at the central bank by a percentage of the value of the newly created deposit. Clearly, the higher the RRR, the greater the proportion of the balance sheet that is made up of reserves, and the less room there is for other loans. This is how raising reserve requirements discourages bank lending. China makes extensive use of the RRR to control bank lending.
If the RRR were raised to 100%, banks would have to obtain new reserves from the central bank in advance of lending to ensure that the new deposit was immediately matched 100% by reserves: the new loan asset would be matched by capital or by forms of debt not subject to the RRR. This is “full reserve lending”. Strict "full reserve lending" or "narrow banking" should therefore perhaps be called "full capital lending".
Historically, central banks have tended to use the RRR to lean against banks’ tendency to over-lend in good times. But since banks’ balance sheets are currently stuffed with excess reserves, the CCB is now a more effective measure.
The CCB is
not a “reserve” built up in good times that can be “drawn down in more challenging times”. It is an additional capital requirement that regulators can add to or deduct from the basic Common Equity Tier1 capital requirement, depending on the state of the economy and the behaviour of banks. The
European Commission explains it thus:
As the name indicates, the purpose of this buffer is to counteract the effects of the economic cycle on banks’ lending activity, thus making the supply of credit less volatile and possibly even reduce the probability of credit bubbles or crunches. It works as follows: in good times, i.e. where an economy is booming and credit growth is strong, it requires a bank to have an additional amount of CET1 capital. This prevents that credit becomes too cheap (there is a cost to the capital that a bank must have) and that banks lend too much.
When the economic cycle turns, and economic activity slows down or even contracts, this buffer can be “released” (i.e. the bank is no longer required to have the additional capital). This allows the bank to keep lending to the real economy or at least reduce its lending by less than would otherwise be the case.
So the purpose of the CCB is to dampen credit booms and busts.
Bank lending amplifies the natural business cycle, and as we have seen in recent years, can cause disastrous credit crunches and major crashes. Banks enthusiastically lend more and take more risk when times are good, then cut back hard when there is a downturn. As lending increases, the total size of the balance sheet increases but the proportion of equity to total assets (leverage) diminishes. And as banks “risk up”, the proportion of equity to risk-weighted assets (capital ratio) also diminishes. Conversely, when banks cut back, capital ratios rise precipitously. The CCB therefore “leans against” the tendency of capital and leverage ratios to reduce in good times and rise in bad times.
More importantly, the CCB influences lending activity. Banks profit from the spread between the return on their assets and their cost of funds. Equity funding is more expensive than debt, not least because of preferential tax treatment of debt. Increasing the CCB therefore raises banks’ funding cost, forcing them to raise rates to borrowers and/or tighten credit standards. Conversely, the CCB can be reduced in a downturn, lowering banks’ funding cost and therefore encouraging them to reduce interest rates and relax credit standards.
This, of course, explains why banks complain about the CCB. After all, raising their cost of funding by forcing them to use equity instead of debt hurts their profits, poor darlings, and makes them less willing to lend. That, Caroline, is its purpose.
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