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DSF Policy Paper Series
Regulatory Capital:
Why Is It Different?
Dirk Schoenmaker
December 2014
DSF Policy Paper, No. 47
Regulatory Capital: Why Is It Different? 1
Dirk Schoenmaker*
Abstract
The global financial crisis has highlighted that deviations between the accounting and regulatory
concepts of equity capital have gone too far. Accounting standards have been overshooting in
the application of fair value accounting. If there are no markets during times of crises, it does
not make sense to mark-to-market. These exceptions have now been included in the
accounting standards. At the same time, regulatory capital has gone astray by allowing debt
elements, such as subordinated debt, to be incorporated, which did not absorb losses during
the crisis. The new Basel III capital framework is rightfully reinforcing the central role of equity
capital.
While the special liquidity function of banks may justify lower levels op capital than those of
industrial firms, the social cost of bank failures (externalities) requires higher levels than the
extremely low levels of bank capital before the crisis. The level of regulatory capital has been
increased, with a systemic surcharge for the large banks, to reduce the too-big-to-fail (TBTF)
subsidy for these banks.
* Duisenberg school of finance
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This paper was presented at the Information for Better Markets Conference “Capital: reporting, regulating and
resource allocation” of the Institute of Chartered Accountants in England and Wales, 16 December 2014. The author
would like to thank Elena Carletti, Christiaan van Laecke, Paul Sharma and Arnoud Vossen for useful comments. Views
in this paper are those of the author.
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1. Introduction
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The main purpose of equity capital is to provide a first line of defence against bankruptcy. The equity
capital buffer has the capacity to absorb losses. In European industry, the average capital ratio
(defined as equity capital divided by total assets) is about 70 per cent, and typically well above 50 per
cent (Damodaran, 2014). As there is no capital regulation for industries, we are using here accounting
definitions of capital.
Moving to the financial sector, the unweighted capital ratio is well below 10 per cent in banking and
insurance. Some banks had capital ratios as low as 2 per cent before the global financial crisis struck
in 2007/8. With such little loss absorbing capacity of the banking industry itself, the costs of bank
bailouts has been squarely put on the taxpayers. Governments and supervisors have taken, and still
are taking, action to change this game.
To an outsider, it may be surprising that the regulated financial sector has far lower levels of capital
than the unregulated industrial sector. A first explanation is that finance, in particular banking with its
liquidity providing services (in the form of deposits), is special. Nevertheless, there are strong
arguments why the regulated capital levels should be beyond the levels that banks would keep
themselves. The social costs of bank failures are higher than the private costs, due to externalities
(also labelled systemic risk). The paper sets out the arguments for the regulation of capital in the
banking sector. After the global financial crisis, there are calls for substantially higher levels of
regulatory capital. The full range is from 3 per cent (the minimum leverage ratio of the new Basel III
capital adequacy framework) up to 20 per cent (e.g. Admati and Hellwig, 2013; Miles et al., 2013).
The regulatory capital debate has progressively shifted toward the large banks. The global financial
crisis brought into sharp focus the massive costs associated with the bail out of complex global
systemically important banks (G-SIBs), which were perceived as too-big-to-fail. The too-big-to-fail
doctrine has been reinforced, if anything, by governments’ handling of the financial crisis. As a result,
the most significant regulatory reform proposals have focused on the question of how to curtail the
too-big-to-fail problem. Namely, how can one reduce moral hazard and rein back expectations of
future bailouts of G-SIBs?
The outcome of this regulatory reform is higher Basel III capital requirements, with a systemic capital
surcharge for G-SIBs. In addition, these G-SIBs have to adopt so-called Living Wills. The objective is
to put in place, ex ante, conditions that would allow a wider range of options other than having the
whole bank rescued (Goodhart et al., 2013). A Living Will is a recovery and resolution plan drawn up
ex ante with the purpose of using it if a bank gets into difficulties. The G20 requires Living Wills for the
top 30 global banks (G-SIBs) and top 9 insurance companies (G-SIIs) (Claessens et al., 2010).
An interesting question is to what extent the accounting and regulatory definitions of capital are
diverging? Until the global financial crisis, the regulators, pushed by banks, had increasingly stretched
the definition of regulatory capital by including capital ‘instruments’ such as subordinated term debt
(Basel I) and even short-term subordinated debt (Basel II). As these classes of subordinated debt did
not really absorb losses during the crisis, regulators, as well as rating agencies, are now stressing the
use of Common Equity Tier 1 (CET1) capital, which consists of common shares issued (including
share premium) and retained earnings. So, we are rightly returning to straight accounting equity
capital for regulatory purposes.
The paper is organised as follows. Section 2 explains why capital requirements are needed. Financial
stability concerns are the key driver of regulatory capital requirements. Next, Section 3 introduces the
concept of regulatory capital and describes the history of capital regulation. The focus is on banking
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Another objective is to mitigate risk-taking incentives. Higher levels of equity capital reduce the put option value of equity and
thus reduce the incentive to take risks for managers, who are assumed to work on behalf of the shareholders.
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capital regulation. We also discuss the difference between the accounting and regulatory concept of
capital. Section 4 explains in detail the new Basel III capital requirements for banks. The new
concepts of bail-inable debt and cocos (contingent convertible bonds) are also discussed. Finally,
Section 5 concludes and provides some policy recommendations.
2. From private to regulatory capital
In the absence of market failures, the appropriate amount of capital can be left to private market
forces. That is what happens in most industries, as discussed in the introduction. De Haan et al.
(2012) review the reasons for regulation of financial services. The case for government intervention is
based on market failures. A market failure occurs when the private sector if left to itself (i.e. without
government intervention) would produce a sub-optimal outcome. Goodhart et al. (1998) identify three
main reasons for government intervention in the financial sector:
1. Asymmetric information: customers are less informed than financial institutions. Financial
supervision aims to protect customers against this information asymmetry.
2. Externalities: the failure of a financial institution may affect the stability of the financial
system. Systemic supervision aims to foster financial stability and to contain the effects of
systemic failure.
3. Market power: financial institutions or financial infrastructures, such as payment systems,
may exert undue market power. Competition policy aims to protect consumers against
monopolistic exploitation. This is beyond the scope of this paper.
Asymmetric information arises in two cases. First, customers are generally unable to properly assess
the safety and soundness of a financial institution, because that requires extensive effort and
technical knowledge (Dewatripont and Tirole, 1994). Establishing some sort of oversight may be
needed, as financial institutions have an incentive to take too much risk. This is because high-risk
investments generally bring in more revenues that accrue to the institution, while in case of failure a
substantial part of the losses will be borne by the depositors. The information asymmetry creates
problems of adverse selection (a riskier financial institution may make a more attractive offer to
potential customers) as well as moral hazard (a financial institution may increase its risk after it has
collected funds from customers). Prudential supervision aims to protect customers by ensuring the
soundness of financial institutions. Capital adequacy regulations, the topic of this paper, form a key
element of prudential supervision. In the new twin peaks regulatory structure, the Prudential
Regulation Authority (PRA) at the Bank of England is responsible for prudential supervision in the
United Kingdom (UK) (Huang and Schoenmaker, 2014).
Second, customers may not be in a position to assess properly the behaviour of a financial institution.
This problem is common in professional services (Goodhart et al., 1998). In most cases, privatesector mechanisms are used to mitigate this principal-agent problem. A disciplinary body of a privately
run medical association can, for example, expel a member when it finds that this member has
(repeatedly) failed to meet the minimum standards of the medical profession. Why, then, is
government supervision of financial services needed? An important explanation draws on the
fiduciary nature of financial services. A customer hands over his money today, while the service is
rendered in the (sometimes far) future. For example, only after retirement does it become clear
whether the advised pension savings scheme is appropriate to meet the financial needs of the
retirees. Moreover, the amount of money at risk is typically larger in financial services than in other
professional services. Conduct-of-business supervision focuses on how financial institutions conduct
business with their customers and how they behave in markets (see Llewellyn (1999) for an excellent
overview). The Financial Conduct Authority (FCA) is responsible for conduct-of-business supervision
in the UK.
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The second market failure that may give rise to government regulation is externalities. There is a risk
that a sound financial institution may fail when another financial institution goes bankrupt (spill-over
effects). This externality is not incorporated in the decision making of the financial institution. The
social costs of the failure of a financial institution thus exceed the private costs. In particular, banks
are subject to spill-over effects as their balance sheet contains illiquid assets financed by redeemable
deposits. When rumours about the quality of a bank’s assets spread, depositors may withdraw their
deposits. The liquidity and subsequently the solvency of a bank will be threatened when it has to
liquidate its assets at fire sale prices (i.e. prices well below prices under normal market conditions).
The failure of multiple banks may lead to a banking crisis. Macroprudential supervision aims to foster
financial stability and to contain the effects of systemic failure. The task of maintaining financial
stability is usually assigned to the central bank. The Financial Policy Committee (FPC) at the Bank of
England is responsible for macroprudential supervision in the UK.
The financial cycle
Because of these externalities, the social optimal level of capital is higher than the private level.
Nevertheless, financial stability related externalities were largely neglected before the financial crisis.
The global financial crisis has revived interest in Minsky’s ‘financial-instability’ hypothesis (Minsky,
1986). In the Minsky model the events leading up to the crisis start with a ‘displacement’ -some
exogenous, outside shock to the macroeconomic system- an invention or an abrupt change of
economic policy about which investors get excited. Subsequently there are five stages to the boom
and eventual bust:
1. credit expansion, characterised by rising assets prices;
2. euphoria, characterised by overtrading;
3. distress, characterised by unexpected failures;
4. discredit, characterised by liquidation; and
5. panic, characterised by the desire for cash.
The displacement sets in a boom fuelled by credit. As a boom leads to euphoria, banks extend credit
to ever more dubious borrowers, often creating new financial instruments to do the job. Then, at the
top of the market, some smart traders start to cash in their profits. The onset of panic is usually
heralded by a dramatic event, such as a bank not being able to meet its obligations. Losses on loans
begin to mount, and the drop in the value of the loans falls relative to liabilities, driving down the
capital of financial institutions. With less capital, financial institutions cut back on their lending
(deleveraging).
Minsky’s financial-instability hypothesis highlights the pro-cyclicality of the financial system. Several
factors contribute to this pro-cyclicality. First, the role of risk assessment is important. While risk tends
to be underestimated in good times (euphoria with ‘low risk’), it is overestimated in bad times (distress
with ‘high risk’). Moreover, risk can be endogenous. For example, when financial institutions sell a
particular asset to reduce risk, the price of that asset may fall further. Second, the amount of debt
(leverage) is a key factor explaining the depth of the financial crisis. The more debt is built up in the
upswing, the more severe is the deleveraging in the downswing. This is not only an argument for
more equity financing in general, but also for more equity capital for banks (see section 4). Adrian and
Shin (2008) show that banks have contributed to the upswing prior to the crisis, by increasing their
leverage (more debt; less equity). This resulted in a declining leverage ratio, defined here as equity
divided by total assets (see Figure 3 in section 4).
Third and last, capital requirements play a role. Banks have to keep minimum capital against new
loans (see section 3). In good times, retained earnings boost capital, which enables banks to increase
lending. In bad times, capital shrinks through losses, which may hamper the granting of new credit.
Figure 1 illustrates how the financial cycle (measured by credit and house prices) can amplify the
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business cycle (measured by GDP). The amplitude of the financial cycle over the 1970-2013 period is
five times that of the business cycle in the United States (US) (Borio, 2014b). Moreover, the duration
of the financial cycle tends to be longer than that of business cycle. While similar patterns can be
found across Europe, Figure 2 represents the financial cycle in the UK. This pro-cyclical role of capital
requirements is behind the new countercyclical capital buffer in Basel III (see section 4).
Figure 1. The Financial and Business Cycles in the US
Note: The blue line traces the financial cycle measured by the combined behaviour of the component series (credit, the credit to
GDP ratio and house prices). The red line traces the GDP cycle.
Source: Updated from Borio (2014b)
Figure 2. The Financial Cycle in the UK
Note: Orange and green bars indicate peaks and troughs of the financial cycle measured by the combined behaviour of the
component series (credit, the credit to GDP ratio and house prices). The blue line traces the financial cycle measured as t he
average of the medium-term cycle.
Source: Borio (2014a)
3. Regulatory capital and accounting
Capie and Wood (2013) provide an excellent overview of bank capital in the UK. During the early-mid
nineteenth century, there were a number of banking crises. Banks responded to these crises by
holding higher levels of capital. An analysis of bank capital shows that banks adjusted their capital
ratios according to the risks
that they were taking and that they were well capitalised in comparison
with the later standards set by the Basel regulators. Capie and Wood (2013) argue that these capital
rules led banks trying to game the rules.
The concept of regulatory capital, often described as capital adequacy requirements, was only
introduced in the 1970s. The UK moved to a risk-weighted capital ratio in 1975 (Goodhart, 2011). The
aim of risk-weighted assets (RWAs) is to move from a static capital requirement to a requirement
based on the riskiness of a bank’s asset classes i. Risk weights range from 0 per cent for assets that
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are deemed the ‘safest’ to a 100 per cent for the riskiest assets. For example, EU authorities allow for
a zero risk weight being applied to EU sovereign exposures. The risk-weighted capital ratio (RWCR)
is:
(1)
The level of 8 per cent is explained below. It is clear that such a framework invites regulatory
arbitrage, but that is beyond the scope of this paper. During my spell at the Supervisory Policy
Division at the Bank of England in the 1990s, we got regular visits from parties arguing that a lower
risk weight should apply to them.
The question of capital adequacy moved into the international policy arena in the early 1980s
(Goodhart, 2011). There were concerns about the rate of growth of international lending. In particular,
Japanese banks -which had low capital levels- were competing for larger market shares. To create a
level playing, the Basel Committee on Banking Supervision introduced the Basel Capital Accord in
1988.
The basic purpose of regulatory capital is to absorb losses in order to protect other claimholders,
especially deposit holders (Dewatripont and Tirole, 1994). Regulatory capital comes in different forms
that serve different purposes. There are two types of capital:
 Going concern capital: this allows an institution to continue its activities and helps to prevent
insolvency. Tier 1 capital is considered to be the going concern capital. The purest form is
Common Equity Tier 1 (CET1) capital.
 Gone concern capital: this helps ensuring that depositors and senior creditors can be repaid if
the institution fails. This category of capital includes hybrid capital and subordinated debt. Gone
concern capital is named Tier 2 capital.
Tier 1 capital is seen as the best form of capital, with Common Equity Tier 1 (CET 1) instruments,
mainly common shares and retained earnings, being the predominant form of Tier 1 capital. Tier 2
capital is known as supplementary capital. The latter consists of undisclosed reserves, revaluation
reserves, general provisions, hybrid instruments (which combine certain characteristics of equity and
certain characteristics of debt) and subordinated debt. At the same time, there are certain deductions
from regulatory capital, such as goodwill and investments in bank and other financial subsidiaries
(Basel Committee on Banking Supervision, 1988). Equity capital consists of issued and fully paid
ordinary shares/common stock and non-cumulative perpetual preferred stock (but excluding
cumulative preferred stock), and disclosed reserves (including retained earnings). This key element of
regulatory capital is the only element common to all countries' banking systems and wholly visible in
the published accounts.
Basel I introduces subordinated term debt (as well as the hybrid instruments) in addition to core equity
capital (Basel Committee on Banking Supervision, 1988). The Basel Committee recognises that
subordinated term debt instruments have significant deficiencies as constituents of regulatory capital
in view of their fixed maturity and inability to absorb losses except in a liquidation. The Committee
puts therefore restrictions on the amount of such debt capital. Only subordinated term debt
instruments with a minimum original term to maturity of over five years may be included within the
supplementary elements of capital, up to a maximum of 50 per cent of the core equity capital. More
generally, Basel I sets the target standard ratio of capital to risk-weighted assets at 8 per cent, of
which the core equity capital was at least 4 per cent (Basel Committee on Banking Supervision, 1988)
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Basel II introduces a third tier of capital (Tier 3) in the form of short-term subordinated debt to meet a
proportion of the capital requirements for market risks (Basel Committee on Banking Supervision,
2006). While subordinated term debt has an original maturity of at least five years, this new short-term
subordinated debt needs only an original maturity of at least two years. It is subject to a lock-in
clause, which stipulates that neither interest nor principal may be paid (even at maturity) if such
payment means that the bank falls below or remains below its minimum capital requirement.
Differences between accounting and regulatory capital
Having discussed the regulatory capital concept, the accounting concept of capital refers to equity
capital. There are several differences between accounting and regulatory capital. We discuss here
two major differences. A first difference is the use of debt in regulatory capital. The tax-deductibility of
interest has spurred the push towards the increasing use of debt as regulatory capital, in an attempt
to have the best of both worlds: Telling the regulator that these ‘capital instruments’ can absorb
losses, like equity, while at the same telling the taxman that these instruments are debt, so that
interest payments can be deducted for corporate tax. Nevertheless, the crisis has led to a rethink of
the use of debt as regulatory capital. Some forms of regulatory capital did not absorb losses. Notably
subordinated debt would only absorb losses in case of insolvency, but not in the case of bailout,
which was the commonly used instrument of government support during the crisis.
In this case, the regulatory deviation from straight equity capital should be adjusted. Basel III is
reinforcing the central role of equity (CET1) in regulatory capital (see section 4).
A second difference is the use of fair value accounting for financial instruments. The accounting
profession, represented in the International Accounting Standards Board, promotes fair value
accounting. Since 2005, firms have to apply the International Financial Reporting Standards (IFRS),
which require fair value accounting for financial instruments (IAS 39 and IFRS 7). Allen and Carletti
(2008a and 2008b) have reviewed the merits of mark-to-market accounting for financial institutions.
Many argue that market prices provide the best estimate of value available and should always be
used. However, others suggest that in times of crisis market prices are not a good reflection of value
and their use can lead to serious distortions. Allen and Carletti (2008b) distinguish between the
circumstances where market prices do reflect future earning power and those where market
imperfections imply that they do not. They suggest that in financial crisis situations where liquidity is
scarce and prices are low as a result, market prices should be supplemented with both model-based
and historic cost valuations. The rest of the time and in particular when asset prices are low because
expectations of future cash flows have fallen, mark-to-market accounting should instead be used.
Similarly, the Basel Committee on Banking Supervision (2009) has drawn some accounting lessons
from the financial crisis. The Basel Committee argues that the IAS 39 standard for financial
instruments should:
(a) reflect the need for earlier recognition of loan losses to ensure robust provisions;
(b) recognise that fair value is not effective when markets became dislocated or are illiquid;
(c) permit reclassifications from the fair value to the amortised cost category; this should be
allowed in rare circumstances following the occurrence of events having clearly led to a
change in the business model; and
(d) promote a level playing field across jurisdictions.
More generally, the Basel Committee (2009) argues that fair value should not be required for items,
which are managed on an amortised cost basis in accordance with a bank’s business model. In this
case, the accounting treatment has rightly been changed. Amending IAS 39 and IFRS 7, the
International Accounting Standards Board (IASB, 2008) has permitted the reclassification of securities
out of the trading category in rare circumstances. The IASB has also permitted the reclassification to
loan category (cost basis) if intention and ability to hold for the foreseeable future (loans) or until
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maturity (debt securities). These reclassifications of some financial instruments, which were already
permitted under US GAAP, allow financial institutions to discontinue fair value accounting for these
instruments.
4. Basel III capital framework
The global financial crisis did painfully show that large parts of the regulatory capital could not absorb
losses on a going concern basis. Moreover, the widespread use of internal models led to very low
levels of regulatory capital. These models were used to reduce the risk weights in the risk weighted
capital requirements. Figure 3 highlights this massive reduction in risk weights. While risk weighted
capital requirements stayed flat, the actual level of capital -appropriately measured by the
(unweighted) leverage ratio- declined sharply from 1994 up to 2007.
The main purpose of Basel III is to improve both the quality and the level of capital (Basel Committee
on Banking Supervision, 2011). On the quality side, the key role of Common Equity Tier 1 (CET1) is
reinforced. Rating agencies are also looking at CET1 ratios to assess the soundness of banks.
Looking more closely, there is distinction between the accounting concepts of tangible equity and
intangible equity. The latter concept includes intangible assets. Basel III (just like Basel I and II)
requires that goodwill and all other intangibles must be deducted in the calculation of CET1. In other
words, Basel III uses the stringent definition of tangible equity. In addition, Basel III will require -as a
new element- that deferred tax assets (DTAs) that rely on future profitability of the bank to be realised
are to be deducted in the calculation of CET1. Moreover, a bank’s holding of its own common shares
are deducted from CET1 (unless already derecognised under the relevant accounting standards).
Figure 3. Average risk weights and leverage ratio of large banks
Note: The series represent the weighted averages across a sample of 17 global banks (Bank of America, Barclays, BNP
Paribas, Bank of New York Mellon, Citigroup, Commerzbank, Deutsche Bank, HSBC, ING, JPMorgan, Lloyds Banking Group,
Royal Bank of Scotland, Santander, State Street, UBS, UniCredit and Wells Fargo). Leverage ratio measured as Tier 1
capital/total assets.
Source: Bank of England (2014)
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Higher levels of capital
In addition to the quality, Basel III also substantially increases the level of capital. Previously, banks
had to hold total capital of at least 8 per cent of RWAs. But the minimum requirement for CET1 capital
was only 2 per cent. CET1 has been increased from 2 per cent to 4.5 per cent, while total Tier 1
capital should be 6 per cent. This produces additional Tier 1 capital of 1.5 per cent, which may include
cocos (see below). Tier 2 capital should be at least 2 per cent. Furthermore, several new buffers have
been introduced. Figure 4 provides an overview, including the new buffers. The dark shaded blocks
represent the high quality CET1 capital.
Figure 4. The new Basel III risk-weighted capital framework
Note: This figure represents the new capital requirements as percentage of risk weighted assets. The dark shaded blocks
indicate the high quality capital in the form of common equity tier 1 capital (CET1).
The capital conservation buffer is a capital buffer of 2.5 per cent of total exposures of a bank that
needs to be met with an additional amount of CET1 capital. It sits on top of the 4.5 per cent CET1
capital requirement. As its name indicates, the buffer’s objective is to conserve a bank’s capital. When
a bank breaches the buffer, i.e. when its CET1 capital ratio falls below 7 per cent, automatic
safeguards kick in and limit the amount of dividend and bonus payments a bank can make. The
further the bank “eats” into the buffer, the stricter the limits become. This prevents the bank’s capital
to be further eroded by such payments.
Next, the purpose of the countercyclical 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 and/or amplitude of credit bubbles or crunches, as discussed in section 2. 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 between 0 and 2.5 per cent. This prevents that credit becomes too cheap and
that banks lend too much. If a bank does not have enough capital to fill this buffer, the same
restrictions as in the case of the capital conservation buffer kick in. When the economic cycle turns,
and economic activity slows down or even contracts, this buffer can be “released” (i.e. the bank is no
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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. Moreover, the
countercyclical buffer can also fulfil its function of absorbing losses and can thus be depleted.
Finally, the Financial Stability Board (FSB) introduces a mandatory systemic risk buffer of CET1
capital for banks that are identified as globally systemically important banks (G-SIBs). The
identification criteria and the allocation into categories of systemic importance include size, cross
border activities and interconnectedness (Basel Committee, 2013). The mandatory surcharge will be
between 1 and 3.5 per cent CET1 capital of RWAs.
Figure 4 illustrates that total CET1 of a major bank can move from 2 per cent to 11.5 per cent
(assuming a full countercyclical buffer of 2.5 per cent and an average systemic surcharge of 2 per
cent). The total capital requirement (RWCR) will then move to 15 per cent of risk-weighted assets.
A new leverage ratio
In addition to the risk-weighted capital ratio (RWCR), Basel III introduces a minimum leverage ratio,
i.e. the ratio between a bank’s Tier 1 capital and its non-risk-weighted assets, as a supplementary
measure to the risk-based framework of Basel II. The leverage ratio (LR) is defined as follows:
(2)
The leverage ratio is intended to be a hard backstop against the risk-based capital requirements
(Equation 1) and is also designed to constrain excess leverage (i.e. debt financing), which was
common amongst many banks before the crisis. This excess leverage also contributed to the depth of
the financial crisis, as explained in section 2. The capital measure is made up of Tier 1 capital and is
currently set at a minimum of 3 per cent. But more data and experience will be gathered before an
effective leverage ratio is introduced as a binding requirement in each jurisdiction (Basel Committee,
2011).
Nevertheless, some interesting applications of the leverage ratio are emerging. The first is on the
rationale for the systemic surcharge for G-SIBs. If one increases the risk-weighted capital ratio with a
systemic surcharge, then one should also increase the leverage ratio (Schoenmaker, 2013). Several
countries, such as Switzerland, Sweden, the Netherlands, the UK, and the US, are applying this logic,
with a systemic surcharge on the leverage ratio. The second is a time-varying component, which will
produce a countercyclical leverage ratio buffer. The Financial Policy Committee (FPC) at the Bank of
England has recently proposed this innovation, which has subsequently been approved by HM
Treasury (Bank of England, 2014).3
This new approach towards the leverage ratio is to be applauded. First, it uses Tier 1 capital (i.e.
equity) and thus excludes Tier 2 debt elements. In that way, there is a close alignment between
accounting and regulatory capital. Second, several studies find that the leverage ratio is a better
predictor of bank failure than the risk-weighted capital ratio (e.g. IMF, 2009). Third, it incorporates the
macroprudential lessons: a countercyclical buffer to dampen credit growth; and a systemic risk
surcharge to reduce the TBTF subsidy.
The new leverage ratio will buck the trend of declining capital levels in banking. The FPC estimates
that the calibration of the new leverage ratio could be up to 4 per cent for the major UK banks and to
3
The FPC uses a 35 per cent conversion factor from RWCR to LR buffers (which is equivalent to an average risk weight of 35
per cent). Using Tier 1, the RWCR (the minimum Tier 1 requirement and the conservation buffer) is 8.5 per cent and the LR is 3
per cent. The conversion factor is then 8.5/3=0.35.
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almost 5 per cent in case of full application of the countercyclical buffer (Bank of England, 2014).
Figure 5 illustrates the long-term trend of capital for the large UK banks, measured as the leverage
ratio (Tier 1 capital/total assets). It shows a decline from 7.5 per cent in 1969 to just below 3 per cent
in 2008. Since then the leverage ratio has increased to about 5 per cent.
Figure 5. Leverage ratio of large UK banks
Leverage ratio UK banks
8
7
6
5
4
3
2
1
0
Note: The series represent the weighted averages across the 4 large UK banks. Leverage ratio measured as Tier 1 capital/total
assets.
Source: Knott et al. (2014)
There is a heated debate in academia on the appropriate level of regulatory capital in banks. Admati
and Hellwig (2013) and Miles et al. (2013), for example, argue for unweighted capital ratios of up to
20 per cent. Their argument for higher (equity) capital requirements is twofold: 1) to reduce the
probability of a public bailout and thus reduce the exposure of taxpayers; and 2) to reduce incentives
for managers to take excessive risks (and play games with risk weights). On the first, they make a
clear distinction between costs to individual institutions (private costs) and overall economic (or social)
costs (see section 2). Miles et al. (2013) estimate the long-run costs and benefits of having banks
fund more of their assets with loss-absorbing equity capital. The benefits are related to the reduction
of the chance of banking crises, which generate substantial economic costs. The offset to any such
benefits comes in the form of potentially higher costs of bank intermediation (e.g. higher lending rates
or lower savings rates). They find that the amount of equity capital that is likely to be desirable for
banks to use is very much larger than banks have used in recent years and also higher than targets
agreed under the Basel III framework.
By contrast, DeAngelo and Stulz (2013) stress the liquidity function of banks and argue for lower
levels of equity capital. High leverage is optimal for banks in order to have a meaningful role in liquidclaim production (i.e. demandable deposits). Their model has a market premium for (socially valuable)
safe/liquid debt in the form deposits, but no taxes or other traditional motives to lever up. Because
only safe debt commands a liquidity premium, banks with risky assets use risk management to
maximise their capacity to include such safe debt in the capital structure. In that way, the model of
DeAngelo and Stulz (2013) explains that banks have higher leverage than most industrial firms, and
also that leverage limits for regulated banks impede their ability to compete with unregulated shadow
banks.
12
Finally, it may be useful to look beyond capital ratios based on book values and look at market based
ratios, using stock market data (Acharya et al., 2012). A market based leverage ratio can be
calculated as a bank’s market capitalisation divided by that bank’s total assets. Developments in this
market based leverage ratio provide additional information to supervisors and investors about the
soundness of a bank. The book and market value approaches are complementary.
Bail-in of debt and cocos
The regulatory capital debate has moved beyond Basel III. To reduce the exposure of taxpayers,
ministers of finance have promoted the concept of bail-in debt. The Bank Recovery and Resolution
Directive (BRRD Directive 2014/59/EU) permits recapitalisation through the write-down of liabilities
(debt) and/or their conversion to equity. This would allow the bank to continue as a going concern,
while avoiding the disruption to the financial system caused by stopping or interrupting its critical
services, and giving the authorities time to reorganise it or wind down parts of its business in an
orderly manner. If a bank needs to resort to bail-in, authorities would first write down all shareholders
and would then follow a pre-determined order in bailing in other liabilities. Shareholders and other
holders of instruments such as convertible bonds and junior bonds would bear losses first.
In addition, Basel III allows cocos, which are contingent convertible bonds that convert to equity if the
regulatory capital ratio drops below a certain pre-determined threshold. Cocos can be issued as
additional Tier 1 capital (as well as Tier 2 capital), and can thus contribute up to 1.5 per cent of the
risk weighted capital ratio (Basel Committee, 2011).
It looks like history is repeating itself. Before the crisis, subordinated debt was promoted by
academics because of its disciplinary function (e.g. Flannery, 2001). As banks with higher asset risk
have to pay higher interest rates on subordinated debt, such debt can induce banks to lower asset
risk in order to reduce interest payments. Next, indirect discipline may happen when regulators take
prompt corrective actions against banks with high subordinated debt yields or banks unable to roll
over subordinated debt. These corrective actions may not only prevent further losses of problem
banks, but also stop bank managers from pursuing unsound risk.
But it did not work as envisaged. First, subordinated debt yields were only partly rising, as investors
(with hindsight rightly) expected to be bailed out. Next, subordinated debt (and future bail-in debt) may
work in the case of an idiosyncratic failure, but not during widespread banking crisis as authorities
may not want to spread contagion by writing down subordinated / bail-in debt.4
Several academics question the financial stability implications of bail-in debt and cocos. Goodhart and
Avgouleas (2014) call for a closer examination of the bail-in process, if it is to become a successful
substitute to the unpopular bailout approach. They argue that bail-in regimes will fail to eradicate the
need for an injection of public funds where there is a threat of systemic collapse, because a number
of banks have simultaneously entered into difficulties, or in the event of the failure of a large complex
cross-border bank, except in those cases where failure was clearly idiosyncratic.
Similarly, Chan and Van Wijnbergen (2014) show that while the coco conversion of the issuing bank
may bring the bank back into compliance with capital requirements, it will nevertheless raise the
probability of the bank being run, because conversion is a negative signal to depositors about asset
quality. Moreover, conversion imposes a negative externality on other banks in the system in the likely
case of correlated asset returns, so bank runs elsewhere in the banking system become more
probable too and systemic risk will actually go up after conversion. This is a form of information
4
A good example is ING: doubt arose about the interest payment on the subordinated debt of ING at the height of the financial
crisis in Autumn 2008. Some investors questioned publicly whether ING would meet the upcoming interest payments on its
supervisor did not permit ING to say so as payments on subordinated debt are conditional on meeting certain capital ratios at
the time of payment. After a sharp drop in the share price, the supervisor gave special permission to ING to announce that it
was planning to meet its upcoming interest payments (Avgouleas et al., 2013).
13
contagion. Cocos thus lead to a direct conflict between micro- and macroprudential objectives. There
is an emerging consensus that macro stability concerns should have priority over micro soundness
concerns (Schoenmaker, 2014).
So, there is a limit to the extent that bail-in debt or contingent convertible capital can replace real
upfront equity capital.
5. Conclusions and policy recommendations
The global financial crisis has highlighted that deviations between the accounting and regulatory
concepts of capital have gone too far, on both sides. Accounting standards have been overshooting in
the application of fair value accounting. If there are no markets during times of crises, it does not
make sense to mark-to-market. These exceptions -in the form of reclassification under IAS 39 and
IFRS 7- have now been included in the accounting standards.
Regulatory capital has gone astray by allowing Tier 2 (subordinated term debt) and Tier 3
(subordinated short-term debt), which did not absorb losses during the crisis. Basel III is rightfully
reinforcing the central role of Common Equity Tier 1 and abolishing Tier 3. Moreover, the smart use of
risk weight lowered actual levels of capital. Basel III is thus complementing the risk weighted capital
ratio with an unweighted leverage ratio. More generally, the use of complementary approaches is
useful to gain more information for supervisor and investors.
It is important to define the objective(s) of regulatory capital very carefully. A stated objective is to
absorb losses, while preventing failure and thus protecting depositors (and policyholders). We support
the use of high quality of capital in Basel III. It is better to have real equity. At the same time, we
question the popularity of cocos, which are debt instruments that can convert to equity. This
conversion may or may not happen. In times of crisis, supervisors may be reluctant to allow
conversions and more broadly to bail-in debt to avoid sending a bad signal to markets and depositors.
If that were to happen, we would be back at square one: only real equity absorbs losses and all kind
of fancy ‘debt’ instruments, from subordinated debt to cocos, escape losses. This reinforces the point
of having real equity to absorb losses.
A neutral tax treatment of debt and equity would reduce the incentive for more debt and less equity.
Allen et al. (2011) recommend abolishing the interest rate deductibility for corporate taxes (not only for
financial firms as discussed in this paper, but also for non-financial firms). That would reduce the
incentive for debt financing. As the Group of Twenty (G-20) ministers of finance are in charge of the
regulatory reform agenda at the FSB, they would be able to implement this recommendation in their
tax codes.
From the macro-prudential side, there are two main concerns arising from the financial crisis. The first
is cyclical. Minsky (1986) argues that the boom-bust cycle of credit lies at the heart of financial
instability. An important innovation of the new Basel III framework is the introduction of the
countercyclical buffer and the leverage ratio, which will help to counter the building up of the credit
cycle. The second concern is addressing too-big-to-fail (TBTF). Basel III is increasing capital levels,
with a systemic surcharge for the large global banks. This will help to reduce the TBTF subsidy to
large banks.
The overall conclusion is that the accounting and regulatory concepts of capital are converging. In
particular, the increasingly prominent role of the leverage ratio aligns the two concepts. Both the
Basel Committee and the International Accounting Standards Board have taken their responsibility.
But the use of cocos, debt instruments that may (or may not) convert to equity, is again causing
unwelcome deviations.
14
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