Principles of Financial Regulation Chapter 14 PDF

Principles of Financial Regulation John Armour et al. https://doi.org/10.1093/acprof:oso/9780198786474.001.0001 Published: 2016 Online ISBN: 9780191828782 Print ISBN: 9780198786474 CHAPTER...

Principles of Financial Regulation John Armour et al. https://doi.org/10.1093/acprof:oso/9780198786474.001.0001 Published: 2016 Online ISBN: 9780191828782 Print ISBN: 9780198786474 CHAPTER Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 14 Capital Regulation  John Armour, Dan Awrey, Paul Davies, Luca Enriques, Je rey N. Gordon, Colin Mayer, Jennifer Payne https://doi.org/10.1093/acprof:oso/9780198786474.003.0014 Pages 290–315 Published: July 2016 Abstract If bank managers and shareholders under-price the risks attached to the bank’s business model, there is a potential role for regulation to address this market failure. The core idea behind capital rules for banks is that shareholders’ equity should fund a minimum proportion of the current value of the bank’s assets in order to increase the chances that a bank will be able to absorb losses on the assets side of its balance sheet without becoming insolvent and, more importantly, without triggering a run on its deposits or other short-term funding. The implementation of this simple idea requires, however, a series of further decisions to be taken: (i) Against which risks should capital be held? (ii) How should the capital requirement be formulated? (iii) How much capital should be required? After the nancial crisis, answers were also sought to additional questions: (iv) How can procyclical consequences of capital requirements be avoided? (v) Should higher capital charges be imposed on systemically important banks? This chapter examines how the Basel Committee decided these central policy questions and how those decisions changed over time as the limitations of the initial policy choices became apparent. It also considers the arguments in favour of di erent choices. Keywords: financial regulation, banking regulation, banks, capital adequacy, Basel III, Basel Accord Subject: Constitutional and Administrative Law, Company and Commercial Law Collection: Oxford Scholarship Online  14.1 Introduction 14.1.1 The role of capital and liquidity regulation In Chapter 13, we outlined the basic business model of commercial banks: taking on liabilities by way of short-term debt provided by retail depositors and the wholesale money markets and using them to make medium- and long-term loans to businesses and households (the principal component of the bank’s assets). The core of the bank’s business thus expresses itself in the transformation it e ects between the Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 liability and the asset sides of its balance sheet. This transformation process has three facets. The bank turns short-term funding into medium- and long-term loans (maturity transformation), liquid liabilities 1 (demand or short-notice debt) into much less liquid loans (liquidity transformation), and riskless deposits into risky loans (credit transformation). Or, looking at it the other way around, the bank provides short- term, liquid, and riskless deposits (and other short-term liabilities) on the back of medium-term, illiquid, and risky assets. This is a very valuable societal function. Without this process of transformation, the supply of investment funds to the productive economy would be reduced and households would be less able to manage their nancial needs. Yet, the risks attached to such transformation are stark. The bank may misjudge the creditworthiness of its borrowers (credit risk) so that the value of its assets sinks below its liabilities and the bank becomes insolvent in the balance sheet sense. Or the bank may su er an unexpected withdrawal of funds by short-term lenders, which exhausts its liquid assets. Here the risk is of inability to pay debts as 2 they fall due. In short, the lack of ‘ t’ between assets and liabilities means that banks’ nancial structure is inherently fragile. The standard mechanisms for addressing these risks are also well established. The higher the level of the bank’s capital (sometimes referred to as the ‘shareholders’ equity’—that is, funding contributed by the shareholders either by way of purchase of shares from the bank or retention by the bank of pro ts earned), the less the risk of balance sheet insolvency, because any losses the bank incurs on its assets will rst fall on the shareholders. So long as the bank’s losses do not exceed its equity, it will still have positive net assets (that is, assets less liabilities). Thus, ‘leverage’—the ratio of the bank’s debt funding to its funding through p. 291 equity or capital—is always a central issue in bank regulation. The more equity, the safer the bank; but a bank funded entirely by equity would achieve no transformation. Equally, the higher the level of liquid assets the bank holds (that is, cash or assets easily convertible into cash), the easier it will be to meet demands from depositors, thus reducing the risk of liquidity crises. Again, however, a bank with wholly liquid assets would do no transformation. It would be wrong to conclude that capital regulation addresses only the risks on the asset side of a bank’s balance sheet (such as making bad loans), while liquidity regulation addresses only the risk of an unexpected withdrawal of short-term deposits. Problems on one side of the balance sheet quickly spread to the other side. Consequently, both types of regulation have an impact on both sets of problems; and both are central to promoting the safety and soundness of banks. Take an unexpected and extensive withdrawal of deposits (a ‘bank run’). This risk is addressed through the bank’s holding of liquid assets. However, if the withdrawal demand exceeds the bank’s store of liquid assets, it will turn to selling its illiquid loans or to using them as collateral for loans to the bank from third parties. It is unlikely to realize the full value of its loans in this way: it will obtain low prices in a sale or su er large 3 ‘haircuts’ if the assets are used as collateral. First, the bank will be under greater pressure to sell than buyers will be to buy (in other words, it will be a ‘ re sale’). Second, bank loans are notoriously di cult for outsiders to value, so the principle of adverse selection will mean buyers (or lenders) will treat the loans as having a lesser value than they may in fact have. However, a bank will be better able to absorb the losses on a  forced sale of its assets or the implicit marking-down of the value of its assets when borrowing against them, if it has a high level of capital. So, in terms of the bank’s capacity to survive a run, a very high level of capital could function as a substitute for a very high level of liquidity. Similarly, a problem on the asset side of the balance sheet may—in fact is very likely to—have its rst impact on the bank through a withdrawal of funds by either retail or wholesale funders, as the asset problem becomes known outside the bank. A bank with a high level of liquid assets may thus secure enough time to x the problem with its assets, even though it holds only a modest level of capital. Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 None of this is news to those who manage or invest in banks. Thus, the question arises, why not leave it to bank boards and shareholders to decide how much equity capital the bank should hold and what percentage of its assets should be in liquid form? This is the approach corporate law adopts towards these issues in 4 non- nancial companies. The answer, by and large, is to be found in the prediction that bank boards and shareholders will under-price the risks of failure, because only some of the negative consequences of bank 5 p. 292 failure will be borne by them. As we noted in Chapter 13, a substantial proportion of the costs of bank 6 failure are externalities, accruing beyond the failing bank itself and indeed outside the nancial sector. If, for example, the failure or prospective failure of a bank causes other banks to hoard cash and not to lend, the resulting ‘credit crunch’ may severely restrict the ow of funds to businesses and households and thus contribute to a signi cantly lower level of economic activity, as the aftermath of the recent nancial crisis showed only too well. 7 If bank managers and shareholders under-price the risks attached to the bank’s business model, there is a potential role for regulation to address this market failure. That is, regulation could aim to mimic the capital and liquidity decisions which would be taken by bank controllers fully exposed to the costs of bank failure and thus to internalize the full costs of banks’ activities. In terms of our typology of regulatory strategies, 8 this is prudential regulation. However, it may not be wise for regulation to go so far as full internalization of the costs of bank failure. Ordinarily, banking generates positive externalities—that is, the bene ts from lending to businesses, households, and society in general (for example, higher employment and higher tax revenues), and these too are not fully captured by the banks’ shareholders and managers. Regulation should take account of the positive as well as the negative externalities of banking activity. More generally, this argument for regulation shows that it is the ‘systemic’ consequences of bank failure which provide the most powerful rationale for regulation, to minimize the impact of bank failure on the ‘real’ economy. This has important implications for how the regulation of banks should be perceived, the implications of which were not fully appreciated until the recent nancial crisis. The aim of regulation should be to promote the safety and soundness of the banking system, not necessarily of individual banks. Individual banks can—and should—be allowed to fail, if the systemic consequences of failure can be 9 contained. Ensuring the survival of all banks, but at the cost of a severe impairment of their transformation potential, cannot be regarded as the achievement of systemic health. This insight has two further important implications for capital and liquidity regulation of banks. First, it may be appropriate to have more demanding capital and liquidity requirements for banks which are systemically important—assuming such can be e ectively identi ed. Second, the impact of capital and liquidity regulation on the capacity or incentives of banks to lend to the real economy needs to be carefully considered, both in relation to their overall capacity to lend and in relation to their capacity or incentives to p. 293 lend at di erent points in the business cycle. We will see both these factors at play throughout this chapter. The role of regulation in providing systemic protection will be discussed further in Chapter 19.  14.1.2 What is a bank? What is a ʻBankʼ? Legal Definitions EU: ‘“Credit institution” is an undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account…’ Regulation (EU) No 575/2013, Art 4.1(1). Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 US: ‘An institution…which both—(i) accepts demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others; and (ii) is engaged in the business of making commercial loans. Bank Holding Company Act 1956 (US), §2(c). So far, we have treated the de nition of a bank as non-contentious. Legal de nitions of a bank focus on precisely the elements we have identi ed as generating the central risks of the bank’s business model. These are funding via short-term deposits and the making of loans. These de nitions are based on function, so it does not matter what the institution is called if in fact it engages in the activity described. For example, a ‘building society’ in the UK or a ‘savings and loan association’ in the US borrows short from depositors and lends long to individuals who wish to purchase 10 living accommodation and so is to be regarded as a bank within the de nitions. A more signi cant feature of these de nitions of the banking function is that they omit a substantial proportion of what large banks actually do. Small banks may not discharge much more than the core functions of taking deposits and making loans to households and businesses, but as we saw in Chapter 2, large universal banks, such as Barclays, Citigroup, Deutsche Bank, and HSBC, do a great deal more. They provide services such as underwriting to companies seeking access to the capital markets, provide advice to companies seeking to carry out mergers or acquisitions, act as market makers in various securities markets, create derivative instruments, and even trade in securities on their own account—that is, proprietary trading. The safety and soundness of deposit-taking banks that engage in this wider range of activities are obviously important for the stability of the nancial system. But how can capital and liquidity regulation reach such activities, given the narrow legal de nition of a bank? A large part of the answer is that, once a company engages in activities which qualify it as a bank, all its activities are taken into account in assessing its capital and liquidity requirements. Equally, the parent company of a group containing a bank is subject to capital and liquidity requirements that re ect the p. 294 nancial activities of the group as a whole. On this approach, investment banking (or ‘broker-dealer’) activities are assessed when setting the capital and liquidity requirements of the bank or banking group, even though those activities are not relevant to the legal de nition of a bank. Thus, the Basel rules apply to 11 the holding company of a banking group so as to take into account all group nancial activities. However, this extension of banking regulation gives rise to a further puzzle. Should a nancial institution or group which engages in the same range of activities as a large bank, but is not funded by deposits, be subject to the same capital and liquidity requirements as a deposit-taker that engages in this wider range of activities? We might be prepared to give a negative answer if such non-bank nancial institutions were free of the mismatch between assets and liabilities at the heart of the standard commercial bank model. But this is not the case. As we shall see in Chapter 21, non-deposit-taking broker-dealers (as well as ones that are members of a banking group) fund themselves extensively in the short-term credit market, especially the ‘repo’ market, thus using short-term loans to nance the acquisition of assets. Those assets may typically be tradable but, in a crisis, may quickly lose their liquidity. Their value as collateral in repos is substantially  reduced in consequence, thus giving rise to a ‘repo run’ not dissimilar from a retail depositor bank run. 12 Non-bank broker-dealers are, in general, even more highly leveraged than commercial banks. And their capacity for the transmission of contagion is high. A good example of the issue was the collapse of Lehman Brothers, a non-deposit-taker, in late 2008, which 13 considerably intensi ed the nancial crisis. However, this particular problem of non-bank broker-dealers has largely been resolved since the crisis: the large US broker-dealers either failed, were forced into mergers with commercial banks, or their parents chose to recon gure themselves as bank holding companies. The problem was largely a US phenomenon in any event, probably a result of the banking legislation of the Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 1930s. Elsewhere in the world, the ‘universal’ banking model prevailed, whereby investment banks also functioned as, or were members of groups which contained, deposit-takers. The takeaway is that, although deposit-taking and granting loans are the key constituents of the de nition p. 295 of a bank, prudential regulation—in the form of bank capital and liquidity rules—needs to take account of the fact that the largest banks engage in a much wider range of activities. In this chapter, when we refer to a ‘bank’, we mean a rm which takes deposits and makes medium- and long-term loans, no matter what else it may do or what its formal title may be. When we want to refer to a rm which does not fall within the statutory de nition of a bank, we will use the term ‘ nancial institution’ or qualify the term ‘bank’ in some way, for example by using the phrase ‘investment bank’. 14.1.3 The Basel Committee on Banking Supervision For the purposes of the discussion in this chapter, we will focus primarily on the rules developed by the Basel Committee on Banking Supervision (the ‘Basel Committee’ or ‘BCBS’)—de facto, the global standard- setter in this area. The Basel Committee, through its Accord of 1988 (‘Basel I’) and its successors (Basel II 14 (2004) and Basel III (2010)—although the latter is not yet fully in force), has become ‘the dominant power in banking regulation’ despite being, initially, an informal creation of central bankers lacking ‘powers, 15 constitution or even legal existence’. Its rules on banks’ capital and liquidity are widely followed, not only by the thirty or so states represented on the Committee, but also by a much wider range of countries. While the Basel rules have no legally binding force at national level—even in states represented on the Committee 16 —there is a system of peer pressure, organized by the Basel Committee, to promote compliance. The Basel rules are also expressed to be minimum standards, so that more demanding standards may be set in national implementation, consistently with the Basel framework. Substantial lobbying e orts over national implementation of particular aspects of the Basel rules are thus common. In particular, the Accords apply formally only to internationally active banks, but some jurisdictions (for example, the US and the EU) apply them to all banks. However, from our point of view the crucial thing about the Basel rules is that they illustrate the policy dilemmas that any set of capital and liquidity standards will have to resolve. By understanding how to analyse the Basel choices, you will be able to analyse any di erent set of choices made by national and regional regulators. Today, the Basel rules deal with both capital and liquidity regulation (though initially they left out liquidity). We will deal with capital regulation in this chapter and liquidity regulation in the following one. Besides avoiding an over-long chapter, this approach can be justi ed on the grounds that the two regulatory strategies have di erent impacts on banks’ transformation processes—liquidity requirements being potentially much more intrusive but also arguably more useful in providing a safety net for banks in nancial crises. p. 296 These minimum capital and liquidity rules constitute just one of the three ‘pillars’ of the Basel regime, though we will analyse the other two pillars less deeply. Pillar 2 deals with the role of national or regional supervisors. Supervision is considered more fully in Chapter 26, but we should note here that supervisors  under Pillar 2 may add to the capital and liquidity requirements of particular banks which cause them concern. Such additions are often made after ‘stress tests’ which reveal that a particular bank or banks would not have a good chance of survival in the stressed scenario, despite their compliance with the Basel minima. Or the Pillar 2 powers may be used to implement the Basel III requirements more quickly than is 17 formally required. Pillar 3 requires banks to disclose to the market data on how they approach capital adequacy, in order to co-opt market discipline to the regulator’s goals. The rest of the chapter proceeds as follows. We examine in turn the fundamental choices made by the Basel Committee when designing the capital rules and consider various critiques of those choices which have been Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 advanced. By the end of the chapter you should have a good understanding of the potential and limits of capital regulation to reduce the fragility of banks. 14.2 Setting Capital Rules: The Main Issues The core idea behind capital rules for banks is that shareholders’ equity should fund a minimum proportion of the current value of the bank’s assets, in order to increase the chances that a bank will be able to absorb losses on the assets side of its balance sheet without becoming insolvent and, more importantly, without triggering a run on its deposits or other short-term funding. This requirement is imposed, not only at formation, but on a continuing basis. Moreover, it is adjusted as the amount and quality of the bank’s assets 18 varies. It is a restriction on the bank’s leverage—that is, it constrains the extent to which the bank can nance itself through debt. Thus, a 10 per cent capital requirement would require the bank to hold capital equivalent to 10 per cent of the value of the bank’s assets. The other 90 per cent of the value of the assets could be nanced by debt. A 10 per cent capital requirement would imply a debt-to-equity ratio of 9:1. The implementation of this simple idea requires, however, a series of further questions to be answered. The main ones, since inception, were as follows. Against which risks should capital be held? Should the capital requirement be formulated as a percentage of the face value of the assets or should that value be risk weighted? How should capital be de ned? How much capital should be required? p. 297 After the nancial crisis, an answer was given to these additional questions. How to avoid the procyclical impact of capital requirements, namely that they are too lax in an economic upswing and too constraining in the downswing? Is the same ratio appropriate for all banks, no matter what their systemic importance? Should the ratio vary depending on factors that increase the bank’s risk of failure (eg a greater fraction of ‘wholesale’ short-term liabilities)? In the following sections we shall examine how the Basel Committee decided these central policy questions and how those decisions changed over time as the limitations of the initial policy choices became apparent. We shall also examine the arguments in favour of di erent choices.  14.3 Against Which Risks Should Capital be Held? The commercial banking model suggests that the main risk against which capital should be held is credit risk—that is, the risk that borrowers will not repay. This indeed is the basis upon which Basel I approached this question. Banks were required to hold capital only against credit risk. As we discuss in Chapter 20, signi cant amounts of credit intermediation have moved from commercial banks to market intermediaries, a transition initially spurred by free-standing investment banks. Commercial banks have followed into market intermediation, if only for competitive reasons. With the expansion of the investment banking Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 activities of large banks (or banking groups), however, it became clear that trading risk was an important source of fragility for such banks. Trading risk is the risk that securities which banks hold, for market- making or proprietary-trading purposes, su er a decline in market value. With the ‘market risk amendment’ of 1996 (coming between Basel I and Basel II), the Committee moved to bring trading risks explicitly within the Basel Framework. At this time, banks’ non-loan assets consisted principally of relatively simple positions taken in relation to equity or debt securities that traded on liquid markets. The potential loss the bank faced was conceived as continuing for a relatively short time, only until the securities could be disposed of in the market. The task was thus to calculate the possible loss on the portfolio in this period and apply the capital charge as a percentage of the resulting number. By the time of the crisis, however, large banks had moved beyond holding simple positions in traded securities into large holdings of credit instruments that often did not trade in deep and liquid markets. The largest losses in the crisis resulted from mortgage trading, trading in asset-backed securities, credit 19 derivatives, loan origination and syndication, and securitization warehousing. In all these cases the p. 298 assumption of an always-available liquid market was inappropriate. Absent an e ective market, the holders of such instruments faced the risk of a default by, or credit-downgrade of, the counterparty (counterparty credit risk). This risk, although central to risk assessment in the banking book, was not part of the risk assessment in the trading book. Both gaps were plugged by measures introduced immediately after the nancial crisis (usually referred to as 20 ‘Basel 2.5’) and, more fully, in Basel III. Referring to the latter, the Committee has estimated that, ‘the revised trading book framework, on average, requires banks to hold additional capital of around three to 21 four times the old capital requirements’. Despite these patches being applied, with apparently increasing desperation, to the machinery for the assessment of market risk, the regulatory structure for market risk does not inspire a high level of con dence, even in the Basel Committee itself. Risk weightings for market risk vary very widely across banks, the variations not being fully explained by variations in banks’ holdings 22 but seemingly by their choice of model for assessing market risk. In its recently completed ‘fundamental 23 review’ of the trading book the Committee pointed out that the division between the banking book and the trading book (which currently turns on the bank’s intentions—to hold or to trade—in relation to the asset) is very di cult to police and yet of fundamental importance in the light of the di erent risk-assessment methodologies deployed in the two areas. Overall in relation to market risk, the Basel rules have been playing ‘catch up’ with what banks actually do. In addition to credit risk and trading risk, operational risk has been identi ed as a third capital-triggering category. With the growing complexity of investment banks and the opacity of their trading operations even to insiders, the risk of large losses from employee fraud has risen (as notoriously happened in the cases of Barings Bank in 1995 and Société Générale in 2008). Operational risk embraces a number of internal risks beyond employee fraud, including, for example, the breakdown of computer systems or even simple failure of di erent parts of complex organizations to coordinate their activities e ectively (the problem of ‘silos’). This risk was recognized for capital purposes in Basel II. The capital charge for operational risk is set, essentially, as a percentage of the bank’s gross income rather than its assets. In light of the now-critical  importance of IT for bank operations and the growing intensity of malware attacks, it seems likely that this 24 p. 299 calibration will also become viewed as too coarse. 14.4 Risk-Weighting of Assets 14.4.1 The idea of risk-weighting Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 The Basel Committee can thus be said to have been rather slow at identifying the full range of risks to which internationally active banks (the Basel constituency) are subject and in setting capital requirements to match that range. However, much more controversial has been the question of how the amount of required (or ‘regulatory’) capital should be calibrated, once the risks have been identi ed. There are two sub-issues in the calibration debate: how much capital should be required and should that capital requirement be risk- weighted? In this section we deal with the second issue and again we shall see that trading risk posed the most di cult issues. We then turn to the rst issue in the next section. The capital requirement is set as a percentage of the bank’s assets. It is not a xed monetary amount. It is a ratio and so it can be adjusted by changing either of its two elements: the numerator—the bank’s capital— or the denominator, its assets. In particular, a higher ratio can result from increasing capital or lowering the value of the assets. Even after all the classes of risky assets held by the bank have been identi ed, there remains the question of whether the percentage capital charge should be applied equally across all the bank’s assets. Although the Basel headline charge is presented as a single gure (8 per cent), only a modest amount of investigation into the Basel rulebook reveals that the value of the denominator in the ratio varies according to the perceived riskiness of di erent classes of asset. This is achieved by risk-weighting di erent types of asset, so that the 8 per cent capital charge is applied to a notional valuation of the asset, which may be greater or lesser than the face value of the asset. The capital charge in consequence may be either greater or less than 8 per cent of face value. For example, if the loan is weighted at 100 per cent and the amount of the loan is $200, the capital charge is $16 (0.08 x 200). However, if the loan is weighted at 50 per cent, the capital charge is reduced by half to $8 (0.08 x 100), whereas if the weighting is 150 per cent, then the capital charge is increased by half to $24 (0.08 x 300). So, depending on the composition of the bank’s loans, its e ective capital charge may be signi cantly di erent from the headline gure of 8 per cent. In particular, if the loans are concentrated in the less risky half of the rating distribution, the e ective charge will be signi cantly lower. The Basel Accords have always adopted a risk-weighted approach but, over time, the risk-weighting methodology has become more sophisticated and responsibility for risk-weighting has moved increasingly from the regulators to the banks themselves. The intuition behind risk-weighting is obvious enough: a bank which, for example, lends $10 billion to the German government is running less risk than a bank which lends a similar amount to a company set up for the purpose of searching for oil in a part of the world that is geologically and politically challenging. A non- risk weighted requirement would not capture this risk di erential and would therefore incentivize banks to engage in the latter type of lending. p. 300 However, the decision to risk-weight still leaves open the question of how granular the risk assessment is to be. Under Basel I, bank loan assets were divided into a small number of di erent types (‘buckets’) and risk- weights were assigned to each bucket by the rules themselves. This was a rather unsophisticated approach, taking no account of varying risks within each bucket. Under Basel II, the process became more  sophisticated and complex. Within each bucket, the capital requirement is adjusted upwards or downwards according to the riskiness of the asset. Tables 14.1 and 14.2 set out two examples of the results of this process, relating to bank exposures to corporate borrowers (the vast majority of the claims owned by any bank) and to sovereigns or their central banks. These loans are risk-weighted according to the borrower’s credit rating. Table 14.1 Standardized approach—claims on corporates Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 Credit Assessment AAA to AA− A+ to A− BBB+ to BB− Below BB− Unrated Risk Weight 20% 50% 100% 150% 100% Table 14.2 Claims on sovereigns and central banks Credit Assessment AAA to AA− A+ to A− BBB+ to BBB− BB+ to B− Below B− Unrated Risk Weight 0% 20% 50% 100% 150% 100% Source: BIS/BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework— Comprehensive Version, bcbs128 (2006), paras 53 and 66. Loans to retail customers (another big chunk of banks’ business) are more simply risk-weighted. A well- diversi ed portfolio of unsecured loans to individuals and small businesses is typically risk-weighted at 75 per cent, and claims secured on residential property at 35 per cent. 14.4.2 Using banksʼ internal models to produce risk weights While the risk-weighting approach has roused some controversy, still more controversial has been the migration of the risk-weighting exercise to the banks themselves. The market risk amendment of 1996 introduced the principle that banks, subject to supervisory permission, could do the risk-weighting on the basis of their own historical data relating to losses and on the basis of their own evaluation models. This permission was extended to credit risk assessment in Basel II. Since that time, there have been two general approaches to risk weighting: one embodied in the rules (the ‘standardized’ approach), and one carried out 25 by the banks themselves (the ‘internal ratings-based’ approach or ‘IRB’ for short). p. 301 The intellectual justi cation of the IRB approach is that the standardized approach, by adding up risk assessments on a class-of-asset by class-of-asset basis, gives no value to the spread of the bank’s overall portfolio of assets across the di erent classes, the risks of which may be uncorrelated. The IRB approach also allows the bank to bene t from investment in superior systems for evaluating risks. Since the bank uses its own internal data to compute the risk-weighting, the bank’s actual historical experience with losses is re ected in the result.  14.4.3 Critiques of IRB approach Large banks enthusiastically embraced the IRB approach. This approach involved only marginal extra expenditure, since the banks had elaborate risk-assessment systems in place for their own purposes, and it produced the welcome (to the banks) result that the capital charge was signi cantly reduced below the level demanded by the standardized approach. From the point of view of nancial stability, however, the system 26 worked poorly in the run-up to the crisis. This was particularly true of the risk-weighting of items in the trading book. As the Basel Committee later commented: Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 One of the underlying features of the crisis was the build-up of excessive on- and o -balance sheet leverage in the banking system. In many cases, banks built up excessive leverage while still 27 showing strong risk based capital ratios. The left-hand graph in Figure 14.1 shows that the assets of ten of the world’s largest banks approximately doubled in the decade prior to the crisis, whereas their risk-weighted assets increased by only one-third. This would have made sense if the banks had been shifting into less risky assets as well as expanding their total assets. But hindsight suggests this was not the case in the decade before the crisis, as does the right- hand graph. The two core activities of these banks—taking deposits and making loans—both fell as a proportion of total assets, while securities holdings (‘investments’) increased. The most plausible explanation is that the assessed risk-weights on bank assets were falling at the very time that the risks to which banks were exposed were increasing. This casts considerable doubt on the utility of the IRB approach. Fig. 14.1 Balance sheet profiles for ten large publicly traded banks Source: IMF, Global Stability Report (April 2008) 31. Three arguments competed to explain the pre-crisis data. First, there was a widespread suspicion—but no proof—that banks were able to manipulate the IRB approach. What is clear is that banks’ risk assessments under IRB vary signi cantly from bank to bank. In relation to credit risk, the largest component in a typical bank’s overall risk-weighting, the Basel Committee found that up to three-quarters of the variation could be explained by variation in the asset pro le—a variation the IRB approach is designed to produce—while 28 p. 302 the rest was due to variations in either bank or supervisory practice. Greater variation was found in  relation to trading book assessments, of particular signi cance for institutions active in investment 29 banking. The second argument questioned the quality of the internal data available to the banks. These data did not go back very far and so related to an unusually benign economic period. In particular, they failed to capture crisis risks (or ‘tail’ risks—risks that are very unlikely to eventuate, but which will have a major impact on the bank if they do). The banks’ models thus failed to allow for the nancial crisis, which was a tail risk event. Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 The third argument related to the models the banks used. This criticism builds on the distinction between 30 ‘risk’ and ‘uncertainty’ drawn by economist Frank Knight in the 1920s. In his terms, the probability distribution of a risky event occurring is known or at least knowable, and so risk can be modelled, priced, and traded. More information is a good thing, because it brings the model closer to the actual distribution of the risk. The probability of an uncertain event, such as a major nancial crisis, is not in principle knowable. p. 303 Consequently, there is no reason to suppose that more data and more sophisticated models will improve the reliability of predictions. However, at least for some uncertain events, experience shows that simple 31 indicators (‘heuristics’), while imperfect, are reasonably good predictors. This approach raises the question whether such heuristics exist in relation to bank failures. If they do, they present a fundamental challenge to the IRB approach and perhaps to the whole policy of risk-weighting banks’ capital 32 requirements. 14.4.4 Responses to the critiques International and national authorities have developed responses or proposed responses, addressing each of the critiques. The rst is to rein in the IRB, by making the criteria for access to the IRB approach more stringent, by specifying the qualities the IRB must display, or by setting a oor below which the IRB 33 approach cannot reduce the capital charge set on the standardized approach. A second and more important response, developed by national and regional authorities, is the ‘stress test’. A stress test involves the generation of a hypothetical situation by the regulator that is aimed at reproducing tail risk. The amount of capital needed to survive the hypothetical situation is then calculated and if it is 34 more than the existing level of the bank’s regulatory capital, then that requirement is adjusted upwards. Although stress tests, at least in the EU, were initially undemanding (and found to be unconvincing in the market), they have improved over time. The 2014 stress test run by the Bank of England—a domestic version of the test run by the European Central Bank (ECB) at the same time—required banks to imagine an economic downturn which has occurred only once in the UK in the past century and a half, namely at the end 35 of the First World War. The stress test is a major quali cation of the IRB approach, since it implies that banks are no longer able to rely exclusively on their own historical loss data when setting capital requirements. Given the stress test requirement, one may wonder whether the IRB approach still has substantial advantages for the bank. It appears that it does, because the bank still uses its internal model to compute its capital requirements in the stressed scenario. Nevertheless, e ectively executed stress tests constitute a signi cant shift of capital- setting power back into the hands of the regulators. They also demonstrate the increased importance of p. 304 Basel ‘Pillar 2’ (supervisory review) supplementing ‘Pillar 1’. The minimum, uniform capital requirements of Pillar 1 are supplemented by institution-speci c capital requirements resulting from the stress test carried out by national or regional regulators. The stress test generates a capital requirement which is still formulated on a risk-weighted basis. The third, and potentially most radical, approach is to develop a non-risk-weighted capital test and to use that to set a oor below which the risk-weighted requirements cannot fall. The non-risk-weighted capital requirement  is referred to as a leverage ratio. The Basel Committee has moved, cautiously, in this direction with 36 proposals for a ‘backstop’ leverage ratio (LR) of 3 per cent. The term ‘backstop’ refers to the role of the LR in constraining the activity of banks in economic upswings, when banks’ historical internal data are likely to indicate that borrowers are less likely to default and that markets are more benign, so that the same amount of capital can support a higher level of activity. But a larger role for the LR could be envisaged, for example, to combat ‘model risk’ (that is, the risk that banks’ internal models are defective) or to deal with events 37 which are uncertain in the Knightian sense. Some major nancial jurisdictions have moved more quickly 38 than the Basel regulators to impose an LR. Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 Even with a broader role for the LR, however, it does not displace, but rather supplements, the risk- weighted approach. The rationale for this twin-track approach is that a leverage ratio can easily be manipulated: a bank that increases the riskiness of its activities but not the value of associated assets leaves its unweighted leverage ratio unchanged. Regulators in at least some major countries can be said to be moving towards an approach to capital regulation in which both risk-weighted and non-risk-weighted elements play a signi cant role in setting regulatory capital. Firm believers in heuristics might argue that the risk-weighted elements could be removed entirely from the regulation. However, a simulation of capital requirements of various types against known default rates on one core class of corporate assets (loans to corporates) showed that the standard Basel approach to risk-weighting worked well. Moreover, the performance of the IRB approach was substantially improved if the number of prior years’ data fed into the model was signi cantly increased, and the IRB approach had the virtue of minimizing the need to hold 39 ‘surplus’ capital (that is, more than required to meet losses). If the stress test is regarded as the functional p. 305 equivalent of feeding more years of data into the internal models, this study is some support for the twin-track approach to setting regulatory capital standards. 14.5 What Counts as Capital? Basel III Requirements The most controversial debate in relation to the Basel capital requirements concerns the level of capital required. The Basel III requirements have been widely criticized by academics and some policymakers as too low. At the same time, banks have resisted any increase on the ground that increased capital requirements are expensive for them and will raise the cost of lending, thus depriving marginal business projects of funding they would otherwise receive. In order to assess this debate we need to proceed in stages, starting with the apparently simple question: what level of capital does Basel III require? At rst sight, this seems a question to which an uncomplicated answer can be given. The remarkable thing about the amount of minimum capital which is required under the Basel rules is that the headline gure—8 per cent of Risk Weighted Assets (RWA)—was set in Basel I and has remained the same ever since. However, Basel III has done two signi cant things: it has altered the composition of the 8 per cent minimum gure, and it has introduced capital ‘bu ers’ to supplement the minimum capital requirements. 14.5.1 Composition The Basel minimum capital requirement is made up of two, or more accurately three, components. The rst is indeed shareholders’ equity—funds contributed to the company by investors through ordinary share subscriptions and undistributed pro ts held within the bank. This is core equity tier 1 capital (‘CET1’) in the Basel nomenclature. Under Basel II, only one-quarter of the 8 per cent (that’s right, 2 per cent) had to be contributed through CET1. Under Basel III that requirement is raised to 4.5 per cent. The remainder of the 8 per cent is made up of Additional Tier 1 (AT1) or Tier 2 (T2) capital. This further capital may be shareholders’ equity (or some types of non-cumulative preference share), but, remarkably, it  may also be supplied by subordinated debt. This seems wrong in principle, since although the issue of debt securities brings assets into the company, it increases the liabilities of the bank by exactly the same amount. 40 The ratio of shareholder equity to assets is thus not improved; in fact, it falls slightly. It can be argued that subordinated debt will protect creditors higher up in the ranking against loss once the bank is in insolvency, but importantly, debt in its standard form has no loss-absorbing capacity outside insolvency. As we shall see in Chapter 16, governments in the nancial crisis proved unwilling, probably rightly, to allow banks to fall into insolvency. Instead they were bailed out without entering insolvency. So, subordinated debt o ered p. 306 banks no loss-absorbing capacity in this situation, leaving them with only their—very thin—layer of equity as genuine protection. The Basel response was not to remove subordinated debt entirely from Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 counting against minimum capital requirements. Instead, a form of hybrid subordinated debt, which converts into equity or is written o at or before the resolution of the bank, was permitted to continue as 41 AT1 or T2 capital. Moreover, the more than doubling of CET1 to 4.5 per cent reduced the scope for utilizing hybrid subordinated debt signi cantly. The resulting numbers are shown in Table 14.3. Table 14.3 Composition of Basel III minimum capital requirement Core Equity Tier One (CET1) 4.5% Additional Tier One (AT1) 1.5% Tier Two (T2) 2.0% Many analysts and commentators concerned with the safety of banks focus solely on the CET1 position of the bank. So too do the new Basel bu ers, discussed in section 14.5.2. The new CET1 minimum implies a 42 permitted leverage ratio of over 20:1, based on risk-weighted assets —before, however, the bu ers are added on. 14.5.2 Bu ers The persistence of the Basel ‘8 per cent’ requirement is misleading because it relates only to the minimum capital requirement for banks. Basel III introduced a number of additional capital bu ers, which—when applicable—require banks to increase CET1 capital. The formal di erence between bu ers and minimum capital requirements concerns the consequences of failure to meet their requirements. The minimum capital requirement is a condition for continued operation: a bank which falls below its minimum capital requirement, or even gets near to it, is likely to be closed down by regulators. In contrast, the sanction for falling below a bu er requirement is that distributions to shareholders and managers (by way of bonuses) are constrained, so that the bank’s CET1 can be rebuilt. There may be a complete prohibition on distributions or a cap, depending on how far below the bu er requirement the bank has fallen. Although less draconian than closure, a distribution constraint is still a powerful incentive to comply with the bu er requirement. There are three principal bu ers introduced by Basel III, which we now consider in turn. One applies to all banks all of the time. A second applies to some banks all of the time. The third applies to some or all banks some of the time. These bu ers are each to a greater or lesser degree ‘macroprudential’ in their orientation, 43 and are discussed in this context in Chapter 19. p. 307 Capital Conservation Bu er (‘CCB’). This bu er applies to all banks all of the time. It addresses a criticism made of the previous rules that they were procyclical. Applied to the downswing of the economic cycle, the  argument was that banks maintained their capital ratios despite poorer borrower performance and more volatile markets, not by adjusting the capital side of the ratio (raising more capital), but by adjusting the asset side of the ratio (reducing their assets, especially by making fewer loans). This preserved banks’ regulatory capital yet worsened the impact on the real economy, as bank loans became harder to obtain. Basel III introduces a 2.5 per cent CET1 capital conservation bu er. The CCB is ‘designed to ensure banks 44 build up capital bu ers outside periods of stress which can be drawn down as losses are incurred’. In theory, banks will be able to maintain their previous levels of lending in the downturn by allowing the CCB to absorb the temporarily higher level of losses. In practice, it is doubtful whether the CCB will work in this Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 simple way. Given the restrictions on distributions, both management and shareholders will prefer to restore the bu er as soon as possible and so are likely to eschew a routine policy of going below the bu er in hard times. So, the private interests of bank shareholders and managers will probably still favour the traditional policy of reducing assets in a downturn. Indeed, early empirical studies of the operation of such 45 measures suggest they have the potential to in fact exacerbate the problems they are supposed to cure. Supervisory pressure on the banks to behave di erently will be needed if the rationale of the CCB is to be realized. Systemically important banks. The Global Systemically Important Bank (G-SIB) bu er is an additional CET1 requirement that applies to only some banks, but all of the time. It addresses the argument that the Basel rules are focused on the safety and soundness of individual banks rather than on the banking system as a 46 whole. Before Basel III, the rules were based on the assumption that the negative externalities of bank failure are linearly related to the size of the bank’s assets. If that relationship is non-linear or if matters other than the size of the bank’s assets are relevant in determining the likely externalities of bank failure, then it might be appropriate to impose a higher capital requirement on those banks likely to generate disproportionate externalities. The importance of a risk depends not only on the chances of its materializing but also on its impact if it does. The Basel III rules respond to this point by di erentiating within the Basel population between ‘systemically important’ and other banks. The Basel criteria for the G-SIB capital surcharge focus on the size, interconnectedness, complexity, scale of cross-border operations, and the non-substitutability of the services provided by a bank to determine its 47 status as a G-SIB. By 2015, these criteria, as applied by the Financial Stability Board (FSB), had produced a p. 308 list of thirty G-SIBs, with di ering top-up requirements. Depending on the predicted impact of failure, the potential top-up varies from 1 to 3.5 per cent CET1, though no bank has received the maximum top-up 48, 49 of 3.5 per cent and only six have top-ups of 2 per cent or more. The Basel rules extend the system to domestic SIBs (D-SIBs) from 2016. The identi cation of banks which are systemically important within a national jurisdiction and the size of the bu er to be imposed are a 50 matter for national regulators, acting within principles set by the Committee. This is consistent with the notion that the Basel rules are minima and that states have ‘Pillar 2’ powers to add to these minima as appropriate. Thus, under the Dodd–Frank Act in the US, the Federal Reserve is required to apply ‘enhanced prudential supervision’, including potentially higher capital standards, to banks with assets in excess of 51 US$50bn, whether they appear on the FSB’s list of global systemically important banks or not. Counter-cyclical capital bu er (‘CCCB’). This bu er may be applied to all or some banks, but only applies some of the time. Like the CCB, it aims to address concerns about procyclicality, but this time in an economic upswing, where existing capital will support a higher level of bank activity because of better borrower performance and more benign markets. In other words, the CCCB is designed to constrain lending by banks during an economic boom and to prepare banks for the coming ‘bust’. The CCCB operates only when a (national) regulator decides to impose it, and may be set at any level up to 2.5 per cent CET1. In the case of the US, the current (2016) rate is 0, whilst in the UK it will be 0.5% from 2017.  The relationship between the minimum CET1 requirement and the three bu ers discussed in this section can be presented schematically as shown in Figure 14.2. The cycle neutral bu er can be equated with the CCB and the G-SIB bu er, if one applies. The overall CET1 level can be seen as varying over time as the CCCB is imposed on banks or removed and as banks fall below and then restore their bu ers. Fig. 14.2 Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 CET1: Minimum requirement plus bu ers (constant and varying) Source: Bank of England, Financial Stability Review (June 2010), 11. Overall. Taking account of the bu ers, the minimum CET1 requirement is actually raised from 4.5 to 7 per cent for all banks, potentially to 10.5 per cent for G-SIBs (though it is unlikely to reach this level since there is no G-SIB in the 3.5 per cent category at present), with the possibility of macroprudential authorities adding up to a further 2.5 per cent if an asset bubble is developing, as Figure 14.3 shows. Whether the ‘real’ p. 309 CET1 requirement is 4.5 or 13 per cent, or indeed somewhere in between, depends on (i) the strength of incentives to maintain bu ers intact, (ii) how authorities set the CCCB and the bu er for systemic p. 310 importance, and (iii) how they classify the large international banks. Fig. 14.3 Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 Basel III CET1 Requirements 14.6 Are Basel III Capital Levels High Enough? 14.6.1 Is equity more expensive than debt? We are now in a position to move on to the second part of the answer to the question: are the CET1 requirements, as laid down in Basel III, correctly set? Most commentators see the answer to the question as a trade-o : equity is somewhat more expensive than debt to banks—opinions di er as to how much—and so more equity risks raising the costs of borrowing, against which the bene t of higher equity is that bank stability is promoted. However, one view, closely associated with Professors Admati and Hellwig, holds that 52 equity is not more expensive than debt, implying that no trade-o is required. Even they do not propose that banks should be required to be nanced with 100 per cent equity. This would destroy the transformation function of banks, which would be prohibited from channelling pools of short-term excess cash into term loans through the deposit mechanism or other forms of short-term funding. The result would likely be a reduction in the supply of loans to rms and households—paradoxically, the very result 53 the capital requirements are ultimately aimed at avoiding. Consequently, it is better to think of the ‘how- much-equity?’ question as one about the balance between funding via equity versus long-term debt, such as bank bonds. Nevertheless, Admati and Hellwig (A&H) propose an equity requirement of 20–30 per cent of 54 non-risk-weighted assets (in other words, a leverage ratio), equivalent to over 50 per cent RWA, very substantially bigger than the current Basel requirements and bigger than UK and US banks have actually 55 achieved over the past 150 years. In support of A&H, the Modigliani–Miller theorem shows that, under strong assumptions, the value of a 56 rm is not increased or decreased by its funding structure. The rm’s value depends upon its earnings, not how its business is nanced. Modigliani and Miller accept that, in most states of the world, debt is cheaper than equity because debt holders rank ahead of equity holders and so take less risk. Nevertheless, they show that the gains to rm value from any increase in the proportion of debt in the funding structure will be exactly counterbalanced by an increased cost of the equity, which has been made more risky by the rm’s  increased leverage. Conversely, any costs resulting from decreased debt will be matched by the gains from now cheaper, because less risky, equity. However, there are three real-world frictions which plausibly support the suggestion that debt is more expensive than equity for banks. Indeed, A&H do not dispute their existence. Their counterargument is that p. 311 these costs are private costs to banks, not social costs: in other words, costs to banks are balanced by equivalent gains to society at large. This may not be an adequate response, however, if the private cost to the bank causes it to take action which is socially costly. Consider the rst friction: in many jurisdictions debt interest bene ts from a tax shield which is not available for dividends. A shift from debt to equity increases Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 the bank’s tax costs, all else being equal, but the state bene ts by an equivalent amount from increased tax revenues. However, banks may pass these increased costs on to borrowers, with the result that marginal projects are no longer funded—potentially a social cost. In theory, the state could redress the balance by using the additional tax revenues to subsidize the nancing of marginal projects. More plausibly, it could alter the tax system so as to be neutral between debt and equity. However, in the absence of state action of some sort, the social cost may not be redressed. 57 The second friction is the debt-overhang problem. A nancially constrained company will be able to raise new equity only at a signi cant discount to the current market price because investors understand that part of the bene t of the new funds will be captured by the company’s creditors, whose position is thereby strengthened. New shareholders protect themselves through the price mechanism, so what actually happens is a transfer of wealth to the bank’s creditors from its existing shareholders (and managers). This makes shareholders and managers reluctant to raise new equity when the bank is performing poorly. They may instead prefer to raise capital ratios by reducing assets, thus reducing the supply of funding to business projects. Again, regulatory solutions are available, such as mandatory share issues or increasing capital through constraints on distributions (including distributions by way of share repurchases). 58 A third friction is the loss of the implicit state guarantee of bank debt, arising from the expectation that the bank will be bailed out rather than allowed to go into insolvency. In this situation debt-holders (normally) will not bear losses, so that bank debt becomes less risky and investors will lend to banks at lower rates than in the absence of the implicit guarantee. A shift from debt to equity thus reduces the value of the implicit guarantee to the bank and is a private cost to the bank. However, in this case the private cost is socially bene cial. The implicit guarantee amounts to a state subsidy of banking activity (as against other forms of economic activity nanced by debt where no implicit guarantee is in place) for which no obvious rationale exists, at least for the extent of the subsidies enjoyed prior to the nancial crisis. As we shall see in Chapter 16, since the nancial crisis states have been engaged in concerted e orts to reduce or even eliminate such implicit guarantees, so that in this case a shift from debt to equity would complement, rather than cut across, other policy initiatives. However, there is an argument that capital is costly for banks, which goes beyond such ‘frictions’, to question the basic Modigliani–Miller hypothesis as applied to banks. For a bank, unlike a non- nancial rm, the composition of the balance sheet is essential to its value. The business of a bank is not just about screening and monitoring when extending credit to rms and households but also about extending liquidity p. 312 services to depositors in the form of claims that are sum certain and continuously redeemable. One might go so far as to say that the business of a bank is nancing medium- and long-term credit claims with deposits. This means that an all-equity bank will be a less valuable bank than one funded at least in part by deposits. The idea of the ‘irrelevancy’ of nancing to business project value does not hold where the 59 business project itself is a particular form of nancing.  14.6.2 Costly equity vs financial security? If capital is not only privately but also socially costly, the trade-o question cannot be avoided, though the 60 calculations are fearsomely di cult because of the assumptions which have to be made. Most simulations suggest that non-trivial additions to the Basel requirements would put banks’ lending rates up by only modest amounts, and that these higher lending rates would in turn lead to only moderate reductions in 61 economic output, compared with the world based on the Basel III minima. Nevertheless, any loss to output is a cost. As to the bene ts, since the costs of a large-scale crisis in terms of economic output forgone are very large, the estimated bene t of more rigorous capital requirements can be a very large number, even if Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 the reduced chance of a crisis is only modest. The results of these analyses can be sense-checked against the actual experience with recent nancial crises. The Independent Commission on Banking in the UK did this and suggested that CET1 gures in the range of 16 to 24 per cent of RWA would have enabled 95 per cent of 62 banks to survive recent crises. 14.6.3 Are we stuck with a debt/equity dichotomy? The debate referred to in the previous section has been carried on by reference to a dichotomy between debt and equity: only equity absorbs losses short of insolvency; debt absorbs loss only in insolvency; the costs of bank insolvency are too high for society to bear; so the solution is more bank equity. But it is perfectly p. 313 possible, by legislative at, to make bank debt bear loss short of insolvency. As we shall see in Chapter 16, this process is usually referred to as ‘bail in’: some categories of the debt of a failing bank are written o or converted into equity when the bank is in nancial distress but before it is bailed out by the state, so that debt bears loss at that point. Only debt which has this characteristic now counts, as we have seen, towards AT1 or T2 capital under the Basel rules. Or a bank may choose to issue debt on terms that it will be written o or converted upon some ‘trigger’ event short of resolution. If the focus is on the loss-absorbing capacity of nancial instruments issued by banks rather than on their equity characterization, then some of the private costs to banks associated with higher equity can be made to disappear. Hybrid debt may carry the tax shield of debt (depending on local tax rules) and no immediate debt-overhang issue exists, since equity is not being issued (though a debt-overhang problem may be created for the future). Hybrid debt will not bene t from the implicit state guarantee—the whole purpose of its creation is that it should not—and, as we have seen, removal or reduction of this guarantee is the aim of many post-crisis reforms. Long-term debt capable of bearing losses in resolution will certainly be more costly to the bank than debt likely to be bailed out, but that is what removal of the subsidy entails. Thus, the route to increasing banks’ loss-absorbing capacity beyond the Basel III minima and bu ers may be less troublesome than had initially been thought. Taking advantage of the concept of writing o and converting debt in resolution, the Independent Commission on Banking (ICB) in the UK proposed that banks should have a minimum ‘total loss absorbing capacity’ (‘TLAC’) of 17 per cent for a retail bank or 20 per cent for an investment bank, well above the Basel minima. The di erence would be made up by ‘bail-inable’ bonds—that is, bonds capable of being written o (or converted into equity). And this approach has now 63 been recommended by the FSB for all global systemically important banks. We examine it in Chapter 16. 64 However, the extent to which debt capable of bail-in is a substitute for equity is still highly controversial. 14.7 Conclusion That the Basel Committee has been, and continues to be, active in its responses to the nancial crisis is not open to doubt. We can identify the following major changes:  Risk-weighting, although still at the centre of the Basel rules, has been supplemented by an unweighted leverage ratio and banks’ own rating mechanisms have been subject to greater controls (for example, p. 314 stress tests). The sophistication of the Basel approach to market risk has been substantially increased as a result of the current ‘fundamental review’ of the trading book. The requirements for CET1 capital have been substantially increased. E orts have been made to reduce the procyclicality of the capital rules through the introduction of two Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 bu ers (CCB and CCCB). Systemic importance has been recognized through the introduction of a further bu er for systemically important banks. Yet, the overall levels of capital required, even after Basel III, seem small compared with the actual losses banks have su ered in nancial crises. As we have noted, the UK’s ICB concluded that a requirement of 24 per cent of RWA would have been needed to absorb the losses su ered by 95 per cent of the banks involved 65 in the crises. Of course, some states have gone further through the exercise of their Pillar 2 powers, especially in relation to large banks. Nevertheless, in neither the UK nor Switzerland—the two countries with the biggest banking sectors relative to GDP and therefore most at risk from a banking crisis—has the CET1 requirement actually been raised much beyond about 10 per cent of RWA. Why have the changes been so modest? Part of the answer is that movement to higher levels of capital is thought to require long transition periods. Another concern is the competitive advantage thought to be given to banks from other countries if an individual jurisdiction goes ahead alone with very much higher CET1 requirements while other jurisdictions remain with the international standard and foreign banks 66 cannot be required to operate through local subsidiaries. Both answers imply that policymakers do not accept the proposition that equity is not expensive. More important, high levels of CET1 only increase the chances that a bank will survive an external or internal shock. Only at very high equity levels, which might interfere with the bank’s transformation function, will equity provide something approaching a guarantee of survival. Thus, the question becomes whether higher levels of equity in the 25 per cent range are likely to appear persuasive to short-term funders (depositors and short-term wholesale market funders) on an ex ante basis, so as to induce them to keep their money in the bank if a bank is suspected of having incurred heavy losses. We do not know the answer to this question. It may well be possible to say, ex post, that equity equivalent to 24 per cent of RWA would have allowed 95 per cent of banks to survive recent crises. However, even this does not guarantee survival, and a short-term investor in any individual bank is unlikely to wish to hang around in order to discover the outcome. In short, it appears that capital requirements, at any acceptable level, are not likely to provide by themselves a su cient inducement for short-term funders not to withdraw from the bank in the case of serious uncertainty about the value of its assets, while a capital requirement that did do this job might seriously inhibit bank transformation. Other mechanisms to promote the safety and soundness of banks are needed to p. 315 supplement the capital mechanism. In terms of surviving a shock, liquidity regulation—considered in the next chapter—has an important part to play. E ective resolution mechanisms—considered in Chapter 16—may help to prevent the spread of contagion from a failing bank, aided possibly by structural regulation (Chapter 23), while better bank governance (Chapter 17) and macroprudential policy (Chapter 19) may make it less likely that the bank will su er a shock in the rst place. Notes 1 ʻRisklessʼ not in the sense that the depositor is sure to be repaid (indeed the risk to depositors of non-payment is central to this chapter) but in the sense that the value of the deposit is not expected by the depositor to vary with the creditworthiness of the bank in the way that the value of a bond does. In the jargon, this liability is expected to be ʻinformation insensitiveʼ. 2 In relation to non-financial firms, inability to pay current debts and a shortfall of assets against liabilities are both referred to as ʻinsolvencyʼ. In the context of banks, however, the term is generally used only for the latter, with the former being referred to as ʻilliquidityʼ. Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 3 A common form of borrowing is the ʻrepurchaseʼ agreement (ʻrepoʼ) in which the assets serve as collateral for loans. Valuation uncertainties will induce lenders to insist on greater discounts (or ʻhaircutsʼ) to ensure that the repo loans are fully secured. Repos are more fully described in Chapter 20, section 20.3.2, and Chapter 21, section 21.2. 4 Even in those jurisdictions which have minimum capital requirements for public companies, these are normally set at a trivial level; and constraints on distributions rarely go beyond setting profits earned as their outer parameter. 5 This is not to say that bank managers and shareholders su er no losses if a bank fails. In fact, the more valuable the bank franchise, the greater the losses they are likely to su er. Consequently, competition policy is a double-edged sword here. It may reduce costs to consumers but may also reduce the incentives to run the bank safely. 6 Of course, the failure of a large non-financial corporation may also give rise to externalities (think of its trading partners or the local community in which it operates), but the scale of the problem is far larger with the collapse of a large financial company. 7 Diversified shareholders might be less prone to under-price these risks because they may bear the externalities of bank failure through a diminution in the value of their non-financial holdings, yet the governance set-up of banks undercuts the pursuit of this set of interests: see J Armour and JN Gordon, ʻSystemic Harms and Shareholder Valueʼ (2014) 6 Journal of Legal Analysis 35. 8 See Chapter 3, section 3.5. 9 See Chapter 16 on ways of resolving failing banks. 10 Perhaps for this reason, the EU definition does not claim to be a definition of a ʻbankʼ but of a ʻcredit institutionʼ. 11 On the significance of the Basel rules see section 14.1.3. They state as follows: ʻThe scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank.…To the greatest extent possible, all banking and other relevant financial activities (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation.ʼ BIS/BCBS, International Convergence of Capital Measurement and Capital Standards: A Revised Framework—Comprehensive Version, bcbs128 (2006), paras 20 and 24. This document contains the Basel II rules, but the same scoping provisions apply to Basel III. There is a separate question, which we discuss in Chapter 23, as to whether restrictions should be placed, for financial stability reasons, on the range of financial activities that banking groups may carry on. In this chapter we discuss the capital and liquidity consequences of the set of permitted activities. 12 Even a er the crisis, the US Financial Stability Oversight Council (FSOC) reports that broker-dealers operate on aggregate at twenty-two times leverage, more than the typical commercial bank: FSOC, Annual Report 2013 (2014), 82. 13 Discussed in more detail in Chapters 1 and 21. 14 In fact the timetable for the introduction of Basel III is an elongated one. The capital and liquidity requirements of Basel III are not required to be fully implemented until January 2019. The analysis in this chapter generally assumes they are fully in force. 15 S Gleeson, International Regulation of Banking, 2nd ed (Oxford: OUP, 2012), 33. We discuss the Basel Committee in the context of international financial regulatory coordination in Chapter 28. 16 Within the EU, implementation is largely a matter for Union law. 17 See ʻGlobal Banks Reach Almost All 2019 Capital Standardsʼ (Financial Times, 15 September 2015), reporting that at the end of 2014 the 100 largest internationally active banks met the 2019 Basel requirements for CET1 capital, but less progress had been made in relation to liquidity requirements and the leverage ratio. 18 It is thus very di erent from the minimum capital requirement known to some corporate laws. That is aimed at undercapitalized start-ups and is calculated only once—on formation—and, typically, is specified as an amount of money rather than as a proportion of the assets. 19 BIS/BCBS, Fundamental Review of the Trading Book, bcbs219 (2012), Annex 1, Figure 2. 20 See generally, BIS, International Regulatory Framework for Banks (Basel III), http://www.bis.org/bcbs/basel3.htm  (accessed 25 August 2015). 21 BIS/BCBS, The Basel Committeeʼs Response to the Financial Crisis: Report to the G20, bcbs179 (2010), 5. 22 BIS/BCBS, Regulatory Consistency Assessment Programme (RCAP): Analysis of Risk-Weighted Assets for Market Risk, bcbs240 (2013); BIS/BCBS, Regulatory Consistency Assessment Programme (RCAP): Second Report on Risk-Weighted Assets for Market Risk, bcbs267 (2013). 23 BIS/BCBS, Fundamental Review of the Trading Book, bcbs219 (2012). For the resulting reform see Minimum Capital Requirements for Market Risk, bcbs352 (January 2016). 24 BIS/BCBS, Operational Risk—Revisions to the Simpler Approaches: Consultation Document, bcbs291 (2014). 25 The IRB approach comes in two forms: a foundation IRB, in which the bankʼs internal system sets only some of the elements of the risk-weighting, and an advanced IRB, in which the bankʼs internal system does the whole job. Thus, in Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 relation to loans, under foundation IRB, the bank sets only the probability of default (ʻPDʼ) but not the loss given default (ʻLGDʼ) or exposure at default (ʻEADʼ); under advanced IRB, the bank sets all three. LGD takes account of the fact that the bank may recover something even in default, for example where the loan is secured; EAD takes account of the fact that, for example, the loan might not be fully drawn down at default. 26 The IRB approach may also create a barrier to entry, since new banks will not have the historical data to feed into their model. 27 BIS/BCBS, Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, bcbs189, revʼd June 2011, para 151. 28 BIS/BCBS, Regulatory Consistency Assessment Programme (RCAP): Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, bcbs256 (2013). 29 BIS/BCBS, Analysis of Risk-Weighted Assets for Market Risk,n 22. This paper is coy in assigning percentages to the possible explanations for the divergences. 30 F Knight, Risk, Uncertainty and Profit (Boston: Houghton Mi lin, 1921). The modern application of this distinction to financial markets is associated above all with Gerd Gigerenzer: see G Gigerenzer, Risk Savvy (New York, NY: Viking, 2014), esp Ch 11. 31 Gigerenzer,n 30. The role of heuristics in decision-making is discussed more fully in Chapter 10, in relation to consumer financial decision-making. 32 Over one-quarter of the pages of Basel II (ignoring annexes) are devoted to this topic. 33 BIS/BCBS, Reducing Excessive Variability in Banksʼ Regulatory Capital Ratios: A Report to the G20, bcbs298 (2014). The revised market risk framework (n 23) requires internal models to be calibrated to periods of stress (so that the bank cannot rely wholly on its own historical data) and makes regulatory approval of internal rating systems more granular (it operates at the level of the regulatory trading desk, not the whole bank). In the US, Dodd–Frank Act §171 (the so-called ʻCollins Amendment,ʼ a er Sen. Susan Collins) specifies that the Basel I capital requirements are to serve as a floor to regulatory capital. 34 Stress tests are more fully discussed in Chapter 19 (section 19.6) as part of the macroprudential approach to financial regulation that has emerged post-crisis. 35 Bank of England, Stress Testing the UK Banking System: Key Elements of the 2014 Stress Test (2014), 9. 36 BIS/BCBS, Basel III Leverage Ratio and Disclosure Requirements, bcbs270 (2014). A leverage ratio of 3 per cent would have constrained the level of UK bank activity in the two to three years prior to the crisis: Bank of England, Financial Stability Report (December 2011), chart 2.4. 37 Bank of England, The Financial Policy Committeeʼs Review of the Leverage Ratio (2014) (proposing leverage ratio mimicking standard capital requirements, save for absence of risk-weighting). 38 Dodd–Frank Act of 2010 §171 (the Collins amendment) in the US. In the case of large banking groups (more than $700bn assets or $10,000bn under custody), this provision imposes a leverage ratio of 6 per cent on the deposit-taking member of the group and a 5 per cent leverage ʻbu erʼ at group level. The aim is to maintain the impact of the leverage ratio, given the higher risk-weighted capital requirements imposed on such groups, rather than to expand the function of the leverage ratio. See (2014) 79 Federal Register, 84, 24528. For the UK see the previous note. On bu ers and global systemically important banks, see section 14.5.2. The leverage ratio consists of a numerator (CET1 [Common Equity] and Additional Tier 1 capital) and a denominator, designed to pick up on-balance sheet assets and o -balance sheet exposures. The definition of the denominator has been controversial. 39 D Aikman, M Galesic, and G Gigerenzer, ʻTaking Uncertainty Seriously: Simplicity versus Complexity in Financial Regulationʼ, Bank of England Financial Stability Paper No 28 (2014), 13–14. 40 If a bank has $100 in assets funded by $10 of equity, and then purchases $10-worth of additional assets funded by subordinated debt, the proportion of its assets funded by equity falls from 10 per cent to ≈ 9 per cent. 41 AT1 hybrid debt must be perpetual; T2 debt must have a minimum maturity of five years. 42 However, some assets, permitted under normal accounting rules, are excluded when computing the bankʼs CET1.  Examples are intangibles, goodwill, and deferred tax assets. This makes the 4.5 per cent figure slightly more constraining than it appears at first sight. Eliminating classes of assets has a proportionately bigger impact on the bankʼs capital (assets less liabilities) than it does on the bankʼs assets considered on their own. 43 Chapter 19, section 19.3.1. 44 BIS/BCBS, Basel III, n 27, para 122. 45 E Cerutti, S Claessens, and L Laeven, ʻThe Use and E ectiveness of Macroprudential Policies: New Evidenceʼ, IMF WP 15/61 (2015). 46 For this argument applied to bank regulation as a whole see J Gordon and C Mayer, ʻThe Micro, Macro and International Design of Financial Regulationʼ, Working Paper Columbia Law School/Oxford University (2012), available at http://www.ssrn.com. See also Chapter 19. Downloaded from https://academic.oup.com/book/35860/chapter/308566864 by OP Jindal Global University user on 14 September 2023 47 BIS/BCBS, Global Systemically Important Banks, bcbs207 (2011), para 15. 48 The 30 G-SIBs, with their applicable top-ups, are: HSBC, JP Morgan Chase (2.5 per cent); BNP Paribas, Barclays, Citigroup, Deutsche Bank (2 per cent); Bank of America, Credit Suisse, Goldman Sachs, Mitsubishi, Morgan Stanley (1.5 per cent); Agricultural Bank of China, Bank of China, Bank of New York Mellon, China Construction Bank, Groupe BPCE, Groupe Crédit Agricole, Industrial and Commercial Bank of China, ING Bank, Mitzuho FG, Nordea, Royal Bank of Scotland, Santander, Société Générale, Standard Chartered, State Street, Sumitomo Mitsui FG, UBS, Unicredit Group, Wells Fargo (1.0 per cent) (FSB, November 2015). 49 The Federal Reserve has recently proposed to augment the Basel Framework for US G-SIBs by assessing an additional charge based on a measure of the bankʼs ʻshort-term wholesale fundingʼ. Such funding, which can materially increase run- risk, adds to a bankʼs susceptibility to failure. The Federal Reserveʼs proposed implementation of Basel III would produce a G-SIB surcharge with a 4.5 per cent cap. 50 BIS/BCBS, A Framework for Dealing with Domestic Systemically Important Banks—Final Document, bcbs233 (2012). 51 Dodd–Frank Act of 2010 §115. See alson 38. 52 A Admati and M Hellwig, The Bankersʼ New Clothes (Princeton, NJ: Princeton UP), 2013. 53 This is, however, precisely what supporters of ʻnarrow bankingʼ advocate. On their view, deposit insurance should be available only to banks whose assets consist wholly of high-quality and highly liquid assets; that is, mainly cash and cash- like instruments. 54 Seen 52, 179. 55 P Alessandri and A Haldane, ʻBanking on the Stateʼ, Bank of England (2009), Chart 2. 56 F Modigliani and M Miller, ʻThe Cost of Capital, Corporation Finance and the Theory of Investmentʼ (1958) 48 American Economic Review 261. 57 See J Tirole, The Theory of Corporate Finance (Princeton, NJ: Princeton UP, 2006), 3.3. 58 There is, of course, an explicit guarantee in the case of deposits (see Chapter 15) but, as stated, we assume in this section that the equity would replace long-term bank debt. 59 A thought experiment shows the limited relevance of the Modigliani–Miller hypothesis for bank regulation. For a given level of equity, the value of the bank, and separately, the fragility of the bank, will be critically a ected by the make-up of the liabilities: deposits, short-term wholesale claims, and term debt. For example, at a given leve