Category / Capital and Contingent Instruments

Orderly failure vs. no failure March 12, 2014 at 3:00 pm

Quoth SEC Commissioner Daniel Gallagher:

In the banking sector, which features leveraged institutions operating in a principal capacity, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole. Bank capital requirements serve as an important cushion against unexpected losses. They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure. They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.

Capital requirements for broker-dealers, however, serve a different purpose, one that, to be fair, can be somewhat counterintuitive. The capital markets within which broker-dealers operate are premised on risk-taking – ideally, informed risks freely chosen in pursuit of a greater return on investments. In the capital markets, there is no opportunity without risk – and that means real risk, with a real potential for losses. Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk – and the corresponding potential for failure – by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer.

As I said, it’s counterintuitive, but the possibility – and the reality – of failure is part of our capital markets. Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.

How much is too much? February 26, 2014 at 8:27 am

Marco Onado at Vox EU makes a couple of good points:

  • European Banks’ gross and net profitability are at a historical low level, so
  • They have an incentive to remain on the present levels of leverage to obtain a ‘reasonable’ return on equity and
  • the rate of increase of capital allowed by retained earnings is modest.

To this I would add:

  • Credit in Europe will remain rationed and expensive until capital and leverage standards are reduced, or banks’ earnings increase.

I think Prof. Onado implies that this situation isn’t sustainable for much longer: to agree one only needs to think that a fix that requires a decade or more of austerity isn’t politically tenable.

Eating your own Coco February 11, 2014 at 11:12 pm

Dealbreaker catches a deeply amusing story from the WSJ:

banks including the U.K.’s Barclays PLC, Germany’s Deutsche Bank AG and Switzerland’s UBS AG could shore up their U.S. subsidiaries… the U.S. units would issue to their parents a type of bond that converts into equity if the U.S. business’s capital falls below a certain level… The European parent companies would finance the purchases of their subsidiaries’ debt by issuing bonds to investors, these people say.

Coco double leverage: very cool. But not very chocolatey, sadly. You can call it an internal convertible if you must. I’m gonna call it something else…

8 is the new 0 July 3, 2013 at 6:32 am

From the FT’s account of the new Eurozone bank resolution framework:

From 2018, the so-called “bail-in” regime can force shareholders, bondholders and some depositors to contribute to the costs of bank failure. Insured deposits under €100,000 are exempt and uninsured deposits of individuals and small companies are given preferential status in the bail-in pecking order.

While a minimum bail-in amounting to 8 per cent of total liabilities is mandatory before resolution funds can be used, countries are given more leeway to shield certain creditors from losses in defined circumstances.

Under the compromise, after the minimum bail-in is implemented, countries are additionally given an option to dip into resolution funds or state resources to recapitalise the bank and shield other creditors. The intervention is capped at 5 per cent of the bank’s total liabilities and is contingent on Brussels approval.

Anyone wanna buy two new credit derivatives, one with an 8% digital payout on bail-in, the other a 2nd loss instrument on the remaining 92%?

Capturing `hard to resolve’ November 26, 2012 at 6:56 am

An article from a little while ago about a speech by Michael Cohrs, a former Goldman Sachs banker who now sits on the Financial Policy Committee, has one good idea.

He suggested that “too big to fail” banks should be forced to pay “penalties or taxes to create insurance funds” to be used to cover the costs of a major bank collapse “and to create an economic incentive for the firms to downsize”.

The “penalty” should be “in addition to the 2.5pc capital surcharge” global regulators have recommended. In addition, he said: “We must accept that both shareholders and debt holders should suffer losses when a financial company goes into receivership.”

I like the idea that bigger banks are harder to resolve, with likely higher costs, and hence they should pay more. At first I was musing on the idea of a compulsory issuance of `write down on resolution’ instruments — something that I do think would help — but these don’t benefit from the small measure of diversification in the situation, so perhaps a government run insurance fund would be better, with premiums based on some `resolvability index’ which measures the cost and complexity of the process. In any event, thinking about how to pay for failures before they happen may be more sensible than increasingly stringent economy-destroying regulations which aim to prevent failure (and don’t succeed).

More capital not less RWAs October 5, 2012 at 12:59 pm

From a Citi research note ‘UK Banks and the Quantum of Capital’:

The FPC’s last meeting recognised that “some actions which boosted the resilience of individual banks could adversely affect near-term credit availability, for instance if requirements to increase capital ratios provoked deleveraging focused on UK lending”. To mitigate this risk, the FPC recommends banks reduce non-UK lending assets and increase their levels of equity capital. For the FPC, more capital in absolute terms could help fulfill its dual mandate, while higher capital ratios alone can be achieved by de-leveraging and this may not fulfill its dual mandate.

It is thinking like this that is (for better or worse) creating the ROE problem we discussed this morning.

What happens when they are gone? September 3, 2012 at 6:35 am

What is bank capital for? It is a good question, with many possible answers including going concern loss absorption, giving confidence to debt buyers and gone concern loss absorption. There is no need for these functions to be performed by the same security and indeed there are some benefits to separating going and gone concern issues. Given that banks will typically be resolved these days rather than going into bankruptcy, gone concern is mostly about resolution. Suppose then that we have a security that only suffered losses in resolution, when it is available to absorb any losses that equity is not sufficient to deal with. It would sit between equity and more senior debt instruments. It could even be convertible into new equity supporting a bank recapitalisation (although you might not want that, as you might not want the holders of these instruments to try to hedge the embedded equity option). However it would not be convertible before resolution, nor would its coupons be deferrable except during resolution. The price of such an instrument would therefore precisely reflect the market’s perception of the probability of resolution of a bank. The existence of such an instrument would allow regulators to intervene rather later than if it did not exist, as the instrument would be available to reduce losses to deposit protection schemes. The moral hazard whereby regulators seize a bank from its existing shareholders would be mitigated as seizure would only occur when the equity was worth close to nothing anyway.

I know that the history of bank hybrid capital instruments has not exactly been glorious, but I think a lot of prior problems relate to the lack of a clear trigger for taking losses/deferral. A pure play on resolution might just work.

Another hybrid for equity swap February 22, 2012 at 9:40 am

Standard procedure, this, for European banks these days. Bloomberg reports:

Commerzbank AG (CBK) will ask investors to swap hybrid capital instruments trading below face value for new shares, adding to steps by Germany’s second-largest lender to boost its financial strength.

The measures, announced as Commerzbank unveiled earnings that beat analyst estimates, could boost the German company’s core Tier 1 capital by more than 1 billion euros ($1.33 billion), it said… The principal amount of the capital instruments included in the offer totals about 3.16 billion euros, Commerzbank said.

In other words, you buy the hybrids (which are trading well below par) back at market or close to it, and issue new equity. This is Basel 3 capital enhancing as the hybrids are not good capital in the new regime, and you (probably) get a pop from the sub par buyback.

Update. As FT alphaville says, one of the things that is interesting about CBK’s progress is its progress on RWA mitigation. They quote Nomura research from Chintan Joshi and Omar Keenan and as follows [MSB = Mittelstandbank, a corporate banking unit, ABF = Asset-based finance]:

In MSB there was a lot of progress made on RWAs. The effects of adding collateral into systems was EUR 5bn alone and CBK staff are getting better at this. There is a team of 200 people working on this, and previously CBK in moving from Basel 1 to Basel 2 was also a laggard in taking advantage of capital efficiencies. Second, there were better ratings in MSB. Third, the bank adjusts the model parameters once a year. Germany experienced a low recovery rate historically because the average equity in German companies used to be 17%. However, this is now 28% on average and implies higher recovery rates. This reduces LGD and risk RWAs…

200 people just to optimize their regulatory capital calculation in one part of the bank? Wow.

The other part of the story of course is synthetic securitization to optimize capital, and unsurprisingly CBK are doing that too

Rescheduled talk at LSE on Wednesday this week February 6, 2012 at 10:31 am

My talk at the LSE which was postponed due to the strike in November will now (if the Gods are willing) happen on Wednesday.

Title: Post crisis Bank Regulation and the Rôle of Capital
Time and date: 6-8pm, Wednesday 8th February
Location: Room NAB 1.04, New Academic Building, London School of Economics (entrance from the West side of Lincoln’s Inn Fields)

The slides are here.

ROE, capital, and false conclusions September 30, 2011 at 5:22 pm

This post is an attempt to figure out what ROEs, returns on capital, and capital structure really tells us about the risk of banks. It is partly a response to Martin Wolf’s FT blog post What do the banks’ target returns on equity tell us? but also more generally a comment on the whole banks can have more equity and it won’t cost much meme.

First, we should define some terms. By ROE or return on equity, I mean the return on equity based on the current market price. So if I buy a share for a dollar, and my total return (price appreciation plus dividend yield) in a year is seven cents, I have a 7% ROE.

Return on regulatory capital is slightly different. This is because capital is not the market price of a firm’s equity; rather it is* shareholders funds. This includes money raised from issuing equity, retained earnings, and a few other (typically smaller) items. Thus the return on capital is based on the price of equity at issue, plus whatever earnings have been retained, and a few other bits and bobs. Firms typically cannot issue meaningful amounts of new equity at the current price, as new equity dilutes existing shareholders. It also usually irritates them. Therefore it is usually easier to increase capital by retaining earnings rather than by issueing new stock.

The naive ‘banks can easily have more capital’ crowd typically argue thus:

  • The Miller Modigliani theorem says that capital structure does not matter; if you have more equity, you are safer, hence your debt trades tighter, hence the extra cost of the equity is made up for in having cheaper funding;
  • Remember that more equity makes banks safer?
  • Get more of it.

The problem with this is that the Miller Modigliani theorem is false. Amongst other things, it assumes no taxes; it assumes that investors are risk neutral; and it assumes that risk is perfectly known by all investors. None of these things are true, and thus those who trade capital structure based on MM alone are known as ‘bankrupts’. For me, the biggest issues in MM are the linked ones of no risk premiums and perfectly known risk. Of course if I know the distribution of a firm’s earnings precisely then I can price the stock. It is the very fact that I don’t that makes equity investment difficult: it means that investors demand a variable but high premium for taking equity risk. Because an equity issuer has to pay this extra premium whereas a debt issuer doesn’t (or at least doesn’t have to pay as much of a one, assuming we are not in high yield territory), equity cannot be substituted for debt without cost.

Note that the existence of risk premiums means that you cannot assert that just because a bank’s target ROE is 15%, it is highly risky. Wolf makes this mistake, saying that mid teens ROEs demonstrate that ‘these desired returns must represent the result of extreme risk-taking’. Of course, he may be right, but one cannot conclude that from the evidence available.

What happens if you raise capital requirements above current levels? Clearly a bank has two choices:

  1. Raise more capital; or
  2. Reduce risk (as measured by capital requirements).

The first of these is typically done by retaining earnings, unless the new capital required is large, due to the aforementioned pissing-off-the-stockholders feature of issueing new equity.

It is the second I want to focus on, though. What would we do to reduce risk? Well, clearly, we need to cut those businesses with a low return on regulatory capital. And that, sadly, means commercial lending. Both retail banking (because it has relatively low regulatory capital requirements for the risk) and investment banking (because it, historically at least, has high returns) look better under return on reg cap than commercial banking. So that’s where you cut. And you cut savagely as your whole portfolio generates regulatory capital, so to meaningfully affect it, you have to make a dramatic change to the speed of origination of new business.

This is why I think that meaningful changes to banking regulation are best done in good times, not bad ones. In a boom, a decrease in the supply of credit is probably a good thing. It is certainly less bad than it is in a recession.

Note, by the way, that both increasing capital and reducing risk have the effect of reducing ROE. The first because either there will be more shares for the same earnings or because increasing retained earnings will be reflected in a higher stock price; the second because reducing risk will typically reduce earnings. The effect is not linear and not easily modelled though, especially capital tends to be sticky. For a large bank, raising another hundred million dollars of capital will often not budge the stock price at all, but a couple of billion will move it substantially.

At the end of the day, economics should be about what works. Yes, we want a more stable financial system. But we also want economic growth. Whether increasing bank capital requirements should or should not lead to decreased lending in your model or mine does not ultimately matter. What matters is whether it in fact does, and what the macroeconomic consequences of that are. It would be truly irresponsible to attempt banking reform in the depths of a recession without at least being alert to the possibility of adverse consequences, and moving quickly to address them if they occur.

*For simplicity here I have ignored deductions and a few other wrinkles which mean that common equity tier 1 is not quite the same as shareholder’s funds.

Vickers outside the ring fence: part 3 September 15, 2011 at 6:23 am

So far we have seen that the Vickers Commission proposals are reasonably penal in terms of both the levels of capital they suggest for the largest UK banks and the concomitant leverage ratio.

How much do these capital measures help? We can get some insight from Chapter 7 of the report. First some scene setting:

small banks might be disproportionately affected by prudential regulation… There are three potential ways in which small banks or new entrants might face higher capital requirements than large incumbents: they might be penalised for less experienced management or lack of a track record (especially new entrants); they might be required to hold extra capital to compensate for concentration in a particular market or geographical region (especially small banks); or the risk weights on their assets might be higher due to using a standardised rather than advanced approach to risk-weighting.

So, to look at this, the report studies the actual risk weights, and hence the actual amounts of capital, that various UK bank are subject to. The big determinant here is first whether the bank has an IRB model and second (because IRB models are particularly generous to retail mortgage assets), how many mortgages you have. The following table illustrates this generosity:

Vickers IRB

So Lloyds and Barclays have a capital charge for residential mortgages that is less than half of the standardised charge, whereas for Nationwide it is an astonishing seven times cheaper. As the Commission notes

The result may be that small banks are less systemic and easier to resolve than large banks, and yet are required to hold proportionally more capital.

Vickers outside the ring fence: part 2 September 13, 2011 at 6:24 am

After yesterday’s part 1, here is part 2 of my brief survey of the Vickers Commission report. As before, it concentrates on the proposals which are not related to ring fencing.

First an encouraging section that shows that Vickers understands something of the role of capital:

For banks’ CCBs [capital conservation buffers] to provide efective pre-resolution loss-absorbing capacity which can be used without immediately raising concerns about a bank’s viability, it is important that the market does not regard them as simply extending the hard minimum equity requirement. The authorities should make it clear that they do not consider the CCB as doing so, and give due regard to this when conducting stress-testing. If market perception will drive a bank to do all it can to avoid dipping into the bufer, it is likely to reduce lending to do so, if necessary. If a signifcant part of the banking system is similarly afected and responds in the same way at the same time, a system-wide contraction in the supply of credit could result – even with the banking system well-capitalised. Hence the importance of communication from the authorities on this point.

However, note that communication alone is not enough. The market needs to believe that a bank can use some of its CCB to absorb losses and still be worthy of funding.

Next, the Commission’s proposals on the leverage ratio:

[Previously] the Commission recommended that the 7% Basel III baseline for the ratio of equity to RWAs be increased to 10% for large ring-fenced banks. This would also increase the Basel III baseline for the ratio of Tier 1 capital to RWAs from 8.5% to 11.5%.

In order that the leverage ratio provides an equally robust backstop for large ring-fenced banks it should be increased proportionately from 3% to (11.5/8.5) x 3% = 4.06%… an abrupt change in regulatory requirements
when a bank crosses a size threshold should be avoided by increasing the minimum leverage ratio from 3% to 4.06% on a sliding scale as the RWAs-to-UK GDP ratio increases from 1% to 3%.

On non-equity capital:

The Commission recommends that the SRR [special resolution regime] should be supported by giving the resolution authorities two complementary bail-in powers available for use in resolution.

First, the authorities should have a ‘primary bail-in power’ to impose losses in resolution on a set of pre-determined liabilities that are the most readily loss-absorbing. This should include the ability to be able to write down liabilities to re-capitalise a bank (or part thereof) in resolution… the class of (non-capital) liabilities that bears loss most readily is long-term unsecured debt. The Commission’s view is therefore that all unsecured debt with a term of at least 12 months at the time of issue – ‘bail-in bonds’ – should be subject to the primary bail-in power…

Second, the authorities should have a ‘secondary bail-in power’ that would allow them to impose losses on all unsecured liabilities beyond primary loss-absorbing capacity (again, including the ability to write down liabilities to re-capitalise a bank) in resolution, if such loss-absorbing capacity does not prove sufficient…

The minimum ratio of primary loss-absorbing capacity to RWAs required of a ring-fenced bank should therefore be increased from 10.5% (the minimum amount of primary loss-absorbing capacity required under the Basel III rules) to 17% on a sliding scale as the RWAs-to-UK GDP ratio increases from 1% to 3%.

Thus, roughly, we have a 10% equity requirement and a 7% bail-in bond requirement for the largest UK banks. This is however not a at-all-times requirement. Sensibly, Vickers says

A minimum primary loss-absorbing capacity requirement should be regarded as a bufer, rather than a hard minimum. (Imposing it as a hard minimum might result in a G-SIB with 16.5% of primary loss-absorbing capacity – much of which could be equity – being put into resolution. This would obviously not be desirable.) The consequences for falling below the minimum should therefore not be a breach of regulatory threshold conditions. Instead, restrictions should be imposed on a bank’s ability to pay out discretionary distributions such as dividends and bonuses (as happens when a bank falls into its CCB – see Box 4.2). If a bank’s ratio of primary loss-absorbing
capacity to RWAs falls below the minimum, this means the bank can continue to
operate (although its supervisor would no doubt expect to see evidence of a
management plan demonstrating how the bank would restore its level of primary
loss-absorbing capacity in due course).

What we end up with, then (once you include an extra 3% resolution buffer for investment banks), is this:

Vickers Capital

Next up, some interesting disclosures from Chapter 7. I know, you can hardly wait…

Vickers outside the ring fence: part 1 September 12, 2011 at 9:52 am

For me, the interesting parts about the Vickers Commission report on the future of British banking are not the widely reported recommendations to ring fence retail from investment banking. Here are some quotes, lightly edited:

First… if capital requirements could be increased across the board internationally, then the best way forward would be to have much higher equity requirements, in order greatly to increase confdence that banks can easily absorb losses while remaining going concerns. The Commission is however conscious that unilateral imposition of a sharply divergent requirement by the UK could trigger undesirable regulatory arbitrage to the detriment of stability. Second, a leverage cap of thirty-three is too lax for systemically important banks, since it means that a loss of only 3% of such banks’ assets would wipe out their capital. Third, in contrast with the Basel process, the Commission’s focus is on banks with national systemic importance, as well as on ones with global importance. Fourth, the loss-absorbency of debt is unfnished business in the international debate.

In other words, Basel III notwithstanding, the Vickers Commission recommends higher capital requirements for the large UK banks. Specifically, a CET1 ratio of at least 10%:

Equity is the most straightforward and assuredly loss-absorbing form of capital, and there is a strong case for much higher equity requirements across the board internationally. For the UK, taking the international context and the tax regime as given, and having regard to transitional issues and the potential for arbitrage through foreign banks or shadow banks, the Commission recommends that large UK retail banks should have equity capital of at least 10% of risk-weighted assets. This exceeds the Basel III minimum, even for G-SIBs, and the backstop leverage cap should be tightened correspondingly.

Chapter 4 is the interesting part here; I will return to this tomorrow.

George says give them a break August 30, 2011 at 7:37 am

In a great article on Bloomberg, George Magnus reprises his what we can learn from Marx about the current crisis theme. He has five policy prescriptions, all of which are worth reading; here I will concentrate on the third

…to improve the functionality of the credit system, well-capitalized and well-structured banks should be allowed some temporary capital adequacy relief to try to get new credit flowing to small companies, especially. Governments and central banks could engage in direct spending on or indirect financing of national investment or infrastructure programs.

Exactly. Now is precisely the wrong time to be increasing minimum capital requirements. As George says, our prime focus should be on creating jobs, and a frozen credit system is not helping. I would cut capital requirements on corporate loans (only) by 50% for at least two years.

Solvency uncertainty August 26, 2011 at 10:02 am

I have said this before, but not as starkly as Steve Randy Waldman:

“hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless*. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.

(*I would say ‘uncertain’ rather than ‘meaningless’ here. These ratios do tell you something, just nothing precise.)

John Hempton gets this too:

Bank capital [ratios] can’t be accurately measured…

Because banks have quite a lot of discretion about how they book their losses and most losses can be spread over-time just running out of stated capital is not the common way for a bank to get into trouble.

You see banks deferring losses every cycle. When the crisis hits everyone screams the bank is under-reserving and guess what – everyone is right. But the bank gets to take its losses over time and that suits the bank because the bank tends to have high pre-tax pre-provision earnings in a crisis and time cures things. When you take losses is subjective most of the time. In bad times banks lie about losses because they can and it is their interest to lie. This is – as Buffett has noted – a self-assessed exam where the penalty for failure is death.

The key point is that most of the time this does not matter. The world thinks for instance that BAC’s ‘true’ capital ratio (to the extent that it makes any sense to talk about something that you could never discover) is between 6% and 12%, and as 6% will do, it doesn’t care. The problem comes when either losses or more likely concerns over likely future losses turns that range from 6% to 12% to 2% to 8%. In my judgement that was what the market was saying about BAC before the Buffett deal: that BAC just might be badly capitalized and no one knows.

We are always looking at large financials through a fog. Little about them – and nothing important about their solvency – can be seen precisely. It’s all about confidence. If the market is confident that you are OK, then it lets you borrow and, mostly, you are actually OK. If it isn’t, then you better find a way of restoring confidence pretty quickly because while solvency is fantasy, liquidity is very very real.

A bad, bad day August 2, 2011 at 6:06 am

I hate this. Really I hate it. But I have to admit that Alan Greenspan is right about something. Don’t worry, he is wrong headed about many things. The lone insight is this:

Bank managements, currently repairing their demonstrably flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend. For the moment they are expanding their loan portfolios only marginally. Most of the new capital appears to have buffer status, rather than being directly involved in spurring day-to-day lending. Deep uncertainty about our economic future, as well as the potential level of regulatory capital, has unsettled bank lending. More than $1,600bn in deposits (excess reserves) at Federal Reserve banks are lying largely dormant despite available commercial and industrial loans that, according to the Fed, entail “minimal risk” and are yielding far more than the 25 basis points reserve banks are paying on such deposits. The excess reserves thus seem to have taken on the status of a buffer, rather than actively participating in, and engendering, lending and economic activity.

There are two things going on here.

First, as Tyler Cowan points out, there is plenty of evidence that higher bank capital requirements lower growth, so there is a real policy choice between recovering faster from the recession and having a more stable banking system. Yes, Victoria, I know you want both, but sadly the world is not built that way. All Greenspan is doing is pointing out the unpalateable truth that we have chosen financial stability over growth.

Second, we want banks not to fail. Higher minimum capital requirements ensure that if they fail, more of the costs are born by equity holders and less by depositors or the deposit insurance body or senior creditors (Krugman is right about that). But what higher minimum capital requirements don’t do is to make the probability of failure much lower. This is because failures are typically liquidity rather than solvency driven, and so (as we have argued before) required capital is not available to absorb losses, only capital above the minimum is.

There is one more point Greenspan should have made and didn’t. It is that insurance mechanisms often involve lower aggregate cost than everyone having sufficient capital to support their own risk. This is why we let insurance companies take the tail risk for example of fires rather than everyone self insuring. Thus the total cost to the system of the state bearing some tail risk of financial instability is probably lower than asking each bank to separately capitalize it. Now I am not arguing that because of this the state should just write a blank cheque to the bankers (again). But I am suggesting that there is a legitimate debate to be had about capital requirements vs. insurance premiums; about risk mutualization and incentive structures.

Do higher minimum capital requirements for banks do any good? July 21, 2011 at 5:24 pm

Here’s the problem.

If we set a minimum capital requirement, it is just that, a minimum. Banks have to meet it. The capital that they use to meet that requirement is trapped: it can’t absorb losses, as if it does, the bank is below the minimum, and that is not allowed.

The market also plays a role here. If a certain level of capital is required, then the market will demand that banks have at least that much before they will allow them to roll their debt. So again this capital is not available to absorb losses.

There is an argument then that raising minimum capital levels does not improve the ability of banks to absorb losses at all. All it does is decrease the loss to the taxpayer after banks fail. (In this argument banks fail for liquidity reasons while still close to being well capitalized due to the market declined to roll their debt.)

Rather, what makes banks more likely to be able to continue as going concerns is a relatively low level of required minimum capital, with banks holding higher levels of actual capital above that. The excess over the minimum is actually available to absorb losses.

Food for thought, perhaps, as Basel III implementation begins in Europe.

Climbing out vs. pushing under: the ‘everyone step down a notch’ theory of bank resolution May 14, 2011 at 10:35 am

I could be wrong. I had thought that the idea of bank bail ins was to dilute or extinguish ordinary shareholders, to turn bail-in (tier 2 or coco) instruments into new equity, but to preserve senior debt holders. It seems that the last bit is not necessarily true. It is being contemplated, I understand, that bank resolution regimes may also convert some portion of the senior into equity. That’s going to make selling all that long-dated senior debt that the Basel III liquidity requirements demand quite difficult. Perhaps if you took your foot off my head, I might be able to climb out of the water…

Take your foot off my head

What should we do instead? Well, the priority order of securities gives a strong clue. If a bank is in resolution, it by definition it cannot carry on. Therefore shareholders, as bottom of the priority order, should be wiped out. The new equity in turn comes from the sub debt holders; the conversion of their instruments gives us the vast majority of the new equity as we are massively diluting the equity holders. Logically then senior debt holders should step down too, with some of their notional being converted into new sub debt.

Now for a really delicate question: what do you do about covered bonds? Well, a covered bond is a claim which first has assets supporting it and second is senior. Following the logic above, the covereds keep their assets, but a part of their claim should become subordinated. Now I full admit that it is likely that this particular policy choice will be ignored, but it is the logical consequence of the ‘everyone steps down a notch’ theory of bank resolution.

Update. An FT alphaville post on the Swedish bail-in/out/shake it all about regime made me think that it is worth clarifying how much you need to do at each step in the ladder. The first decision is whether to bail in or just let the institution go into bankruptcy. Then if you bail in, you first decide how much equity you need. You compare that with how much you have, based on an independent valuation, with how much you need. Convert enough Cocos to get you there. Then compare the remaining Coco stock, if any, with how much you need, and convert enough senior debt into Cocos to get you there too.

Why valuation matters more than capital May 8, 2011 at 9:30 am

An article by Raihan Zamil on makes – albeit a little unclearly – a point I have emphasised for a long time: valuation matters more than capital. (See also for instance here and here.)


Well, let’s take a typical bank. Say it has 100 of assets, supported by 90 of liabilities and 10 of equity.

Adding 2 or 3 to the equity is really controversial: asking for a Basel ratio of 12% is a hard sell. (15% is crazy, by the way. Just saying.) So going from 100/90/10 to 100/88/12 is difficult for supervisors.

But what if the assets aren’t really worth 100? If they are only ‘really’ worth 95, then what we really have is 95/90/5, and the ‘true’ Basel ratio is only 5.2%. Then increasing the equity by 2 points would still leave the bank a significant distance from being well capitalised.

Moreover, a 5% difference in asset valuation across something as big and complicated as a bank can easily happen. Ensuring that provisions in the banking book and marks in the trading book are accurate is really, really hard (even if you are not trying to pull the wool over the shareholder’s eyes).

What does this mean for bank supervision? It means that before worrying about capital, supervisors have to put a lot – and I mean a lot – of effort into checking valuation methodologies, both in theory and in practice. To be fair this happens to some extent in most juristictions already, but given how critical it is, and how hard it is to do correctly*, it would be far better to be over- than under-resourced here.

Now, once you are sure that the valuations are reasonable, you can then look at how leveraged the bank is and how quickly it might lose its capital. But you can’t look at that absent confidence in valuations as you basically know nothing about an institition if you don’t know that its valuations have been diligently determined.

Eat Me

* The above might be seen to imply that there is a ‘correct’ value which can be discovered with sufficient diligence for all assets and liabilities. I don’t believe that is true. In many ways the process – the process of testing valuations and reporting uncertainties, of checking methodologies – is more important than the precise answers.

Overcooked Coco April 13, 2011 at 6:27 pm

Andy Haldane thinks that we should consider Cocos with market triggers as capital instruments for banks. Um. Dunno.

For me the issues are complex. First, whatever the Coco trigger is, it should be objective. There market will react badly to a trigger which is, in effect, whatever the supervisors want. That’s partly because as we have a longer period of calm the wisdom will develop that Cocos are never triggered; then, if they are, the shock will be enormous. So having an objective trigger – and one that is not too far from the money – is important.

Second, partial triggering is important. You do not want to be in a situation where the bank needs a bit more capital but not so much that the whole Coco needs to be triggered with the accompanying dilution for shareholders. IThe way to do that is to allow partial conversion.

Third, there is the hedging issue. Some folks will hedge Cocos by shorting equity against them. (And/or trading CDS.) The way to ensure that this hedging is not too disruptive, and is less likely to push the bank down, is to spread the gamma of the Coco around a range of strikes. This is a particular form of partial conversion where as the share price slides, more and more of the Coco converts. (Of course you need to adjust the current trigger for the dilution effect of earlier conversions.)

Fourth, false positives. Haldane is reasonably convincing that market based triggers do detect troubled firms. But do they detect trouble where none exists? My gut feeling is that part of the answer here is improved disclosure, but I’d want to see a thorough historical analysis of market based Coco conversions – and a behavioural analysis of how they would have been hedged – before truly embracing these instruments.

Update. See here for an interesting further discussion from VoxEU.