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