PRIMER: bank capital

Author: Amélie Labbé | Published: 3 Nov 2017
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

What is bank capital?

It’s both an easy and difficult question to answer. A bank can use its some of its own assets – known as bank capital or regulatory capital – as a buffer to stay afloat when it faces financial difficulties. But the components of bank capital, how they are accounted for or at what point a financial institution can be deemed failing are issues that have been subject to much debate.

All financial institutions are required by law to hold a certain amount of capital, which is used to measure their ability to withstand losses. In that sense, bank capital is simply the amount of assets that a bank is able to lose (or use as a buffer) without going insolvent. The world’s largest banks (known as global systemically important banks (G-Sibs)) have to abide by a total loss absorbing capacity (TLAC) standard devised by the Financial Stability Board. Non- G-Sib banks in the EU have to comply with the minimum requirement for own funds and eligible liabilities (MREL), while their counterparts in jurisdictions such as the US and Australia have similar standards.

"As with many things when it comes to financial regulation in the past 10 years, the answer is the financial crisis"

“TLAC and MREL are tools that support banks’ internal preparedness to a crisis,” Single Resolution Board (SRB) board member Dominique Laboureix told delegates at the SRB’s annual conference last month in Brussels. “They also level the playing field between banks as all have to be ready in case the worst happens.”

Where does Basel come into it?

The Basel Committee on Banking Supervision is responsible for establishing rules on the appropriate level of capital for banks globally. The latest version of these rules, known as Basel III, came as a result of the 2008 financial crisis, and sets the ratio at eight percent of its risk-weighted assets (RWAs). The framework has been transposed in the EU via a series of Capital Requirements Directives.

Based on the Basel III definition, bank capital is divided into two main tiers depending on their ability to absorb losses and their position in the creditor hierarchy. Tier one capital (core capital) has the highest subordination, and includes common shares and a bank’s disclosed reserves. Tier two capital covers assets including unsecured subordinated debt and undisclosed reserves. Banks also started issuing a new type of bank bond last year commonly referred to as senior non-preferred debt (or tier three in some cases), whose value can be written down too in the event they fail or close to failing. This opens up a while new discussion on the point of non-viability (when capital levels reach the minimum required) and how banks, investors and regulators disagree on where this should be.

All these combined are known as gone concern capital meaning they will be only be called upon when a bank is in resolution.

Additional tier one capital (CoCo bonds for instance) is known as going concern capital as it can be written down or converted into equity even before the bank’s in difficulty. As such, it’s much riskier to hold.

There is some consensus as to what kind of assets can be used to establish bank capital, but because banks are now allowed to use their own internal models to assess asset risk, problems are emerging.

Why is it important?

As with many things when it comes to financial regulation in the past 10 years, the answer is the financial crisis. The more assets a bank holds, the less likely it will have to rely on a taxpayer-funded bailout – as was the case for a number of financial institutions which had to be rescued using public money after 2007 – because it will be able to write down (bail-in) its own capital. Owners of bail-inable capital (shareholders and subordinated bondholders for example) agree to absorb losses in the event the bank has to be resolved.

So far, so good: bank capital has been credited with stabilising the financial system and helping end the problem of too-big-to-fail. In theory. Things aren’t that straightforward as recent market developments have shown.

“Some banks still have some funding gaps when it comes to MREL,” said European Banking Authority chairman Andrea Enria at the SRB conference. “But the problem is they can’t take liquidity from the public sector for granted.”

What’s the problem?

Banks and regulators can’t agree on how much capital is needed, especially for the larger institutions. Banks can’t come to an agreement between themselves either on some other issues.

Bailouts are out: banks have to be able to absorb losses using their own money
One key point of discussion has been the level of a bank capital floor, which saw regulators from a number of jurisdictions clash in recent IMF meetings and delay discussions concerning additions to the Basel III system. Under the framework, banks can evaluate the credit risk attached to their assets based on standardised market assessments as well as their own internal models. 

A bank’s own capital can’t fall below a certain percentage of the level determined under the standard approach – currently set at around 72.5%, subject to confirmation by regulators in jurisdictions following the Basel framework. France, however, has spoken out against any major increases in bank capital for fear of EU institutions becoming less competitive than their US counterparts.

“The US version of the Basel framework isn’t quite the same as the EU’s,” said Mayer Brown partner Kevin Hawken. “The EU one is closer to the original Basel framework in some ways.  Also, similar rules give different results for different banks – large EU banks often have higher leverage than US banks (before risk weighting) because of different rules and holding safer assets.”

Regulators in a number of jurisdictions are also growing increasingly concerned that there are some differences in the ways banks calculate RWAs. Some of the differences stem from the fact that banks hold different assets, but others originate from how banks determine and attribute risk.

José María Roldán, vice president of the European Banking Federation, highlighted the existence of doubts in the EU capital markets that the rules of the game are the same for all banks especially among the medium sized financial institutions.

The fact that banks are allowed to rely in part on their own internal modelling systems to address risk is becoming increasingly problematic. According to Bank of England data, banks in the UK have a £116 billion ($155 million) shortfall of debt meeting MREL rules to plug by 2022. US G-Sibs are estimated to have anything a shortfall of between $150 to $360 billion, though the figures changes constantly.   

As such, regulators have pushed for stricter rules and oversight surrounding bank capital (including a capital floor, stricter stress tests, limited internal asset risk assessments, enhanced capital adequacy ratios etc). Even though Basel III is only set to take full effect in 2019, recent changes to the framework are already referred to as Basel IV.

 Where next?

Hawken notes that capital proposals affect countries differently. “Differences also stem from policy views of how banks should be constrained," he said. The US approach to capital requirements for large banks has been more conservative than some other countries or international standards."

Bloomberg data shows that Deutsche Bank’s own RWAs account for 28% of its balance sheet, while the figure is nearly 50% for the US’ six largest banks.

The divergence between the US and the EU approaches was recently seen in the discussions surrounding capital floors, with the former backing 75% of RWAs and the latter 70%. US banks have had to comply with a strict risk weighting methodology devised under the 2010 Dodd-Frank Act, so a higher floor under Basel III would have little to no impact on them.

Coupled with the fact that bank lending is one of the main contributors to eurozone GDP (90%) - in the US, the figure is roughly around 15% - an increase in regulatory capital would affect EU banks far more significantly than their US counterparts.

Société Générale chief executive Frédéric Oudéa recently said that EU and US banks were not operating on a level playing field. This is in part due to the practical implementation of Basel III as well as the wide-ranging impact of the new Markets in Financial Instruments Directive.

See also

PRIMER: the Bank Resolution and Recovery Directive

DEAL: Europe’s first TLAC bond

For more primers, click here