More astute commentators have started to talk about both numbers in bank capital ratios recently. Numerator and denominator. Raising capital and shrinking assets. But there is a third number with just as much relevance. Capital expectations.
We have a 9% minimum number in Europe. As Charles Goodhart’s Law suggests, this number has started to lose its regulatory use now it has become a public target for European regulators and banks — and therefore a target painted on the backs of Europe’s weakest banks.
With much of Europe stagnating or slipping back into recession, the last thing banks need is tougher capital requirements.
Asset values will slip with poor macroeconomic performance. Sure, some assets will slip particularly far, because of particularly irresponsible lending, fiscal profligacy or some other perceived slight.
But even the best-behaved bank that astutely navigated the shoals of subprime and sovereign debt will be vulnerable to a weak economy. Capital ratios will unavoidably decline, unless they take economically harmful and unnecessary actions — such as forcible, fire sale deleveraging.
The cusp of recession is the worst possible time to raise capital requirements for banks. International regulators have accepted the principle of a countercyclical capital buffer for banks, but the cyclical part of this extra capital requirement has been roundly ignored.
Part of this is because of political pressure.
Being soft on banks is a vote killer (or at least, a more immediate vote killer than an artificially induced credit-squeeze recession) so there are few political voices raised in favour of easing capital requirements. But this is exactly what the logic of regulatory discussion over the last four years suggests.
This is also partly the market’s fault. Analysis of bank capital ratios has glibly bracketed the countercyclical buffer with the basic requirements, the systemic surcharge, and any national finish. The elements that go into forming a capital ratio target have distinct purposes behind them, but this appears to be forgotten, as banks race to prove that they are ahead of the Basel III game — in the process accelerating towards a macroeconomic train wreck.
With an inflated capital target in the public domain, no possibility of raising the required capital, and unpalatable deleveraging ahead, something has to give.
Messing with what counts as capital — the numerator — was among the least appealing of pre-crisis bank financing practices. Better to mess with the third number of the capital ratio, and try to change capital expectations.