Where will all the risk-takers come from?
When the G20 finalises the next round of bank capital requirements at its Brisbane meeting in November, few things are certain. But regulators are united in a push to keep whatever new loss-bearing liabilities out of the hands of retail investors – raising the question of who, if anyone, should be on the hook for bank failure.
“Going concern” capital is mostly a done deal. European banks know they need equity, or additional tier one, to meet leverage ratio and risk-based capital rules. It’s all over bar the shouting (deferred tax assets, central bank stakes).
But “gone-concern” capital remains an international battleground. This is capital that absorbs losses after a bank has failed, either to recapitalise the institution and return it to strength, or to protect taxpayers and depositors.
European authorities can use senior debt for this purpose, but regimes around the world differ, and many market participants doubt whether, when the chips were down, anyone would risk writing down senior.
The Financial Stability Board plans to lay out rules on what this capital will look like following the G20 meeting in Brisbane in November, unifying the acronyms “MREL” (minimum requirement for own funds and eligible liabilities), “PLAC” (primary loss-absorbing capital) and GLAC (gone-concern loss-absorbing capital), under the new heading “TLAC” (total loss-absorbing capital, or capital, as it was formerly known).
The parameters of the new measure are yet to be determined, with the size, structure and format of the buffers all up for discussion.
Most regulators, however, can agree that if something is supposed to absorb losses, it should not be sold to retail (at least, not local, taxpayer retail). Spanish banks and Italian banks were fond of selling their own capital notes through retail networks, with Bankia and Monte dei Paschi hit by scandal and lawsuits over preference shares and convertables sold as “retail investments”.
Holders of “permanent interest-bearing shares” in Bristol & West building society faced down potential writedown by the Irish government in 2011, as the instruments had become part of Bank of Ireland’s capital buffer. But vociferous protests from the mainly retail buyer base forced the Irish government to back down later that year.
If not retail?
The question, though, is if not retail then who?
Professional investors have better defences against pushy salespeople, but mostly manage money for pension funds or for insurers — both pools of capital which largely expect to get their money back. They buy bank debt because it is a safe place to park cash, not because they want to be liable for bank risk-taking.
A big bank going down will already blow a hole in the equity portion of pension funds, but a commitment to force losses on fixed income will mean howls from savers, even if the loss comes indirectly through a fund rather than directly in their own portfolio.
And the scale of the problem is huge. According to a leaked document from the Financial Stability Board, the likely number is 16%-20% of risk-weighted assets (though both the number and basis for calculation could still change).
European banks had risk-weighted assets of just over €9tr at the end of last year, and tier one capital ratio of 13.1%. Loss-bearing gone-concern capital could therefore be somewhere between €270bn and €630bn, including rolling off tier two, just within EBA-regulated banks.
The number of risk-takers, however — those that want to supply permanent, loss-absorbing capital to banks — is much smaller, at least within the fixed income world. Family offices, hedge funds and high net worth individuals might have a natural appetite to bear bank losses for the right reward (whether banks can afford to pay up this much for their debt liabilities is another question).
Turning savings into investment means a certain amount of concealed risk, since the appetite of savers to take risk does not match the desire of entrepreneurs for risk-bearing capital. Banks operate this concealment process, and get paid for doing so.
When bank debt is no longer risk-free, but must be loss-bearing when a bank goes down, this process will stop working. Savers looking for risk-free investments will need to turn elsewhere, or look to manufacture such risk-free assets — a process at the start of the slippery slope to AAA-rated CPDOs.
Stopping retail from buying loss-bearing fixed income products is not a huge danger in itself. But it does not take account of the big picture of the financial system. It is not possible to supply savers with risk-free assets and borrowers with risk-bearing loans, while remaining transparent about the risks in between.
Something has to give, and ideally, it should be savers accepting more risk.
Taking retail out the pool of risk-bearing savers concentrates risk in a narrower pool of investors, most of whom have no more appetite to swallow the writedowns that a big bank failure would mean than the retail investors (many no doubt well-heeled) which used to buy capital products directly.
When the G20 meets in Brisbane, it needs to consider the big picture. Not just how to make banks safer, but what banks do in the world.