The FIG Idea: Capital Chaos
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The FIG Idea: Capital Chaos

Today’s capital regime for banks is the result of compromise and incrementalism. Hardly a surprise, but the result is unworkable. CFA-qualified, brain-on-a-stick analysts will breeze through a series of 3D Sudoku puzzles, yet struggle to understand the capital situation of a bank.

As a result, confusion reigns, efficient markets are hampered, and progress towards a more resilient banking industry is stalled. This is neither tolerable nor inevitable.

The nostalgic remember Basel I with fondness. In all, it had only 30 pages. A simple weighting was applied to exposure classes to determine overall capital requirements, which were set at 8% of the risk weighted asset amount. A bank could use a modest amount of preference shares, hybrid instruments and subordinated bonds to meet its capital requirements.

Fast forward 25 years and we have a tangled mess of capital regulation. Basel has taken two steps forward, one step back — or is it one step forward, two steps back?

Risk metrics are now set based on a shifting blend of subjective statistics modelled by the banks themselves and flat charges which are insensitive to risk.

Even adding up the target figure is hard. Capital requirements are a complex series of “buffers”, most of which are, frankly, actually just “add-ons”, raising the total permanently, with no intention of banks ever dipping below the maximum. This is a complete contravention of the vital scientific rule of “Keep It Simple, Stupid”.

Recently, the authorities’ totally justified focus on the resolution of failed banks has developed from an honourable “carry two spare wheels” approach towards capital, into an incoherent and inaccessible framework. How do you begin to compare “tier three” with “junior-senior” with “HoldCo senior”? It’s the banking equivalent of kabaddi: a sport with a huge number of impenetrable regional variations, which only makes sense to aficionados.

None of this is ideal, all of it could be better, but really, what’s behind the problem?

Firstly, too many cooks are spoiling the broth. For example, capital standards are proposed globally by Basel, parallel rules for the largest banks are developed by the Financial Stability Board, and then local requirements are set by the European Commission in the EU and nationally by dozens of regulators.

In theory, it could be a mess. And, in practice, it generally is too.

Only with such a backdrop could the overlapping notions of regulatory capital, TLAC and MREL take shape, triplicating and unnecessarily complicating a relatively simple affair.

Secondly, it’s like nailing jelly to a moving wall. Banks are not just keeping up with changes in requirements, they’re keeping up with different ways to measure capital. (Do you know your transitional capital ratios from your fully loaded?)

Thirdly, the concepts behind the ratios are artificial and out of touch with reality, like the mathematician who assumes a perfect sphere in a perfect vacuum to make calculations.

In banking, this has led to the hypothecation of capital requirements with a multitude of buffers, buckets and curiously precise trigger levels. In short, a mechanical view of capital that bears no relation to market reality, and indeed the supervisory process. It’s a ridiculous fabrication and a distortion of reality.

These factors combine to give the Byzantine backdrop to today’s capital regulations. A genuine desire for simplicity has resulted in ever greater complexity. Pursuit of the elusive “level playing field” has distorted the chance for considered, subjective assessments.

Which qualities are more important: simplicity and harmonisation, or flexibility and accuracy?

As regards bank capital, the answer implied by the authorities seems to be neither.

None of this would matter, were it not for the fact that capital regulation is actually quite important.

The authorities’ quest for more capital has not paused for breath, but then nor has the industry’s attempts to meet the new requirements while attempting to meet shareholder return expectations.

This clash of objectives is now resulting in noticeable shifts in the industry. Capital markets activities are shrinking, arguably beyond the point of common good. Mortgage lenders are pulling back, pushing large chunks of the market outside the banking sector. Balance sheet management is now about optimising around inane regulatory constraints, with good risk management playing second fiddle.

All the time, unnecessary uncertainties are leading to waste and slippage. It’s 2016 and most banks in Europe don’t know what their capital requirements are or how they are supposed to meet them.

We’re desperately overdue a fresh rethink on bank capital regulation. We urgently need a new, better framework for risk metrics, capital requirements and capital supply mix.

The new framework needs to be both simple and effective. It can be.

The FIG Idea is an occasional column taking an offbeat look at the weird world of banks. It is written by a market professional with more than 20 years involvement in the FIG market.

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