Bank Capital

Introduction

The following is an introduction to bank regulatory capital. This is the amount of capital that the authorities require a bank to hold. It’s a complex topic and has a lot of interested parties. They include banks, taxpayers, regulators and politicians. That’s because increased capital reduces risk but costs banks and potentially may lead a slowdown in the growth of credit.

The Importance of Capital

We normally think of capital as shareholder’s equity. The purpose of equity is to absorb losses before any creditor is adversely affected. Banks, just like companies, have capital and can borrow against that capital to buy assets. In banking the assets are normally loans. As the level of borrowing increases, then gearing (debt/equity ratio) increases. In banking, we call this gearing “leverage”.

As leverage increases then the potential for equity to get a larger return also increases but so does risk. If loan losses mount the capital may be insufficient to cover those losses. The bank becomes insolvent and goes into a process known as resolution. The consequences can be widely felt.

Depositors may lose savings, credit may be withdrawn from the economy, other banks may be affected directly or indirectly thereby damaging the financial system. In some cases, the taxpayer will need to cover the costs of the failed bank.

This is what happened in the 2007/8 crisis. It has led to a prolonged reduction in economic growth and after a decade GDP is probably 10%-20% lower than it would have otherwise been. To reduce the chance and cost of this happening again there has been a concerted attempt to increase the amount and quality of capital banks hold.

At the time of writing International standards, known as Basel III have been agreed and are being phased in during a period lasting to 2019. The effect on individual banks varies.

Risk Weighted Assets (RWA)

When a bank lends, it is anticipated that the loan will be repaid. However, we do know that some loans will default. RWA attempts to take this risk into consideration. It adjusts the asset (loan) for the risk that is being incurred. Safe assets therefore have very low weightings and more risky assets have higher weightings. How this is done varies.

Either simple risk factors can be used. These are provided by the regulatory authorities. Alternatively, the bank can model risk factors itself.  It is widely acknowledged that RWAs are estimates of risk. In the UK, the FPC has made explicit reference to this and assumes that the process of calculation will become more robust over time.

Two Types of Capital

Regulators have identified two types of capital. They are:

1. Going concern capital. This is Tier 1 capital.  It comprises Common Equity (CET1) and Additional Tier 1 (AT1) capital. CET1 is share capital. It covers losses and is there to ensure the bank can keep operating in times of stress, eventually repairing the balance sheet and recovering. This is the best type of capital. It absorbs losses before anything else, it’s perpetual and only pays discretionary dividends. AT1 capital may, to limited extent, be used to “bulk-up” Tier 1 capital. AT1 takes the form of specially issued subordinated debt like Contingent Convertible Bonds (Cocos). Debt that under certain conditions converts to equity or is written down.

2. Gone concern capital. This is Tier 2 capital. It does not have to be permanent capital and can have non-discretionary coupons.

Total Loss Absorbing Capital (TLAC)

TLAC standards apply to globally systemic banks (G-SIBS). G-SIBS are the largest banks. If they were to fail, the size, cost and disruption they would create would be on a different scale to smaller firms.

From 2022, G-SIBS outside emerging markets, will need to hold TLAC of at least 18% RWA and have at least a 6.75% Leverage Ratio.

To put this in perspective if going concern, Tier 1 capital, is 6% and Tier 2 capital is 2% of RWA then G-SIBS will end up holding a further (18%-8% = 10%) of capital against their RWA.

Furthermore, this excludes certain additional buffers. These are the capital conservation buffer, the systemic importance buffer and firm-specific supervisory buffers. In total these addition buffers are expected to add about five additional percentage points to the TLAC of 18% of RWA. Therefore, the G-SIBS will hold circa 23% of their RWA as capital.

Minimum Requirements For Own Funds and Eligible Liabilities (MREL)

MREL is EU law. It requires that banks that could cause major disruption should they fail need to hold sufficient capital that would allow them to continue operations and recapitalise. It casts the net wider than just G-SIBS.

Leverage Ratios

The use of RWA is not without criticism. In particular, some observers do not trust banks to make a truly independent assessment of the risk involved. The Leverage Ratio is designed to overcome this weakness. The Leverage Ratio divides equity (CET1) by the assets held. The asset figure being unweighted. In the UK the minimum Leverage Ratio is 3% (being met by CET1).

How Much Capital?

The following explains the UK standards and estimates of capital requirements.

The Starting Point – Going Concern Equity

Pilar 1 Capital (6%) must be maintained at all times of this 6%. 4.5% must be CET1. This is an international standard and is current.

Additional Buffers

Capital Conservation Buffer (2.5%). This can be used to absorb losses. Its use means the bank in question is still compliant with its minimum Pillar 1 capital. This is an international standard and is being phased in by 2019.

Countercyclical capital buffer (an unknown percentage). This is a variable buffer that can be increased with the perception of the financial cycle and strength of the banking system. It may vary between banks based on their different business exposures. This is set by the authorities in individual countries. In the UK it is set by the FPC. It is being phased in with no set date.

Global Systemic Importance Buffer (0%-2.5%)*. This is for G-SIBS to cover the potential risk that their failure would cause great disruption. It is being phased in by 2019.

Systematic Risk Buffer (0%-3%). This is for ring fenced banks and large building societies that, if they failed, would cause major disruption to the UK economy. This is set by the PRA and is being phased in by 2019.

So far and as an approximation these add up to a Tier 1 Capital requirement relative to RWA of 11%

Additional supervisory requirements

Pillar 2A (2.4%). The PRA acknowledges that certain risks (like trading books and pension deficits) are not adequately caught in the current Pilar 1 calculation. This requirement adjusts accordingly and is expected to reduce over time. It is set by the PRA and is current.

The total so far approximates at 13.5% of RWA as Tier 1 capital.

PRA Buffer (Unknown %). This is a firm specific buffer that is applied where banks are deemed to have poor risk management, governance or increased risk to the business cycle. It is set by the PRA and is current.

Gone Concern Total Loss Absorbing Capacity (Unknown %). This absorbs losses allowing a bank to recapitalise. For G-SIBS is an international standard. For other banks, it is set by the Bank of England. This capital can be made up of liabilities that are not issued for the purpose (not equity).

The result is that Total Loss Absorbing Capacity will be approximately 23% of RWA.

*Under TLAC rules these banks require an additional level of capital of between 1% and 3.5% of risk adjusted assets. To prevent losses falling on retail depositors TLAC rules push senior debt below depositors. This is controversial if the holders of that debt are also retail customers. Germany has changed the law to subordinate senior bonds. In France Tier 3 Instruments can be issued also known as “senior-non-preferred” and “junior senior”. Some EU banks have large capital issuance requirements.

First published by Barbican Consulting Limited 2017