Bank Capital Adequacy: Where to Now?

Bank Capital Adequacy: Where to Now? Kevin Davis Professor of Finance, University of Melbourne Research Director, Melbourne Centre for Financial Stud...
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Bank Capital Adequacy: Where to Now?

Kevin Davis Professor of Finance, University of Melbourne Research Director, Melbourne Centre for Financial Studies [email protected] 03 9666 1001

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Outline • • • • •

What is bank capital? A brief history of bank capital Bank capital experiences during the GFC Capital lessons from the GFC Proposals for bank capital requirements

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The Concept of Bank Capital Assets Cash Loans Securities

Liabilities Deposits Debt Equity

Capital = a residual

• Asset/Liability valuation critical to measuring capital – Loan loss provisioning also matters • Regulatory capital includes other items – subordinate to deposits and a buffer to absorb loss • Stock market value of capital differs – and important 3

A Brief History of Bank Capital • Bank equity/assets – 1800’s > 50% in USA; 20% in UK • Some situations of unlimited/double liability – 1900’s – declined to around 5-8% in 1970s • Other industries have equity/assets of 30-40%! • Basel Accord, 1988 – 8% risk weighted capital requirement (why 8% ?) • Tier 1/Tier 2 include non-equity liabilities • Risk weighted capital ratios tended to stabilize – But 21st century decline in equity/assets • Very low levels for European & US investment banks

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A Brief History of Bank Capital

Source: Bank of Canada

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A Brief History of Bank Capital • Basel II Accord – 2006 • Three Pillars: Capital requirements; supervision; disclosure • Standardized and Internal Ratings Based approach – Use of ratings agencies and bank credit models • Changes to the risk weights • Capital requirement for operational risk • Provision for capital requirements for interest rate risk in the banking book • Calibration of overall requirements - no planned change in aggregate capital requirements for the banking sector as a whole. 6

Bank GFC Capital Experiences Estimated Global Bank Writedowns: 2007-2010, $US bill Loans and Securities Implied Cumulative Estimated Estimated Loss Rate Holdings Writedowns (percent) U.S. Banks U.K. Banks Euro Area Banks Other Mature Europe Banks Asia Banks

12,561 8,369 22,901 3,970 7,879

Source: IMF

1,025 604 814 201 166

8.2 7.2 3.6 5.1 2.1

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Bank GFC Capital Experiences 200 180 160 140 120 100 80 60 40 20 0

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Market Cap $b, May 31,1999 Market Cap $b March 17, 2009

Source: Financial Times

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Bank GFC Capital Experiences 1200

1000

800

Bank Capitalization $b, 1999 600

Bank Capitalization $b 2009

400

200

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Source: Financial Times

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Some GFC Bank Capital Lessons • • • • • •

Inadequacy of Value at Risk (VAR) Incorrect risk weights Liquidity risks not adequately captured Asset valuation problems Significance of collateralised financing Systemic problems from complex interdependencies due to bilateral exposures • Market reactions inhibit capital conservation measures • Inadequacy of core capital • Ratings and model inadequacies 10

Current Proposals (1) Increased capital levels • General agreement on need for higher levels • How high? – Greenspan (2010) gives ballpark estimate of 14 per cent equity/assets ratio required for US Banks • Based on CDS spread sensitivity to leverage • What regulatory minimum? – Geneva Report (2009) emphasizes need for ladder of requirements with associated regulatory responses prescribed

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Current Proposals (2) a “bigness” capital charge • Rationale (a) – TBTF – Competitive advantage – Taxpayer subsidy • Rationale (b) – systemic risk – Large institutions create systemic externalities due to risk concentration • Failure involves many counterparties • Scramble for liquidity creates pecuniary externalities • How to determine the appropriate capital charge?

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Current Proposals (3) contingent capital • Requirements for banks to issue hybrid securities which convert automatically into equity if some “trigger point” is reached – Restores core capital – Market discipline through monitoring by investors • Reduces likelihood of government injections of equity in crisis or provision of guarantees (which is essentially equivalent)

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Current Proposals (3) contingent capital • Some examples – Flannery – reverse convertible debentures (like converting preference share structure) – Squam Lake Group – conversion requires both regulatory declaration of systemic problems and issuing bank having inadequate capital – Kashyap, Rajan, and Stein – Catastrophe insurance – Hart & Zingales – CDS spreads as trigger for required new equity issuance

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Current Proposals (3) contingent capital • Lloyds Bank (and others) have issued (Nov 09) CoCo’s – How will markets react if trigger point is approached? • “death spiral convertibles”? • Would partly-paid shares be an alternative? – A return to pre limited liability arrangements?

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Current Proposals (4) Regulatory Risk weight changes • Basel II (July & Dec 2009) • Increase in the relative counterparty risk weights for financial institutions versus corporates • Increased capital requirements for counterparty risk on derivatives, repo and securitization transactions. • Lower relative risk weights for counterparty derivatives exposures to CCCPs versus bilateral exposures. • Use of “downturn” PD estimates (and “downturn” LGD) • “Stressed” VAR in determining capital requirements • Reduced reliance on ratings agency assessments • Expected loss provisioning.

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Current Proposals (5) a leverage ratio • A complement to risk weighted capital ratio – Limit to balance sheet expansion – Offset to model risk, incorrect risk weights – Used in USA, Canada, Switzerland • Bank of Canada study suggests it has value • Problems – Dealing with off-balance sheet activities – Downgrades role of risk weighting • Australian banks and regulators not supporters – But introduction may change behaviour 17

M ex R ic o H us on g T si a K u U on rke ni g y te S d A St R at e B In ra s do z Si n e il ng si ap a o Ko re So u t F rea h inl Af an ri d M c a2 al 7 ay s Sp ia G a in re Au e ce st ria Ita l In y d C ia D hi n en a U m ni te Ir a r d el k Ki an ng d C do a m Au nad st a N rali o a Sw rwa ed y J en G ap er an m Be an lg y N Fr iu m et a he nc rl a e nd s

Risk Weighted Ratios and Leverage

25 Regulatory capital/risk w eighted assets

Capital/Assets

20

15

10

5

0

Source: IMF 18

Ratings Agencies Estimates Alternative capital ratios: Major Australian Banks 2009a

Bank NAB CBA ANZ

S&P RAC

Basel II Tier 1 Leverage 6.9 8.3 4.5 6.3 8.1 3.3 6.1 8.2 4.8

(a) Figures for CBA are June 2009, and for NAB and ANZ are March 2009 Source: S&P (2009b)

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Current Proposals (6) improved quality of capital • Basel Committee – Larger share of Tier 1 capital to be shareholders funds (common equity and retained earnings) – Stricter requirements for hybrids (perpetual, discretionary non-cumulative dividends/coupons) – Calibration to occur following an impact assessment study • How to incorporate contingent capital?

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Current Proposals (7) procyclical capital requirements • Inherent procyclical nature of banking – In downturn, loan losses reduce capital and prompt lending restraint • Higher minimum capital requirements in upswing and lower in downswing – In good times build up of capital buffers for use in poor times • Rules v Discretion?

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Conclusions • Significant changes to bank capital requirements in progress • Overall consequences far from obvious – What proposals will be implemented? – How will they interact? • Increase in cost of bank financial intermediation? – What was the social cost of pre-GFC bank intermediation?

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