Peston on Banking (3) Risk Absorbing Capital

Bank capital is supposed to be capable of absorbing losses. Robert Peston explains how the Basel Rules encouraged banks to exaggerate the ability of the capital they possessed to absorb losses. Capital was divided into two classes: Tier 1 and Tier 2. The best capital is shareholders equity. The Basel Rules said that banks had to hold capital equal to at least 8 percent of risk weighted loans, but only a quarter of this had to be equity capital. Another quarter could be debt that had potential to be converted in equity. Half could be Tier 2 capital, which was long-term subordinated debt, which is debt that does not need to be repaid for many years.

• Those providing Tier 1 capital to banks were supposed to be well-heeled sophisticated investors who were capable of absorbing losses. In practice, banks and regulators were frightened to force these investors to write down their loans, because they were scared that they would pull their money out of weaker banks, causing worse problems.

• Much of the Tier 2 capital was held by insurance companies. If these companies were forced to take big losses, the banking crisis would spread to the insurance industry. Banking regulators did not want to be faced with rescuing big insurance companies too.

• In practice, most Tier 2 and Tier 1 capital turned out to be completely useless in respect of its central function, that of absorbing losses.

The Basel Rules focussed on the solvency of banks, but almost complete ignored liquidity. Liquidity is probably more important for a bank than solvency. A ban that is solvent, but has too little cash when deposits or want their money back is dead, By contrast a bank that is solvent, but manages to hide its loss can stay afloat, and possibly rebuild its capital and become solvent again.

Peston looks at the example of the Royal Bank of Scotland, which was one of the biggest banks in the world. Under the Basel Rules it appeared to have lent a mere 7.6 times its capital, when in reality, it had lent 45 times its capital. The rules created a fiction that it was being managed in a conservative way and was being generously supported by its owners. This fiction disguised its fundamental weakness.

The problem with all government regulations intended to create safety or security is that providers stop worrying about safety and security, and focus on meeting the minimum requirement of the regulations. Receivers assume that because the provider has complied with the regulations, they are getting safety and security. This is of an illusion