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

Peston on Banking (2) Risk Weighting

Robert Peston highlights the problems caused by the Basel Accords. Their aim was to standardise capital requirements, so that banks would not be put at a disadvantage, if their local regulations required more capital than their competitors in other countries.

With banks going international, they would be put at a disadvantage if they were compelled to hold more capital than their competitors. So the Americans decided to push for worldwide minimum standards for the amount of capital banks have to hold, relative to their assets, to create a level playing field.

The Basel rules on the capital requirements for banks were formalised in 1988. The outcome was that capital held by banks turned out to be totally inadequate. There were a number of reasons.

• The rules undermined banks sense of institutional responsibility for their lending and for the way they managed their balance sheets. Banking shifted away from being almost exclusively based on an assessment of the credit worthiness of individual customers and moved towards the development of strategies to maximise gross lending subject to the Basel Rules.

• The Basel Rules specified the risk in inherent in different types of loans to different borrowers, eg mortgage versus loans to businesses or loans to government. The regulators distorted the flows of credit to those borrowers in ways that were unexpected and dangerous.

• The Basel Rules introduced two concepts, risk weightings for loans and relative loss absorbency for capital, which proved to be flawed.

• Risk weightings grouped types of loans according to their riskiness, as determined by the Basel Committee. All business loans had a risk weighting of one. Residential mortgages were deemed less risky so they were given a risk weighting of a half. Loans to other banks were given a risk weighting of a fifth, and loans to governments a risk weighting of nil.

• Capital requirements were tied to risk weightings. Banks had to hold capital equal to at least 8 percent of risk-weighted loans. This meant that Banks had to hold $8 for every $100 loaned to a business, but only $4 dollars for every $100 lent on housing mortgages. Only tiny amounts of capital had to be held against loans to other banks. No capital at all had to be held for loans to governments. AAA-rated collateralised debt obligations faced very small capital requirements.

• These weightings gave banks incentives to make loans to the groups that had the lowest capital requirements and the highest returns. These often turned out to be high risk.

• Loans to business were all treated the same, regardless of the size of the business. Big companies did not want to pay high interest rates need to cover the large capital charge, so they tended to bypass the banking system, and sell bonds to investors directly. This made big business dependent on short-term money markets.

• Banks had very strong incentives to channel disproportionate volumes of loans to house buyers.

• The credit rating agencies were given excessive power, because they could determine the capital requirements for many loans.

• Banks were encouraged to use flawed Value at Risk models to determine how much capital they needed to cover the risk of trading losses and their holdings of securities.

Peston on Banking

In the last couple of years, I have read at least twenty books on the causes and cures of the Global Financial Crisis. I try to grab every one that turns up in our local library. The last one to arrive is “How do We Fix This Mess” by Robert Peston and Laurence Knight. This is the first one by a British author, so it gives and interesting perspective. Robert Peston is the Business Editor for the BBC.

One interesting fact that he brings out is that during the 1930s, no significant banks failed in the United Kingdom. This is different from the United States, where thousands of banks failed. The reason British banks survived that disaster was that they had more adequate capital and liquidity back then.

Peston notes that the leverage of banks has been increasing for more than a century. In the 1840s, banks in the United States would typically hold capital equivalent to around half of their loans and investments. By 1880, a typical US bank had capital equivalent to around a quarter of its loans and investments, whereas the equivalent ratio for British Banks was not far off twenty percent. However, by mid-2008, Royal Bank of Scotland held capital capable of absorbing losses of around a tenth of that, or only 2.23 percent of gross loans and investments, while Northern Rocks capital-to-assets ratio in 2007 was just 1.7 percent.

Peston explains what this difference means. A century ago, a bank would go bust if a quarter of its loans went bad. In the latest financial crisis, one of the biggest bans in the world, RBS was no longer viable if could not get back 2% of what it was owed. In the case of Northern Rock, if it lost just one in every 60 dollars, it was kaput. By the time of the 2008 banking crisis, British banks had on average capital equivalent to less than 3 percent of their loans and investments, a fall of more than three quarters through the course of the twentieth century. The US banks had only a little bit more.

In the latest crisis most of the large banks in the UK had to be rescued. It is not surprising, given the inadequacy of their capital.