News of Regulatory Capital importance

The European Banking Authority today published its new Basel 3 monitoring exercise of European Banks. For those of you who don’t know what Basel 3 is, it is the latest iteration of the global banking guidelines defined in Basel, Switzerland, which roughly covers minimum capital, liquidity and funding requirements that banks have to achieve by 2019. I’ll come back to the details in another post.

There is some partially good news. European banks seem to become more capitalised and more liquid. I have doubts regarding the process though, and I am not even questioning the centralised decision-taking in Basel, which I am evidently against. I am also against undercapitalised banks, but for other reasons.

No, what ‘worries’ me is the method that regulators used to push banks to recapitalise. The Basel accord asked banks to achieve balance sheet targets by 2019. Then came the EBA and other national regulators, who ‘stress-tested’ banks and almost publicly shamed them if they failed the tests. Now, the EBA proudly announces that pretty much all European banks will achieve capital and liquidity targets (“fully loaded Core Equity Tier 1 capital ratio”, “Liquidity Coverage ratio”…) five years ahead of schedule.

Hold on… Why even come up with a 2019 deadline in the first place then? The consequence of this is that banks have been under massive pressure to quickly ‘recapitalise’ in the middle of a European economic crisis, instead of doing it more progressively. This certainly did not help economic recovery, and we can also question the quality of the capital ratios achieved as a result.

Why? Many banks have tried to bolster their regulatory capital ratio and their liquidity by… reducing their balance sheet. Meaning? They decided to reduce lending, maintaining their capital base stable (or even declining!). Moreover, many banks are also playing with risk-weighted assets (RWAs). RWAs allow banks to apply a “weight” on a specific asset class according to the perceived risk of this class. For example, US debt is judged as risk-free and hence will carry a 0% weight, thereby allowing the bank to hold no capital against it to absorb potential losses.

Regulatory capital ratios are calculated this way: regulatory capital/RWAs. Regulatory capital comprises equity and “supplementary hybrid capital”, which lies in between equity and debt. The ratio is flawed: hybrid capital often does not adequately absorb losses and banks have an incentive to ‘arrange’ RWAs (lowering them to artificially increase the ratio). It happens frequently and I’ll get back to that another day. A clue to the fact that banks’ capitalisation might not be that good is the Basel 3 Leverage ratio. While we can criticise this leverage ratio on methodological grounds, it uses total assets and not RWAs on the denominator. Well, guess what? This ratio has not changed since the latest EBA review…

Another ‘good’ news, HSBC will hire 3000 more compliance staff this year, following a similar move by JPMorgan. Surely this is good news as it creates jobs? Not really. HSBC already employs 2000 compliance officers. Hiring so many people to deal with red tape instead of working in more productive activities represents a big economic loss.