We now need PhDs in Bank Capitalisation

Banks’ capital structure is becoming ever messier and micromanaged by the day. Previous Basel iterations had already introduced Tier 1, Tier 2 and Tier 3 capital, leading to various types of regulatory capital ratios. The crisis demonstrated that only Tier 1 capital, as the most junior liability in a bank’s capital structure, was effective in absorbing losses. Basel’s capital requirements had effectively deceived investors, bankers, and financial markets in general.

Basel 3 decided to get rid of Tier 3 capital and changed the definitions of Tier 1 and Tier 2 capital, and introduced CET1 (core equity) becoming the most basic regulatory ratio available. CET1 was complemented by ‘Additional Tier 1’ (usually a form of perpetual deeply subordinated debt with discretionary coupon payments and equity-conversion features) and Tier 2 capital (often long-dated subordinated debt with no step-up or incentive to redeem) (see all details here).

Minimum capital ratios for all those capital ‘categories’ have also been defined or increased, and Basel had the idea of adding two extra capital buffers on top of that. The capital conversation buffer is a capital buffer made of…capital to protect the rest of the bank’s…capital. The concept sounds a little strange to say the least and its goal is to force banks to build up their capitalisation in good times so that they don’t breach regulatory minima in bad times. The idea is that banks should never ever breach those minima. Which made me question those statutory minimum requirements some time ago. What’s the point of having what is essentially ‘dead’ capital if one cannot use it to absorb losses without triggering a bankruptcy procedure? As a result it becomes necessary to add another buffer of capital to protect this ‘dead’ capital. You really couldn’t make that up.

On top of that, Basel also introduced a countercyclical capital buffer. This is a discretionary buffer of capital that banks need to raise or build up when regulators believe that the economy is overheating. How regulators will figure out that the economy is indeed overheating is anyone’s guess. But I believe that this ‘countercyclical’ buffer would actually be pro-cyclical in the presence of risk-weighted assets (and without applying certain macro-prudential tools): RWAs already incentivise banks to channel loanable funds to real estate borrowers. By raising capital requirements, real estate lending is likely to be the only remaining capital-efficient lending type. Which indeed would not slow down the growth of a housing bubble…

So that’s already quite a lot of rather opaque capital measures and instruments that regulators had devised, with unclear economic effects.

But that’s not it. Over the past few months regulators have been pushing for what is called TLAC (Total Loss Absorbing Capacity). TLAC requirements set that banks’ capital structure must comprise a minimum of ‘bail-inable’ debt equivalent to between 16 and 20% of RWAs. Europe is trying to implement those measures under the name MREL (Minimum Required Eligible Liabilities). This makes banks’ capital structure and balance sheet even less flexible. Despite boasting a very high CET1 ratio, the purest definition of regulatory capital, and a funding structure almost exclusively composed of deposits, a bank would still have to raise that sort of expensive hybrid capital (apparently bail-in-eligible unsecured long-term debt that would be junior to other senior creditors).

Evidently, those extra costs are going to be reflected in lending rates, which seems contradictory to the current monetary policy goal of reducing those same rates. Moreover, they are likely to exacerbate economic distortions as banks will intensify capital optimisation by picking the most capital-efficient sector to lend to (…real estate of course).

This is KPMG’s summary:

And that’s not it (you thought you were done, didn’t you?). As I described a few weeks ago (and here, as described by KPMG), regulators are now thinking of also adapting the RWA framework. While the newly-proposed risk-weights seem to be even more distortionary than the previous regime, Fitch, the rating agency, has come up with a rather embarrassing study. Basel wanted to replace RWAs’ reliance on credit ratings with ‘hard’ measures such as leverage. Fitch compared the proposed changes with the current approach and declared that:

The proposed use of balance sheet leverage is surprising given the more common use of cash-flow leverage metrics (e.g. debt/EBITDA) in corporate credit assessments, and leads to some surprising results. The new proposals would assign a number of highly-rated issuers to the highest risk buckets, and conversely, would have treated the majority (60%) of defaulted issuers in the Fitch portfolio as low risk (risk weighted below 100%). This indicates that the proposed metrics would fail to discriminate adequately between different credits.

Decrease in Rated Corporate Risk-Weights: Analysis of the Fitch-rated portfolio of global corporates indicates the proposals lead to a decline in average risk weights to 84% from 102% as compared to ratings based risk weights, with lower-rated corporates and cyclical sectors such as property and real-estate benefitting most. Risk weights for higher-rated corporates increased. However, the overall decrease would likely be offset by the proposed increased requirements for off balance sheet exposures. The overall impact will depend on the size and make-up of a bank’s portfolio, and the portion of corporate lending to rated entities.

Exposures to Banks

Missing Important Factors, Lack of Comparability: The BCBS proposes to determine risk weights for banks’ exposures to other banks based on the common equity Tier 1 (CET1) risk- based ratio and non-provisioned impaired exposures. In contrast, the current Basel framework provides two options, both ratings-based; the first based on the sovereign rating, and the other (more risk sensitive) based on banks’ issuer ratings. Fitch agrees that asset quality and capital ratios are important considerations in bank credit assessment. But these metrics on their own provide an incomplete basis for credit differentiation, as they omit important factors such as the bank’s operating environment (especially important for emerging-market banks), company profile, governance, liquidity and profitability. The proposed metrics also suffer from lack of comparability and consistency across jurisdictions (as reflected e.g. in the BCBS’s efforts to address consistency of risk-weighted assets, which underpin the CET1 ratio).

Ouch. While relying on credit ratings certainly isn’t perfect, it remains relatively close to a free market outcome in which specialised agencies would provide their assessment of borrowers’ creditworthiness to other market actors. But the proposed system makes it so much worse. As RWAs are the denominator of all regulatory capital ratios, this implies that those ratios essentially become meaningless (despite already being pretty flawed, we could nevertheless extract some information from them).

Banks’ capital structures are becoming opaque nightmares that introduce numerous distortions that have not been studied beforehand, despite the critical role of banking in our economy. A number of regulatory agencies are essentially playing Lego with various forms of capital layers. The complexity of capital regimes is such that it is time for universities to create PhD programmes in Bank Capitalisation*.

*This is a joke of course, although…