Capital adequacy

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See also bank capital, Basel 3, Basel Committee on Banking Supervision and liquidity.

Contents

Overview of capital adequacy

Role of banks in an economy Banks have been described as fulfilling a variety of roles in any economy. Among many other things, they provide payments services, transform liquid short term deposits into illiquid long term loans, and monitor borrowers on behalf of depositors. In short they are a vital element of any economy, and weak performance in the banking sector will inevitably result in wider adverse economic consequences. This was most recently demonstrated by the sub-prime crisis, which originated in the US but whose shockwaves are being felt globally. Emergency infusions of capital at fire sale prices and of liquidity, often at the expense of taxpayers, have had to be made to strengthen the balance sheets of major international banks, in order to limit wider damage to the global economy.

Why is equity capital important for banks? The amount of shareholder equity in banks is typically very small relative to their borrowings and deposits. Thus, banks are very highly leveraged and operate on a higher level of borrowings in comparison with typical business enterprises. Businesses typically borrow funds roughly equal to their net worth. Banks by contrast, typically have liabilities which exceed 10 times their equity capital, with the bulk of those liabilities representing deposits of relatively small sums received on trust from millions of members of the public. Given the risks inherent in the way banks fund their operations, their systemic importance, and the high economic and social costs of their failure, banks everywhere are expected to operate with a high degree of commercial prudence, and under tight regulation, as a matter of public policy.

In particular, capital regulations require banks to hold a minimum level of equity as a percentage of their loans and other assets. This minimum level of capital is designed to protect the bank against unanticipated losses and to provide confidence to depositors who accept the risk of asymmetric information i.e. depositors are not in a position individually to know whether a bank has taken on risks beyond its capacity to absorb them, and rely on the cushion of equity, as well as close regulatory supervision, independent audits and sound credit ratings to provide a level of comfort. The amount of a bank’s equity therefore defines the limit to which it can attract deposits, which in turn limits the extent to which it can lend.

An erosion of the net worth of banks, for example due to large credit or trading losses, reduces funds available for lending if declining bank capital occurs on a systemic and material basis. This occurred recently with sub prime losses, where a vicious global cycle of reduced lending and declining economic growth was set in motion. It has been estimated (Bank of England Quarterly Bulletin, Spring 2004) that the amplification effect of falling bank net worth takes approximately 10 quarters, before output returns to its initial level. Whatever the estimate of the duration of the impact, it is likely that since output was initially produced with capital that was already in place, bank capital erosion affects output with a lag, rather than immediately.

Capital and risk While there is universal acceptance of the need for banks to maintain adequate capital, what is meant by “adequate” and what is meant by “capital”, evolve over time, in response to changing market and economic conditions both globally and at home, and to the rapidly changing risk profiles of banks. There is little doubt however, that regulators everywhere have made capital adequacy rules increasingly stringent. They are also seeking through the Basle I and II initiatives, to ensure some degree of uniformity of definition across the world. However, since the adequacy of capital depends both on a bank’s risk characteristics and the environment in which it operates, uniformity may be an unattainable goal in a non-uniform world.

Changing risks and recent banking crises The changing nature of risk, to which regulators are responding inter-alia with calls for additional capital, is illustrated by two recent banking crises, which had significant impacts on national, regional or global economies.

Asian crisis The Asian economic crisis of 1997 was rooted in a combination of flawed economic policies, and poor governance practices over a long period. A regime of fixed exchange rates led to excessive foreign borrowings to fund domestic operations, to the creation of real estate bubbles, and eventually to unmanageable currency risks, as market forces overwhelmed overvalued exchange rates. At an institutional level, bank performance was impacted by the influence of dominant individual or family owners and by political direction and patronage. Owners eroded the independence of boards and management in making operational decisions. They also pursued their broader visions with depositors’ money, resulting in illiquid quasi-equity assets being booked on balance sheets, heavily disguised as commercial debt or project loans.

The impact of the crisis on the former Tiger economies of East Asia and on their banking systems was contagious and severe, but regionally confined. One positive outcome of the crisis was the consolidation of the banking industry. Small family-owned banks were unable to find the capital needed to make good their losses. The survivors were those who built the scale that was needed to improve operational efficiency and to raise new equity, through mergers and acquisitions. The new consolidated architecture of the banking systems resulting from crisis, was inevitable and beneficial in the long term. However, in the shorter run, it was a painful exercise, which crippled many Asian economies for many years. More than 10 years on, the effects of this Asian financial tsunami are still being felt in a few countries such as Indonesia.

Sub-prime crisis The present crisis which started stealthily and unexpectedly a decade later in August 2007 at large OECD based banks, is more complex and far reaching in impact. The numbers demonstrate the scale of the problem – US$475 billion in write offs by major banks so far, the forced raising of US$350 billion of highly dilutive new equity, in unfavourable market conditions, and the reduction of $ 1.6 trillion from global market capitalization of banks.

The crisis has caused a severe downturn in housing markets, triggered a global credit squeeze, jeopardized the health of banking systems and pushed the world to the brink of economic recession. It is rooted in the fiscal excesses and lax monetary policies of the last few years in the US and other developed countries, where budget deficits were kept too high, and interest rates too low for too long, in order to stimulate economic growth. To this was added at global banks, a toxic mix of bad lending practices on a massive scale, mainly housing loans to low income, high risks borrowers, and poor liquidity management, with long term loans being funded by short term borrowings. “Ninja loans” to borrowers with no income, no jobs and no assets”, were an extreme example of unreal credit standards in use. Additionally, lack of transparency and accountability, management compensation which was aligned to revenues and not to risks, combined to threaten financial systems and economic stability globally.

A negative feedback loop was created, as banks sold assets and cut lending, in order to improve their capital position. However, these asset sales reduced prices further, which resulted in the need for more assets sales, at even lower prices, and the infusion of more capital to make good the resulting losses. Severe pressure was put on new lending and on capital, by this vicious de-leveraging.

The crisis was also based on the collapse of conventional wisdom in two critical areas. Firstly, the US Federal Reserve was convinced that financial innovation using mathematically sophisticated derivative instruments, had changed the nature of risk by spreading it across the globe. It was assumed that this made the financial system more stable, and permitted banks to cut their capital despite explosive growth in the issuance of debt securities. Secondly, that highly liquid markets, based on lax monetary policies, would persist indefinitely. “Abundant market liquidity led some firms to overestimate the market’s capacity to absorb risk” in the understated words of the Institute of International Finance in Washington.

Disclosure and accounting – the wider impact Two technical aspects of the problem in the US also deserve mention, as they illustrate the importance and wider economic impact, of disclosure and accounting rules. In the past, when a bank made a loan, it was held on its balance sheet, and it therefore needed to ensure that the borrower was credit worthy and that adequate supporting capital was held. However, the bank needed less capital, and could make more loans, if they were held in special purpose vehicles off its balance sheet, which was permitted under the Fed’s new philosophy and rules.

This process of non transparent disintermediation meant that banks had less need to check credit worthiness. Instead, they were incentivised simply to write more loans, take a fee and sell on the loans. The responsibility for credit worthiness was in effect passed on to a handful of credit rating agencies on the basis of whose unrealistically optimistic ratings, investors across the world scrambled to buy these securities, without much appreciation of the risks they were taking. It has been estimated that off-balance sheet assets of major banks amount to around US$5 trillion. Moves by FASB, the US accounting standards board to bring these assets onto balance sheets have been deferred to 2010, because of fears of the potential impact on the capital of the banking system.

The problem was exacerbated by the fact that US accounting standards were moving quickly to the concept of a “fair value” approach to the computation of profits, as opposed to conventional historic cost and accrual accounting. To oversimplify the issue for the purpose of illustrating the problem, under fair value accounting, financial assets and liabilities are stated in the balance sheet at market value, and any surplus or deficit over cost is credited or charged to profit. The old adage that “cash is fact, everything else is opinion” once more proved its relevance in the crisis, as “fair value” became virtually impossible to determine in increasingly illiquid markets. In shallow or non-existent markets it became impossible for investors to ascertain the true state of finances of a bank, which resulted in the paralysis of inter bank lending based on mutual mistrust, and the need for Central Banks to inject an estimated US$450 billion of liquidity, to prevent systemic collapse.

In good times, fair value accounting can temporarily flatter profits, balance sheets and bonuses, and therefore needs to be underpinned with clear disclosure, and definitions of management responsibility. In bad times, banks have been compelled to write down assets and earnings, by hundreds of billions of dollars, based on artificial estimates of asset prices.

Fair value accounting is pro-cyclical, exaggerating both the peaks and the troughs of the business cycle. Its limitations in terms of the difficulty of determination of asset values in shallow markets, and its impact on profit volatility need to be carefully considered before its principles are adopted in smaller markets like Sri Lanka.

Regulators, regulations and crises Banking crises develop slowly, but then strike with unexpected speed. Regulators need to have the capacity to identify adverse trends early, and challenge the unholy trinity of complacency, vested interests and conventional wisdom, in a timely manner. Timely action to deal with issues is a lot less expensive, than responding to lines of anxious depositors outside the doors of banks, with calls on the public purse. Providing an implicit government safety net to banks encourages risky behaviour and raises the risk of moral hazard. “Too strong to fail” is better than “too big to fail”.

Recent crises recognized the need to strengthen both the performance and the independence of regulators. Banking has become a complex and technical profession, and regulators need to develop the competencies to keep pace with the industry. Recruitment, remuneration and training policies should reflect this reality. In terms of independence, the IMF has recently highlighted the importance of avoiding “capture” of supervisors, either by political or industry interests. To whom supervisors report, and how they are funded, will largely determine their level of independence and effectiveness.

Lessons to be learned from these crises Banking crises are not uncommon and have occurred periodically in many countries. They cause wide and severe economic and social damage when they strike. They are rooted in unsound policies and practices, both at macro economic and at institutional levels, which may have become ingrained as conventional wisdom for many years. Unsound policies are connected to unsound banks by a slow burning fuse. The price to be paid for a robust banking system is constant vigilance by independent stakeholders, (boards, management, auditors, rating agencies and regulators) who have the professional judgment and technical capacity to strike the appropriate balance between risk and reward, and economic policies which look not just at goals of economic and employment growth, but at their associated risks and costs.

Problems of banks are amplified by complexity, and in a globalised world, by opportunities for wide product and risk dispersal. However, they are usually based on the breach of the twin fundamentals of banking, namely credit and liquidity risk management

Capital is a first line of defense for any banking system. Banks should not only be well capitalized, but should have the capacity to access new capital during times of stress. This capacity is based on their reputation both for integrity and for high quality management. These qualities give comfort to providers of new equity that sufficient profits will be generated to service their capital. However, no amount of capital or regulations can protect a bank against poor management, conflicts of interest or other unethical conduct. Consolidation of the banking industry in Asia eventually produced the desired institutional scale and systemic stability in many countries. However, banking sector reform is best undertaken in a proactive rather than a reactive manner, in good times rather than as a response to crisis, to avoid high economic and social cost.

The understandable response of regulators to crisis is to impose more regulations. Much higher level of control mechanisms for banking institutions compared with other commercial organisation is justified, given their fiduciary responsibilities arising from high leverage of public deposits, and the dire consequences of their collapse. However, an appropriate balance must be struck between the need for control, and the need to operate profitably as commercially viable enterprises, accountable for returns to the providers of their capital. Capital and returns are two sides of the same coin. Achieving this balance requires mature judgement, both on the part of those who frame the rules, and those who implement them. Regulators are now also moving to a more proactive role in anticipating rather than reacting to crisis e.g. the recent introduction of stress testing and contingency planning for banks in the US. It should be recognized that banking regulations, governance rules and accounting standards add to complexity and costs. If they are to be adopted, they must pass the test of relevance for purpose. Rules designed to deal with the issues facing banks in New York or London, but adopted on a “one size fits all” basis in smaller markets can in fact be counterproductive, if they divert management and regulators into time consuming technical complexities, and away from recognizing and managing the real risks which may be at ones own doorstep or add to costs without producing commensurate benefits. It’s all about balance.

Conclusion Opinion is developing now that we may have seen the worst of this particular crisis, although relief may not come soon enough for many investors and banks. “Markets can stay irrational, longer than you can stay solvent” -- J M Keynes. However, as the global economy slows, and consumer defaults start to increase, the questions of whether a second tsunami wave is due, and whether banks have sufficient capital to protect themselves against it, are now being raised.

Estimating capital adequacy

Key Takeaways:

  • Pitfalls in Estimating Regulatory Capital:
  • Dangers involved in extrapolating beyond the observed data
  • Under-determination of models by data
  • Difficulties in applying the Loss Distribution Approach (LDA)
  • Dominance of high-severity, low-frequency categories
  • Sensitivity to the largest losses
  • Sensitivity to the loss categorization scheme

Heavy-Tailed Losses Tend to Dominate Other Losses:

  • Instability of estimates: Occurrence of an extreme loss can cause estimates of the mean or variance of losses to change dramatically.
  • Dominance of sums: The sum of a set of losses is typically of the same order of magnitude as the largest single loss.
  • Dominance of mixtures: If losses from a heavy-tailed category are mixed with lighter-tailed losses, the mixture will also be heavy-tailed.

EU bank stress tests complete

2010 EU Wide Stress Testing


National Authorities Websites
* Austria	OeNB		FMA		 				 		 	
* Belgium		 		 		 			
* Cyprus		 		 		 			
* Denmark		 		 		 				 		 	
* Finland		 		 		 			 		 	
* France		 		 		 				 		 	
* Germany	BuBa		BaFin		 				 		 	
* Greece		 		 		 				 		 	
* Hungary		 		 		 			 		 	
* Ireland	
* Italy
* Luxembourg	CSSF		BCL
* Malta	MFSA		CBM
* Netherlands
* Poland
* Portugal
* Slovenia
* Spain
* Sweden
* UK


The Committee of European Banking Supervisors (CEBS) was mandated by the ECOFIN of the European Council to conduct in cooperation with the European Central Bank (ECB), the European Commission and the EU national supervisory authorities a second EU-wide stress test exercise.


EU bank stress tests underway

BRUSSELS (Reuters) - A leading EU official on Tuesday urged full disclosure on how the region's banks perform in stress tests, but sources said the bloc's finance ministers remained divided on what data should be published.

The 27-nation bloc plans to announce on July 23 how its banks would fare under further adverse conditions, including a deeper fall in value of sovereign bonds, in a bid to boost market confidence damaged by the Greek sovereign debt crisis.

The tests will encompass 91 EU banks, which make up 65 percent of the bloc's banking sector. The list includes most of Europe's large banks that operate in more than one country, but also many German and Spanish regional banks, known as landesbanks and cajas, thought to be among the weakest.

"It is fully in the self interest of ... every bank for there to be full disclosure of the results of the stress tests, that is the best way of restoring confidence to the banking sector," Economic and Monetary Affairs Commissioner Olli Rehn said.

"Of course, in parallel, member states need to have national financial backstops in place in case there are pockets of vulnerability in the banking sector. However, I am confident that overall the European banking sector will show resilience in these stress tests," Rehn said.

But EU finance ministers, meeting 10 days before the results' publication, were still divided over what data should be released, sources close to the talks said.

"Several countries are strongly reluctant to publish certain ratios from the stress tests," one EU source said. "Others, on the contrary, want full transparency."

French Economy Minister Christine Lagarde said the final decision on what information would be published could only be taken in a teleconference of EU finance ministers on July 22. "Discussions will continue until the last minute," she said.

Sources said France was questioning the need to publish the exposure of banks to sovereign debt and underlined the difficulties of having a harmonized tier one capital ratio which would enable comparisons across the EU.

Britain and Spain, on the other hand, were pushing for full transparency and Germany supported the publication of banks' sovereign debt exposure, sources said.

Doubts about European banks' ability to clean up their balance sheets have limited their ability to raise funding and made them highly dependent on the massive liquidity taps the ECB opened after Lehman Brothers' collapse in 2008.

Federal Reserve issues rules on capital actions

The Federal Reserve Board on Wednesday issued guidelines for evaluating proposals by large bank holding companies (BHCs) to undertake capital actions in 2011, such as increasing dividend payments or repurchasing or redeeming stock. The criteria provide a common, conservative approach to ensure that BHCs hold adequate capital to maintain ready access to funding, continue operations, and continue to serve as credit intermediaries, even under adverse conditions.

The criteria for evaluating capital distributions are outlined in a revised temporary addendum to Supervision and Regulation letter 09-4, "Dividend Increases and Other Capital Distributions for the 19 Supervisory Capital Assessment Program Firms." The guidelines state that any capital distribution plan will be evaluated on the basis of a number of criteria, with particular emphasis on:

  • the firm's ability to absorb losses over the next two years under several scenarios, including an adverse macroeconomic scenario specified by the Federal Reserve and adverse scenarios appropriate for a particular firm's business model and portfolios;
  • how the firm will meet Basel III capital requirements as they take effect in the United States, in the context of the proposed capital distributions as well as any anticipated impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act on the firm's business model or capital adequacy; and
  • the firm's plans to repay U.S. government investments, if applicable. BHCs are expected to complete the repayment or replacement of any U.S. government investments in the form of either preferred shares or common equity prior to increasing capital payouts through higher dividends or stock buybacks.

The Federal Reserve expects to respond to capital distribution requests beginning in the first quarter.

The Federal Reserve will evaluate requests for planned capital actions in the context of its broader process for assessing capital adequacy at the largest BHCs. As part of the regular supervisory process, the Federal Reserve is requesting that large U.S. BHCs submit comprehensive capital plans by early next year, regardless of whether a capital action is planned.

The capital plan review is the latest step in the Federal Reserve's efforts to enhance supervision of banking organizations. As recognized by the Dodd-Frank Act and demonstrated by the Federal Reserve-led Supervisory Capital Assessment Program in 2009, regular, horizontal reviews across groups of firms provide regulators with both firm-specific and industry-wide perspectives of various issues and trends. The Federal Reserve plans to undertake these capital plan reviews on a regular basis and will consult with primary federal bank regulators.


Bernanke rules out repeat of Scap stress tests

US Federal Reserve chairman Ben Bernanke played down the prospect of further stress tests for systemically important banks, describing the 2009 tests under the Supervisory Capital Assessment Program (Scap) as "a one-time event" in a speech in Chicago today.

Speaking to the Chicago Fed's annual conference on bank structure and supervision, Bernanke said the Scap tests had been valuable, but were "a watershed event – unprecedented in scale and scope". He added: "Circumstances may not again call for a simultaneous evaluation of institutions holding two-thirds of the banking system's assets".

Previously, Fed officials had hinted that Scap-type imposed stress tests might become a regular feature of US bank supervision.

Evan Sekeris, an assistant vice-president in the bank supervision and regulation department at the Richmond Federal Reserve Bank, told the Risk USA conference in October 2009: "There is talk within the Fed and other regulatory agencies of repeating a Scap-like exercise on a more regular basis in the future, or making some kind of stress test part of our normal regulatory standard. This is just talk, and we don't know what might come out of it, but given the insights that came out of the Scap I think it was a very interesting exercise."

Instead, Bernanke said, banks should attach more importance to their own stress tests. "To conduct effective stress tests, banks need to have systems that can quickly and accurately assess their risks under alternative scenarios. During the Scap, we found considerable differences last year across firms in their ability to do that. It is essential that every complex firm be able to evaluate its firm-wide exposures in a timely way," he noted.

But while this echoes recent disclosures about the failure of risk measurement at Lehman Brothers – a March report from bankruptcy examiner Anton Valukas found significant gaps in the bank's stress testing, which ignored private equity and commercial real estate completely – it ignores the question of whether banks' own stress tests have been too mild to be effective.

In August 2009, the Congressional Oversight Panel for the Troubled Asset Relief Program called for the tests to be expanded to cover smaller banks. The panel also criticised their failure to include potential losses from commercial real estate after their 2010 endpoint, in a report published in February this year.

But Bernanke said this recommendation would not be practical. "For logistical reasons – including the large number and diversity of smaller banks in the United States – we have not attempted a full-scale simultaneous stress test of these banks but instead have worked with them on an individual basis to evaluate their capital needs. Although the results vary considerably across institutions, prospective losses are such that many of these organisations may need additional capital over the next few years."

US Treasury delays first step in new capital rules

  • Treasury misses Dec. 31 deadline for capital report
  • Could signal other slipping deadlines for capital accord
  • Bank regulators already enforcing higher capital levels

The U.S. Treasury Department has missed the first deadline in its work to draft tougher capital standards, raising questions about the timeline of international efforts to ensure stronger bank balance sheets.

Treasury had given itself until the end of 2009 for an internal working group to produce a report assessing existing capital requirements.

The report is expected to inform the department as it tries to reach a domestic and then international agreement on stricter capital and leverage standards.

Policymakers are rewriting the rules after confidence crises and liquidity crunches led to the collapse of Bear Stearns, Lehman Brothers and other major financial institutions. Many firms had strong capital ratings shortly before they failed or were rescued by the government.

Treasury's first missed deadline could push back other targets, but there is not an extreme urgency to get new rules in place, said Kevin Petrasic, a financial services attorney with Paul Hastings in Washington and a former bank regulator.

"Certainly banking regulators are already doing a lot of work to bolster capital on an institution-by-institution basis," Petrasic said.

GLOBAL DEAL

In September Treasury issued principles for reforming regulatory capital rules and set out a timeline. It is hoping for "a comprehensive international agreement on the new global framework" by the end of 2010. Implementation of the reforms would be effective at the end of 2012.

Treasury is working with other G20 countries and with the Basel Committee on Banking Supervision, the global bank standard-setter.

Treasury Secretary Timothy Geithner has made it clear he is not in a rush to throw out new numbers for capital standards.

He has said that while markets remain fragile and risk averse, policymakers are more likely to overshoot and seek standards that are too strict.

"Treasury continues to work with the other regulatory agencies and our international colleagues on the key issues in reforming capital standards," Treasury spokesman Andrew Williams said about the missed deadline. "That work is ongoing, based on the policy statement that Treasury released in September."

Douglas Elliott, a former JPMorgan investment banker now with the Brookings Institution think tank, said capital standards are a high priority but not necessarily at the top of Treasury's to-do list.

"Given everything they've been up to, it's easy to imagine them not meeting the deadline," Elliott said.

WIDER OVERHAUL

Increased capital standards is just one component of a broad financial regulatory overhaul Treasury has proposed and continues to try to sell to lawmakers.

Treasury is urging Congress to give the government the ability to dismantle large, troubled financial firms, create an independent Consumer Financial Protection Agency, and to structure a new systemic risk regulator, among other reforms.

Elliott also said that bank regulators are already making firms hold higher capital levels than the new rules will likely call for.

He predicts other missed deadlines, but said concrete numbers about future capital standards should start floating around within a few months.

That will provide some clarity for the financial firms clamoring to position themselves in the face of a changing rule book, Elliott said.

"It's basically a race -- do banks hate uncertainty more or excessively conservative capital requirements?" Elliott said.

UK banks must add $47 billion in trade capital, FSA says

U.K. banks must find as much as 29 billion pounds ($47.3 billion) of additional capital by 2011 to put against their trading books under proposals published by Britain’s financial regulator.

Today’s proposals by the Financial Services Authority to strengthen balance sheets would also limit the amount banks and building societies can lend to any single borrower, and tighten rules on what counts as capital. The proposals come in response to changes to European Union rules covering bank capital, one of which is still being debated, the FSA said in a statement.

“The wide range of changes address some of the lessons learned from the financial crisis,” the FSA said. More capital will have to be put aside “to ensure that a firm’s assessment of the risks connected with its trading book better reflects the potential losses from adverse market movements in stressed conditions.”

Lawmakers and policy makers worldwide are grappling with how to overhaul regulation in the wake of the worst financial crisis for a generation. FSA Chairman Adair Turner said in a March report, which was largely endorsed by both the U.K. government and the Group of 20 Nations, that banks would have to put more capital aside and have tighter liquidity rules.

While Turner is against a legal split between banks that take customer deposits and those that trade on their own account, he has said making banks put more capital against risky trades will make certain investments economically unviable.

Proprietary Trading

He told lawmakers as early as February that banks would need to hold several times more capital in “revolutionary” changes to regulations that would lead to the downsizing of proprietary trading.

Proprietary trading is when a bank or financial institution trades securities and other financial instruments with its own money rather than for its customers.

The FSA said today that on average, firms will have to put aside 119 percent more capital against their trading books.

With the overall extra capital, including trading books, needed by banks standing at 33 billion pounds, annual ongoing costs from today’s proposals for firms could total 6 billion pounds, the London-based regulator said. The trading capital proposals would cost banks with “significant” trading books about 1.4 billion pounds a year, the FSA said.

Reducing Costs

“Affected firms may seek to reduce or change the composition of their trading-book assets, thus giving rise to a smaller increase in capital requirements, which would reduce the costs,” the regulator said.

The FSA said that its reforms will help prevent future crises and could boost the U.K. economy by 4 percent of gross domestic product, or 50 billion pounds. The agency’s consultation on the proposals ends in March 2010 with rules taking effect in January 2011.

“Our biggest issue relates to the implementation date, which we think is premature,” said Simon Hills, executive director at the British Bankers’ Association. “A 2012 implementation date would seem to be much more pragmatic and allow alignment with Basel and give banks time to adjust their capital and systems and controls accordingly.”

Basel, or the Basel Committee on Banking Supervision, sets minimum capital rules for banks worldwide.

Skin-in-the-Game

Banks also would only be able to invest in securitizations in which their originator had kept an economic interest of at least 5 percent, a so-called skin-in-the-game. They will have to also undertake significant research into the loans behind the securities before investing, or risk “heavy capital penalties,” the regulator said.

A lending cap would limit to 25 percent of overall lending capital the amount banks can loan to a single borrower, under the proposals.

There will be more stringent rules on what can be counted toward capital buffers, the FSA said. Hybrid capital, which has elements of both debt and equity, must be able to absorb losses for it to be counted as part of a bank’s tier 1 capital ratio, a key measure of banks’ strength. Core tier 1, a subset of that, is mainly shareholder equity.

Lloyds CoCos

Banks would have three “buckets” that would limit the amount of different types of hybrid capital they can hold within tier 1 to 15 percent, 35 percent and 50 percent respectively, the FSA said. The biggest bucket would be limited to hybrid capital that would convert to equity at an emergency trigger point.

Lloyds Banking Group Plc, in which the U.K. government owns a 43 percent stake, is bolstering its capital to avoid the U.K.’s Asset Protection Scheme, which would have increased the government’s stake to about 62 percent and cost the bank 15.6 billion pounds in fees. The bank is issuing $13 billion of enhanced capital notes, also known as contingent convertible securities, or CoCos, that become equity if the bank’s core tier 1 ratio drops below 5 percent.

The FSA said last month Lloyds’ CoCos could be treated as hybrid capital.

FSA too weak on hybrid capital

The author is a Reuters Breakingviews columnist. The opinions expressed are his own – By George Hay

"The Financial Services Authority needs to be tougher on bank capital. The UK regulator is considering allowing banks to count their current stock of hybrid securities as part of loss-absorbing reserves for another decade, and potentially longer. Such a grandfathering goes against the FSA’s policy goal of improving the quality of bank capital.

Hybrid securities pay interest and have a par value like debt but are supposed to lose value like equity if the issuer gets in trouble. In the recent crisis, though, the existing hybrid issues were seen, by investors and governments alike, as insecure capital — not sufficiently permanent and with dividends that could not easily be cut.

The FSA has responded by leading the charge for contingent convertibles — debt instruments that automatically convert into equity if certain triggers are met. These so-called CoCos allowed Lloyds Banking Group <LLOY.L> to kill two birds with one stone. The bank raised 7.5 billion pounds in capital while at the same converting its stock of unloved hybrids.

If it wanted to, the FSA could force all UK banks to follow suit, by announcing that after next year non-compliant Tier 1 securities would not be recognised as loss-absorbing. But although its latest consultation will improve hybrid quality, it contains a get-out clause. Banks will be allowed to count the offending securities as Tier 1 capital until 2020, and then in a reduced capacity until 2040. They can even keep issuing new non-compliant hybrid debt until the end of next year.

The FSA has reasons for being timid. It may not want to overburden bank investors. They could already be asked to help UK banks raise 33 billion pounds of extra capital to meet new adequacy standards for trading books and securitisations. Other reforms will require even more. The regulator also may not want to get too far ahead of EU nations, or of the Basel Committee, the sector’s global regulator.

But the FSA has already shown it is willing to take a lead on critical reforms — it unilaterally published views on new liquidity buffers ahead of the Basel group. It should get tougher on capital as well.

  • The Financial Services Authority has proposed allowing UK banks to hold current Tier 1 capital instruments which do not comply with its new rules for ten years after the guidelines become official at the end of next year.
  • Under new proposals put out to consultation on Thursday, hybrid capital held by banks — such as permanent interest-bearing shares (PIBS) and preference shares — must meet new standards on permanence, flexibility of payments and loss absorbency from Dec. 31, 2010 to be eligible as Tier 1 capital.
  • However, instruments issued before Dec. 31, 2010 will remain eligible as Tier 1 capital until Dec. 31, 2020, and will afterwards still be allowed to count as a declining proportion of Tier 1 capital until 2040.

China: Lending growth during credit expansion

"China’s lending boom may erode the quality of bank balance sheets as a jump in lending was “unavoidably” linked to an easing of credit standards, the Bank for International Settlements said.

“While strong loan growth in China has fuelled the current economic recovery, it is not without risks,” the Basel, Switzerland-based BIS said in a quarterly report published today. The credit expansion “raised concerns about excessively loose credit conditions.”

The warning underscores a need for higher loss provisions at the nation’s lenders that China’s financial regulator has already identified. The agency is pushing banks to raise ratios of reserves to non-performing loans to 150 percent by the end of this year, according to the BIS.

“Some of the banks are in need of additional capital” given the surge in credit this year, Jing Ulrich, Hong Kong-based chairwoman of China equities and commodities at JPMorgan Chase & Co., said in a Bloomberg Television interview before the BIS release. “Some time next year we will see some more banks coming to the market to raise equity capital,” she said, adding that the central bank may boost the reserve requirement ratio.

Chinese officials encouraged a $1.3 trillion credit boom in the first 10 months of 2009 to aid stimulus plans, pushing the economy to its fastest pace of growth in a year last quarter. A “significant” part of loans doled out by banks may have flowed into equity and property markets, the BIS said.

Investment Projects

The credit-fueled increase in investments “may imply additional demand for loans in the future, to complete the underlying project,” the document said. Should China tighten monetary policy, that could “leave projects incomplete and lead to a build-up of bad loans.”

China Banking Regulatory Commission Vice Chairman Wang Zhaoxing wrote in an article published in China Finance magazine that the agency has asked the nation’s larger lenders to increase their minimum capital adequecy ratios to 11 percent.

The regulator last year raised the minimum required capital adequacy ratio for publicly traded banks to 10 percent from 8 percent. It said in September it plans to tighten capital requirements by capping cross-holdings of subordinated bonds.

Industrial & Commercial Bank of China Ltd., the world’s largest bank by market value, had a capital adequacy ratio of 12.6 percent as of Sept. 30, while Construction Bank Corp. was at 12.11 percent. Bank of China Ltd.’s capital adequacy ratio stood at 11.63 percent and the ratio at Bank of Communications Ltd. was 12.52 percent.

China has been among Asian nations that have strengthened guidelines for bank loss provisioning in recent years, in part stemming from their experience during the region’s 1997-98 financial crisis, the BIS said in its report.

“This has contributed to stronger banking systems in the region,” the bank said.

The BIS was founded in 1930 and is the world’s oldest international financial organization, according to its Web site. The BIS says it serves as a bank for central banks and acts as a forum for policy discussions and analysis among central banks.

Australian prudential regulation and capital adequacy

"...Three particular global reform initiatives are now shaping APRA’s prudential policy agenda. The first involves a p rogram of measures, under development by the Basel Committee, to raise the quality and quantity of capital in the global banking system and introduce a framework for countercyclical capital buffers.

These measures involve an enhancement of the Basel II Framework, the new global capital regime for banking institutions. The Framework was introduced in Australia from 1 January 2008 and we believe it has been a positive factor in the prudential soundness of ADIs, not only in establishing more risk-sensitive and comprehensive capital requirements but also in promoting more rigorous risk management.

The second global initiative concerns the management of liquidity risk, an area where serious weaknesses were exposed by the global financial crisis. Lulled by years of ample global liquidity, many major global banking institutions failed to contemplate how suddenly liquidity risks can materialise and funding sources dry up. The Basel Committee has released revised principles for sound liquidity risk management and supervision and APRA is now translating these principles into its prudential framework for ADIs, with a series of proposals currently out for consultation. I will say more about these proposals shortly.

The third global initiative concerns remuneration. APRA has been at the forefront of work to address poorly designed incentives in remuneration, another of the key factors contributing to the crisis. Within the next few days, we will be releasing our prudential requirements for remuneration for ADIs and insurers. Our principles-based approach puts the onus on boards to do two things. One is to determine sound remuneration arrangements for all staff who can materially affect the performance of their institution. The other is to inject a longer-term horizon into remuneration arrangements by requiring that they be aligned with the long-term financial soundness of the institution and its risk-management framework.

These global reform initiatives are comprehensive, and serious. Reforms will happen; they are happening now. At this stage, however, the increasing media and other ‘chatter’ about the burden of the reforms on our regulated institutions must be taken with a grain of salt. Obviously, where Australia’s prudential framework is already consistent with emerging global norms, or where our institutions were not enticed into the excessive risk-taking to which some of the specific reforms are targeted, the reform burden is likely to be muted.

Take the issue of the quality of bank capital, for example. The Basel Committee is proposing to raise the quality of the Tier 1 capital base (the highest quality capital) by limiting the predominant form of Tier 1 capital to common equity and retained earnings. APRA’s decision several years ago to tighten its predominance test positions Australia well on this issue. Take the tougher Basel II capital requirements for securitisation and trading book activities, released a few months ago, as another example. These are likely to have only a modest impact in Australia because our ADIs have only limited reliance on the income streams from these activities compared to many of their overseas counterparts.

In other areas, however, Australia is not an exemplar and our prudential framework will emerge strengthened by global reform initiatives. I am referring here, in particular, to initiatives to improve the shock absorbers in the financial system that are so vital to preserving financial stability — namely, capital, provisioning and liquidity buffers.

I mentioned the Basel Committee’s proposed framework for countercyclical capital buffers. What global policymakers want are resilient banks that build up capital buffers in good times, when it is easier and cheaper to do so, and use these buffers at times of stress to absorb losses and enable lending activities to continue. This is simply the ‘rainy day’ principle. Global policymakers also want to build countercyclical buffers into loan loss provisioning practices to ensure that banks take a forward-looking or ‘expected loss’ approach to provisioning.

It is difficult to see that the ‘rainy day’ principle was at work in Australia. Our banks did not take advantage of Australia’s sustained economic expansion to build up their capital bases; the total capital ratio when the global financial crisis struck was little different to the ratio a decade earlier. Over this decade, of course, listed banks were under constant market pressure to demonstrate capital efficiency and to return so-called ‘lazy’ capital to investors through share buy-backs. Banks in fact funded the necessary growth of their capital bases through extensive use of hybrid and innovative instruments, significantly reducing the share of the highest quality forms of capital in their total capital. The introduction in 2005 of [IFRS|International Financial Reporting Standards], which take a backward-looking approach to loan losses, also resulted in an immediate and substantial reduction in the level of provisions held by banks.

Let me emphasise that banks and other ADIs in Australia have been well capitalised before and during the global financial crisis. My point is simply that we are in no position to lecture the rest of the world on countercyclical capital management."

APRA draft proposal for the supervision of conglomerate groups

Conglomerate groups, referred to as Level 3 groups, are groups comprising APRA regulated institutions that perform material activities across more than one APRA-regulated industry and/or in one or more non-APRA-regulated industry.

The consultation package released today includes a discussion paper and two reporting standards together with associated reporting forms and instructions.

The proposed Level 3 data collections will assist APRA to ensure that Level 3 groups are capitalised in accordance with the proposed capital adequacy prudential standards that were released for consultation in May 2013. The capital adequacy framework encompasses all material risks to a Level 3 group’s APRA beneficiaries, including risks emanating from non-APRA-regulated institutions in the group.


The Australian Prudential Regulation Authority (APRA) has today released a discussion paper containing proposals on supervising conglomerate groups. These are groups with APRA‑regulated entities that have material operations in more than one APRA‑regulated industry and/or have material unregulated entities.

APRA’s proposed ‘Level 3’ supervision framework is designed to complement its existing industry‑based supervision of stand-alone entities (Level 1 supervision) and its supervision of single industry groups (Level 2 supervision).

The Level 3 framework contains proposals, building on APRA’s existing capital requirements, to ensure that a conglomerate group holds adequate capital to protect the APRA‑regulated entities from potential contagion and other risks within the group. The framework also contains proposals on a range of principles‑based risk management and governance standards that will apply to the parent company of the Level 3 group.

APRA Chairman Dr John Laker said that the global financial crisis has highlighted the importance of taking a broad, group‑wide view of prudentially regulated entities.

‘APRA’s proposals are intended to strengthen the financial soundness of APRA‑regulated entities within a conglomerate group, without unduly constraining the structure or scope of operations of the group. The flexibility of Level 3 supervision will give both APRA and the group itself a better understanding of the risks that arise from the group and its activities.’

Submissions on the Level 3 proposals are invited by 18 June 2010. Following this initial consultation, APRA will release draft prudential standards and reporting standards to implement the Level 3 framework. These standards will also be subject to public consultation.

The discussion paper can be found on the APRA website.

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