Chapter 13
Risk and the Need for Capital
1. INTRODUCTION
The world economy, and financial markets in particular, are at the time of this writing still traumatised by the global financial crisis and its huge macroeconomic effects. Policymakers and regulators around the world are debating the introduction and imposition of new models of financial regulation. Consequently, a major programme of financial regulatory reform was introduced to strengthen capital and liquidity management in the global banking system. The main objective of this initiative is twofold: to uphold confidence in the global banking system and to put in place measures that would prevent or lessen spread of systemic risk to the broader financial systems.
This chapter discusses the key issues that arise in risk and the need for capital. Three key linked themes will be discussed and analysed:
The analysis is structured around these three themes in four main sections. After the introduction, an overview of capital regulation and the evolution of international capital standards is presented. This is followed by discussion on the introduction of the “risk-based regulation” concept, which encompassed the types of risks faced by banking institutions. Before concluding, the chapter touches on two inter-linked development in capital regulation: first, the globalisation of financial regulation and the impact of the global regulatory framework proposed in Basel III, which aimed at promoting a more resilient banking sector worldwide; second, the rise and fall of contingent capital instruments used by the global systemically important financial institutions (G-SIFIs). The conclusion presents the key challenges of global standardisation of capital management regulation and the concerns of banks in implementation and compliance.
One of the main lessons learned from the global financial crisis (GFC) is the excessive leverage employed by the internationally active banks, and the subsequent erosion of the capital base of these banks. In addition, the crisis identified the vulnerability of the banks’ business models and strategies, and more importantly the banks’ vulnerability to financial and economic shocks.1 Hence, bank supervisory authorities regard capital as a key element in the regulatory framework. For institutions whose liquid assets are a small proportion of their liabilities, banks have traditionally needed to show a good margin of reserves in order to retain the confidence of their depositors and the public. This practice was codified in the 1998 Basel Capital Accord, and more recently in the 2004 Revised Capital Framework, promulgated by the Basel Committee on Banking Supervision (BCBS). The 1998 Accord was justifiably regarded as a regulatory landmark and has had a profound influence on banking institutions around the world. More importantly, the BCBS recently introduced a new major set of reforms to Basel regulations, aimed at addressing global capital regulatory framework in light with the prevailing global crisis—Basel III. The main objective of this development in Basel regulation is twofold: to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, and thus reduce the risk of spillover from the financial sector to the real economy. Between 2010 and 2011, the BCBS produced two important policy documents. The first document sets the concept and approach to enhance bank regulation globally. The second addresses the requirements for strengthening liquidity regulation.2
The GFC has highlighted not only the importance of the absolute amount of a bank’s equity position, but most importantly the quality of capital held by a bank. Thus, any attempt to address issues relating to risk and capital regulation cannot overlook the importance of capital adequacy and liquidity risk measurements necessary to improve the level and quality of capital and the ability to withstand liquidity crises. But what exactly is capital? In practice, it can be defined in various ways depending on the source of the question. For the public and the bank depositor in particular, it represents the cushion available to absorb losses. For the accountant, it represents the surplus of assets over liabilities (i.e., equity). For the bank, it represents its share capital and reserves (equity) and nondeposit liabilities, forming a distinction between internal and external capital. This is also largely how the supervisors see it, though supervisors may differentiate not so much between external and internal capital as between share capital and free reserves on the one hand, and lesser-quality reserves and junior and senior debt on the other.
What is especially critical is that the measure of capital is only accurate if the assets (and liabilities) are on the balance sheet at their fair values. Since capital is only a relatively small part of a bank’s balance sheet, it can evaporate rapidly if only a small proportion of its assets are impaired or turn out to be irrecoverable.
The Basel capital ratio is based on a carefully defined numerator (the capital definition) and denominator (the measure of risk). The numerator of the equation, capital itself, is divided into a number of eligible components with different limits and sublimits. The first tier of capital, largely shareholders’ paid-up capital built up from retained profits, has to represent at least half of the total measure of capital.
The second tier of capital can be made up from other elements that add to the strength of the bank, such as revaluation reserves arising from unrealised book profits or upwards remeasurement of assets to fair value, general loan-loss provisions under certain conditions, and a subset of liabilities with characteristics of capital, such as hybrids of debt and equity instruments and subordinated term debt.
The denominator of the capital ratio represents the asset base. Under regulatory capital requirements, the assets are weighted according to broad categories of perceived risk. It is important to note that this includes off-balance-sheet as well as on-balance-sheet exposures. Under the original Basel Accord, the on-balance-sheet risk categories were deliberately broad—the Accord used a portfolio approach designed to estimate an appropriate measure of capital.
2. THE EVOLUTION OF INTERNATIONAL CAPITAL STANDARDS
When the Basel Committee first began discussing capital adequacy seriously in the early 1980s, a global standard was far from its thoughts. The committee began with a fact-finding survey, with the intention of comparing the arrangements in different markets and examining whether it might be possible to develop best practice guidelines.
A sequence of events triggered more focused efforts that eventually resulted in the 1988 Accord. The first was the work in the European Community on defining a common capital standard. Then, as the gravity of the Latin American debt crisis of the early 1980s became clearer, many bank supervisors and other policy makers began to express the view that bank capital standards had been allowed to fall to a level that exposed the world’s major banks to a systemic crisis. Supervisors at the Federal Reserve and other U.S. institutions with banking oversight responsibilities were particularly strong voices for change, as they observed the significant burden of the Latin American debt crisis on several large U.S. banks. The Bank of England also saw the gravity of the situation from the perspective of the world’s largest financial center.
In response to these events, in the early 1980s U.S. regulators attempted to introduce a tighter capital standard for U.S. banks. However, these efforts ran into strong opposition from the banking industry, which was concerned about possible negative effects of tighter capital standards on their international competitiveness. At the time, Japanese banks were expanding rapidly on the back of a strong domestic market and attempting to increase market share abroad.
A number of high-profile takeovers, or takeover attempts, of U.S. banks by Japanese interests raised protectionist concerns. Policy makers in the U.S. and in other G10 countries concluded that the only way in which the capital levels of the world’s principal banks could be raised was through a global agreement. In 1985, the G10 Governors therefore gave the Basel Committee a mandate to report to them on the modalities of achieving agreement among committee members on a minimum capital standard.
By 1987, the committee had held a number of tightly focused meetings in which the main elements of the Capital Accord were put in place. In that year, committee members moved forward with an arrangement in the Accord that would divide capital into two tiers of different quality. By the fall, members reached agreement on an 8 percent risk-weighted capital ratio, 4 percent for each tier, and by December a consultative paper was ready for approval by the G10 Governors. It is important to understand that the level of 8 percent was not selected as a result of calculations of historical non-repayment for default risk, even though the 8 percent ratio was measured against credit risk alone. While somewhat of a judgment call by the supervisors who negotiated the 1988 agreement, the 8 percent ratio was not agreed upon without conducting a considerable amount of testing based on banks’ existing capital mixes and balance sheets. In this way it was possible to make a fairly close assessment of the capital ratios of the banks in the G10 countries and to judge what ratio would represent an acceptable level of capital cover.
3. THE RISK-BASED FINANCIAL REGULATION APPROACH
The Basel Committee never regarded the initial Capital Accord as a static measure of capital adequacy. Several times since 1988 changes were introduced, in respect of the definition of capital (tightening up on the definition of general provisions within Tier 2 and redefining the eligibility of hybrid instruments within Tier 1), the risk weights and the treatment of netting. The most significant revision to the 1988 Accord was the market risk capital amendment of 1996, which allows certain risks such as foreign exchange, security, and commodity trades to be carved out of the credit risk measure and given separate capital charges calculated according to the net uncovered position.
The simplicity of the 1988 Accord was one of its key strengths and one of the reasons for its broad acceptance at a time when international prudential standards in any industry were considered by many to be a novel, if not alarming, idea. But over time its very simplicity became one of its key drawbacks, as the Accord became a target for creative bankers to circumvent. In particular, the institutional approach to risk allocation provided an incentive to remove some high-quality assets that attracted high capital charges from the balance sheet. In the decade following the Accord’s introduction, financial markets had become increasingly more complex, with the result that the Accord could no longer credibly assign capital charges in relation either to the risks of these products—such as securitised assets with different tranches of risk and derivatives products—or to the risk mitigation techniques commonly employed by banks. In addition, advances in technology and risk management practices had led to more sophisticated approaches to default and loss estimates, and spoke to the possibility of calibrating capital charges with greater granularity than the broad exposure classifications of the 1988 Accord.
While recognising the need for a capital standard that could address these developments, the committee realised that the standard would also have to remain appropriate for less sophisticated banks both in the developed industrialised world and in economies of the emerging markets that mainly undertake more traditional credit provision functions. This viewpoint influenced the decision to create supervisory options for capital calculations that could be scaled to the sophistication of jurisdictions’ banking industries, and even to the sophistication of categories of banks within a jurisdiction. This was clearly beyond the scope of simple amendments to the original Accord, and also argued in favor of an entirely new capital standard.
The limited scope of the 1988 Accord also weighed in the decision to rethink capital standards entirely, rather than add amendments to the original document. Specifically, the objective of the 1988 standard was to provide a general capital cushion against all risks, including market risk, operational risk, interest rate risk, and legal risk. However, the original capital ratio was expressed only in terms of credit risk, because that was historically the greatest risk for banks and the one that could be measured most simply through a broadly institutional approach. The market had in fact validated this judgment in its own manner—banks were not only expected by equity investors, creditors, and rating agencies to have capital ratios above 8 percent, but those that did not maintain a healthy margin above this level were not regarded as having the highest standing. In the ensuing years, however, the greater complexity of banking institutions and their growing involvement in noncredit activities spoke to the need to design a standard that would separately assess capital adequacy against different types of risk.
Committee members also recognised that while capital adequacy is a vital component of a banking institution’s success and viability, the quality of management and of internal controls has consistently proven to be an equally critical element of success. Indeed, these elements can rightfully be viewed as a bank’s first line of defence, since experienced management and robust controls can lessen the probability of significant losses that would eat into capital. Committee members thus sought appropriate ways to incentivise banks to continue improving their risk management practices. Clearly, this added goal broadened the scope of the capital framework well beyond that of the 1988 agreement, and further tilted the committee’s thinking toward an entirely new standard and away from a patchwork of amendments to the original Accord.
The new framework addresses the expanded goals of the committee by introducing three mutually reinforcing “Pillars.” It is critical that all of the Three Pillars are implemented effectively, because the greater freedom provided by the adoption of a risk-based approach requires additional checks and balances.
Pillar 1 consists of minimum capital requirements; Pillar 2, the concept of supervisory review; and Pillar 3, market discipline. The first pillar seeks to align bank capital more closely with the actual risks that banks face, while presenting banks and their supervisors with options that allow the capital rules to be scaled to the level of sophistication. Thus, banks with a more traditional banking business will be able to readily apply more risk-sensitive capital charges using information technology and management practices that are compatible with the complexity of their operations. More sophisticated institutions, however, will be able directly to use aspects of their risk quantification and management techniques in regulatory capital calculations. This will result in capital charges that are more closely aligned with actual risk, and thus provide incentives for all banks to refine their risk measurement practices.
Another important feature of Pillar 1 is the adoption of a specific charge for operational risk. It is fair to say that the concept of operational risk is still relatively new and the approaches to measuring and managing it are still in a developmental stage, but it is a risk that is already significant and is plainly growing in importance as a direct result of the sheer complexity of modern finance. The intention to adopt a capital charge has given the industry a significant incentive to develop methodologies to address this complex risk.
Pillar 2 recognises the responsibility of the supervisor to promote the overall safety and soundness of the banking system, while also stressing that individual banks have primary responsibility for managing their own risks. Pillar 2 stresses the critical role of dialogue between supervisors and banks, which can serve to provide additional incentives for banks to manage risk in a prudent fashion. Of equal importance under the second Pillar, however, is that by establishing a set of common guidelines for supervisory review, supervisors around the world would implement the new Accord with greater consistency, thereby encouraging a more level playing field and decreasing the regulatory burden on banks operating in different jurisdictions.
Pillar 3 involves the market in the capital adequacy regime. The new Accord stipulates a number of minimum public reporting standards on risk and risk management. These will enhance the ability of market participants to understand each bank’s risk profile and the sufficiency of its capital relative to its risk and should enable competitors, analysts, rating agencies, and academics to exert the market discipline required to reinforce the relative freedom in the new Accord. Essentially, the more a bank uses internal methodologies to measure its risk capital, the greater the disclosure requirement will be.
4. GLOBALISATION OF FINANCIAL REGULATION?
An important point to remember about the Basel Accord is that it was negotiated specifically as an agreement between Basel Committee countries, and thus was intended to apply only to “internationally active” banks in these countries. And while in theory the Basel Committee has no legal powers to enforce the Accord, in practice the public endorsement of the G10 Governors and the publicity surrounding the Accord made it difficult for the then G10 countries to evade it. The process has been eagerly embraced by the credit rating agencies, which enthusiastically used the Accord as a means of comparing different banks. Expressed in different words, the delivery of a common measurement tool has provided additional market discipline in an industry for which systemic risk is an ever-present threat.
Over the years, the Basel Accord has had a significant influence on banks, supervisors, and investors around the world, initially in the G10 and OECD countries, but in recent years even more broadly, with well over 100 countries eventually adopting the original capital standard, and the full support of the wider G20. The risk-based financial regulation concept gained recognition internationally and was adopted in many developed and emerging economies. The Accord has clearly led to the strengthening of capital standards among the world’s banks, particularly the large, internationally active banks for which it was intended, and has also led to a more level playing field by ensuring against slides in prudential standards in any one country that could in turn lead to competitive imbalances.
Building on the Three Pillars of the Basel II framework, the newly developed Basel III continued to supplement the risk-based approach and designed new set of regulations to promote a more resilient banking sector in three key areas: First, it aimed to raise the quality, consistency and transparency of the capital base of banks. In doing so, Basel III stipulated that “banks’ risk exposures are backed by a high quality capital base,” and proposed an increase (to be implemented over time) of Tier 1 capital to at least 4.5 percent of risk-weighted assets at all times for Core Tier 1 (i.e., common equity), while total Tier 1 including Additional Tier 1 capital must be at least 6 percent of risk-weighted at all times. Moreover, the new set of changes stipulated an enhancement of risk coverage of the banking institutions, and suggested continued stress tests. In addition, the reforms also raised the standard of the Pillar 2 supervisory review process and strengthened Pillar 3 disclosures requirements. Other new reforms included the introduction of a leverage ratio requirement (Tier 1 capital divided by total on and off balance sheet exposures to exceed 4 percent) to constrain banks’ excessive leverage. Another important feature of the reforms is the introduction of “internationally harmonised global liquidity standard.” To complement this principle, Basel III developed two minimum standards for funding liquidity. The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ration (NSFR).
5. THE SHORT-LIVED RISE OF CONTINGENT CAPITAL INSTRUMENTS
Driven by the post-crisis capital regulatory changes, the banking industry witnessed the emergence of new asset classes mainly used to supplement a bank’s funding and capital requirements. Different forms of contingent capital instruments emerged and were used by the so-called global systemically important financial institutions (G-SIFIs) to meet additional capital requirements set by the new Basel III regulation. The instruments have gained increasing support as a potential option to reduce the need for public bailouts and government support. Generally, two forms have evolved. One is a new hybrid capital instrument in the form of fixed income securities serving as an equity buffer in time of financial stress, which are generally termed Contingent Convertible Bonds or CoCos. CoCos are designed to convert to common equity when a certain “trigger event” occurs, such as the Tier 1 ratio falling below the required level. CoCos would thus count as “going concern capital,” as they become fully loss-absorbent while the bank is still solvent. The other is the bond creditor “Bail-ins,” that is, a type of subordinated debt which is automatically written down to a specified percentage of face value on the occurence of a specified trigger event. Such bonds would be “going concern capital” if the trigger were set at a level such that the write-down made the bank solvent, and “gone concern capital” if they would be loss-absorbent only in the event of insolvency.
However, the use of these new contingent debt instruments had mixed levels of success. In January 2011, the International Monetary Fund produced a Staff Discussion Note debating the economic rationale and reviewed the merits and limits of contingent capital.3
The main conclusion of this Note can be summarised as follows:
Essentially, the term contingent convertible capital is used very generally to describe a kind of put option enabling the issuer to issue new equity at prenegotiated terms.5 The types, operational and regulatory impact are beyond the scope of this chapter. However, in January 2011, the Basel Committee introduced a set of new rules to supplement Basel III regulations. The supplement banned the use of all kind of contingent convertible debt instruments (CoCos) that did not meet stringent loss absorbency criteria.6
6. CONCLUSION
The overall goal of Basel III of promoting a more resilient banking sector remains challenged, with unresolved weaknesses in national and international financial oversight and implementation.
As always with new regulation, successful adoption requires firm and consistent application by regulators. It also requires an understanding by banks that effective regulation essentially places limits on banks’ ability to maximise short term profit (if it did not, it would be ineffective) but that these limits are in the firm’s own best interests.
NOTES
1. “Financial Risk Outlook: Banking Sector Digest,” Financial Services Authority, UK, 2010, www.fsa.gov.uk/pages/library/corporate/outlook/fro_2010.shtml.
2. “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems,” Basel Committee on Banking Supervision, Bank for International Settlements, December 2010 (revised June 2011), www.bis.org/publ/bcbs189.htm.
“Basel III: International Framework for Liquidity Risk Measurement, Standards, and Monitoring,” Basel Committee on Banking Supervision, Bank for International Settlements, December 2010, www.bis.org/publ/bcbs188.htm.
3. “Contingent Capital: Economic Rationale and Design Features,” IMF Staff Discussion Note, SDN/11/01, 2011, www.imf.org/external/pubs/ft/sdn/2011/sdn1101.pdf.
4. Ibid.
5. “Contingent Convertibles: Banks Bonds Take on a New Look,” Deutsche Bank Research, May 23, 2011, www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000273597.pdf.
6. “Basel Committee issues final elements of the reforms to raise the quality of regulatory capital,” Press release, Bank for International Settlements (January 13, 2011), www.bis.org/press/p110113.pdf.