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Posts Tagged ‘capital adequacy’

Deeper in debt

‘The world is sinking under a sea of debt, private as well as public, and it is increasingly hard to see how this might end, except in some form of mass default.’ So claims the article below by Jeremy Warner. But just how much has debt grown, both public and private? And is it of concern?

The doomsday scenario is that we are heading for another financial crisis as over leveraged banks and governments could not cope with a collapse in confidence. Bank and bond interest rates would soar and debts would be hard to finance. The world could head back into recession as credit became harder and more expensive to obtain. Perhaps, in such a scenario, there would be mass default, by banks and governments alike. This could result in a plunge back into recession.

The more optimistic scenario is that private-sector debt is under control and in many countries is falling (see, for example, chart 1 in the blog Looking once again through Minsky eyes at UK credit numbers for the case of the UK). Even though private-sector debt could rise again as the world economy grows, it would be affordable provided that interest rates remain low and banks continue to build the requisite capital buffers under the Basel III banking regulations.

As far as public-sector debt is concerned, as a percentage of GDP its growth has begun to decline in advanced countries as a whole and, although gently rising in developing and emerging economies as a whole, is relatively low compared with advanced countries (see chart). Of course, there are some countries that still face much larger debts, but in most cases they are manageable and governments have plans to curb them, or at least their growth.

But there have been several warnings from various economists and institutes, as we saw in the blog post, Has the problem of excess global debt been tackled? Not according to latest figures. The question is whether countries can grow their way out of the problem, with a rapidly rising denominator in the debt/GDP ratios.

Only mass default will end the world’s addiction to debt The Telegraph, Jeremy Warner (3/3/15)

Questions

  1. What would be the impact of several countries defaulting on debt?
  2. What factors determine the likelihood of sovereign defaults?
  3. What factors determine the likelihood of bank defaults?
  4. What is meant by ‘leverage’ in the context of (a) banks; (b) nations?
  5. What are the Basel III regulations? What impact will they have/are they having on bank leverage?
  6. Expand on the arguments supporting the doomsday scenario above.
  7. Expand on the arguments supporting the optimistic scenario above.
  8. What is the relationship between economic growth and debt?
  9. Explain how the explosion in global credit might merely be ‘the mirror image of rising output, asset prices and wealth’.
  10. Is domestic inflation a good answer for a country to the problems of rising debt denominated (a) in the domestic currency; (b) in foreign currencies?
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Has the problem of excess global debt been tackled? Not according to latest figures.

According to a report by the McKinsey Global Institute, global debt is now higher than before the financial crisis. And that crisis was largely caused by excessive lending. As The Telegraph article linked below states:

The figures are as remarkable as they are terrifying. Global debt – defined as the liabilities of governments, firms and households – has jumped by $57 trillion, or 17% of global GDP, since the fourth quarter of 2007, which was supposed to be the peak of the bad old credit-fuelled days. In 2000, total debt was worth 246% of global GDP; by 2007, this had risen to 269% of GDP and today we are at 286% of GDP.

This is not how policy since the financial crisis was supposed to have worked out. Central banks and governments have been trying to encourage greater saving and reduced credit as a percentage of GDP, a greater capital base for banks, and reduced government deficits as a means of reducing government debt. But of 47 large economies in the McKinsey study, only five have succeeded in reducing their debt/GDP ratios since 2007 and in many the ratio has got a lot higher. China, for example, has seen its debt to GDP ratio almost double – from 158% to 282%, although its government debt remains low relative to other major economies.

Part of the problem is that the lack of growth in many countries has made it hard for countries to reduce their public-sector deficits to levels that will allow the public-sector debt/GDP ratio to fall.

In terms of the UK, private-sector debt has been falling as a percentage of GDP. But this has been more than offset by a rise in the public-sector debt/GDP ratio. As Robert Peston says:

[UK indebtedness] increased by 30 percentage points, to 252% of GDP (excluding financial sector or City debts) – as government debts have jumped by 50 percentage points of GDP, while corporate and household debts have decreased by 12 and 8 percentage points of GDP respectively.

So what are the likely consequences of this growth in debt and what can be done about it? The articles and report consider these questions.

Articles
Instead of paying down its debts, the world’s gone on another credit binge The Telegraph, Allister Heath (5/2/15)
Global debts rise $57tn since crash BBC News, Robert Peston (5/2/15)
China’s Total Debt Load Equals 282% of GDP, Raising Economic Risks The Wall Street Journal, Pedro Nicolaci da Costa (4/2/15)

Report
Debt and (not much) deleveraging McKinsey Global Institute, Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva (February 2015)

Questions

  1. Explain what is meant by ‘leverage’.
  2. Why does a low-leverage economy do better in a downturn than a high-leverage one?
  3. What is the relationship between deficits and the debt/GDP ratio?
  4. When might an increase in debt be good for an economy?
  5. Comment on the statement in The Telegraph article that ‘In theory, debt is fine if it is backed up by high-quality collateral’.
  6. Why does the rise is debt matter for the global economy?
  7. Is it possible for (a) individual countries; (b) all countries collectively to ‘live beyond their means’ by consuming more than they are producing through borrowing?
  8. What is the structure of China’s debt and what problems does this pose for the Chinese economy?
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Five years on from Lehman’s: what have we learned?

On 15 September 2008, Lehman Brothers, the fourth-largest investment bank in the USA, filed for bankruptcy. Although the credit crisis had been building since mid 2007, the demise of Lehmans was a pivotal event in the unfolding of the financial crisis and the subsequent severe recession in most developed economies. Banks were no longer seen as safe and huge amounts of government money had to be poured into banks to shore up their capital and prevent further bankruptcies. Partial nationalisation seemed the only way of rescuing several banks and with it the global financial system.

A deep and prolonged recession followed (see Chart 1: click here for a PowerPoint). In response, governments pursued expansionary fiscal policies – at least until worries about rising government deficits and debt caused a lurch to austerity policies. And central banks pursued policies of near zero interest rates and subsequently of quantitative easing. But all the time debate was taking place about how to reform banking to prevent similar crises occurring in the future.

Solutions have included reform of the Basel banking regulations to ensure greater capital adequacy. The Basel III regulations (see Chart 2) demand considerably higher capital ratios than the previous Basel II regulations.

Other solutions have included proposals to break up banks. Indeed, just this week, the Lloyds Banking Group has hived off 631 of its branches (one sixth of the total) into a newly reformed TSB. Another proposal is to ring-fence the retail side of banks from their riskier investment divisions. In both cases the aim has been to avoid the scenario where banks are seen as too big to fail and can thus rely on governments to bail them out if they run into difficulties. Such reliance can make banks much more willing to take excessive risks. Further details of the new systems now in place are given in the Robert Peston article below.

But many critics maintain that not nearly enough has been done. Claims include:

• The Basel III rules are not tough enough and banks are still being required to hold too little capital.
• Rewards to senior bankers and traders are still excessive.
• The culture of banking, as a result, is still too risk loving in banks’ trading arms, even though they are now much more cautious about lending to firms and individuals.
• This caution has meant a continuing of the credit crunch for many small businesses.
• Higher capital adequacy ratios have reduced bank lending and have thus had a dampening effect on the real economy.
• The so-called ring-fences may not be sufficient to insulate retail banking from problems in banks’ investment divisions.
• Banks are not being required to hold sufficient liquidity to allow them to meet customers’ demands for cash in all scenarios.
• Banks’ reliance on each other still leaves a systemic risk for the banking system as a whole.
• Fading memories of the crisis are causing urgency to tackle its underlying problems to diminish.
• Problems may be brewing in less regulated parts of the banking world, such as the growing banking sector in China.

The following articles look at the lessons of the banking crisis – those that have been learned and those that have not. They look at the measures put in place and assess whether they are sufficient.

Lehman Brothers collapse, five years on: ‘We had almost no control’ The Guardian, Larry Elliott and Jill Treanor (13/9/13)
Lehman Brothers collapse: five years on, we’re still feeling the shockwaves The Guardian, Larry Elliott (13/9/13)
Five years after Lehman, could a collapse happen all over again? The Observer, Larry Elliott and Jill Treanor (15/9/13)
Five years after Lehman, all tickety-boo? BBC News, Robert Peston (9/9/13)
What have we learned from the bank crash? Independent, Yalman Onaran, Michael J Moore and Max Abelson (14/9/13)
We’ve let a good financial crisis go to waste since Lehman Brothers collapsed The Telegraph, Jeremy Warner (12/9/13)
The Lehman legacy: Lessons learned? The Economist (9/9/13)
The dangers of debt: Lending weight The Economist (14/9/13)
The Lehman anniversary: Five years in charts The Economist (14/9/13)

Questions

  1. Why did Lehman Brothers collapse?
  2. Explain the role of the US sub-prime mortgage market in the global financial crisis of 2007/8.
  3. In the context of banking, what is meant by (a) capital adequacy; (b) risk-based capital adequacy ratios; (c) leverage; (d) leverage ratios?
  4. Explain the Basel III rules on (a) risk-based capital adequacy (see the textbook and the chart above); (b) non-risk-based leverage (introduced in 2013: see here for details).
  5. Explain and comment on the following statement by Adair Turner: ‘We created an over-leveraged financial system and an over-leveraged real economy. We created a system such that even if the direct cost of bank rescue was zero, the impact of their near-failure on the economy was vast.’
  6. Under what circumstances might the global financial system face a similar crisis to that of 2007/8 at some point in the future?
  7. Why is there an underlying conflict between increasing banks’ required capital adequacy and ensuring a sufficient supply of credit to consumers and business? What multiplier effects are likely to occur from an increase in the capital adequacy ratio?
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Rebuilding UK banks: not easy to do

Following the banking crisis of 2007/8 a new set of international banking regulations was agreed in 2010 by the Basel Committee on Banking Supervision. The purpose was to strengthen banks’ capital base. Under ‘Basel III’, banks would be required, in stages, to meet specific minimum capital adequacy ratios: i.e. minimum ratios of capital to (risk-weighted) assets. The full regulations would come into force by 2019. These are shown in the chart below.

The new Financial Policy Committee of the Bank of England has judged that some UK banks have insufficient ‘common equity tier 1 capital’. This is defined as ordinary shares in the bank plus the bank’s reserves. According to the Bank of England:

… the immediate objective should be to achieve a common equity tier 1 capital ratio, based on Basel III definitions and, after the required adjustments, of at least 7% of risk-weighted assets by end 2013. Some banks, even after the adjustments described above, have capital ratios in excess of 7%; for those that do not, the aggregate capital shortfall at end 2012 was around £25 billion.

Thus the banking system in the UK is being required, by the end of 2013, to meet the 7% ratio. This could be done, either by increasing the amount of capital or by reducing the amount of assets. The Bank of England is keen for banks not to reduce assets, which would imply a reduction in lending. Similarly, it does not want banks to increase reserves at the expense of lending. Either action could push the economy back into recession. Rather the Bank of England wants banks to raise more capital. But that requires sufficient confidence by investors.

And the end of this year is not the end of the process. After that, further increases in capital will be required, so that by 2019 banks are fully compliant with Basel III. All this will make it difficult for certain banks to raise enough capital from investors. As far as RBS and the Lloyds Banking Group are concerned, this will make the prospect of privatising them more difficult. But that is what the government eventually wants. It does not want the taxpayer to have to find the extra capital. Re-capitalising the banks, or at least some of them, may prove difficult.

The following articles look at the implications of the FPC judgement and whether strengthening the banks will strengthen or weaken the rest of the economy.

Articles
Financial policy committee identifies £25bn capital shortfall in UK banks The Guardian, Jill Treanor (27/3/13)
Banks Told To Raise Capital By Financial Policy Committee To Cushion Against A Crisis Huffington Post (27/3/13)
UK banks’ £25bn shortfall: positive for banks, negative for BoE credibility, Sid Verma (27/3/13)
Doubts over Bank of England’s £25bn confidence game The Telegraph, Harry Wilson (27/3/13)
Bank of England tells banks to raise £25bn BBC News (27/3/13)
Q&A: Basel rules on bank capital – who cares? Laurence Knight (13/9/10)
U.K. Banks Seen Avoiding Share Sales After BOE Capital Review Bloomberg Businessweek, Gavin Finch and Howard Mustoe (27/3/13)
Banks Cut Basel III Shortfall by $215 Billion in Mid-2012 Bloomberg (19/3/13)
Will strengthening banks weaken the economy? BBC News, Robert Peston (27/3/13)

Bank of England News Release
Financial Policy Committee statement from its policy meeting, 19 March 2013 Bank of England (27/3/13)

Questions

  1. Explain the individual parts of the chart.
  2. What do you understand by risk-weighted assets?
  3. Distinguish between capital adequacy ratios and liquidity ratios.
  4. What could the banks do to increase their capital adequacy ratios? Compare the desirability of each method.
  5. If all banks around the world were Basel III compliant, would this make another global banking crisis impossible?
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Watering down liquidity

In the wake of the financial crisis of 2007/8, the international banking regulatory body, the Basel Committee on Banking Supervision, sought to ensure that the global banking system would be much safer in future. This would require that banks had (a) sufficient capital; (b) sufficient liquidity to meet the demands of customers.

The Basel III rules set new requirements for capital adequacy ratios, to be phased in by 2019. But what about liquidity ratios? The initial proposals of the Basel Committee were that banks should have sufficient liquid assets to be able to withstand for at least 30 days an intense liquidity crisis (such as that which led to the run on Northern Rock in 2007). Liquid assets were defined as cash, reserves in the central bank and government bonds. This new ‘liquidity coverage ratio’ would begin in 2015.

These proposals, however, have met with considerable resistance from bankers, who claim that higher liquidity requirements will reduce their ability to lend and reduce the money multiplier. This would make it more difficult for countries to pull out of recession.

In response, the Basel Committee has published a revised set of liquidity requirements. The new liquidity coverage ratio, instead of being introduced in full in 2015, will be phased in over four years from 2015 to 2019. Also the definition of liquid assets has been significantly expanded to include highly rated equities, company bonds and mortgage-backed securities.

This loosening of the liquidity requirements has been well received by banks. But, as some of the commentators point out in the articles, it is some of these assets that proved to be wholly illiquid in 2007/8!

Articles
Banks Win 4-Year Delay as Basel Liquidity Rule Loosened BloombergJim Brunsden, Giles Broom & Ben Moshinsky (7/1/13)
Banks win victory over new Basel liquidity rules Independent, Ben Chu (7/1/13)
Banks win concessions and time on liquidity rules The Guardian, Dan Milmo (7/1/13)
Basel liquidity agreement boosts bank shares BBC News (7/1/13)
Banks agree minimum liquidity rules BBC News, Robert Peston (67/1/13)

The agreement
Group of Governors and Heads of Supervision endorses revised liquidity standard for banks BIS Press Release (6/1/13)
Summary description of the LCR BIS (6/1/13)
Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools BIS (6/1/13)
Introductory remarks from GHOS Chairman Mervyn King and the Basel Committee on Banking Supervision’s Chairman Stefan Ingves (Transcript) BIS (6/1/13)

Questions

  1. What is meant by ‘liquid assets’?
  2. How does the liquidity of assets depend on the state of the economy?
  3. What is the relationship between the liquidity ratio and the money multiplier?
  4. Does the size of the money multiplier depend solely on the liquidity ratio that banks are required to hold?
  5. Distinguish between capital adequacy and liquidity.
  6. What has been the effect of quantitative easing on banks’ liquidity ratios?
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M4 in record fall despite QE

Figures released by the Bank of England show that M4 fell by 5.0% in the year to March 2012. This record fall comes despite over £320 billion of assets purchased by the Bank under its quantitative easing programme. These are funded by the creation of reserves in the Bank of England. (See the Bank of England site for details of the timing and amounts of QE.)

Because of the considerable injection of new money into the banking system, notes and coin plus banks’ reserve balances in the Bank of England rose by 44.9%. So how is it that this measure of narrow money has increased massively and yet M4 has fallen?

One problem with using figures for changes in M4 to gauge economic activity is that they include intra-financial sector transactions – transactions between ‘other financial corporations’ (OFCs). Such transactions do not impact on the real economy. For this reason, the Bank of England prefers to focus on a measure that excludes these transactions between OFCs, a measure known as ‘M4 excluding intermediate OFCs’. This measure rose by 2.7% in the year to March 2012. Although this was positive, it was still weak.

So why does quantitative easing seem to be having such a small effect on bank lending? The following articles look at the issue.

Articles
Record collapse in UK money supply blamed on banks The Telegraph, Philip Aldrick (2/5/12)
UK March mortgage approvals rise unexpectedly London South East (2/5/12)
UK March Net Consumer Lending +GBP1.4 Billion NASDAQ, Jason Douglas and Nicholas Winning (2/5/12)
M4 Hits Record Low; Non-Residents Sell Gilts Market News International (2/5/12)

Data
Bankstats (Monetary & Financial Statistics) – March 2012 Bank of England (2/5/12): see Tables A1.1.1, A2.1.1 and A2.2.3

Questions

  1. How does quantitative easing impact on the narrow measure of money: notes, coin and banks’ reserve balances in the Bank of England?
  2. How might an increase in narrow money lead to an increase in broad money (such as M4)?
  3. How is it that notes, coin and banks’ reserve balances rose so rapidly in the year to March 2012, while M4 fell and even M4 excluding OFCs rose only slightly?
  4. Does this suggest that money supply is endogenous? Explain.
  5. How does requiring banks to rebuild their capital base impact on the relationship between narrow and broad money?
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Reflections of the Old Lady’s Governor

On 2 May 2012, Sir Mervyn King, Governor of the Bank of England, gave the BBC Today Prgramme’s public lecture. In it, he reflected on the causes and aftermath of the banking crisis of 2007/8.

He said that the main cause of the banking crisis was the risky behaviour of the banks themselves – behaviour that they had been allowed to get away with becuase regulation was too light. The cause was not one of inappropriate fiscal and monetary policy.

According to Dr King, there had been no classical macroeconomic boom and bust. True there had been a bust, but there was no preceding boom. Economic growth had not been unsustainable in the sense of being persistently above the potential rate. In other words, the output gap had been close to zero. As Mervyn King puts it

Let me start by pointing out what did not go wrong. In the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. Whether in this country, the United States or Europe, there was no unsustainable boom like that seen in the 1980s; this was a bust without a boom.

In terms of monetary policy, inflation had been on track and interest rates were not too low. And as for fiscal policy, government borrowing had been within the Golden Rule, whereby, over the cycle, the goverment borrowed only to invest and kept a current budget balance. Indeed, the period of the late 1990s and early to mid 2000s had become known as the Great Moderation.

So what went wrong? Again in the words of Dr King:

In a nutshell, our banking and financial system overextended itself. That left it fragile and vulnerable to a sudden loss of confidence.

The most obvious symptom was that banks were lending too much. Strikingly, most of that increase in lending wasn’t to families or businesses, but to other parts of the financial system. To finance this, banks were borrowing large amounts themselves. And this was their Achilles’ heel. By the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. So even a small piece of bad news about the value of its assets would wipe out much of a bank’s capital, and leave depositors scurrying for the door. What made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. So it was difficult to know which banks were safe and which weren’t. The result was an increasingly fragile banking system.

But doesn’t his imply that regulation of the banking system had failed? And if so why? And have things now been fixed – so that banks will no longer run the risk of failure? Dr King addresses this issue and others in his speech and also in his interview the next day for the Today Programme, also linked to below.

Podcasts
The Today Programme Lecture BBC Radio 4, Sir Mervyn King (2/5/12) (Transcript of speech)
Also on YouTube at Governor’s Today Programme lecture, 2 May 2012
Sir Mervyn King: The full interview BBC Today Programme, Sir Mervyn King talks to Evan Davis (3/5/12)
Sir Mervyn King analysis ‘verging on delusional’ BBC Today Programme, Dylan Grice and Ngaire Woods (3/5/12)

Articles
Sir Mervyn King rejects criticism for crisis BBC News (3/5/12)
The boom and bust of Mervyn King BBC News, Robert Peston (3/5/12)
Sir Mervyn King admits BoE failed over financial crisis The Telegraph, Philip Aldrick (3/5/12)
Sir Mervyn King admits: we did too little to warn of economic crisis Guardian, Larry Elliott (2/5/12)
King Says BOE Will Risk Unpopularity to Prevent Crises Bloomberg, Jennifer Ryan and Scott Hamilton (3/5/12)

Data
Economic Outlook Annex Tables OECD (See Annex Tables 1, 10, 14, 18, 27, 28, 32, 33, 61 and 62)
Statistical Interactive Database Bank of England (See for example, A Money and Lending: counterparts to changes in M4, alternative presentation > Seasonally adjusted > Public sector contribution > PSNCR)

Questions

  1. Why was the period of the late 1990s and early to mid 2000s described as the Great Moderation?
  2. Chart the size of the output gap, the rate of inflation and public-sector deficits as a percentage of GDP in the UK and other major economies from 1995 to 2007. Is this evidence of the Great Moderation?
  3. To what extent would evidence of house prices, consumer debt, bank lending and the balance of trade deficit suggest that there was indeed a boom from the mid 1990s to 2007?
  4. What, according to Dr King were the main causes of the credit crunch?
  5. What, with hindsight, should the Bank of England have done differently?
  6. What UK body was responsible for regulating banks in the run up to the credit crunch? Why might its regulation be described as ‘light touch’?
  7. In what sense was there a moral hazard in central banks being willing to bail out banks?
  8. What banking reforms have taken place or will take place in the near future? Will they address the problems identified by Dr King and prevent another banking crisis ever occurring again?
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Making sense of Basel

Big challenges face the global community in making its financial institutions more resilient to withstand the difficulties that arise from the macroeconomic environment and, at the same time, better aligning their private interests with those of wider society.

This is no easy task. It is not easy either to keep tabs on the international responses to try and deliver these aims.

This is no better illustrated by some of the recent changes to the capital requirements of financial institutions outlined by the Basel Committee on Banking Supervisions. (Click here for a PowerPoint of the above chart.) The so-called Basel III framework will, in effect, increase the capital that banks are required to hold and, in particular, specific types of capital. In the process this will reduce gearing, i.e. the amount of assets relative to capital. Recent announcements have detailed how large global banks will have to hold even more capital. This blog tries to make sense some of the changes afoot. Further reading is identified below.

The details of the Basel III framework are complex, there are an enormous amounts of financial acronyms to sift through and the definitions of capital change from time. But, at the heart of the proposals is the aim of increasing the resilience of our financial institutions. To do this the proposals focus predominantly on the liability side of a bank’s balance sheet. More specifically, they focus on long-term liabilities which help banks to resource their assets, i.e. to fund their provision of credit (their assets). This capital is ranked by its quality or by tiers; this terminology has recently changed.

Tier 1 capital is now split into two groups: Common Equity Capital (CET1) and Additional Tier 1 (AT1). The former – the ‘best’ capital – is made up of common equity (ordinary share capital) and retained profits. Holders of common equity can expect to receive dividend payments, but these are discretionary, largely dependent on the financial well-being of the firm. The remainder of CET1 are the retained profits of the firms and, hence, that parts of profits which are not distributed to its shareholders (owners). Additional Tier 1 capital – ‘second best’ capital – comprises preference shares and perpetual subordinated debt. Preference shares are more akin to bonds and provide regular coupons. However, their payment continue to place a burden on firms during more difficult financial times. Subordinated debt is debt where the creditors would not have any financial redress before depositors and other creditors have been attended to. Perpetual subordinated debt (bonds) is debt with no maturity date. Finally, Tier 2 capital is subordinated debt where the time to maturity is greater than five years.

The Basel III framework outlines a series of ratios known as Capital Adequacy Ratios (CARs) that financial institutions should meet. The ratios define a type of capital (numerator) relative to risk-weighted assets (denominator). The denominator involves weighting a bank’s category of assets by internationally agreed risk factors. These range from zero for government debt instruments to 1.5 for certain types of loans to companies. In other words, the more risky a given level of assets are the greater is the denominator and the lower is the financial institution’s capital adequacy.

From January 2013, the so-called ‘hard core minimum’ of Basel III, which is a combined level of Tier 1 and Tier 2 capital, will need to be the equivalent to 8 per cent of the bank’s risk-weighted assets. This is actually unchanged from Basel II. But, it is not quite as simple as this. First, the composition of capital matters. The overall 8 per cent ratio must be meet by a Common Equity Capital (CET1) ratio, including retained reserves, of no less than 4.5 per cent (previously 2 per cent). Second, there is the phasing-in between 2016 and 2019 of additional Common Equity Capital (CET1) equivalent to 2.5 per cent of risk-weighted assets. This is known as the Capital Conservation Buffer. Third, depending on the assessment of national regulators/supervisors, like the Bank of England here in the UK, financial institutions generally could be required to hold further Common Equity Capital of between 0 per cent and 2.5 per cent of risk weighted assets. This is known as a Counter-Cyclical Buffer. So, for instance, if the regulators/supervisors become unduly worried by rates of credit growth, they can impose additional capital requirements. This is an example of macroeconomic prudential regulation because it focuses on the financial system rather any one single financial institution.

In September 2011, Basel III added a fourth qualification to the ‘hard core’. This too will be phased-in from 2016. It is to be applied to those financial institutions, which through a series of indicators, such as size, are to be identified as global systemically important financial institutions (G-SIFIs). Depending on their global systemic importance the amount of CET1 relative to risk weighted assets could increase by between a further 1 to 2.5 per cent (and even by as much as 3.5 per cent, if necessary). These four qualifications could take the overall capital adequacy ratio from 8 per cent to as much as 15.5 per cent: 8 per cent plus 2.5 per cent capital conservation buffer plus 2.5 per cent for G-SIB surcharge plus 2.5 per cent for counter-cyclical buffer.

However, capital requirements may be even more stringent in the UK for retail banks. The UK’s Independent Commission on Banking has proposed that retail banks in the UK become legally, economically and operationally independent of the investment part of banks. In other words, that part of the bank which focuses on deposit-taking from households and firms be separated from the investment bank which largely provides services involving other financial institutions. The ICB proposed in its report last Autumn that the separate retail subsidiary faces an overall CAR of between 17 to 20 per cent with a CET1 ratio of at least 10 per cent. We will have to wait to see whether this comes to pass as the government’s legislation passes through Parliament, but it is not expected that the ICB’s proposals come into force before 2019.

Recommended Materials
Final Report: Recommendations Independent Commission on Banking , September 2011. (See Chapter 4 for a readable overview of Basel III and the general principles involved. See Chapter 3 for a discussion of the functional separation of retail and investment banking).
Basel Committee on Banking Supervision reforms – Basel III Bank for International Settlements

Articles
Basel III – the case for the defence Financial Times (23/1/12)
Finance: Banks face a perfect storm that is getting worse Financial Times, Patrick Jenkins (24/1/12)
Banks in EU, US and Japan to face capital reviews BBC News (9/1/12)

Questions

  1. What is meant by capital and by capital adequacy?
  2. Explain the construction of a Capital Adequacy Ratio. Distinguish between the CET1 ratio and the overall CAR ratio.
  3. What do you understand by macro-prudential regulation?
  4. How do liquidity and capital adequacy differ?
  5. If financial institutions provide deposits to individuals who can draw out their money readily but extend credit over long periods of time, why don’t financial institutions regularly face financial problems?
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Taking the gambling out of high street banking (update)

Original post (19/9/11)
The Independent Commission on Banking (ICB), led by Sir John Vickers, has just delivered its report. Central to its remit was to investigate ways of making retail banking safer and avoid another bailout by the government, as was necessary in 2007/8.

The report recommended the ‘ringfencing’ of retail banking from the more risky investment banking, often dubbed ‘casino banking’. In other words, if the investment arm of a universal bank made a loss, or even faced collapse, this would not affect the retail arm. The ringfenced operations would include banking services to households and small businesses. Wholesale and investment banking would be outside the ringfence. As far as retail banking services to big business are concerned, these could be inside the ringfence, but details would need to be worked out about precisely which banking services to big business would be inside and which would be outside the ringfence.

The ICB was keen to stress that the ringfence should be high and that the retail arm should be both operationally and legally separate from the wholesale/investment arm. The ringfenced part of the bank should have a capital adequacy ratio of up to 20% (above the Basel III recommendations), with at least 10% of liabilities in the form of equity. Capital could only be moved from the ringfenced arm to the investment arm of the bank if this did not breach the 10% ratio.

The ICB report also recommends measures to increase competition in banking, including making it easier to switch accounts, greater transparency about the terms of accounts and a referral of the banking industry for a competition investigation in 2015. The cost to the banking industry of the measures, if fully implemented, is estimated to be between £4m and £7m.

Because of the requirement in the report for banks to build up their capital and the danger that a too rapid process here would jeopardise the expansion of lending necessary to underpin the recovery, banks would be given until 2019 to complete the recommendations. Moves towards this, however, would need to start soon.

Update (19/12/11)
In December 2011, the government announced that it would accept most of the ICB report, including separating retail and investment banking. It would not, however, demand such stringent capital requirements as those recommended in the report.

The following articles examine the details of the proposals and their likely effectiveness. The later articles examine the government’s response.

Original articles (some with videos)
Vickers report: main points The Telegraph (12/9/11)
Bank reforms aim to get taxpayers off the hook Money Marketing, Natalie Holt, Steve Tolley (15/9/11)
Vickers report: key point Guardian, Jill Treanor (12/9/11)
Vickers report: banks get until 2019 to ringfence high street operation Guardian, Jill Treanor (12/9/11)
Bank reform: To rip asunder The Economist (17/9/11)
Banking reforms: Good fences The Economist (17/9/11)
Banks barred from putting depositors’ money at risk as Vickers’ reforms increases costs by up to £7 billion The Telegraph, Harry Wilson (12/9/11)
Vickers report: Q&A The Telegraph (12/9/11)
Vickers report: reaction The Telegraph (12/9/11)
ICB bank reforms could cost UK banks £7bn a year The Telegraph, Harry Wilson (12/9/11)
Money Insider: Will reforms really shake up the high street? Independent, Andrew Hagger (17/9/11)
Bank reforms bring quick improvements Financial Times, Elaine Moore (16/9/11)
Vickers’ critics are missing the point Financial Times, Diane Coyle and Jonathan Haskel (12/9/11)

Audio podcasts
The Business podcast: The Vickers report Guardian, Aditya Chakrabortty, Jill Treanor and Nils Pratley (13/9/11)
Vickers: Bank reforms ‘will get taxpayers off the hook’ BBC Radio 4, Today Programme, Sir John Vickers (12/9/11)
‘Enormous dilemma’ for UK’s biggest banks BBC Radio 4, Today Programme, Robert Peston (12/9/11)

ICB report and press conference
Press Conference: Vickers: Banks ‘must be ring-fenced’ BBC News (12/9/11)
Portal to Full Report and Transcript of Opening Remarks by Sir John Vickers at Press Conference. Independent Commission on Banking

Later articles and webcasts
Chancellor George Osborne to announce banking split BBC News, Nigel Cassidy (19/12/11)
Osborne to address MPs on Vickers’ report into banking BBC News (19/12/11)
Bank break-up law by 2015 BBC News. Robert Peston (18/12/11)
Osborne to Pledge U.K. Bank Legislation by 2015 Bloomberg, Gonzalo Vina and Jennifer Ryan (19/12/11)
In bank reform, ‘in full’ must mean exactly that Independent (19/12/11)
How far and how fast is key to the reforms Independent, Ben Chu (19/12/11)
George Osborne poised to bring in full banking reforms The Telegraph, Louise Armitstead and Harry Wilson (18/12/11)
EU will not impede Vickers reforms Financial Times, George Parker and Sharlene Goff (18/12/11)

Questions

  1. Explain the difference between a capital adequacy ratio and a liquidity ratio. Will the Vickers proposals help to increase the liquidity of the retail banking arm of universal banks?
  2. Does it matter if equity capital in excess of the 10% requirement for retail banking is transferred to a bank’s investment arm?
  3. What risks are there for a bank in retail banking?
  4. What are the advantages and disadvantages of bringing in the measures gradually over an 8-year period?
  5. Does it matter that the capital adequacy requirements are higher than under the internationally accepted standards in Basel III?
  6. Assume that there is another global financial crisis. Will the proposals in the report mean that the UK taxpayer will not have to provide a bailout?
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Central banks to the rescue?

The debts of many countries in the eurozone are becoming increasingly difficult to service. With negative growth in some countries (Greece’s GDP is set to decline by over 5% this year) and falling growth rates in others, the outlook is becoming worse: tax revenues are likely to fall and benefit payments are likely to increase as automatic fiscal stabilisers take effect. In the light of these difficulties, market rates of interest on sovereign debt in these countries have been increasing.

Talk of default has got louder. If Greece cannot service its public-sector debt, currently standing at around 150% of GDP (way above the 60% ceiling set in the Stability and Growth Pact), then simply lending it more will merely delay the problem. Ultimately, if it cannot grow its way out of the debt, then either it must receive a fiscal transfer from the rest of the eurozone, or part of its debts must be cancelled or radically rescheduled.

But Greece is a small country, and relative to the size of the whole eurozone’s GDP, its debt is tiny. Italy is another matter. It’s public-sector debt to GDP ratio, at around 120% is lower than Greece’s, but the level of debt is much higher: $2 trillion compared with Greece’s $480 billion. Increasingly banks are becoming worried about their exposure to Italian debt – both public- and private-sector debt.

As we saw in the news item “The brutal face of supply and demand”, stock markets have been plummeting because of the growing fears about debts in the eurozone. And these fears have been particularly focused on banks with high levels of exposure to these debts. French banks are particularly vulnerable. Indeed, Credit Agricole and Société Générale, France’s second and third largest banks, had their creidit ratings cut by Moody’s rating agency. They have both seen their share prices fall dramatically this year: 46% and 55% respectively.

Central banks have been becoming increasingly concerned that the sovereign debt crisis in various eurozone countries will turn into a new banking crisis. In an attempt to calm markets and help ease the problem for banks, five central banks – the Federal Reserve, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank – announced on 15 September that they would co-operate to offer three-month US dollar loans to commercial banks. They would provide as much liquidity as was necessary to ease any funding difficulties.

The effect of this action calmed the markets and share prices in Europe and around the world rose substantially. But was this enough to stave off a new banking crisis? And did it do anything to ease the sovereign debt crisis and the problems of the eurozone? The following articles explore these questions.

Articles
Central banks expand dollar operations Reuters, Sakari Suoninen and Marc Jones (15/9/11)
Europe’s debt crisis prompts central banks to provide dollar liquidity Guardian, Larry Elliott and Dominic Rushe (15/9/11)
From euro zone to battle zone Sydney Morning Herald, Michael Evans (17/9/11)
Global shares rise on central banks’ loan move BBC News (16/9/11)
Geithner warns EU against infighting over Greece BBC News (16/9/11)
How The European Debt Crisis Could Spread npr (USA), Marilyn Geewax (15/9/11)
No Marshall Plan for Europe National Post (Canada) (16/9/11)
Central banks act to help Europe lenders Financial Times, Ralph Atkins, Richard Milne and Alex Barker (15/9/11)
Central Banks Seeking Quick Fix Push Dollar Cost to August Lows Bloomberg Businesweek, John Glover and Ben Martin (15/9/11)
Central banks act to provide euro zone dollar liquidity Irish Times (15/9/11)
Central banks pump money into market: what the analysts say The Telegraph (15/9/11)
Central banks and the ‘spirit of 2008′ BBC News, Stephanie Flanders (15/9/11)

Central Bank statements
News Release: Additional US dollar liquidity-providing operations over year-end Bank of England (15/9/11)
Press Release: ECB announces additional US dollar liquidity-providing operations over year-end ECB (15/9/11)
Additional schedule for U.S. Dollar Funds-Supplying Operations Bank of Japan (15/9/11)
Central banks to extend provision of US dollar liquidity Swiss National Bank (15/9/11)

Questions

  1. Explain what is meant by debt servicing.
  2. How may the concerted actions of the five central banks help the banking sector?
  3. Distinguish between liquidity and capital. Is supplying extra liquidity a suitable means of coping with the difficulties of countries in servicing their debts?
  4. If Greece cannot service its debts, what options are open to (a) Greece itself; (b) international institutions and governments?
  5. In what ways are the eurozone countries collectively in a better economic and financial state than the USA?
  6. Is the best solution to the eurozone crisis to achieve greater fiscal harmonisation?
  7. What are the weaknesses of the European Financial Stability Facility (EFSF) as currently constituted? Should it be turned into a bank or special credit institution taking the role of a ‘European Monetary Fund’?
  8. Should countries in the eurozone be able to issue eurobonds?
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