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
- What is meant by ‘liquid assets’?
- How does the liquidity of assets depend on the state of the economy?
- What is the relationship between the liquidity ratio and the money multiplier?
- Does the size of the money multiplier depend solely on the liquidity ratio that banks are required to hold?
- Distinguish between capital adequacy and liquidity.
- What has been the effect of quantitative easing on banks’ liquidity ratios?
At the Mansion House dinner on 15 June, the Chancellor, George Osborne, and the Governor of the Bank of England, Sir Mervyn King, announced a new monetary policy initiative to increase bank credit. The idea is to stimulate borrowing by both firms and households and thereby boost aggregate demand.
There are two parts to the new measures:
1. Funding for lending. The aim here is to provide banks with cheap loans (i.e. at below market rates) on condition that they are used to fund lending to firms and households. Some £80 billion of loans, with a maturity of 3 to 4 years, could be made available to banks under the scheme. The details are still being worked out, but the scheme could work by the Bank of England supplying Treasury bills to the banks in return for less secure assets. The banks could then borrow against these bills in the market in order to lend to customers.
2. Providing extra liquidity to banks through six-month repos. The Bank of England will begin pumping up to £5bn a month into the banking system to improve their liquidity. This is an activation of the ‘Extended Collateral Term Repo Facility’ (see also), which was created last December, to provide six-month liquidity to banks against a wide range of collateral.
But whilst it is generally accepted that a lack of borrowing by firms and households is contributing to the slowdown of the UK economy, it is not clear how the new measures will solve the problem.
In terms of the supply of credit, banks have become more cautious about lending because of the increased risks associated with both the slowdown in the UK economy and the euro crisis. They claim that the issue is not one of a shortage of funding for lending, but of current uncertainties. They are thus likely to remain reluctant to lend, despite the prospect of extra loans from the Bank of England.
In terms of the demand for credit, both businesses and consumers remain cautious about borrowing. Even if bank loans are available, firms may not want to invest given the current uncertainties about the UK, eurozone and world economies. Consumers too may be reluctant to borrow more when people’s jobs may be at stake or at least when there is little prospect of increased wages. Even if banks were willing to lend more, you cannot force people to borrow.
Britain fights euro zone threat with credit boost Reuters, Matt Falloon and Sven Egenter (14/6/12)
Debt crisis: emergency action revealed to tackle ‘worst crisis since second world war’ Guardian, Larry Elliott, Jill Treanor and Ian Traynor (14/6/12)
Q&A: Funding for lending scheme Financial Times, Norma Cohen (15/6/12)
Bank lending plan: How will it work? BBC News (15/6/12)
Bank of England’s loans to high street banks start next week Guardian, Phillip Inman (15/6/12)
Mervyn King: Bank of England and Treasury to work together The Telegraph (15/6/12)
Bank of England offers £80bn loans Channel 4 News, Sarah Smith (15/6/12)
Bank funding scheme plans unveiled Independent, Holly Williams (15/6/12)
Banking: King hits panic button Independent, Ben Chu (15/6/12)
Bankers raise doubts on credit scheme Financial Times, Patrick Jenkins and Sharlene Goff (15/6/12)
We should not pin our hopes on Britain’s plan A-plus Financial Times, Martin Wolf (15/6/12)
Throwing money at banks won’t solve economic crisis, Ed Balls says Guardian, Patrick Wintour (15/6/12)
UK lending plan faces risk of low take-up BloombergBusinessweek, Robert Barr (15/6/12)
Will Bank of England’s new lending schemes work? BBC News, Robert Peston (15/6/12)
Bank and Treasury’s plan A-plus for UK BBC News, Stephanie Flanders (15/6/12)
Questions
- How would the schemes incentivise banks to lend more?
- Explain what is meant by the Extended Collateral Term Repo Facility. How similar is it to the long-term repo operations of the ECB (see the news item More bank debt to ease bank debt)?
- What factors are likely to determine the take-up of loans from banks?
- Will the new arrangements have any implications for taxpayers? Explain.
- To what extent are fiscal and monetary policy currently complementary?
- What is the significance of calling the new measures ‘Plan A-plus’? What would ‘Plan B’ be?
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
- What is meant by capital and by capital adequacy?
- Explain the construction of a Capital Adequacy Ratio. Distinguish between the CET1 ratio and the overall CAR ratio.
- What do you understand by macro-prudential regulation?
- How do liquidity and capital adequacy differ?
- 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?
On several occasions in the past on this site we’ve examined proposals for a Tobin tax: see, for example: A ‘Robin Hood’ tax (Feb 2010), Tobin or not Tobin: the tax proposal that keeps reappearing (Dec 2009) and A Tobin tax – to be or not to be? (Aug 2009). A Tobin tax is a tax on trading in financial products, sometimes known as a ‘financial transactions tax’ (FTT). It could also be levied on trading in foreign currencies. It is considered in Economics (7th ed) (section 26.3) and Economics for Business (5th ed) (section 32.4).
The tax would be levied at a very low rate: somewhere between 0.01% and 0.5% and would be too small to affect trading in shares or other financial products for purposes of long-term investment. It would, however, dampen speculative trades that take advantage of tiny potential gains from very short-term price movements. Such trades account for huge financial flows between financial institutions around the world and tend to make markets more volatile. The short-term dealers are known as high-frequency traders (HFTs) and their activities now account for the majority of trading on exchanges. Most of these trades are by computers programmed to seek out minute gains and respond in milliseconds. And whilst they add to short-term liquidity for much of the time, this liquidity can suddenly dry up if HFTs become pessimistic.
The President of the European Commission, José Manuel Barroso, has announced that the Commission has adopted the idea of a financial transactions tax with the backing of Germany, France and other eurozone countries. This Tobin tax could be in operation by 2014. According to the Commission, it could raise some €57bn a year. Unlike earlier proposals for a Tobin tax (sometimes called the ‘Robin Hood tax’), the money raised would probably be used to reduce EU deficits, rather than being given in aid to developing countries.
The UK government has been highly critical of the proposal, arguing that, unless adopted world-wide, it would divert trade away from the City of London.
The following articles consider how such a tax would work and its potential advantages and disadvantages.
Theory inches ever closer to practice Guardian, Larry Elliott (28/9/11)
Osborne expected to oppose EU’s proposal for Tobin tax on banks Guardian, Jill Treanor (28/9/11)
Tobin tax could ‘destroy’ business models Accountancy Age, Jaimie Kaffash (30/9/11)
Tobin tax is likely, says banking chief Accountancy Age, Jaimie Kaffash (5/10/11)
Could a transactions tax be good for capitalism? BBC News, Robert Peston (3/10/11)
EU to propose tax on financial transactions BusinessDay (South Africa), Mariam Isa (5/10/11)
European politicians plot to block UK veto on ‘Tobin tax’ The Telegraph, Louise Armitstead (3/10/11)
Opinion Divided on EU Transaction Tax Tax-News, Ulrika Lomas (5/10/11)
Tobin taxes and audit reform: the blizzard from Brussels The Economist (1/10/11)
Questions
- What are HFTs and what impact do they have on the stability and liquidity of markets?
- Explain how a Tobin tax would work.
- What would be the potential advantages and disadvantages of the Tobin tax as proposed by the European Commission (the ‘financial transactions tax’)?
- Are financial markets efficient? Can a market be ‘excessively efficient’?
- How are ‘execute or cancel’ orders used by HFTs?
- Why do HFTs have an asymmetric information advantage?
- How does a financial transactions tax differ from the UK’s stamp duty reserve tax?
- Explain why the design of the stamp duty tax has prevented the flight of capital and trading from London. Could a Tobin tax be designed in such a way?
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
- Explain what is meant by debt servicing.
- How may the concerted actions of the five central banks help the banking sector?
- Distinguish between liquidity and capital. Is supplying extra liquidity a suitable means of coping with the difficulties of countries in servicing their debts?
- If Greece cannot service its debts, what options are open to (a) Greece itself; (b) international institutions and governments?
- In what ways are the eurozone countries collectively in a better economic and financial state than the USA?
- Is the best solution to the eurozone crisis to achieve greater fiscal harmonisation?
- 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’?
- Should countries in the eurozone be able to issue eurobonds?
