How much bank capital is just enough bank capital to survive a crisis?
Reading this Bank of England paper on the issue, you might think the authors are simply arguing that banks ought to be made to hold more loss-absorbing capital (double, actually) than Basel III will be asking.
But that would be too simple.
David Miles, Jing Yang, and Gilberto Marcheggiano do say that a 19 per cent ratio of common equity to risk-weighted assets looks preferable to Basel’s (minimum) 7 per cent. But that wasn’t their first number, which was 50 per cent — or around five times less leverage than by UK banks currently.
Why? Because it’s very easy to underestimate asset price falls across financial crises, especially including tail risk. From the paper:
Table 8 suggests that if risk-weighted assets fall in line with GDP then banks would need far more capital than has been typical in recent years to be truly robust. For example, the probability that banks’ risk-weighted assets fall in value by 15% or more is 1.2%. It follows that banks should have loss-absorbing capital of at least 15% of risk weighted assets (which might correspond to about 5% of total assets) to weather such an event…
We assume that the percentage fall in asset values is equal to the risk weight multiplied by the fall in GDP. But it is likely that the fluctuation in the value of banks’ assets is larger than the fluctuation in GDP.
In Table 9 [above] we report the optimal level of bank capital implied by each combination of cost and benefit estimates. It is remarkable to note that our central estimate for the marginal cost and benefit of higher capital suggests an optimal capital ratio of about 50% of risk weighted assets – which might mean a capital to total assets ratio of around 17% and leverage of about 6. This would be about 5 times as much capital – and one fifth the leverage – of banks now. But as noted above that result is hugely influenced by our assumption that there is a non-negligible probability of a fall in GDP and risk weighted assets of the order of 38% or so. If we set that to one side – perhaps because the uncertainty around the probability of such a huge fall in incomes is great – the implied optimal levels of capital for the central assumptions on costs and benefits is very much lower…
So if GDP can fall 10 per cent during a financial crisis (such as the UK between the first halves of 2007 and 2010), you can see why current capital levels still pose a problem. If you also consider that a high-teen ratio would shave 6 percentage points off GDP according to the paper, though, the solution’s itself a problem.
Moreover, if you consider the point about asset prices falling harder than GDP in some instances, you only have to look at the property losses that have already occurred in Ireland to see why the tail risk threat to banks’ capital is really even more complicated for rule-makers.
And we doubt it’s just an issue for Ireland any more.
Related links:
Capital ratios — for realsies – FT Alphaville
Basel-ed again – FT Alphaville