Still Too Big To Fail (1)?  Capital Adequacy Explained for Beginners

Introduction

One of the most notable features of the financial crisis of 2008 was the bailout of big banks by the taxpayer.

Since that time there has been a significant effort by banking regulators to reduce the possibility of this happening again.  This doesn’t get a lot of publicity.  It’s quite technical, can be difficult to understand, and for some reason seems to have far too many acronyms.  As a result it tends not to appear in mainstream news articles.

This article attempts to describe some of these measures in terms that normal people can understand.  It’s really aimed at computer folk who are going for interviews in the banking regulation sector and need a basic primer.

It’s also aimed at those who like to say ‘nothing has been done to prevent it happening again’.  Quite a lot has been done, it’s just a lot less dramatic than Lehman’s employees leaving their office with boxes after their bank has blown up.  Whether these measures are sufficient to avoid the need for taxpayer bailouts during the next crash remains to be seen of course.

The original intention of these articles was only to discuss bail ins, which are new, along with the new ‘total loss absorbing capacity’  (‘TLAC’) and ‘minimum requirement for eligible liabilities’ (‘MREL’) requirements associated with them.  Most of the other measures taken built on regulation that was already in place.  However, it proved quite hard to to do this without first discussing capital adequacy.

As a result this article has a brief discussion of banks’ balance sheets, and then looks at the capital adequacy requirements and some other changes to regulatory requirements for banks since the crash.  A second article discusses bail ins, and TLAC and MREL, in more detail.

Prerequisites

These articles do assume that you have some idea of how banking works, in particular the basics of how banks make money from borrowing and lending.  Investopedia has quite a good article on this.

These articles also assume you know how bonds work for borrowing or lending money.  I wrote an article on this some time ago.

However, these articles don’t assume you know much about anything else.  In particular you don’t need to know about accounting for banks.  I’m going to start by trying to explain the extreme basics of a bank’s accounting balance sheet.  You need some understanding of this to have a chance of understanding what follows.  If you already know this stuff you can skip the next section.

A Brief Tour of the Balance Sheet for a Bank

Assets and Liabilities

Banks have assets and liabilities.

Assets are mainly money the bank has (cash), or money it has lent and expects to get back.  This is things like mortgages, or loans to companies or individual customers.  There are other assets: if the bank owns its headquarters then that’s an asset, for example.

Liabilities are money the bank owes, that is, money it’s borrowed.  Liabilities include borrowings from the bond market in the form of bonds the bank has issued.  They also include money the bank has effectively borrowed from people who have opened checking or deposit accounts and put money in them.  Thus retail deposits are liabilities.

Capital: Assets Minus Liabilities

If a bank isn’t in financial trouble assets will be larger than liabilities.

That means the bank has some money that it’s spent on things that hasn’t been borrowed and so doesn’t have to be repaid.

There are a few possible sources of this kind of money.  One is money raised in the stock market.  This money isn’t directly repayable, so is not considered a liability.  Also if the bank has been profitable historically then it will have generated money from its operations which clearly isn’t repayable to anyone.  Again, this isn’t considered a liability.  Note here that if the bank makes losses these can offset past profits and reduce this amount.

This is an accounting thing, related to the company’s balance sheet.  The difference between assets and liabilities is usually called equity or capital, and is, roughly, the money raised from issuing stock (also called ‘equity’, confusingly) and money in reserves, which includes money from past profits (‘retained earnings’).

How This Relates to Banks in Financial Trouble

If assets are bigger than liabilities then the bank can theoretically use those assets to pay back its liabilities, should it have to.  In contrast a bank that’s in financial trouble will find its assets no longer necessarily cover its liabilities.  This most often happens if a lot of loans or mortgages it has made (assets, remember) don’t get repaid and have to be written off.  If capital has fallen to zero because of losses then assets equal liabilities and the bank may struggle to pay the money it owes.

Thus capital or equity can be thought of as a cushion that the bank has to absorb any losses before it won’t be able to pay money it owes.

Capital Adequacy

Introduction

One measure that the banking regulators have changed following the crash is ‘capital adequacy’.

To ensure that a bank is healthy the regulator can insist that assets remain significantly larger than liabilities.  That is, that it has adequate capital as discussed above.  In other words, that it has enough of a cushion for losses.

This section discusses how this works in more detail.

The requirements for capital adequacy are part of an internationally agreed set of measures called ‘Basel III’.  These measures were developed by the Basel Committee on Banking Supervision (BCBS) after the crash.

Basic Basel III Capital Adequacy Requirement

Even before the financial crisis of 2008 there were regulatory requirements for banks to hold capital to absorb any losses.  These still exist, and are the capital adequacy requirements (CAR) which define the capital adequacy ratio (also usually abbreviated to CAR).

There are actually several similar rules re capital adequacy requirements in the Basel III Framework.  The first one says:

Common Equity Tier 1 must be at least 4.5% of risk-weighted assets

Let’s look at what that means.

Common Equity Tier 1

‘Common Equity Tier 1’ (CET1) is roughly money raised by issuing stock, plus reserves for retained earnings (profits), plus some adjustments.  The full definition is in the Basel III paper.  That is, it is roughly the definition of capital discussed in the section above.  Banks can increase this by issuing more shares, or by paying smaller dividends, which means they retain more profit.

As mentioned above this capital can be thought of as a cushion the bank has to absorb losses.

Risk-Weighted Assets

Risk-weighted assets are roughly the assets as described in the section above, weighted for how risky they are.  Here ‘weighted’ simply means that the amount of the asset shown on the balance sheet is multiplied by a percentage before being added into the total.

For example government bonds are risk-weighted at 0%, meaning they are effectively excluded, whilst AAA corporate bonds are rated at 20%.  Before the crash the weightings were fairly straightforward, but the Basel III framework has made them more sophisticated.

Interpretation

The rule is ‘Common Equity Tier 1 must be at least 4.5% of risk-weighted assets’.  This says that banks have to have a cushion for losses of at least a certain size relative to the amount of risky lending they have done.

Looked at another way it says banks can’t do too much risky lending without raising more money to cover it.  It’s a clever enough rule to actually be based on numbers that can be checked.

The rule is preventative.  It aims to stop banks getting into trouble by stopping them from lending more than they should.  It doesn’t directly help if a bank does get into trouble.  If a bank does get into trouble then it needs cash from somewhere, or to have to stop paying some of its obligations.  This rule doesn’t help with that.

If the rule is breached regulators have the power to insist it’s rectified, and can impose sanctions.  These sanctions might include forcing the bank to suspend all dividends, or forcing the bank to issue more stock immediately.

Changes to Capital Adequacy Since 2008

This rule existed in 2008.  Obviously it didn’t help that much in the crash, although the percentage was much lower then.

One of the things the regulators have done since then is to introduce a series of tests with broader definitions of capital than the one above.  Another is to increase the size of the cushion by increasing the percentage in the capital adequacy ratio.  As mentioned, they’ve also improved the definition of risk-weighted assets.

Other Measures Introduced by the Basel III Framework

There are some other measures introduced by the new regulations in Basel III with similar aims to the capital adequacy requirements, many of which are based on ratios in a similar way.  These include:

Countercyclical Capital Buffer

The capital adequacy requirements can be increased by up to 2.5% at any time the local regulator thinks there is ‘a period of excess credit growth to be leading to the build up of system-wide risk’.  This can be a way to force banks to reduce risky lending if it looks like a crisis is brewing.

Capital Conservation Buffer

This is an additional 2.5% added to the requirement for Common Equity Tier 1 described above for the capital adequacy ratio.  The difference here is that the regulators will allow the capital to breach this limit for certain periods, and the only sanction may be that the bank is not able to pay dividends until that is rectified.  This is intended as an outer buffer.   The amounts of capital and assets in the capital adequacy calculation fluctuate continually so it’s hard to have a hard barrier.

Leverage Ratio

This is similar to the capital adequacy ratio but replaces the risk-weighted assets in the that ratio with, roughly, total assets per the balance sheet with no risk weighting, and some adjustments for off-balance sheet exposures.  It also uses a different percentage (3%).  That is, roughly, it’s a similar calculation to the capital adequacy ratio that doesn’t reduce the contribution of assets that aren’t risky.  This is a little bit similar to a traditional definition of ‘leverage’, and was introduced because during the crisis some banks had very high traditional leverage whilst their capital adequacy ratios were still fine.

Liquidity Coverage Ratio

This ensures a bank has enough cash on hand by requiring cash and liquid assets be available at all times to pay it’s bills falling due in the next 30 days, net of cash received.  This is actually quite onerous on the banks, who don’t like to have cash that isn’t earning them a lot of interest.  Obviously it was introduced because ultimately banks go bust because they can’t pay their bills, not because they didn’t issue enough stock.

Conclusion

This article has discussed some attempts by banking regulators to make banks safer in the wake of the financial crash of 2008, in particular the requirements introduced by the Basel III framework.

The end result is there are many more requirements for a bank to meet, they are more onerous, and they’ve got more complicated.  However, these changes should make it much less likely that banks get into trouble in future.

These requirements built on existing requirements.  In the second article of this series we look at some new regulations that have arisen since the financial crisis related to bail ins.

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