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The author is a founding companion of Veritum Companions
What do Silicon Valley Financial institution, Credit score Suisse, Citigroup and Royal Financial institution of Scotland all have in frequent? If you happen to guessed the reply as “they failed and needed to be rescued by their rivals or by their governments” then you definitely can be appropriate. However there was one different factor they’d in frequent; robust capital ratios on the time of their failure, nicely above the extent their regulators demanded. It is a helpful reminder that for all of the discuss how a lot capital banks want, quite a lot of the dialogue merely misses the purpose.
The argument has come alive once more over the previous few months, fired by proposed modifications to the principles governing financial institution capital that look set to hit US banks particularly severely. There was in depth debate about how a lot capital banks want. The US banks have lobbied furiously in Washington and within the media, arguing not solely that extra capital is pointless however that lending to “laborious working households and small companies” will merely dry up if the principles are carried out as drafted.
Others declare the other, citing analysis that the extra capital banks have, the extra they’ll lend. Some query the true agenda of banks, claiming the true downside is that extra capital means decrease returns on capital, which subsequently means decrease government pay.
This debate misses the purpose of financial institution regulation. It isn’t to stuff banks with a lot capital that they can’t fail. As an alternative, it’s to create a banking system that has the suitable degree of danger.
Capital is just one enter into that danger evaluation, and arguably it’s a comparatively small one. Silicon Valley Financial institution failed as a result of mismanagement of rate of interest danger. Credit score Suisse failed as a result of its structurally unprofitable enterprise mannequin. Citigroup and Royal Financial institution of Scotland failed as a result of weak credit score and market danger underwriting. The one factor that their degree of capital decided was how shortly they collapsed.
Given the poor historical past of capital ranges as a predictor of financial institution failure, regulators owe it to each banks and people who use them to actively embrace extra revolutionary measures. One thought — floated a number of years in the past by Andy Haldane (then on the Financial institution of England) — was to observe a “market-based” capital ratio, whereby the calculation of capital wasn’t the quantity proven within the accounts however the inventory market worth of the financial institution.
Within the case of Credit score Suisse, Citigroup and Royal Financial institution of Scotland, their market-based capital ratios would have been screaming pink for greater than a yr earlier than their collapse. In fact, such an strategy is perhaps open to market manipulation, however as an enter into regulation it might be an awesome addition.
Much more proactively, regulators would do nicely to actively issue within the tradition of the financial institution and make particular calls for on these whose “tradition ratio” was weak. Calculating such a ratio isn’t simple, however that doesn’t imply it’s not price doing. The prize may very well be huge.
For instance, there’s proof that having gender range on danger committees improves danger outcomes. Maybe Harriet Harman, the previous deputy chief of the UK Labour social gathering, was proper when she claimed that Lehman Brothers won’t have gone bust in 2008 if it had been Lehman Sisters. Possibly regulators ought to penalise or reward banks primarily based on their danger committee gender range?
Thought experiments apart, the overarching level is that the standard capital ratio is just too clunky, imprecise and is usually deceptive as a metric for financial institution regulators to position a lot reliance upon. It has a task to play, however these commentators who declare that ever extra capital is a panacea are misguided, whereas banks that argue they’re already protected with their present capital degree are silly.
Regulators owe it to all of us to concentrate on actively creating way more subtle measures for maintaining the system protected.