The capital adequacy of banks - today's issues and what we have learned from the past

A good read on Capital adequacy of Banks by Andrew Bailey.

There are a number of reasons, which cover both the numerator and denominator of the capital ratio. In brief: the definition of capital set in Basel I included instruments that did not properly absorb losses; capital requirements were too low in relation to the underlying riskiness of assets, particularly for the trading book; and banks were able to move risk assets increasingly into the trading book. The finger is often pointed at Basel II for enabling all of this to happen, but the timeline suggests that the problems built up under the combined Basel I and Market Risk Amendment regime

Basel I allowed hybrid debt instruments to count as Tier 1 capital even though they had no principal loss absorbency mechanism on a going concern basis. They only absorbed losses after reserves (equity) were exhausted or in insolvency. It was possible to operate with no more than two per cent of risk-weighted assets in the form of equity. The fundamental problem with this arrangement was that these hybrid debt instruments often only absorbed losses when the bank entered either a formal resolution or insolvency process. It was more often the latter in many countries, including the UK, since there was no special resolution regime for banks (unlike today). But the insolvency procedure could not in fact be used because the essence of too big or important to fail was that large banks could not enter insolvency as the consequences were too damaging for customers, financial systems and economies more broadly.

The big lesson from this history is that a going concern capital instrument must unambiguously be able to absorb losses when the bank is a going concern.

On the form and use of capital instruments, the Basel I Accord also allowed hybrid debt capital instruments to support the required deductions from the capital calculation, such as goodwill, expected losses (introduced later under Basel II with the internal models regime for credit risk) and investments in other banks' capital instruments. However, as a matter of fact, rather than reporting, any losses arising from these items hit common equity because it will absorb losses first in the going concern state, according to the hierarchy of the capital structure. As a result applying these deductions at the level of total capital, or Tier 1 capital, has the effect of overstating the core equity capital ratio.

The Market Risk Amendment and Basel II dramatically increased the complexity of the capital framework, and whilst it intended to increase the scope of risk capture in the regulatory capital measure it ended up creating new opportunities for "optimising" regulatory capital. Even more difficult, the potential benefits - better differentiation and rank ordering of risk - were undermined by the problems of calibrating overall capital standards, and poor implementation in the rush to achieve compliance. Under Basel I and II, capital ratios were too low to sustain confidence in banks, and thus the system as a whole, through a severe stress, as the crisis sadly demonstrated. The minimum Tier I ratio was 4% of Risk Weighted Assets. And, crucially as the Tier I ratio included capital instruments with the flaws I described earlier, the core (equity) ratio could be as low as 2%. In the trading book, under the Market Risk Amendment, capital requirements could be less than 1% of trading book assets