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Bank Of England, Everyone Else, Thinks Banks Are Lying About Capital

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Aaahhh I love the Bank of England's latest Financial Stability Report. I mean: I haven't read it, per se. But it follows the wonderful official-sector-report layout of blandly apocalyptic text running down the right side and lovely charts running down the left, so you can close one eye and it's a delight. The charts are a nice mix of (1) visually displaying quantitative information and (2) not:

The gist of the report is, as the Journal puts it:

U.K. banks may be misleading investors over the true state of their financial health, the Bank of England said Thursday, in its starkest warning yet to banks to restore investor confidence and get credit flowing.

"One factor which may make stated levels of capital misleading is under-recognition of expected future losses on loans," the committee said in the BOE's twice-yearly Financial Stability Report.Banks may be further overstating their health by making "aggressive" use of risk weights used to determine how much capital different categories of loan require, officials added.

And here's the bottom-line recommendation:

The Committee recommends that the FSA takes action to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights. Where such action reveals that capital buffers need to be strengthened to absorb losses and sustain credit availability in the event of stress, the FSA should ensure that firms either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy.

The "prudent calculation of risk weights" is a topic of particular interest. Here is what they're working with:

One thing you might think here is: if you are a financial regulator - as the BoE sorta kinda is - would you view this chart as a sign of success or failure? Success or failure by you, I mean, not the banks. If you view your job as being "making sure banks are adequately capitalized" then the fact that, in the wake of tightening regulation and more careful regulatory scrutiny of bank balance sheets after a series of financial crises, investors not only don't trust bank capital levels, but trust them less than they did a year ago, is not exactly a roaring success for your regulatory program.

But it is a kind of success for the near-term program of "make sure everyone knows how screwy Basel capital rules are." And a focus of UK regulators does seem to be showing up how indeterminate bank capitalization is under Basel III rules. This report continues in that vein; here is another chart:

You can mouse over for semi-helpful explanations of what those estimates are but the point is (1) banks have a lot of leeway to risk-weight their assets based on internal models, (2) "risk-weighted assets ... showed very high variation, with estimated capital requirements for the most prudent banks that were well over three times as high as those of the most aggressive banks for the same portfolios of exposures," and (3) on alternative models that the BoE committee considers plausible, "capital ratios for the largest banks in the United Kingdom could be overstated by the equivalent in capital terms of between £5 billion and £35 billion."1

One simple answer to this - which the committee endorses - is that banks should raise more capital. But one question you might ask is, will that solve the problem it's meant to solve? If the problem is just "give the banks enough capital to survive" then I suppose more is always better, but if it's "make investors trust bank capital levels" then I'm not so sure. Selling stock without doing much to address the indeterminacy of measurement doesn't really get to that. One suspects that some people at the BoE take the view that "raise more capital but leave capital measurement pretty fishy" is not a suitable solution to the problems of bank capital.2

Anyway! Here's another chart that I like mainly for its visual appeal and heat-mappiness:

What does it mean? I don't know! I guess your subjective heat-impression from this chart would be that bond markets are pretty pretty good, and bank loan markets are pretty pretty significantly less good, though you'd perhaps be thrown by the UK HY bond markets? Why would bank lending be relatively tight while non-bank lending would be wide open? From skimming the left-hand side of this report, it'd be easy to conclude that the answer is some combination of

  • Banks aren't lending because they'd rather delever by not lending than by raising new capital, and
  • Banks are not a great intermediator of lending because, if you don't trust banks' balance sheets, you'd rather invest your money in corporates directly than by investing in banks so they can lend out your money.

And sure why not. But there's trouble on the horizon for bonds too, according to the report:

While issuance increased, bond market liquidity remained low. For example, market-making inventories in US corporate bond markets (which facilitate trades between buyers and sellers of the bonds) have declined significantly since the start of the financial crisis, in part because low interest rates reduce the income that dealers earn. Trading volumes as a percentage of the outstanding corporate bond market have fallen to less than half pre-crisis levels. Contacts thought that anticipation of regulatory developments constraining proprietary trading may have contributed to this development.

Shame about that first Venn diagram, then - regulators may be prohibiting the only thing banks are good at these days.

Financial Stability Report, November 2012 [BoE, and pdf]
BOE Fires Shot at Banks Over Health [WSJ]

1.That's for four banks - Barclays, HSBC, Lloyd's, RBS - which I calculate to have about £233bn of common equity capital (Bloomberg field RR179, Tangible Common Equity), so like a 2 - 15% capital shortfall from a 15-95% understatement in RWAs. Presumably driven by the fact that banks are actually well over their common equity minimums on internal-model accounting?

2.Incidentally, one neat thing that the BoE's Andrew Haldane has noted is that bank (book, unweighted) leverage ratios are a better predictor of distress than risk-based capital ratios. Here, from the Financial Stability Report, is a chart of market leverage ratios, i.e. market value of equity to assets:

I dunno what that says. I feel like it might be revealing to see it charted against risk-weighted assets though.


Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels:

Diego Delso [CC BY-SA 4.0], via Wikimedia Commons

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