Tuesday, 27 April 2010


This continues to plague regulators, investors, legislators, governments and banks. My own view is that purpose, risk, capital, liquidity and (most important) investor expectations are all parts of the same equation, and yet are all being treated as different elements. If this is to continue, we will still have problems.

During the worst of the crisis, some banks were seen to be running out of (and in some cases, did run out of) a sufficient pool of funding to absorb the unexpected and unprecedented losses that they were seeing. Fear drove asset sales, reducing the value of assets still held on books and raising the spectre of further losses, driving further “fire sales” of assets, bank shares and so on , provoking a “vicious circle” or “self-fulfilling prophecy”. I remember one conversation with a fund manager where we speculated on what would happen if no trading were to be allowed for two weeks at the beginning of 2009 to allow people to pause for breath, think and review underlying fundamentals. It might have worked, it might not.

Banks, unlike other organisations, have two classes of capital: Tier 1 and Tier 2 which were first defined in the Basel I Capital Accord of 1988 and later on (in substantially the same form) in the Basel II Accord of 2004.

Tier 1 capital consists of core capital - primarily common shares and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred shares (source: Wikipedia).

Tier 2 capital consists of supplementary capital, i.e. undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered Tier 2 capital up to an amount equal to that of an institution’s core (Tier 1) capital (source: Wikipedia).

What complicates things is that each country's banking has some discretion over how differing types of financial instrument may count in how a bank’s capital is calculated. Although this is probably right as different countries have different legal frameworks, it does mean that not all banks may be on the same level playing field when it comes to assessing their strength and ability to absorb losses.

Capital is there to provide against unexpected losses. Expected losses are covered by provisions, reserves and the current year’s profits (if any). The higher the level of capital a bank has, the higher the level of unexpected losses it can absorb and therefore the “safer” it is. What happened in the crisis was that in some cases unexpected losses from what were perceived as less risky deals crystallised so fast that capital itself proved inadequate.

The development of capital markets over the years has also meant that “traditional” capital providers (shareholders) have been joined by others (hedge funds, pension funds, fund managers) each with their own agenda. Different parts of capital are also subject to different priority in the event of a wind-up, with the “common” shareholders being last in the queue. Equally, different types of capital or finance have different costs and are treated differently for tax purposes. This has resulted for many institutions in a complex cat’s cradle of capital constructed over a number of years to meet different needs.

We need to get back to basics. This is more easily said than done as unwinding or re-structuring the capital of some of the larger players will take time, money and effort. A gradual move to a more unified and simple structure could happen if there is the political will. The current regulatory approach is to break up the large players through “living wills” so that losses in one business, area or country are confined to that area/business/country. Simple? Yes. Practical? Perhaps not, as market sense requires that capital be deployed where it will achieve the highest return.

The global financial system needs capital that is fit for purpose and the risks it undertakes. Should Northern Rock have relied on short-term money markets to finance long-term mortgages (and why did the UK FSA not act on this)? The more expensive capital should, ideally, support the riskier (and rewarding) types of business, but chopping things up like this is easier said than done.

Equally, when there are problems, banks need to be able to shore up capital fast to prevent loss of confidence. The latter may have to be through government stakes until a sale can be arranged and the crisis is over. The other answer is to take fewer risks and see less RoE. IN this case, JPMorgan have predicted that returns will fall from an average of 13.3% to 5.4% - will investors swallow this?

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