Andrew Bailey: Bank capital - debating again
Speech by Mr Andrew Bailey, Deputy Governor of Prudential Regulation and Chief Executive
Officer of the Prudential Regulation Authority at the Bank of England, at Barclays' 2016
Financial Conference, London, 9 March 2016.
* * *
Bank capital has been in the news again recently, or at least parts of the news - there are
some other things going on. There are probably two reasons for this "news": first, because we
have entered another phase of highly uncertain conditions in financial markets, which has had
a strong impact on the market value of banks; and second, as authorities we are pushing on
with implementing the post-crisis reforms to capital standards, and in doing so we have
reached a point where some of the important building blocks are now being put into place.
Today, I am going to reflect on and draw some conclusions for what I would call the bigger
picture, namely what sort of banking system are we seeking to create, what are we not doing,
and why not. I will draw on the detail, and there is no shortage of that, but this is not a talk
about the detail of bank capital, you can find that in plenty of other places.
Another objective is to tackle some urban myths of today. Let me start with an important one,
the so-called "liquidity narrative1" which sets up in order to knock down, and attributes to
regulators, the view that the financial crisis (indeed crises more generally) was caused by a
lack of liquidity rather than solvency in the banking system, and this blinded people, notably
regulators, to the real cause of the problem, namely solvency and capital. Whatever happened
in the past, it is most certainly not true today. Loss of liquidity is much more the symptom than
the cause of crises, and while symptoms have to be observed, and some actions taken to
minimise their effects, I am in no doubt that the cause is usually either an actual solvency
problem or critically rising expectations that there will be such a problem in the future. If you
spend time in the PRA, you would quickly learn that capital is front and centre in what we do
as supervisors.
Why is that so? Banks are different from other financial firms because they provide deposit
contracts to their customers. A deposit is a very particular form of debt contract. For all of us
the essential feature of a deposit contract is simple - we put our money (our asset) on deposit
at a bank, and we expect all of it back, with whatever rate of return is agreed, and we expect
to have access to it in line with the terms of the contract.
Let's contrast that with non-deposit debt (bonds) and equity contracts. If you invest in either of
these, you are not promised all of your investment back, though of course you expect to make
a positive return. Such an investor ordinarily expects the full return of their investment, but this
is not assured. Investment in debt and equity can of course be managed on a collective basis,
as asset management. You may remember the Woody Allen quote that a stockbroker is
someone "who invests your money until it's all gone". Cruel I know, but it illustrates the
difference between deposits, other forms of debt and equity.
A distinguishing feature of banks is that by providing deposit contracts, far more of their
liabilities take the form of value certain contracts. This alone makes capital and solvency critical
for banks. In contrast, for asset managers, the contract does not promise such value certainty.
Two particular conditions need to be met in my view to make asset management effective and
robust to wider economic conditions. First, that there is no lack of clarity of the nature of the
assets held under management. Second, that there is no illusion give to investors about
liquidity of their assets. It follows therefore that capital and solvency matter much more for bank
supervision, and market liquidity conditions matter more for asset management supervision.
So bank capital matters a lot. The next question, rather obviously, is how much of it banks
should have as a liability on their balance sheet? This has been the subject of lively recent
comment. Most of that comment has focussed on the core issue of how much capital and
overall loss absorbency banks should have as part of their balance sheet liabilities to protect
the value certainty of deposits. This is a very reasonable debate because there is no monopoly
of wisdom on such a subject. I do however discount heavily those commentators who have
seamlessly switched from attacking on the grounds that as supervisors we were choking off
lending by requiring too much capital (the so-called at the time "Capital Taliban" argument) to
arguing now that we are falling down by setting the standard too low.
The main argument of late has been whether our recent proposals on capital buffers for the
largest banks operating in UK markets have diverged from previous post-crisis commitments
on the level of capital banks should maintain both in going concern, and the overall level of
loss absorbency available amongst the liabilities of a bank to enable a resolution to occur if
needed. To put it into context, the capital standard we have developed is based on the last
quarter century of bank performance - including the financial crisis - such that the probability
of bank failure during that period would have been extremely low. In aggregate terms we have
not diverged, and if anything our recent proposals put the level a little higher than that
suggested, for instance, by the Independent Commission on Banking, but not by enough to
make a big point of it. It is true that within that aggregate we have introduced a new element
in the form of incentives to protect the stability of the financial system. We have followed
through wherever possible on the principle that larger and more complex banks should have
higher capital buffers because they pose a greater risk to the stability of the financial system.
Consistent with that principle, we have created a tiered system of increasing capital
requirements but left the topmost tier unpopulated. This empty tier is not a product of a craven
fear of putting a bank there, but rather to create a disincentive to further complexity. So, we
don't see this element of the design as contradicting its goal.
We could argue about the merits of small changes in the capital standard, but that is not in my
view a worthwhile exercise. What is more notable is the divide between this view of
strengthening banks' loss absorbency and the alternative view that the answer lies in a radical
restructuring of the banking system to require banks to have loss absorbency which would be
a substantial part (say 20% to 30%) of their total balance sheet2. It is wrong in my view to
conflate an argument about small differences in capital buffers with one that is all about a
different financial system.
I want to spend a few minutes on this alternative view, on what it would mean, and why it is
advocated. To be clear, I am not commenting as a supporter, but rather to try to cast light on
this big issue. The essence of the argument as I see it is that it is asserted by supporters of,
let's call it the "big equity" school, that we cannot value large banks adequately because they
are too complex and opaque, cannot supervise them effectively and cannot resolve them, we
must resort to an approach which requires a sizeable shift in the balance of their funding away
from value certain deposits contracts towards loss absorbing equity type contracts. This is on
the basis that there is then a large buffer to absorb the losses that will flow from inadequate
valuation and supervision, and without recourse to resolution. For me, this begs the question
of the appeal of a proposition which states to the public: "will you please provide equity funding
to something we can't value or properly oversee". Put like that, the idea does not seem
appealing. I cannot see why there would be a desire to provide equity funding for banks on
such terms rather than invest in other companies either directly or through a collective asset
scheme. I recognise that it has been proposed that the equity funding should be built up by
retaining dividends, but to accumulate say 20% of a bank's balance sheet by this means
requires I think an implausibly long transition period. In fact, based on the current position of
the major UK banks, including the average dividend payment rate, the transition period to 20%
equity would be around 90 years. That's a little bit longer than the 17 year transition period for
Solvency II. I do not therefore see "big equity" as a sustainable solution because this sort of
proposal is just not practical.
A more logical alternative to today's approach is the narrow banking model3. Again, to be clear,
I don't support the approach, but it has the greater logic over the "big" equity approach of
creating deposit funded banks which can only hold highly liquid and low risk government
bonds. Loans would be made by other financial intermediaries. I think that the ring fence as
proposed by the Independent Commission on Banking is a better way to achieve sensible and
safe separation of functions within a bank while not causing great disruption to the overall
financial system. Interestingly, the argument against narrow banking from the "big" equity
school is that narrow banking exports all of the risk in the financial system to so-called shadow
banks, thereby making them a danger to the system4. Again, this amounts to an argument that
unmanageable risk should be kept in banks which must therefore attract substantial equity
funding. It's not a winner I'm afraid.
This brings me right back to the argument for what we are doing today, namely to strengthen
the loss absorbency, risk management, governance, supervision and resolvability of the banks
we do have. I do not accept the proposition that we can only abandon all hope of understanding
the risks in banks. Likewise, I do not agree that large banks are unsupervisable and
ungovernable. And, I do not concur with the view that large banks can never be resolved, thus
leaving too big to fail always with us, and with the answer then to either require a lot of equity
funding or to hope that the shadow banking system does not cause risks that threaten the
whole system.
Let me finish by focussing on resolution and supervision. We went through the crisis without
properly functioning bank resolution regimes in many countries including the UK, with the
consequence that the response was a combination of using public money and improvisation
to create resolutions where possible. But now we are well on the way to having properly
functioning resolution regimes in place. So, what is the argument for why they will be
ineffective? This is a crucial piece of the story, because it is a fundamental principle of the big
equity school of thought that they reject resolution as a usable solution. The argument seems
often to come down to doubting the will of the authorities to enact resolution5. True, in the past
it was much harder to enact resolution in the absence of the means to do it, but that will not be
so in the future. It is also true that resolution necessarily involves changing the property rights
of investors which is a big thing. Will the authorities have the nerve? My view is that we must,
because the alternative is much worse. We are making huge strides in resolution as a technical
matter. Last year's agreement on TLAC in the G20 was a landmark. But alongside that is a
vast amount of work to get to grips with what it takes to resolve a major bank. If you are involved
in that work, as I am, you can see that there is no lack of commitment and progress.
The remaining challenge then is whether the authorities will have the nerve to follow through
and carry out a resolution. This is the charge that comes from opponents, namely that it will be
"bottled". I don't see this as likely to be an issue, because if resolution is a credible route to
take, as it will be, why would the authorities want to put the cost somewhere else?
Now for supervision and whether it too can function effectively. Make no mistake, in many
countries supervision failed badly in the run-up to the crisis. Prudential supervision of banks is
all about understanding the risks firms take, the effectiveness of the controls in risk
management, using the framework of rules and regulations to create the right incentives to
control risks appropriately, and where necessary intervening directly to require actions to be
taken that would otherwise lead the firm to a potentially unsafe or unusual position. There is
nothing easy about this activity, and the lessons of the pre-crisis and crisis periods demonstrate
the dangers of encouraging broader attitudes which act to discourage the work of supervision
in favour of a light touch approach in which the risks in the system build up and are praised as
contributors to stability and prosperity, until that is the crash comes.
Supervision is a continuous activity which needs to benefit from constant public attitudes
towards it, and in turn supervisors need to be accountable and explain what they do. We have
made big strides forward on these fronts in recent years. When we talk about banks, solvency
and capital is at the heart of effective prudential supervision. The capital regime that is being
put in place is stronger not just in terms of the quantity and quality of capital that is funding
banks, but also because of the incentives that are being embedded in the regime. To end, I
don't believe that we can ignore the risk in banks, and the consequence if it crystallises. This
helps to explain why the exercise of judgement is such an important part of the supervision of
banks. Therefore we have to create a system of rules, we have to supervise banks and have
the scope and freedom to apply those rules in ways that create the right incentives for banks
to maintain safety and soundness, and to guard against the time when something does go
wrong we must be confident that our resolution regimes will work. I simply do not believe that
the alternative approaches are sufficiently credible.