Andrew Bailey: The capital adequacy of banks - today's issues and what
we have learned from the past
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 Bloomberg, London,
10 July 2014.
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I would like to thank David Curry, Hywel Dawes, Simon Dixon, Marc Farag, John Jackson, Duncan Mackinnon,
Sasha Mills, Jitendra Patil, Rhys Phillips, David Rule and Vicky Saporta for their help in preparing this speech.
The views expressed are my own and not necessarily those of any other members of the Bank of England.
Good morning and thank you for giving me this opportunity to speak on the subject of bank
capital adequacy. I am going to focus on the design of the capital adequacy regime. I am
going to draw out the failings of the old regime and why those failings were so critical,
comment on the major progress made over recent years, and use all of this to draw out
design questions that remain to be settled. In doing so, I will examine a set of key objectives
of the regime: first, that it creates good incentives for the behaviour of regulated firms;
second, that it is appropriately forward-looking - at the risks in the future; and third, that it
encourages and requires appropriate transparency which fosters market discipline.
Covering the failings of previous regimes is not simply some academic exercise, it is crucial
in understanding why regulators have taken the actions they have, and why there is still
some work to be done.
The Basel capital adequacy regime dates back to the Basel Accord of 1988, which led to the
introduction of what we now know as Basel I. This was an historic agreement, representing
the first international initiative on bank capital standards. Basel I focussed mainly on the
assessment of the quantity of credit risk, and had a (what now looks like) simple
categorisation of assets on risk grounds into one of five categories, with risk weightings of
0%, 20%, 50%, 100% and finally a set of assets that were fully deducted from capital, the
most risky sort. There was also a simple reporting framework for off balance sheet items
which were factored into the risk-weighted asset framework. Basel I also set out for the first
time an internationally agreed definition of the quality of qualifying capital for banks.
Basel I was simple, and I will return to the consequences of that later. The first amendment
to Basel I came in 1996 and 1997 in the form of the so-called Market Risk Amendment. It
was significant both in extending the Basel Accord to capture market risk, and in introducing
two alternative approaches to the measurement of market risk, a standardised method and
an internal models approach. The latter was the first appearance of the use of firms' own
models in the capital framework.
Basel II was first published in June 2004, though it was not widely implemented prior to the
outbreak of the financial crisis in 2007. It introduced the concept of "three pillars": Pillar I,
minimum capital requirements; Pillar II, supervisory review which enabled additional capital
to be required on a firm-by-firm basis; and Pillar III market discipline through greater
transparency of information on the application of the capital regime to each bank. In doing
so, Basel II extended the ability to use firms' own models to credit and counterparty credit
risk. It also introduced the requirement to hold capital against operational risk. Basel II did not
make major changes to the definition of capital, or the quality of capital, required to meet
banks' risks.
One further point to note is that a leverage ratio was not a feature of Basel I or II. Some
countries maintained leverage ratio requirements alongside the risk-based Basel regimes eg
the US and Canada1 (though importantly neither incorporated all off balance sheet items,
something that the Basel III leverage ratio seeks to amend) but many, like the UK did not.
I want to turn now to looking at why the pre-financial crisis capital regime failed to provide the
necessary protection to the financial system when the crisis hit. 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. That said, Basel II had its own flaws, and was not well implemented, points I will
return to later.
But, first, I want to look more at the flaws of the pre-crisis regime, starting with the definition
of capital. This was flawed from the outset in the late 1980s, both in the definition of eligible
capital instruments and the approach taken to the adjustments which should ensure that
accounting balance sheet items such as goodwill are not recognised in regulatory capital. A
further issue in my view has been the treatment of provisions.
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.
There were other flaws in the construction of these capital instruments. They often included
incentives to redeem which undermined their permanence. They were supposed to have full
discretion not to pay coupons and not to be redeemed in the event of a shock to the bank's
condition. But banks argued that the exercise of such discretion would create an adverse
market reaction which would be disproportionate to the benefits, thus undermining the quality
of the capital. More broadly, these so-called innovative instruments introduced complexity
into banks' capital structures which resulted from the endeavour by banks to optimise across
tax, accounting and prudential standards.
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. Apologies for
stating the blindingly obvious, but history painfully demonstrates why it is important to state
the obvious. Bringing the issue up to date, this is why there are clear benefits to banks if they
issue contingent convertible capital instruments with a trigger point that is safely above the
point at which there is likely to be a question mark as to whether the bank remains a going
concern - in other words before it is too late. Also, holders of these instruments have to be
very clear that they are at risk of conversion or write-down. We cannot have a situation
where holders gamble on an assumption that the trigger will not be pulled - it will.
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 Accord therefore incentivised
wrongly the issuance of hybrid debt capital instruments to cover deductions. A further flaw
was that deferred tax assets were not deducted from capital and minority interest assets
were recognised in full. This, too, was a mistake. DTAs depend on future profitability (which
is not assured) and minority interests are not fully transferable to absorb losses for a group.
Last on the capital side, there were problems starting in the original Basel Accord in relation
to the treatment of provisions. Under the current international accounting standards
provisions are based on incurred rather than expected losses. As a consequence, the bank
capital framework de facto becomes a partial substitute means of achieving more
forwardlooking provisioning, through the internal models regime for credit risk which requires the
deduction from capital of expected losses in excess of provisions. A forward-looking
approach to provisioning based on expected losses would help move to a more appropriate
position where the accounting standard requires a prudent valuation of banking book assets
and the capital regime can focus on unexpected loss. I hope that implementation of the new
accounting standard for provisioning, IFRS 9, is a step in this direction.
I now want to turn to the issues around risk-weighted assets in the capital framework. Basel I
was a simple framework, as I described earlier. In my view, that was its strength and
weakness. The strength was that it was quite easy (certainly by today's standards) to see the
balance sheets even of the largest banks laid out and broken down by broad risk weights.
The weaknesses were two-fold. First, it provided little insight into how firms measured and
managed risk. As a supervisor in the late 1980s and early 1990s, I remember well meetings
with firms which would start by the firm reminding that while they had filled in the risk
weighted assets form faithfully, it bore no resemblance to how they assessed and managed
risk in the business - what is often called "economic" as opposed to "regulatory" capital. In
one sense, this should not matter if the regulatory capital calculation provides a robust floor
below which the "economic" capital should not fall. But it was unclear how we could know this
was so, and the lack of line of sight into how the firm managed risk was disturbing. The
second weakness is generic to simple systems which conflate different levels of inherent risk,
namely that they tend to create incentives for banks to increase the average level of riskiness
of their assets. And, one thing we now know, incentives are hugely important in the capital
regime.
As I noted earlier, Basel II was not in place properly when the crisis broke, but the Market
Risk Amendment was, and this introduced the use of banks' own so-called "internal" models.
As an aside, my experience suggests that the contribution of Basel II to the crisis was far
more that it diverted the attention and effort of regulators and the industry away from broader
risk management and into the implementation of a new and more detailed approach to
regulation. This was especially so for large banks seeking approval to use their internal
models. Moreover, this process was not well done.
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. To illustrate this last point, here is a quote from the FSA's report into the failure of
RBS.
"The capital regime was most deficient, moreover, in respect of the trading books
of the banks, when required capital for many instruments was estimated using
value-at-risk (VaR) approaches. The acquisition of ABN AMRO meant that RBS's
trading book assets almost doubled between end-2006 and end-2007. The low
risk weights assigned to trading assets suggested that only £2.3bn of core tier 1
capital was held to cover potential trading losses which might result from assets
carried at around £470bn on the firm's balance sheet. In fact, in 2008, losses of
£12.2bn arose in the credit trading area alone (a subset of total trading book
assets). A regime which inadequately evaluated trading book risks was,
therefore, fundamental to RBS's failure. This inadequacy was particularly
significant for RBS, given that the purchase of ABN AMRO significantly increased
RBS's trading book assets. RBS was allowed by the existing regulations
massively to increase its trading risk exposure counterbalanced only by a small
increase in capital buffers available to absorb loss."
The Basel Committee recognised that across internationally active banks, Basel II would
likely lead to an overall reduction in the required capital compared with that required under
Basel I and that the reduction in required capital would be larger for banks adopting the more
advanced modelling options for credit risk.2 In other words, other things equal reported
capital ratios would tend to be higher under Basel II than Basel I. Our own work suggests
that Basel I would have required major UK banks to hold approximately £45bn more capital
than Basel II against the credit and counterparty credit risks in their end-2013 balance
sheets. This amounts to a decrease of about 25% under Basel II compared with Basel I.
Another way of looking at this is to examine the pattern of average risk weights. For a set of
17 major international banks (designated as G-SIBs)3 average risk weights fell almost
continuously from 70% in 1993 to below 40% in 2012. But this fall in average risk weights did
not represent a systematic reduction in risk within the banking system. The level of capital
was therefore wrong - too little capital was required, and the appearance of strong economic
conditions before the crisis appears to have provided a justification for even lower capital,
under Basel II.
What I have described was the application of the Pillar I element of the Basel regime, namely
the minimum capital requirements on the common approach. As I noted earlier, Basel II
introduced the three pillar approach, with the second pillar enabling supervisors to set
additional capital requirements on a firm specific basis. The second pillar was however not
consistently or rigorously applied prior to the response to the financial crisis. In 2008, the
major UK banks had a Pillar II capital requirement £22bn (equivalent to 10% of then Pillar I
capital requirement). In summary, the system was flawed both in terms of the definition of
capital - the quality - and the quantity required to be held.
The first step in response to the financial crisis was agreement in July 2009 to significantly
increase capital requirements against market risk via the so-called Basel II.5 package -
addressing the widely recognised undercapitalisation of risk in banks' trading operations.
Building on that improvement the next step, was the agreement on, and now introduction of,
Basel III. The new standard was very much a response to the financial crisis, the first reform
of the Accord to be backed by a remit from world leaders to effect real change on the global
scale. It built on a number of more immediate domestic responses, including in the UK the
FSA's so-called 4-6-8 approach. The new standard requires more and better quality capital,
and is a step change in capital adequacy.
For the largest UK banks, and taking into account all of the changes brought in by Basel III,
there is a seven-fold increase in the amount of Core Tier I capital, the highest quality of
capital that must have the characteristics of equity which major banks are expected to hold.
Under the Basel II regime, the Pillar I minimum requirement was £38bn of this highest quality
capital for the largest five UK Banks. Compared to this, taking both capital minima and
capital buffers together when Basel III is fully implemented the figure will be £271bn4, as
measured in September 2013 (ie on a like-for-like basis in terms of the point in time).
Breaking down this increase of £233bn in Core Tier I capital, the largest part (£80bn) is
accounted for by the change in the definition of capital resources, a further £61bn relates to
raising the minimum requirement from 2% to 4.5% of risk weighted assets (and changes to
the risk weights), £55bn to the Basel III Capital Conservation Buffer, and £37bn to the Basel
III Globally Significant Banks Buffer.
The changes that we have seen include action under both Pillars I and II of the Basel
framework. The numbers I gave for minimum capital requirements (the change from £38bn to
£271bn) represent Pillar I. I mentioned earlier that Pillar II was not consistently or rigorously
applied before the crisis. Between 2008 and today the Pillar IIA capital requirements for the
major UK banks have risen from £22bn to £53bn. This increase in capital required is
additional to the impact of Basel III and the resulting increase in core capital requirements of
around 7 times I set out above. The PRA's approach to supervision emphasises the use of
judgement on a forward-looking basis, and the use of Pillar II is evidence of that.
A further important element of the new framework of supervision is so-called Asset Quality
Reviews (AQRs), undertaken either by or at the request of supervisors like the PRA. AQRs
are designed to assess the more structural features of loan books as well as their
performance, including whether forbearance is being applied by the lender. The granularity
with which AQRs are undertaken can vary with their purpose, but there is always a fairly high
level of intensity in terms of the closeness of the inspection. In the best of all worlds,
supervisory initiated AQRs should not reveal anything that isn't already known. I will just say
that experience shows that we are not there yet.
Basel III requires more and better quality capital in banks. The good news is that since the
crisis broke, banks in the UK and elsewhere have made significant progress in rebuilding
capital. Evidence to support this is that at its last meeting in June, the Bank's Financial Policy
Committee decided to close its recommendation of March last year that the largest UK banks
and building societies should meet a minimum 7% Common Equity Tier One ratio on the
socalled end-point (ie full implementation) basis set out in the EU rules to implement Basel III,
after taking into account adjustments for expected loss on more vulnerable loan portfolios,
the impact of future conduct of business costs, and prudent use of risk weights. Since then
the actions taken by a number of major UK banks and building societies have put them on
course or ahead of the planned actions to meet the FPC's test. In a few cases, there are
more actions to be undertaken in their plans, but overall this is a welcome story of action
taken to strengthen capital positions.
I do however accept that there remains a perception in some quarters that higher capital
standards are bad for lending and thus for a sustained economic recovery. I agree with those
who argue that banks have a lot more to do to demonstrate that they support lending to small
businesses. Interestingly, in recent weeks the messages I have seen from the Bank of
England's regional agents suggest that the supply of loans on offer has increased, but
businesses are understandably cautious on the take up. Looking at the broader picture, the
post-crisis adjustment of the capital adequacy standard is a welcome and necessary
correction of the excessively lax underwriting and pricing of risk which caused the build up of
fragility in the banking system and led to the crisis. I do not however accept the view that
raising capital standards damages lending. There are few, if any, banks that have been
weakened as a result of raising capital.
Analysis by the Bank for International Settlements indicates that in the post crisis period
banks with higher capital ratios have experienced higher asset and loan growth5. Other work
by the BIS also shows a positive relationship between bank capitalisation and lending
growth, and that the impact of higher capital levels on lending may be especially significant
during a stress period6. IMF analysis indicates that banks with stronger core capital are less
likely to reduce certain types of lending when impacted by an adverse funding shock7. And
our own analysis indicates that banks with larger capital buffers tend to reduce lending less
when faced with an increase in capital requirements. These banks are less likely to cut
lending aggressively in response to a shock8.
These empirical results are intuitive and accord with our supervisory experience, namely that
a weakly capitalised bank is not in a position to expand its lending. Higher quality capital and
larger capital buffers are critical to bank resilience - delivering a more stable system both
through lower sensitivity of lending behaviour to shocks and reducing the probability of failure
and with it the risk of dramatic shifts in lending behaviour.
The capital adequacy framework has made much needed progress in recent years. The
framework is now being designed to be fit for purpose both for the micro-prudential purpose
of each firm's safety and soundness, and for the macro-prudential purposes of addressing
the risk certain major firms individually present to financial stability and the risk that
imbalances building up in the sector as a whole, or part of it, may threaten financial stability.
The key elements of the framework are:
first, a common definition of capital resources focussed on genuine loss absorbency
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in a going concern - Common Equity Tier 1. In doing so, we must define robustly
the boundary between going and gone concern loss absorbency ;
second, a framework for capital which comprises minimum capital requirements and
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capital buffers, with the buffers varying in size depending on a bank's size and the
nature of its activity and risk, and varying through the cycle;
third, using a combination of different approaches to assessing capital adequacy -
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risk-based approaches, stress tests, and a leverage ratio;
fourth, within the risk-based approach, striking a balance which recognises the
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potential benefits of firms' internal models while guarding against their weaknesses
and the incentive problems they create.
A major principle of the new framework is that there is no single "right" approach to
assessing capital adequacy. The very important role that is now given to stress tests
illustrates the point. This year the PRA and FPC are running their first concurrent stress tests
for the major UK banks, building on the past development by the FSA and then PRA of
sequential firm-by-firm stress tests. This is a key device to examine and mitigate tail risks,
and like all good forecasting exercises, the stress test is designed to probe important issues
rather than just provide a single answer.
A second key principle of capital adequacy is that establishing the boundary between the
going and gone concern (or resolution) regimes for loss absorbency is important. This is one
reason why the work on resolution and gone concern loss absorbency is so important. Put
simply, if we don't convincingly deal with the too big to fail problem, the boundary between
going and gone concerns will need to be re-set, and the former will need to be strengthened.
This should not be necessary with a good outcome on the gone concern side. For me, the
issue of gone-concern loss absorbency is the key outstanding one on the current agenda.
The idea that there is no single right measure of the capital a bank requires is gaining
ground. Each approach - risk-based, stress tests, leverage ratio - has its strengths and
weaknesses. For me, there are a number of governing principles. First, supervision is about
assessing and mitigating risks. That is the core of our job. We therefore naturally think in
riskbased terms. That said, the leverage ratio is a very useful complement, which is why the
PRA has moved to using a baseline leverage ratio more rapidly than the international
standard requires. It is a very useful check and balance and it should prompt searching
questions about the danger of model errors in more complex capital assessments. It is not a
substitute for a risk-based approach, but it is a very good complement. The FPC will shortly
be consulting on the scope and form of its application, and that will be a welcome debate.
Getting the incentives right for banks in terms of the capital adequacy regime is hugely
important. The leverage ratio is simple and that is its appeal, but on its own it could
encourage banks to take more risk per unit of assets. In contrast, internal models and stress
tests are complicated, and therefore carry the risk of opacity and model error. There is now a
growing debate on the use of models and stress tests. In many respects, the debate has
common ground, since models are intrinsic to stress tests. My view is that this is not a
debate about whether or not supervisors should use models. That question was answered a
long time ago in the reasoning for the switch away from Basel I. The design and
implementation of Basel II was not done well, and a substantial charge has been required. A
major lesson is that to use models and stress tests effectively requires intensive
development and maintenance by firms and a highly skilled body of supervisors and a
regime where judgement can be used. It also requires the supervisor to have a credible
capacity to withdraw the permission given to a firm to use a particular model if the model is
considered to be inadequate or the firm has not demonstrated the capacity to use it safely. In
another case, the supervisor could withdraw permission for whole types of models, as the
FSA/PRA did for the commercial property models of UK Banks by requiring a substitute
"simple slotting approach" to be used - which is still a model, but a very simple one.
Then I think the debate becomes more around whether the relevant risks can be modelled,
how easy it is for supervisors and firms to observe the performance of models, and the ability
of supervisors to police the performance of models. None of this is easy. There is also a very
good question around whether supervisors should supplement the use of firms' models by
developing their own models. In the US, the Federal Reserve has gone down this road, and
in doing so advanced their use of stress testing. So far, we have gone down the road of
pushing banks to improve their models, and to be more realistic about what the models can
and cannot do. My guess is that we may eventually end up with greater international
convergence of supervisory approaches on the use of models, and that would be a good
thing in terms of more efficient supervision and use of our scarce resources. But I would note
that today I have an open mind as to where that convergence will lead to in terms of the
capital adequacy regime.
Much of this speech has been about the incentives in the regime of capital adequacy for
banks. I want to end with a few words on transparency. Quite simply, there will in my view be
more of it in the future. When I started in supervision in the late 1980s, we prohibited banks
from disclosing their Basel I capital ratios, and we got exercised when they did nonetheless
declare their ratios. That was a relatively simple regime. The Basel III regime is undoubtedly
more complex and it is not about the single capital ratio. Capital requirements and buffers will
vary between firms and over time, for good reasons. Banks and investors do complain about
the lack of clarity about their future requirements in this regime. But that precision is not
realistic. Within defined parameters the regime is designed so that buffers adjust in relation
to risk and the impact of firm failure. Counter cyclical buffers can be varied over time
depending on conditions, and banks can move between GSIB buffers as they change size
and structure. Likewise, supervisory work, including stress testing, can lead our judgement
about appropriate buffers to change. The regime is built this way deliberately to include a
greater element of judgement by supervisors. My view is that this will inevitably lead to more
transparency and disclosure, which is fine and to be encouraged providing it can deliver
useful guidance. That means we have to work hard to deliver as much clarity as is possible
in an uncertain world.
And finally, we know that there is change on many fronts, the scale of which may only be
exceeded by the scale of the crisis to which it is a response. As supervisors we are on the
look out for unintended consequences of this change, and we will assess and refine our
approach as needed. Thank you.