Roderick Carr: Banking on capital punishment
Speech by Dr Roderick M Carr, Deputy Governor of the Reserve Bank of New Zealand, to the New
Zealand Association of Economists, Christchurch, New Zealand, 27 June 2001.
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Introduction
It gives me great pleasure to address the annual gathering of the best and the brightest economists in
the country. Today I am not going to talk to you about the state of the economy or its immediate
prospects; these are matters on which you are well informed. Indeed the transparency which
surrounds the conduct of monetary policy in this country leaves little private information in the hands of
the central bank. Further, with both a single decision-maker structure and long serving incumbent
Governor, there is little new information to reveal about how the Bank goes about managing monetary
policy. In fact as the Bank has served as training ground for many commentators and market
economists, not only are we transparent but reassuringly predictable. I want to take my time today to
stimulate your minds with a different set of issues.
At the heart of capitalism lies capital. Limited liability corporations have facilitated the accumulation
and mobilisation of capital to rival church and state but as we will see the asymmetry of payoffs
inherent in limited liability may induce excessive risk-taking. The provision of financial intermediation
services, particularly banking, has given rise to an extensive theoretical and empirical literature in
economics. By banking I mean the provision of two particular services, liquidity transformation and
credit origination. The efficient provision of these services is essential to the growth and prosperity of
market-based economies. Virtually all banking services are now provided through limited liability
corporations and the question of how much capital should be held has become the subject of
international debate.
Of all the interesting topics we could discuss, today I want to focus on the issue of bank regulation in
general and, in particular, bank capital. I want to update you on recent international initiatives
concerning bank regulation and outline both the case for capital regulation and the risks we take when
regulators go too far. I want to highlight why it is essential to the efficient allocation of resources that
providers of bank capital and even bank creditors must stand ready to take their punishment when
things go wrong and the unexpected happens. I want to highlight the distinction between economic
capital, rating capital and regulatory capital. I want to promote an antidote to the moral hazard created
by asymmetric payoffs, implicit or explicit deposit insurance and regulatory capture. Finally I want to
summarise recent policy initiatives we have taken to enhance the value of disclosure and underpin
market discipline.
The New Zealand regime in brief
Let me briefly remind you of New Zealand's approach to banking supervision. Our regime relies on self
discipline, market discipline, and regulatory discipline. Any organisation wishing to call itself a bank
while carrying on business in New Zealand must obtain a registration from the Reserve Bank. Our
conditions of registration prescribe minimum levels of capital in line with international standards known
as the Basel Accord. We also require mandatory levels of public disclosure. Directors are required to
provide regular public attestations as to the soundness of the bank, the robustness of its systems and
its exposure to risk. We monitor these disclosures and meet with all registered banks annually to
discuss strategy and any emerging issues. We rely on external auditors to verify financial statements.
By year-end, all registered banks will be required to have and publish a credit rating from an approved
rating agency. Where we depart somewhat from traditional supervisory approaches is in our
reluctance to validate what the directors of the bank are accountable for. We weigh more heavily than
most the moral hazard arising from the regulator approving specific actions of the board and
management of the bank. It is the role of the board and depositors to be satisfied as to the condition
and conduct of the bank, not to rely on the supervisor's ability to constrain bank risk-taking. But let me
be clear - New Zealand does not deny there is a case for bank regulation. But as they say - the
devil's in the detail.
Global trends in bank regulation
The draft proposals for the regulation of bank capital recently released by the Basel Committee on
Banking Supervision, often referred to as Basel 2, run to nearly 800 pages. These must be one of the
most extensive, most prescriptive, transnational regulatory proposals ever conceived. Yet in a recent
extensive review of the academic literature Joao Santos of New York University's Solomon Center
concluded:
"The justification for any regulation usually stems from a market failure such as externalities, market
power or asymmetry of information between buyers and sellers. In the case of banking, there is still no
consensus on whether banks need to be regulated and if so, how they should be regulated."
While this conclusion would not go unchallenged, not least by the tens of thousands of people
employed as bank regulators around the world, it serves to highlight the wide range of views which
exist about the issue of bank regulation and the extent to which current problems are the result of past
poor regulation. Let me explain.
The 1988 Basel Accord and the new proposals
In 1988, G10 countries reached a consensus on minimum capital standards for internationally active
banks. The Accord can be summarised in a couple of pages. In essence, it states that for every $100
of loans, a bank should have at least $8 of capital, of which at least $4 must be permanent equity.
Because loans secured over residential property were seen to be less risky than other loans, they only
had to have 50% as much capital. Loans to banks from OECD countries were seen to be less risky
still, so they only had to have 20% as much capital, and loans to governments denominated in their
local currency 0%. There were several other categories and treatment for off-balance-sheet
exposures.
In my view, the 1988 Basel Accord arose mainly from a desire to promote competitive neutrality and to
avoid arbitrage between differing national capital requirements for banks, as it did not seek to
determine a socially optimal level of bank capital. In the 1980s, highly leveraged Japanese banks had
been aggressive participants in the previously lucrative US municipal bond underwriting market. US
banks responded to what they saw as unfair competition by pressing for an internationally agreed
definition of capital standards for credit risk and a uniform methodology for the measurement of
capital. While the 1988 agreement addressed the issue of minimum bank capital, it created a whole
new industry in arbitraging between bank and non-bank capital requirements. Widespread
securitisation of bank assets is perhaps the best example. Today the case is made that the 1988
Accord promotes regulatory arbitrage of this type, rewarding risk-shifting which may undermine the
soundness of financial systems around the world. The solution, Basel 2, proposes to more closely
align bank capital with the riskiness of the bank's assets and operations. Subject to signoff by bank
regulators, banks may adopt their own models for determining how much capital to hold. In the
absence of approval, a standardised, but more flexible than Basel 1, model is proposed. Market
discipline is to be enlisted by requiring greater disclosure of risks facing a bank. While Basel 1 was a
Capital Accord, Basel 2 is an accord having three pillars - capital requirements, regulatory validation
and market discipline. The real question remains unanswered. Is the closer alignment of regulatory
capital with economic capital good public policy? In validating a particular capital allocation model, do
regulators let bank management, bank directors and bank creditors off the hook by, in essence,
providing a warrant of fitness for the model and the bank? In order to evaluate the proposals, we
should go back to first principles.
The case for regulating bank capital
Is there a case for a country to specify minimum levels of capital which banks should hold? No such
requirements exist for pharmaceutical companies, software vendors or telecommunications providers,
where failure might impose externalities which would actually be life threatening. The fact that banks
are risky ventures that go bust from time to time does not alone justify that minimum capital standards
should be imposed.
The traditional case for regulating banks in order to reduce the probability that they might bust is that
when depositors see a bank go bust they act in fear and ignorance as to the true condition of all other
banks. They run to their own bank to be first in line to withdraw deposits and in so doing may force a
perfectly sound bank to run out of liquid assets, sell sound assets at a discount and so become
insolvent. The combination of asymmetric information about the credits created (depositors can not
know the state of the bank's borrowers), the sequential service constraint (all on demand deposits can
be withdrawn in full), and the liquidity transformation services provided by banks (short term deposits
finance long term loans) makes banks inherently vulnerable to a loss of confidence. Further, banks
often borrow from and lend to each other both in the short-term money markets and through the
payment system. Thus, the failure of one bank may indeed pose a threat to the solvency of another,
even absent a run by depositors.
Banks will hold liquid assets and capital at levels high enough to meet some subjective assessment of
the probability of runs and counterparty failures.
An alternative argument used to justify bank regulation is that in a system where central banks are
called on to provide lender of last resort facilities to solvent but illiquid banks, in order to distinguish
solvent from insolvent banks the central bank should undertake on-site examinations to establish the
state of each institution. The prospect of system-wide contagion, in which society is denied the liquidity
transformation and credit origination services of the banking industry, provides the soundest basis for
regulating banks and socialising the costs of individual bank failures. The objective in socialising
losses is to preserve services for future savers, borrowers and transactors, but the consequence is to
protect current depositors from facing losses and to allow bank shareholders to earn excess returns if
the bank holds less than the socially-optimum level of capital.
So the model of public policy for banking in many countries is something like this. Protect the
depositors to stop the run. Stop the run to stop the contagion. Stop the contagion to ensure society
continues to get banking services.
However, once the probability of bank runs has been reduced, banks will hold less liquid assets and
less capital than would otherwise be the case. Indeed capital ratios have been declining relentlessly
during the past 150 years, from 35% in the 1860s to 4% by the mid 1980s. The banks became more
'efficient' intermediaries but, to the extent the risk of failure has increased because of lack of depositor
discipline on the banks and risk has been moved elsewhere (to taxpayers or deposit insurance funds),
efficiency gains are more apparent than real. The predisposition of governments to bail-out the
creditors of failed banks makes all the difference to both the sign and magnitude of the impact of
regulation on the efficiency of liquidity transformation and credit origination in the economy.
Bailing out banks
Perhaps the earliest recorded example of a government bail-out of bankers was the action by the
Roman Emperor Tiberius Caesar who in 33 AD provided support to "reliable bankers" after fraud,
defaults on foreign debt, liquidity draining government policies, sinking of uninsured cargoes, and a
slave revolt precipitated a banking crisis. However, government safety nets were rare before the
twentieth century.
In the era of free banking, market forces prevailed. Bank failures in the nineteenth century were
relatively frequent but smaller in scale, and self-correcting in comparison to the experience in the
twentieth century.
Banks today are playing a larger role in the economy than a century ago. Bank assets in New Zealand
represent 180% of GDP. Payments made every day via the banking system amount to 35% of GDP.
Virtually every adult member of society has a bank account, a credit card, and a debit card to facilitate
non-cash payments. Many households rely on credit services to smooth consumption. Banks also
provide working capital to small and medium size enterprises and facilitate payments both
domestically and internationally. Arguably, the externalities associated with the failure of a single bank
have increased in the last quarter century.
In the last quarter of the 20th century around the world there have been over 100 separate incidents of
banking systems facing a crisis. In some cases, losses have exceeded 40% of annual GDP (Thailand)
and losses of 10-20% of GDP have been common. It has been very rare for bank creditors to bear
losses and in some cases even shareholders have been saved with public money. So what is going
on?
Has the market failed or simply not been allowed to operate? The international consensus, not without
dissenters, is that markets have failed or could be expected to fail, that oversight by regulators and
prescribed minimum levels of capital are essential if banking systems are to be sound. Some countries
have concluded that, because depositors rightly perceive that banks will still fail and therefore
depositors might run from solvent banks, deposit insurance is necessary to prevent runs. However,
given the focus of deposit insurance on small deposits, and the extent of wholesale (uninsured)
deposits in many banks today, deposit insurance is now often justified on the grounds it makes it
politically acceptable to fail banks which should be failed and to limit the extent of taxpayer liability to
insured deposits only.
The contemporary case for bank regulation runs something like this. Once the state is exposed to the
underwriting risk and moral hazard of a deposit insurance scheme (implicit or explicit), it must monitor
the banks to reduce the probability of failure. With an implicit guarantee or explicit deposit insurance
scheme in place and the regulator deeply implicated with any bank failure, markets assess the
probability of loss given default to be lower than otherwise, making them more willing to take risks with
banks. This reduced risk aversion translates into holdings of lower levels of bank capital than would
otherwise be required to underpin a portfolio of risky loans. In this, our current world, the privately
optimal level of capital in banks could well diverge from the socially optimal level. I say "could"
because we cannot rule out the possibility that at some very low probability of failure it may be efficient
for society to underwrite banks rather than have them each carry the higher capital and liquidity levels
necessary to withstand a once in a 500 year incident of general loss of confidence.
While some regulators agree there is a role for market discipline, many believe the market may not
know what information to ask for, or banks may be reluctant to supply it. Consequently even
advocates of market discipline agree there is a role for the regulator in prescribing what information
should be provided. Proponents of market discipline believe it is then more efficient for bank creditors,
through their agents, to monitor the bank rather than to rely on the judgement of a bureaucrat.
Determining the optimal level of bank capital
Let us set aside the issues facing the solvent but illiquid bank by assuming a central bank has the
capacity to act as lender of last resort. This presumes the central bank will be able to distinguish an
illiquid but solvent bank from an illiquid and insolvent one. Let us focus on:
 how banks might determine the privately optimal amount of capital to hold;
 some factors which might cause the socially optimal amount of bank capital to diverge from
the private optimum; and
 strategies to cause convergence between the socially and the privately optimal level of
capital.
Because bank management might have misjudged the quality of its borrowers, because economic
circumstances may cause once sound borrowers to fail and because depositors might withdraw funds
earlier than expected, necessitating asset liquidations at discount rates above expected yield to
maturity, bank management (wishing to preserve their jobs) and bank shareholders (wishing to
preserve the franchise value of their business), will find it optimal to hold some capital. That is, to
retain within the bank assets with an expected net present value in excess of the net present value of
liabilities. But by how much?
If too little capital is held, the probability of failure is too high; if too much capital is held, the rate of
return on equity is less than it might be. Surely this is an equilibrating mechanism where depositors'
interests are protected by shareholder and management incentives to preserve the bank? Those who
advocate a return to free banking would argue so. And did not Modigliani and Miller show nearly 50
years ago that debt/equity ratios do not influence the value of the firm? Well at least in frictionless
markets with complete information and no taxes.
Let us set aside the traditional argument in favour of bank regulation - that banks are opaque,
depositors need agents to monitor the bank on their behalf, and regulators can do this cost effectively.
Let us set aside the strongest argument for regulation - the prospect of contagion. Let us assume
complete markets and symmetric information and that depositors, shareholders and bank
management seek to maximise the expected value of their interests. In this world, let us assume there
is an unnatural person with full contractual capacity and limited liability. That is, payoffs are
asymmetric. This unnatural person is a bank and I contend it will seek to hold less than the socially
optimal level of capital.
Depositors earn high rates of interest, shareholders earn high dividends and management takes high
salaries in the good times when the net present value of claims owned by the bank exceeds the net
present value of the obligations of the bank. In the bad times, depositors do not expect to face losses,
shareholders liability is limited to the capital invested and management can withdraw and retire on
prior period earnings or exit the industry.
Of course, this is a highly simplified model. To ensure its investment in people, processes and
proprietary information is protected and because of the costs of bank failure in terms of reputation and
potential litigation, owners and managers will choose to hold some capital.
The ability of the shareholders to put the bank to the bank's creditors arises from limited liability. The
ability of the creditors to put the bank to the government (taxpayers) arises if the externalities
associated with failing the bank are expected to exceed the cost of recapitalising the bank. This is
most likely if the bank is assessed to be systemically or politically important. Each of the major banks
operating in New Zealand has a significant share of system assets and hundreds of thousands of
personal customers. They would seem to meet any reasonable threshold of systemic or political
importance. While failing a bank might mean liquidation, it is almost certain to involve loss of credit
origination capacity and disruption to the payment system.
"Too big to fail" (not failing a bank because of its size) need not mean all bank creditors should escape
without loss. I would be the first to concede that our large banks are too big to liquidate or to
indefinitely suspend withdrawals, but it would be foolish for bank creditors, including depositors, to
assume that they will necessarily be made whole. Of course, bank shareholders would have lost all
their investment before creditors suffer any loss.
Yes, this is another one of those occasions when the Reserve Bank takes the opportunity to state on
the public record that neither the Bank, nor the government, guarantees any of the deposits of any
registered bank.
Nevertheless, limited liability, systemic impact, and political voice underpin expectations of asymmetric
payoffs for shareholders and bank creditors, and together these suggest that the privately optimal
level of bank capital to cover expected losses might lie below the socially optimal level of capital
required to meet both expected and unexpected losses. Let us call the former "economic capital" and
the latter "regulatory capital".
Economic capital is optimal for shareholders; regulatory capital is optimal for taxpayers. There is also
a level of capital necessary to sustain a given credit rating from an independent rating agent. Let us
call "optimal rating capital" that level of capital optimal for depositors, given the premium over the
risk-free rate paid by the bank to attract deposits allowing for the value of the option debt holders
presume they have to put their deposits to the government.
Bank management has an interesting role. On the one hand, they want the shareholders to assess
their expected rate of return to be high so the bank can access additional capital at the lowest
marginal cost. On the other hand, bank management, on behalf of shareholders, want to convince the
rating agency that their risks are well controlled so that they may be able to access deposits at the
lowest possible cost for a given level of capital. Bank management face an incentive to convince
regulators that the level of capital consistent with that demanded by depositors to protect them (rating
capital) is also the socially optimal level of capital. Enter the so-called hybrid or innovative capital
instruments that the market prices as debt and regulators often count as capital. This device seeks to
provide regulatory capital at levels above economic capital. What makes capital "capital" is something
we will come to shortly.
Let us return to consider the gap which, if it exists, should be of interest. That is, the gap between
optimal economic (private) and optimal regulatory (social) capital.
The draft Basel 2 Accord is based on the assumption that under the 1988 Accord there was such a
gap and that it was material. The implication in the draft Pillar one of the Basel 2 Accord concerning
bank capital is that the total amount of regulatory capital should remain unchanged and that economic
capital was being eroded and should be augmented. More closely tying capital to the probability of
default on loans and the expected loss given default, together with an explicit charge for operational
risk and the retention of a charge for market risk on the trading book, are the essential elements of
Pillar one of Basel 2, which seeks to better align economic and regulatory capital. The alignment of
regulatory capital is seen as good and the complexity of the proposed calculation of regulatory capital
is in part justified as a way of making regulatory capital mimic economic capital, which is presumed to
be the level of capital the market would demand.
Optimal economic capital may fall short of optimal social capital
Asymmetric payoffs to shareholders and depositors mean the privately optimal level of capital lies
below the socially optimal level of capital given the full distribution of returns to all stakeholders from
the portfolio of risky loans originated by the bank's management but underwritten by shareholders,
depositors and ultimately taxpayers in the case of systemically significant banks. In my view,
alignment of economic and regulatory capital leads to an inherently undercapitalised privately owned
banking system. In the absence of market discipline, it would be a mistake for the regulator to go
along with whatever capital banks determine to be privately optimal. But recall it may still be efficient to
socially insure, rather than capitalise the banks to absorb the most extreme unexpected losses.
However, most safety nets have been slung to underwrite much more common events yet fail to
ensure the preservation of the credit origination, liquidity transformation, and payment service
capability of the institution. The analysis is made more complicated if the shareholders, depositors and
taxpayers come from different nation states. Any idea of a utility maximising objective function to
determine socially optimal bank capital needs to recognise the segmentation which occurs when the
three sets of stakeholders cannot be presumed to be in a continuing relationship after a bank failure.
But that is not the full extent of the gap. Economic capital is calculated on the basis of expected
losses. To the extent minimum capital requirements are set consistent with economic capital,
unexpected losses will not be borne by bank shareholders. Unexpected losses must be borne by bank
creditors, a deposit insurance fund, an ex post levy on surviving banks or socialised via taxpayer
support arising from implicit deposit insurance. Losses which are unexpected to an individual bank are
not necessarily unexpected to a banking system. The question is to what extent should banks'
shareholders put up capital to underpin not only each institution but also the banking system? Does
not deposit insurance seek to do just that?
Deposit insurance, moral hazard and undercapitalised banks
The arguments against deposit insurance (whether explicit or implicit) are well rehearsed. Depositors
and banks take more risk (incur moral hazard). Banks make more risky loans, which crowd out safe
loans. Small scale and inefficient banks are protected. Regulatory capture and regulatory forbearance
increase the loss given default. Credible deposit insurance may reduce the probability of bank runs as
a cause of bank failure and increase the political acceptability of failing insolvent banks, but it does so
at the risk of increasing the probability of failure, risks increasing losses given failure and appears to
increase fragmentation and inefficiency in the intermediation process. Increased competition may be
associated with more participants and industry profitability may be reduced. However, it is more likely
that profits are reduced because costs are higher than because fees and margins are lower. A less
profitable banking industry may simply reflect a less efficient one.
To mitigate the moral hazard of insured depositors tolerating excessive risk-taking by bank
management on behalf of shareholders, advocates of deposit insurance promote schemes with: (a)
caps (only a small limited amount of deposits are insured for each depositor); (b) co-insurance (only
pay a percentage of losses); and (c) deposit insurance premiums based on the riskiness of the bank.
However, experience is that coverage provided by deposit insurance is extended over time and by
circumstances. To the extent that deposit insurance makes credible the threat that some depositors
may face some losses by making it clear that small retail depositors with political voice will be
protected, but no others will be, the case is made that deposit insurance adds to market discipline. Of
course, that presumes that the uninsured depositors will discipline the bank but what of the bank that
raises only insured deposits, or of the systemically important bank with material externalities? There
may be little market discipline on such banks and the deposit insurer or regulator must constrain the
rationally excessive risk appetite of the bank. As the regulator becomes ever more prescriptive and
fixed with knowledge (or blamed for the lack of it), so the chances of a bail-out increase, market
discipline weakens further and regulators get drawn in further. In my opinion, public sector
bureaucracies find risk management extremely difficult. Rarely are the payoffs for taking more risk
commensurate with the incentives facing individual decision makers. Consequently bureaucrats are
too risk averse most of the time and not risk averse enough when confronted with the high probability
of a bad outcome becoming even worse.
Is there a better model - one in which there is a realistic prospect that shareholders, having put up
something close to the socially optimal amount of capital, are at risk, and depositors, facing a credible
threat of loss, insist on that level of capital being sustained? Capital needs to stand ready to take its
punishment for being associated with risky ventures that go bad, whether expected or not.
For capital to be punished, it needs to be:
 permanent;
 available at the time of insolvency;
 accessible in the jurisdiction of the obligations of the bank; and
 under no obligations to its holders that rank ahead of any other obligations.
To constitute bank capital, rights accorded to owners must be capable of being irrevocably,
completely, unilaterally, and immediately cancelled in the event all other obligations are not expected
to be settled in full.
An antidote to moral hazard
For bank creditors (all senior unsecured creditors) to have incentives to monitor the soundness of the
bank, they must face the prospect of a loss of some or all of their investment. Such a loss must be:
 reasonably expected even if extremely improbable;
 politically acceptable;
 quickly determined; and
 promptly administered.
A "haircut" is a process involving a reduction in the face value of an obligation of the bank. The
amount of the reduction may reflect the negative equity of an insolvent bank which has been liquidated
(a dead haircut), or the amount necessary to recapitalise a bank in order for it to continue in business.
It is the latter case I wish to focus on. It is the case where bank creditors recapitalise the bank. The
creditor recapitalisation option is far from a done deal but we continue to explore the feasibility of
adding it to the options for managing a bank crisis. In the bank creditor recapitalisation case, creditors
may recover some or all of their haircut from the subsequent sale of the bank. To the extent bank
creditors have become the shareholders of the recapitalised bank, they might have all the rights of
ordinary shareholders and indeed might sell their shares at a profit. Of course, by taking more of the
creditors' money than is necessary to cover losses, creditors are being required to meet a social policy
objective but they are the primary beneficiaries of that policy - gaining immediate access to a
substantial proportion of their deposits, avoiding costly and drawn out liquidation proceedings and
preserving access to the payment system. The alternative is most often the nationalisation of the bank
at the expense of taxpayers.
In most parts of the world, regulators faced with a failing bank with a large number of depositors are
confronted with advising governments to nationalise or liquidate the bank.
Confronted with this choice, liquidation is likely to be an unacceptable option for all but the smallest of
banks. A credible regime to recapitalise the bank using depositors' and other creditors' money possibly
offers a policy option that might be preferable to nationalisation.
The key features of a bank creditor recapitalisation might include the rapid assessment of the rough
order of magnitude of the negative equity, placing the bank into statutory management, freezing
withdrawals for a short period, deduction of a proportion of all obligations of an immediate nature and
recording deductions against the name of the obligatee in a memorandum account, guaranteeing the
residual obligations of the institution, if not the entire institution, and reopening the institution. Over
time, the application of partial equity conversions to other time obligations as they fall due and the
conversion of creditor obligations into equity could take place. While avoiding the complexity, costs
and moral hazard of deposit insurance, ex ante the prospect of bank creditor recapitalisations may
provide creditors with an incentive to monitor their bank and insist on levels of capital closer to the
socially optimal level. A credible creditor recapitalisation option may avoid the need for and inefficiency
induced by a deposit insurance regime. It may avoid the need for intrusive regulatory oversight. It
seeks to protect the taxpayers interest. It may significantly reduce the pu