Second, regulatory capital ratios offer, on average, little if any advance warning of impending problems. These conclusions are essentially unchanged using the Basel III definitions of capital. This visual evidence can be formalised by constructing some Type I (false positive) and Type II (missed crisis) error estimates for the same 33-bank panel. Assume, by way of illustration only, that if a bank’s Tier 1 capital ratio dips below 8%, this is deemed to signal distress (Table 1). The probability of a Type I error using regulatory capital ratios is 50%, while the probability of a Type II error is around 43%. On those assumptions, this suggests regulatory capital ratios do about as well in predicting crises as a coin toss. They are essentially uninformative about future bank stress. Taken together, this does not paint an altogether encouraging picture. A critic might argue that regulatory capital ratios have become too complex to verify, too error-prone to be reliably  7  4  Hayek (1974). BIS central bankers’ speeches  robust and too leaden-footed to enable prompt corrective action. From a first principles perspective, they score poorly as an optimal control device over a complex system such as finance. Resurrecting the third pillar What could be done to strengthen the framework? As a thought experiment, consider dropping risk models and instead relying on the market. Market-based metrics of bank solvency could be based around the market rather than book value of capital.

Chart 6: Market capitalisation to book-value of total assets 14.0% 12.0% 10.0% 8.0% 6.0% 'No crisis' banks 'Crisis' banks 5% threshold Lehman failure 15 Sep 08  4.0% 2.0%  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  May 05  Nov 04  May 04  Nov 03  May 03  Nov 02  May 02  0.0%  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  14  BIS central bankers’ speeches  Chart 7: Market capitalisation to book-value of debt 15.0% 12.5% 10.0% 7.5% 5.0% 'No crisis' banks 'Crisis' banks 5% threshold Lehman failure 15 Sep 08  2.5%  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  Nov 04  May 05  May 04  Nov 03  May 03  Nov 02  May 02  0.0%  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  Chart 8: Market capitalisation to book-value of equity 2.50 2.00 1.50 1.00  'No crisis' banks 'Crisis' banks 1.20 threshold Lehman failure 15 Sep 08  0.50  Nov 08  May 08  Nov 07  May 07  Nov 06  May 06  Nov 05  May 05  Nov 04  May 04  Nov 03  May 03  Nov 02  May 02  0.00  Sources: Capital IQ and Bank calculations (a) 30-day moving average of market capitalisation Other Footnotes as per chart 5  BIS central bankers’ speeches  15  Chart 9: Optimal capital structure – Debt and Equity  Optimal capital structure – D + E  Present value of costs  Expected costs of financial distress  Expected taxes  Optimal leverage ratio  Debt/Equity  Source: Bank of England  Chart 10: Optimal capital structure – Debt, Equity and Contingent Capital  Optimal capital structure – C + D + E  Present value  Expected taxes  Expected bankruptcy costs Taxes paid due to existing equity 0  Optimal portion of convertible debt  100%  Source: Bank of England  16  BIS central bankers’ speeches  Chart 11: Major UK banks’ Tier 1 capital ratio % 12  Including bonuses paid as cocos Including dividends paid as cocos  11  Actual Tier 1 capital ratio  10 9 8 7 6 2000 2001 2002 2003 2004 2005 2006 2007 Sources: Annual accounts and Bank calculations (a) Alliance and Leicester, Banco Santander, Barclays, Bradford & Bingley, HBOS, HSBC, Lloyds TSB, Nationwide, Northern Rock and RBS.