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. * * * 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

and managers tempted to take more risk in a ‘ gamble for resurrection ’. in my view, these risks are common to any profit - seeking financial institution in the business of investment in order to pay annuities. that is why, for example, our response to the recent department of work and pensions consultation on superfunds said : “ the risks faced by db consolidators are similar to those managed by insurance companies providing annuities. and insurance companies may want to enter the defined benefit consolidation market. there may be unintended consequences if the two types of business are regulated differently. ” 4 https : / / www. bankofengland. co. uk / - / media / boe / files / prudential - regulation / publication / pra - response - to - dwp - consultation - paper - definedbenefit - pension - scheme - consolidation all speeches are available online at www. bankofengland. co. uk / publications / pages / speeches / default. aspx overall, i think the pra ’ s implementation of the solvency ii regime addresses these risks well. i would emphasise in particular the following features of the regime : 1. it strongly encourages uk insurers to invest in assets with fixed cashflows that closely match those of their annuity liabilities. this limits exposure to market risk. 2. insurers are required to hold a buffer of assets above the value of their policyholder liabilities that can absorb unexpected losses due to credit defaults, longevity shocks or other reasons. solvency ii limits what counts as own funds to instruments that can genuinely absorb losses. 3. the capital calculation in solvency ii captures all the risks to which the insurer is exposed, including those in other parts of the group. 4. the incentives of owners and managers are brought back into alignment with those of policyholders in a number of ways including : a. requiring owners to put their own money at risk through minimum capital requirements that must be maintained at all times. b. if capital levels fall close to these minimum requirements, a supervisory ladder of intervention shifts control increasingly away from owners and managers at a time when their incentives to act in the interests of policyholders are weakest because of the temptation to gamble for resurrection. c. capital requirements are risk - based, so that owners must put more of their own money on the line as the insurer takes greater risk. d. taking more risk should also never