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The author is a founding companion of Veritum Partners
What do Silicon Valley Bank, Credit Suisse, Citigroup and Royal Bank of Scotland all have in frequent? If you guessed the reply as “they failed and had to be rescued by their competitors or by their governments” you then can be appropriate. But there was one different factor that they had in frequent; robust capital ratios on the time of their failure, properly above the extent their regulators demanded. This is a helpful reminder that for all of the speak about how a lot capital banks want, an excessive amount of the dialogue merely misses the purpose.
The argument has come alive once more over the previous few months, fired by proposed modifications to the principles governing financial institution capital that look set to hit US banks particularly severely. There has been intensive debate about how a lot capital banks want. The US banks have lobbied furiously in Washington and within the media, arguing not solely that extra capital is pointless however that lending to “hard working families and small businesses” will merely dry up if the principles are carried out as drafted.
Others declare the other, citing analysis that the extra capital banks have, the extra they are going to lend. Some query the true agenda of banks, claiming the true downside is that extra capital means decrease returns on capital, which due to this fact means decrease government pay.
This debate misses the purpose of financial institution regulation. It is to not stuff banks with a lot capital that they can not fail. Instead, it’s to create a banking system that has the suitable stage of danger.
Capital is just one enter into that danger evaluation, and arguably it’s a comparatively small one. Silicon Valley Bank failed resulting from mismanagement of rate of interest danger. Credit Suisse failed resulting from its structurally unprofitable enterprise mannequin. Citigroup and Royal Bank of Scotland failed resulting from weak credit score and market danger underwriting. The solely factor that their stage of capital decided was how shortly they collapsed.
Given the poor historical past of capital ranges as a predictor of financial institution failure, regulators owe it to each banks and those that use them to actively embrace extra modern measures. One thought — floated a number of years in the past by Andy Haldane (then on the Bank of England) — was to watch a “market-based” capital ratio, whereby the calculation of capital wasn’t the quantity proven within the accounts however the inventory market worth of the financial institution.
In the case of Credit Suisse, Citigroup and Royal Bank of Scotland, their market-based capital ratios would have been screaming crimson for greater than a yr earlier than their collapse. Of course, such an method is likely to be open to market manipulation, however as an enter into regulation it could be an important addition.
Even extra proactively, regulators would do properly to actively issue within the tradition of the financial institution and make particular calls for on these whose “culture ratio” was weak. Calculating such a ratio isn’t straightforward, however that doesn’t imply it’s not value doing. The prize might be monumental.
For instance, there may be proof that having gender range on danger committees improves danger outcomes. Perhaps Harriet Harman, the previous deputy chief of the UK Labour social gathering, was proper when she claimed that Lehman Brothers won’t have gone bust in 2008 if it had been Lehman Sisters. Maybe regulators ought to penalise or reward banks based mostly on their danger committee gender range?
Thought experiments apart, the overarching level is that the normal capital ratio is simply too clunky, imprecise and is usually deceptive as a metric for financial institution regulators to put a lot reliance upon. It has a job to play, however these commentators who declare that ever extra capital is a panacea are misguided, whereas banks that argue they’re already secure with their present capital stage are silly.
Regulators owe it to all of us to give attention to actively creating way more refined measures for preserving the system secure.