11 November 2012

Simon Nixon: Bank capital question must be resolved

Five years after the financial crisis broke, the question of how much capital a bank should hold is still not resolved, particularly in the UK where it is reaching new levels of intensity, comments Nixon in his WSJ column.

Senior policy-makers have been queuing up in recent weeks to make speeches proclaiming their belief that the UK banking system is undercapitalised, with the governor of the Bank of England prominent among them. The current window of opportunity provided by recent central bank actions needs to be used to restore the capital position of the UK banking system, Mervyn King said last month. "I am not sure Western countries in general will be able to escape their current predicament without significant recapitalisation of their banking systems...In the 1930s, the pretence that debts could be repaid was maintained for far too long. We must not repeat that mistake."

The reason for all this speechifying is that the UK debate is due to come to a head at this month's meeting of the BoE's interim Financial Policy Committee (FPC), which oversees the overall safety of the UK banking system. The FPC has urged banks to raise capital at every quarterly meeting since its creation, but it has never spelled out how much capital it wants raised or why it is needed and so the banks have ignored it.

Everybody agrees the debate must now be resolved. Yet as things stand, there is no consensus... The only thing everyone accepts is that the uncertainty is itself deeply damaging.

What can and should the FPC do about this? Essentially, its choice is binary: either it must demand a one-off, substantial recapitalisation to get banks rapidly to the new levels it thinks necessary for the system to operate safely without public support; or it needs to back down, allow banks time to meet the Basel rules in the hope they will generate new capital organically and use this to support new lending. But in making this decision, the FPC will be bound by two constraints: first, it is only allowed to make system-wide recommendations and can't set capital rules for individual institutions. That means if it believes banks should raise capital, it will likely need to express this view in the form of a stress test, spelling out exactly what stress it wishes to test. Second, any decision to order a recapitalisation requires the cooperation of the government since the Treasury will need to provide a fiscal backstop, not least to Lloyds and RBS where it is majority shareholder. But it is far from clear the Treasury has the appetite for a major clash with investors and the inevitable political fallout from a new round of bank equity injections: "It is what you might do if you were a benevolent dictator", says one senior official.

The BoE is sometimes compared to a benign dictatorship. But fortunately for banks, the UK itself is not. The true answer to how much capital a bank should hold is that it depends on how much risk politicians and investors are prepared to take. That makes it a debate that can never be finally resolved.

Full article

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