13 July 2013

BoE/Tucker: Banking reform and macro-prudential regulation – Implications for banks' capital structure and credit conditions

Tucker looked at the implications for the credit system – from the micro regulatory regime and banks' capital structure to the introduction of new macro-prudential policies and their effect on credit conditions. He sketched the outline of a Capital Accord for the future.

Cyclical fluctuations in credit conditions and macro-prudential interventions to influence them will not play out in an unchanged financial system. In fact, it would be surprising if the market’s own response to the crisis and the regulatory reforms did not drive structural changes in the credit system. The shape of some can perhaps be discerned.

Too-Big-To-Fail effectively subsidised longer-term bond finance for banks. Combined with lax liquidity regulation, this probably left the sector as a whole with larger and longer-maturity asset portfolios than otherwise. A few decades ago we used to talk about government crowding out the private sector from the capital markets. Well, the bloated balance sheets of TBTF firms essentially crowded out other long-term investors from parts of the credit markets. Unlevered sources of funds struggled to compete with the banks, but instead held lots of bank paper, thinking it risk free. Competitors to the banks had to lever up: fragile shadow banks were one result.

Actions to remove the subsidy from banking will, amongst other things, create conditions in which the relative role of unlevered capital market investors can grow. Some of that might come through securitisation, although a mature and resilient market in ABS of loans to SMEs might well require initiatives to produce rich data sets on credit histories. The time may have come to evaluate the utility of the central credit registers that have long existed in some continental European and Asian countries.

None of that, however, can alter banks’ core comparative advantage as monetary institutions: the provision of liquidity through overdrafts, lines of credit and other working capital facilities. That role might be aided by a revival of a market in trade credit.

Banks will always be levered because their core monetary service revolves around transaction-account deposits, which are debt liabilities. And, on the other side of the balance sheet, they will always have somewhat risky asset portfolios because being a monetary institution makes them an efficient supplier of short-term finance to households, firms and the rest of the financial system. But they can do all that only if they are healthy and prosperous: only sound banks can make a credible promise to repay or lend money on demand.

The fragility in banks’ balance sheets is why they are regulated. Today, I have sketched the outline of a Capital Accord for the future. An Accord that would go beyond reducing the probability of failure, by also addressing the need to cope with distressed banks, ensuring that resolution can be orderly. Taking the tax-deductibility of debt interest as a given, the banking authorities can make it beneficial to society as a whole, not just to private interests, by requiring that a minimum level of term bond finance be part of the capital structure. That would provide gone-concern loss-absorbency for new improved resolution regimes to draw on. A still richer Accord might include instruments that aid recovery by converting into equity in the face of meaningful but not life-threatening losses. This approach moves away from seeing runnable short-term wholesale debt as a source of discipline on banks, to instead seeing longer-term bonds as providing a mass de manoeuvre for recapitalising distressed banks. Not all forms of leverage are the same.

But no static regime can ever be enough. If they were, crises would not recur. That is why the new macro-prudential authorities, such as the Bank of England’s FPC, will be able temporarily to adjust capital requirements when circumstances warrant. I have stressed that it is oversimplistic to think of macro-prudential interventions to improve capital adequacy as always inevitably leading to higher funding costs and tighter credit conditions. It will depend upon the prevailing circumstances: whether the banks started out with solid balance sheets, what the market knows and thinks. The FPC will need to be transparent in order to build understanding of its actions.

Full speech

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