Thursday, 1 October 2015

Capital, liquidity and the countercyclical buffer, in plain English

The FT reports that due to “modest but rising credit growth”, the Bank of England’s Financial Policy Committee (FPC) considered raising banks’ countercyclical capital buffer. According to the FT's Caroline Bingham:
This measure requires lenders to build up capital in good times to draw down in more challenging times. 
And she goes on to say this:
The prospect of yet more capital that banks must set aside would come on top of capital rules on a European and global basis that lenders must implement. They complain that these ever-increasing buffers weigh on their profits and therefore lending ability.
No, Caroline, no. Banks do not "build up" or “set aside” capital. Capital is an integral part of the balance sheet structure. As the Bank of England explains, it is a form of funding:
It can be misleading to think of capital as ‘held’ or ‘set aside’ by banks; capital is not an asset. Rather, it is a form of funding — one that can absorb losses that could otherwise threaten a bank’s solvency.
 And you really shouldn't listen to the complaints of banks. They talk their books. 

Like any corporation, a bank’s balance sheet is made up of assets, which are principally but not exclusively loans, and liabilities (debt), which are principally but not exclusively deposits. The equity of the bank (shareholders’ capital) is the difference between assets and liabilities. The bank is solvent if total liabilities are less than total assets. It is insolvent if total liabilities exceed total assets. This can happen if asset values collapse rapidly, as they did in the 2008 financial crisis. Note that a bank run, in which deposits rapidly leave the bank, does not by itself cause insolvency. It is the associated asset value collapse as the bank is forced to sell assets at fire sale prices to raise cash to fund the run that causes insolvency. I’ve explained this previously – see links at the foot of the post.

What we call “capital” for banks is actually various forms of equity and near-equity. It comes in two flavours: Tier1 capital, which is shareholders' funds, and Tier2 capital, which is debt that can be converted to equity (so-called “convergent contingent” bonds (Co-Cos) and other forms of subordinated debt) and various forms of capital reserve.

Tier1 capital is split into two parts. The largest portion is "Common Equity Tier1", which as the name suggests is entirely equity. The smaller portion, "Additional Tier1", may include perpetual preferred stock.

In the event of the bank suffering losses due to bad loans, it is Tier1 capital that is wiped out first. Shareholders of the bank always lose their money before anyone else. If the bank’s losses are so severe that Tier1 capital is entirely wiped, Tier2 capital is next in line.

Tier1 and Tier2 capital therefore protect creditors from losses. A bank’s creditors are unsecured bondholders, unsecured depositors, insured depositors, secured bondholders (including repo funding from other banks) and the central bank. In the event of a major bank failure, they are wiped in that order.

Clearly, the greater the proportion of capital to debt that a bank has – or, if you like, the greater the “gap” between assets and liabilities - the more losses it can absorb before creditors are affected. 

Capital and leverage ratios define the minimum size of the gap between assets and liabilities that is consistent with providing reasonable protection to creditors against losses. They do so in slightly different ways: the capital ratio (capital/risk weighted assets) uses a view of the asset side of the balance sheet that takes into account the risk of each asset, while the leverage ratio (capital/total assets) ignores risk.

But why not protect creditors completely? Why not force banks to keep the gap between assets and liabilities sufficiently wide to absorb all potential losses from risky lending?

Some people argue that banks should do exactly this. Advocates of “full reserve banking”, in its strictest form, want bank lending to be funded only from banks’ own capital, not from deposits. Their view is that deposits should not be placed at risk. So they want banks to match their stocks of deposits with equally large stocks of risk-free assets – cash “reserves” or government bonds.

Cash reserves are not capital. They are cash deposits at the central bank which are maintained by banks to enable depositors to withdraw funds. Since, generally speaking, depositors don’t all withdraw their funds at the same time, the amount of ready cash that banks keep on deposit at the central bank is usually well under 100% of customer deposit value. In the USA banks are required to keep reserves equivalent to 10% of eligible customer deposits - this is the "reserve requirement ratio" (RRR) . But in Canada and Denmark, the RRR is zero, and banks borrow reserves as needed to settle deposit withdrawal.  In the UK, prior to the advent of QE, the required reserve ratio (RRR) was tailored for each bank individually: however, since QE forces banks to maintain much larger cash deposits at the central bank than they need, the UK’s RRR is currently also zero.

Gold and government bonds are not capital either. They are safe liquid assets. They can be sold quickly and easily to meet depositor demands for withdrawals, reducing the likelihood of the bank needing to borrow emergency funds either from markets or from the central bank.

The “Liquidity Coverage Ratio” defines the proportion of safe liquid assets that banks must hold (in this case “hold” is the correct terminology, whereas it is incorrect for capital) to cover short-term outflows. This is how the Basel Committee explains it:
The objective of the LCR is to promote the short-term resilience of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
So, to summarise: capital requirements influence the overall structure of the balance sheet, and in particular the gap between assets and liabilities, while liquidity requirements influence the structure of the asset side only.

Now, about that countercyclical capital buffer (CCB). The CCB and the RRR serve similar purposes, but on opposite sides of the balance sheet: the RRR affects the asset side of the balance sheet, while the CCB affects the liability side.

Raising the RRR forces banks to hold more of their assets in the form of reserves, reducing their lending capacity. It does NOT mean they have less money to “lend out”. Banks create deposits when they lend: every time a bank lends, therefore, the RRR forces it to increase cash reserves at the central bank by a percentage of the value of the newly created deposit. Clearly, the higher the RRR, the greater the proportion of the balance sheet that is made up of reserves, and the less room there is for other loans. This is how raising reserve requirements discourages bank lending. China makes extensive use of the RRR to control bank lending. 

If the RRR were raised to 100%, banks would have to obtain new reserves from the central bank in advance of lending to ensure that the new deposit was immediately matched 100% by reserves: the new loan asset would be matched by capital or by forms of debt not subject to the RRR. This is “full reserve lending”. Strict "full reserve lending" or "narrow banking" should therefore perhaps be called "full capital lending". 

Historically, central banks have tended to use the RRR to lean against banks’ tendency to over-lend in good times. But since banks’ balance sheets are currently stuffed with excess reserves, the CCB is now a more effective measure.

The CCB is not a “reserve” built up in good times that can be “drawn down in more challenging times”. It is an additional capital requirement that regulators can add to or deduct from the basic Common Equity Tier1 capital requirement, depending on the state of the economy and the behaviour of banks. The European Commission explains it thus:
As the name indicates, the purpose of this buffer is to counteract the effects of the economic cycle on banks’ lending activity, thus making the supply of credit less volatile and possibly even reduce the probability of credit bubbles or crunches. It works as follows: in good times, i.e. where an economy is booming and credit growth is strong, it requires a bank to have an additional amount of CET1 capital. This prevents that credit becomes too cheap (there is a cost to the capital that a bank must have) and that banks lend too much.
When the economic cycle turns, and economic activity slows down or even contracts, this buffer can be “released” (i.e. the bank is no longer required to have the additional capital). This allows the bank to keep lending to the real economy or at least reduce its lending by less than would otherwise be the case.
So the purpose of the CCB is to dampen credit booms and busts.

Bank lending amplifies the natural business cycle, and as we have seen in recent years, can cause disastrous credit crunches and major crashes. Banks enthusiastically lend more and take more risk when times are good, then cut back hard when there is a downturn. As lending increases, the total size of the balance sheet increases but the proportion of equity to total assets (leverage) diminishes. And as banks “risk up”, the proportion of equity to risk-weighted assets (capital ratio) also diminishes. Conversely, when banks cut back, capital ratios rise precipitously. The CCB therefore “leans against” the tendency of capital and leverage ratios to reduce in good times and rise in bad times.

More importantly, the CCB influences lending activity. Banks profit from the spread between the return on their assets and their cost of funds. Equity funding is more expensive than debt, not least because of preferential tax treatment of debt. Increasing the CCB therefore raises banks’ funding cost, forcing them to raise rates to borrowers and/or tighten credit standards. Conversely, the CCB can be reduced in a downturn, lowering banks’ funding cost and therefore encouraging them to reduce interest rates and relax credit standards. 

This, of course, explains why banks complain about the CCB. After all, raising their cost of funding by forcing them to use equity instead of debt hurts their profits, poor darlings, and makes them less willing to lend. That, Caroline, is its purpose. 

Related reading:

The equivalence of debt and equity
Anatomy of a bank run
Cleaning up the mess
Liquidity matters
Bank capital and liquidity - Bank of England
CRD IV: Frequently asked questions - European Commission
The Bankers' New Clothes - Admati & Hellwig (book)

I've expanded the section on Tier1 and Tier2 capital slightly after complaints from some readers that it was over-simplified in the original version of this post. However, I've still kept it simple and have deliberately not gone into detail about the additional capital layers in CRD IV, of which the CCB is one. For a more detailed explanation of CRD IV regulatory capital structure, please read the European Commission's Q&A in the links above.  


  1. Interest expense on debt/deposits hurts profits directly. There is no interest or any other required expense on equity and dividends do not hurt profits. CCB is equity and therefore its increase, everything else equal, increases profits because external financing and its costs go down. (Also assuming that the issued debt becomes safer due to higher equity the credit premium on it should go down increasing margin and profits even more). Of course everything is normally not equal but the argument remains.

    Banks complain about their internally required ROE for "profitable" business.

    1. Hmm, not quite that simple. Shareholders expect dividends - which do not attract tax relief, unlike debt interest payments - and share issues are expensive. So is periodically revaluing shares in issue to fair value. And shareholders don't like having their holdings diluted. RoE is not just an "internal requirement". It directly affects share prices.

      The tax shield on debt gives debt financing a considerable advantage, and not just for banks.

    2. Surely not that simple. However your line of thinking is very textbook-ish (sorry). Shareholders (as a class) don't expect anything. If they don't like the share, they sell it for whatever reasons. Low dividend yield, low growth prospects, poor management, portfolio rebalancing. Whatever. At the end of the day there are dividend stocks and growth stocks and all types of investors. One sells and another buys for whatever reasons.

      RoE in lending is purely internal and random. Assets (e.g. where RoE is relevant as a profitability cut-off) is just one source of bank earnings. The others being fees (in principle risk free income, i.e. RoE is infinite), liabilities (generally no RoE defined there), ALM (getting a bit tricky but still no clear cut RoE). So depending on the business model and strategy, the resulting RoE for lending is absolutely artificial for any given bank. In fact one can run a bank with negative RoE on lending and still make decent money.

    3. Treasury and ALM should not be run as profit centres - that is the mistake made by HBOS. Any profits made on funding and book mismatches are purely incidental. Banks' main source of income is net interest margin, though I agree they can and do earn fees as well. This is not "textbook-y", this is how banks work.

    4. Unfortunately you are very wrong. Contribution margins, structural contribution, FTP, interest rate risk, etc. THIS is how the banks work in this world.

    5. No, I'm not wrong, unless your definition of "bank" is different from mine. I look at a lot of bank P&L statements. The single biggest source of income is always net interest income, by a long way.

  2. Sorry but you still missed the point of my reply at 18:56.

    When I look at some real banks' internal operations I can oftentimes see ALM making a quarter of total NII. Nothing special, regular top100 European banks.

    1. But increasing NII is the whole purpose of ALM. All you are doing is drilling down to a lower level of segmentation. Obviously banks aim to manage their balance sheets in such a way as to maximise income.

      Look, I've done ALM work myself in a large bank (well, more than one, actually). I know what it's about. Believe me, I am not simply spouting theory.

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  4. Textbook-ish? And why it would be bad if this is true? In any case, it is the stuff on which Basilea requirements are made. I thank Ms Coppola to explain so clearly.

  5. On my more cynical days I suspect banks of lobbying for depositors to made the first port of call during a run namely the bail in. Not official I know and a last resort as enacted. bill40

  6. One small technical comment: some of Tier 1 is debt like: Cocos and the like.
    It would be interesting to see an explicit CCB, rather than it just being hidden in the Pillar 2 process

    1. "Common Equity Tier1" is, as the name suggests, common equity, not debt. However, some undated subordinated debt forms part of "Additional Tier1". This would most likely be preference shares. Term subordinated debt such as CoCos is Tier2.

      The CCB is explicit.

  7. Nice explainer article, thank you.
    One question: you say that a 100% RRR would require banks to obtain additional reserves *before* issuing new loans. As I see this, it would be basically a >100% RRR with banks carrying a stock of excess reserves against which they can make loans rather than a mechanism of identifying a profitable new loan and then obtaining necessary reserves by overnight close of play. So are you saying a hypothetical increase to 100% RRR would fundamentally change the mechanism of bank loan issuance? i.e the CB would control via the quantity of reserves rather than the price?
    In this regard I don't like the conclusion of the BoE paper which implies a loanable funds model of banking.

    1. This comment has been removed by the author.

    2. Holding excess reserves as a precautionary buffer to prevent required reserves dropping below 100% on lending is the same as obtaining reserves in advance of lending.

      The CB controls price by controlling the quantity of reserves. When there are excess reserves in the system, the means by which it controls the quantity of reserves in circulation changes. I've written about that here:

      I think you may have misunderstood the BoE's paper. The BoE is very well aware of endogenous money. It wrote the definitive piece on it:

    3. Thanks I'll check out your Forbes stuff.
      I'm certainly aware of the BoE money creation paper (different authors to the capital/liquidity)
      It's just that first sentence of the conclusion in the capital/liquidity paper:
      "A key function of banks is to channel savers’ deposits to
      people that wish to borrow. "
      Is that something you would write?

    4. No, it isn't. I missed that. Lack of joined-up thinking at the Bank, seemingly.

  8. Two things:

    First, this is the FT writing for the FT readership. They do not have to explain all the terms with each article, as you kindly do for your readers, who possibly do not read the FT.

    To say that they have to build up a buffer in capital (=equity=shareholders' funds) and draw it down in good times, is a short-hand good description of what would happen if a countercyclical capital buffer was introduced. Everybody who reads the FT will know what is meant.

    Now, clearly the Bank of England is interested first and foremost in the risk to the banking system as a whole, and therefore to build up a buffer, by adding to the equity base of the bank, in good times is a good idea, before "writing off bad loans" in bad times wipe this increase in capital out.

    Now, of course banks have to "build up" the capital buffer, how else are you going to increase the capital if not by building it up?

    What that means in detail, they cannot pay profits out to shareholders, or pay themselves such high bonuses, or shrink their balance sheet (stop giving out new loans after old loans repaid) if they have a legal obligation to build up a buffer.

    These profits, now retained in additional capital, (or "build-up" as additional capital) will still belong to the shareholders. But they are not paid out to them, as dividends; neither are they paid out to the managers, in bonuses.

    Now clearly, shrinking the balance sheet is a very expensive way to increase the capital buffer, as the bigger the balance sheet, the bigger your profits.


    Even if the cost of equity is high (compared to funding with loan finance taken out by the bank), it will make sense to increase the equity if the bank is then able to make more loans and increase its assets.

    So (simplified) if it costs the bank 5% for additional equity (which is the dividend it pays on equity), and it can make new loans now at 10% interest, it is good business for the bank.

    The only reason banks' managers' do not like the increase in equity is because it makes the return on equity (profits divided by equity) number smaller. And that is what bank bonuses for executives are very often based on.

    1. I'd take issue with you on one point, Matt. I know the FT, and I have a fair idea of its readership. Honestly, they don't know what "capital" is. The terminology used by the FT's author is highly misleading, which is why I have criticised her.

      Otherwise I pretty much agree with your comments. Particularly the "return on equity" point.

    2. I'm inclined to agree with Matt here. Sure, there will be some people reading the FT who are less familiar with the concepts and therefore struggle with the article, but for anyone involved with this stuff, it's all pretty clear what's meant.

      It even makes sense to talk about being "set aside" here, notwithstanding the BoE's comment on the term. Ordinarily, there's no meaningful way in which capital can be "set aside". However, there is a dynamic here that is important to understand. What we see in boom times is that higher bank profits add to bank capital. This in turn prompts higher lending volumes because, for a bank, capital that is not allocated against RWAs is a wasted resource.

      What the CCB does is to require some of that excess capital to be allocated to the additional buffer, therefore preventing it from being allocated as the regular capital requirement against new assets. This certainly has the feel of capital being "set aside", rather than adding to bank lending capacity (for a given amount of capital), and banks would certainly think about in that way. You could argue about whether that is really technically "setting aside", since the amount involved itself depends on new asset creation, but if you understand what's going on, it's not really an important distinction.