Bank capital and cryptocurrencies

The BIS's draft proposals for capital regulation of stablecoins and cryptocurrencies have just been released. The headline proposal was a risk weighting of 1250% for what the BIS called "Group 2 cryptoassets", which includes all cryptocurrencies, all algorithmic stablecoins, and reserved stablecoins  that don't meet the capital, liquidity and disclosure requirements for "Group 1 cryptoassets" specified in the same document. Bitcoin and Ethereum, the two major cryptocurrencies, would fall into Group 2, along with most (possibly all) existing stablecoins. 

The proposals were widely misunderstood in the crypto community. As ever, much of the misunderstanding was about the nature of bank capital. 

Many people confuse bank capital with reserves. Reserves are cash deposits at the central bank and vaulted currency. They enable customers to withdraw cash and make payments out of their deposit accounts. Without them, banks would have to go to the market for funding every time a customer withdrew money from their account. 

Banks famously don't keep enough reserves to enable all customers to withdraw all their funds all at the same time. Reserve requirements aim to ensure that a bank has sufficient liquidity to meet normal payment requests. The proportion of reserves to deposits that regulators require banks to keep is called the "reserve requirement", and it varies from jurisdiction to jurisdiction and in some cases even from bank to bank. 

The most famous reserve requirement is the Federal Reserve's 10% of eligible deposits, which is the foundation of the well-known "money multiplier" model of bank lending. Sadly, it is no more. It was abolished in March 2020, superseded by the Basel Committee's liquidity regulations and additional Federal regulations such as living wills, and rendered obsolete anyway by the enormous excess reserve balances banks are carrying because of QE.

But although fewer countries have formal reserve requirements now, banks these days are far more liquid than they were prior to the 2008 financial crisis. The risk that they will literally run out of money and have to close their doors is much lower than it was at the time of the run on Northern Rock. 

Banks also have far more capital than they had before the 2008 financial crisis. But capital is not about liquidity. It's about solvency. Capital requirements aim to ensure that banks don't become insolvent when asset prices fall or borrowers default. The whole point is to prevent any repeat of the taxpayer bailouts of 2008. I'm astonished how many people don't seem to know this.

Capital is on the opposite side of the balance sheet from reserves. This is the basic balance sheet equation: 

Assets = Liabilities + equity

Equity is not cash or assets. It is the difference between total assets and total liabilities. It is typically made up of shareholders' funds, retained earnings and  general provisions. Bank "capital" is equity plus certain types of subordinated and convertible debt. 

Bank capital is often called "loss-absorbing" capital. This means that in the event of asset prices collapsing or bank loans defaulting, the bank's shareholders and junior bondholders bear the  losses, not depositors, senior creditors or taxpayers.* You could regard it as a form of collateral.

If a bank doesn't have enough capital to meet regulatory requirements for the assets it holds, it must either dispose of some of the riskier assets or raise additional capital. Raising capital could mean rights issues and/or issuing convertible bonds or some forms of subordinated debt. Deposits are not capital, and neither are senior bonds. Importantly, convertible and subordinated debt generally doesn't count towards the bank's core Tier 1 capital, the capital that is first in line to take losses. Banks can't borrow their way out of insolvency. 

Now to the Basel Committee's proposed capital requirements for crypto assets. The committee divides crypto assets into two groups: 

  • Group 1: tokenised assets (Group 1a) and fully reserved stablecoins (Group 1b). The committee proposes a draft regulatory framework for these assets. 
  • Group 2: cryptocurrencies, algorithmic stablecoins, and reserved stablecoins that don't meet the capital, liquidity and disclosure requirements for Group 1b.  

The widely-reported 1250% capital weighting applies to Group 2 cryptoassets. The Basel Committee has decided that because cryptocurrencies have no intrinsic value and are highly volatile, the risk of total loss is considerable. Banks must therefore have sufficient capital to ensure that there is no risk of insolvency in the event of a total loss. 

That capital weighting looks wild, but is explained in this footnote to the Basel Committee's paper:


So, for banks that meet the Basel minimum capital requirement, the 1250% weighting is equivalent to 100% equity collateralisation of Group 2 cryptoassets. However, most banks nowadays have more capital than the 8% minimum. For them, the 1250% weighting is overcollateralisation.

To give an example: in 2020, JP Morgan's capital ratio was 13.1%. Applying this to the Basel formula above gives a capital requirement of $163.75 for every $100 of Group 2 cryptoasset exposure. That is significant overcollateralisation.

This capital requirement applies to both short and long positions. There's also a recommendation that supervisors apply an additional capital requirement to short positions because potential losses are unlimited:

These capital requirements are by any standards draconian. They would make it prohibitively expensive for banks to take leveraged positions in cryptocurrencies. This might sound like a good thing - after all, it was excessive leverage that caused the 2008 crash. But for banks, it amounts to banning them from holding or trading crypto on their own account. After all, leveraged position-taking is the entire business model of a bank: even in mundane retail banking, they fund their loan books by borrowing.** If they can't take leveraged positions, there is absolutely no point in holding or trading the asset on their own account. So these proposed regulations therefore amount to banning banks from holding or trading cryptocurrencies or stablecoins that don't meet Group 1 criteria.

And in case this isn't clear enough, the BIS also gives supervisors the option of actually banning banks from holding or trading crypto on their own account: 

Image

So we can summarise the BIS's proposals regarding banks holding or trading cryptocurrencies and unregulated stablecoins on their own account thus:

"Don't do it. But if you do, put your own money at risk - not other people's."

But these regulations would not prevent banks acting as custodian for crypto assets, as some in the crypto community seem to think. Nor would they prevent banks holding and trading crypto on behalf of clients. They are only concerned with banks' own-account activities. Proprietary trading, as it is usually known.  

These regulations also wouldn't prevent regulated banks acting as settlement banks for the fiat side of crypto transactions. However, AML/KYC regulations could still make this problematic.

So, draconian though these proposed capital requirements are, they wouldn't completely prevent banks from participating in the crypto space. They could still offer custody, asset management and settlement services for Group 2 cryptoassets. And the regulatory framework for Group 1 cryptoassets potentially opens the door to regulated stablecoins and tokenised assets becoming a regular part of the global financial system.The Basel committee specifically excludes central bank digital currencies from the scope of its proposals, but this regulatory framework could enable commercial banks to hold, trade and issue fully-reserved stablecoins.

Crypto is coming in from the cold. 


Related reading:

Reserve confusion

Capital, liquidity and the countercyclical buffer, in plain English

Liquidity matters

The equivalence of debt and equity

Cocos and bank capital: a belated explainer

Consultative document: prudential treatment of cryptoasset exposures - BIS (pdf)

Discussion paper: designing a prudential treatment for cryptoassets - BIS (pdf)

* I have considerably simplified capital requirements for the purposes of this post. In practice, losses might not be borne entirely by shareholders: subordinated debt holders might also suffer losses, and under some circumstances, holders of convertible bonds ("cocos") can bear losses before shareholders are affected.

** Yes, I know banks create deposits when they lend. Deposits, even those created in the course of lending, are loans to the bank. Furthermore, when deposits created in the course of lending are drawn down, the bank must borrow to close the balance sheet gap. Loan books are therefore leveraged. 

Comments

  1. Bit of confusion here. You've said that "capital is equity plus other types of subordinated debt", and since Equity = Assets - Liabilities, total capital is

    Capital = Assets - Liabilities + ("other types of subordinated debt")

    Then you say "If a bank doesn't have enough capital to meet regulatory requirements for the assets it holds, it must either dispose of some of the assets or raise additional capital".

    But by the above formula, disposing of assets reduces capital further. Am I confusing something?

    ReplyDelete
    Replies
    1. This comment has been removed by the author.

      Delete
    2. Capital requirements depend on the risk of the assets - indeed that's what this post is about. So if a bank doesn't have enough capital for the risky assets it holds, it must either raise more capital or divest the assets. Although divesting reduces total assets and hence increases leverage (which is not weighted for risk), it actually reduces the capital requirement because the proportion of risky assets in the balance sheet reduces.

      Delete
    3. Disposing assets has no impact on capital unless you sell at a discount to book value, in which case a loss is crystallised and capital is reduced by the same amount.

      In the case Frances mentions (where a bank does not have the capital to meet its regulatory requirements), a bank can sell assets to reduce its capital requirements.

      Frances, I’m not sure on your point that divesting assets increasing leverage. Leverage is constant if you sell assets and do nothing (cash replaces assets). If you sell assets and use the proceeds to repay liabilities, then leverage falls, as the debt:equity ratio falls.

      Delete
    4. Yes, you're right, James. Leverage is either constant or falling. My mistake.

      Delete
  2. Jerred Seisyll, I have removed your comment because it consisted largely of personal attacks on me. May I remind you of the comments policy on this blog:

    - Be polite and refrain from personal attacks on me or others
    - Stick to the topic of the post.

    I will delete posts that do not conform to these rules.

    ReplyDelete

Post a Comment

Popular posts from this blog

The high price of dollar safety

JP Morgan's Coffee Machine

From Carbon To Metals: the Renewable Energy Transition