Sieving the alphabet soup of banks’ capital requirements

Less is more, as every good designer knows. When it comes to bank capital’s blueprint, the UK’s top supervisor of lenders has suggested going back to the drawing board. It is a beguiling concept: complexity can bring cost, inhibit scrutiny and facilitate gaming of the system. Sam Woods, a Bank of England deputy governor, instead wants simplified but more swingeing capital requirements for big banks around the world. His ideas are kite-flying rather than formal proposals. Or as he put it, akin to a concept car designed to prompt a conversation rather than be roadworthy. Still, they are worth examining.

A plethora of safety measures were introduced by governments worldwide in the wake of the financial crisis 14 years ago. On top of the minimum capital requirements banks must comply with, a series of buffers were added by the Basel Committee to enable banks to absorb losses and keep lending in times of stress. The idea was to protect the economy from the banks, and the banks from the economy, reducing the likelihood of future taxpayer bailouts. Each buffer was designed to target a particular risk. But there is now concern among some supervisors that the various buffers do not mesh well, even sometimes coming into conflict.

Woods proposes replacing the alphabet soup of buffers — with abbreviations like CCyB, CCoB and Sifi — with a single, blunter one. Crucially, he would force banks to build this with purer equity of common stock and cash rather than hybrid instruments currently allowed. He also wants to retain today’s mix of weighting assets by their riskiness, as well as the leverage ratio that measures equity against total assets.

There should not be any move to reduce banks’ overall amount of capital; some indeed argue it is not high enough. But consolidation of the buffers, which could amplify their positive effects when released, is an idea with merit.

The caveat is that his vision, if it is to work safely, would require intense regulatory scrutiny and intervention; arguably much more than today. The BoE traditionally favours simplicity paired with discretion — the famous raise of the governor’s eyebrow — but the system is only as good as its supervisors. Woods acknowledges that under his vision, the intensity of balance sheet stress-testing would probably increase. This is already a time-consuming exercise that in the UK is done once a year (and which all lenders have passed of late).

Woods’ blueprint has some shortcomings. The first is that the proposed buffer release, to help maintain lending in times of stress, would leave only a “low level” of minimum capital. But what if a second stress played out immediately after a first: a war, for example, right after a pandemic? Another flaw is that it is market forces rather than regulatory pressure that banks feel most acutely. That will not be readily fixed by favouring a brutalist rather than baroque capital stack. Banks fear the stigma of depleting buffers because of what that might signal to the wider market. No bank wants to raise a red flag.

There are no easy solutions. One possible remedy is to better bolster resolution regimes. Since the crisis, effort has gone into establishing how to resolve or let big banks fail safely. They must have “gone concern” capital alongside going-concern buffers. This is meant to put creditors on the hook through “bailing in” debt rather than calling on a government bailout. But the appetite for bail-in, which could bring its own economic maelstrom, is untested.

Ideas for simplification are welcome. But with economic headwinds blowing hard, now is not the time for this kind of reform. Which means banks and their supervisors will be stirring their alphabet soup for a while longer.