The powers that be of the Basel Committee on Banking Supervision have now decided: seven is the new golden number. That is a 7% tier-one capitalisation ratio to be phased in by 2018.

Tier-1 Capitalisation Stress tests from recent CEBS modelling

The Recent CEBS modelling of tier-one capitalisation noted that even in 'worse' case scenario we should still be above 7%, pretty convenient actually...
Source © 2010

For those curious on what 7% actually means:

Well, it technically means that all banks should have 7% of unencumbered capital available to absorb short-term losses and calls on its reserves: ie. that there must be at least 7% of their assets, available in cash or cash-like securities, for write-downs or a sudden unexpected withdrawal from the bank’s deposit base and short-term financing window (ie a run on the bank).

This number is of primary concern to the banking-folks as it directly impacts their capitalisation ratios and performance metrics: the more cash allocated as reserves, the less can be set towards loans or other investments, and therefore the bigger the hit on their performance margins as a result.

Now, the big question is why 7 and is 7 enough? Well, there are seven days in a week, and the current rate was 2% so they have increased it by 250%, which sounds like a lot, and Snow White did have seven dwarfs, so I suppose… Oh and then there were 7 banks that recently missed out on the stringent Committee of European Bank Supervisors stress tests. And, on that report again, do note that 7% is still much lower than the current aggregate shock-tested capitalisation ratios submitted under the test for systemic shock review, in other words most European banks should still exceed this fabled number.

The Golden Ratio

It’s a tricky thing, this tier-one, and it doesn’t really answer all the questions as liquidity is not the easiest thing to define. In most countries, keeping some of that seven percent in government securities might sound reasonably prudent. But what if that country is undergoing a sudden currency/rating crisis (e.g. Portugal, Italy/Ireland, Greece and Spain)? Is that seven percent then still available? Do you need to prop it up if the securities are marked-to-market down at 70% of par? Does that mean you need to increase your tier one up by another 42.9%? Difficult to do when times are rough….

The biggest catch with these ratios, and that’s where regulators really get their headache from, is that the write-down on share valuations (read share market price or short-term financing yields) over banks is largely due to an expectation of increased cashflow discounts due to write-downs or other activities: ie future reduced earnings. This in turn then makes it increasingly expensive for banks to raise capital to meet their needs. Also note that up to this point, nobody is questioning, per se, a bank’s solvency.

However, once the situation becomes that a bank can no longer afford to raise capital due to the reduced expectation of future earnings, they then come under the risk of becoming ‘insolvent’ or at the least of becoming undercapitalised (ie not meeting their regulatory Tier One obligations). But an increased Tier-One ratio then presupposes a higher capital cost, ergo reduced margins, ergo more expensive capital, ergo harder to raise capital and meet ‘solvency’ requirements. (For a recent rundown of such a nightmare scenario, see my recent post Retrospective Extremity: Insights from the FCIC hearings)

So our regulators have increased Tier-One ratios when we know this can increase insolvency risk… Hmm, okay…

Welcome to the Catch-22 of banking finance: not enough capital and you get caught out, raise minimum capital standards and you increase the risk of being unable to raise capital in times of need, and you get caught out.

I must say, I much prefer being an outside commentator rather than a Basel Committee member. It is worth noting, however, that the Basel group wisely decided to grant 8 years before these requirements come into effect, allowing a gradual build-up towards the new regulatory environment.

One Response to “It’s Decided: 7 is the New Golden Number (and not the new Catch 22)”

  1. Tariq:

    You seem to be saying that Basel III is a crock. If so, I agree.

    I think beefing up bank capital is an all too logical sounding act, but it simply won’t address the temptation to over-leverage in ways that are hard to spot.

    Derivatives are a market where the “players” most easily lose sight of what I might describe as “real economy” needs. And derivatives certainly played a major part in the 2007-2008 collapse. What scares many is that, after a period of contraction in that set of markets, the “players” who were attracted to them are at it again, and I can’t see either Bank capital regulations or any regulations ever being rigorously enough applied to curb such “players” propensity not only to get themselves into trouble but to get all of us into trouble chasing mirages while the real problems simply don’t get attention.

    If this makes any sense to you, would you be willing to review a 2-pager I have written to gain the attention of the IMF and other international bodies for whom a consensus has yet to form on “the problem of derivatives”. If so, here’s its URL:

    Thanks for your attention.


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