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The writer is a founding partner of Veritum Partners
What do Silicon Valley Bank, Credit Suisse, Citigroup and Royal Bank of Scotland all have in common? If you guessed the answer as “they failed and had to be rescued by their competitors or by their governments” then you would be correct. But there was one other thing they had in common; strong capital ratios at the time of their failure, well above the level their regulators demanded. This is a useful reminder that for all the talk about how much capital banks need, a great deal of the discussion simply misses the point.
The argument has come alive again over the past few months, fired by proposed changes to the rules governing bank capital that look set to hit US banks especially severely. There has been extensive debate about how much capital banks need. The US banks have lobbied furiously in Washington and in the media, arguing not only that more capital is unnecessary but that lending to “hard working families and small businesses” will simply dry up if the rules are implemented as drafted.
Others claim the opposite, citing research that the more capital banks have, the more they will lend. Some question the true agenda of banks, claiming the real problem is that more capital means lower returns on capital, which therefore means lower executive pay.
This debate misses the point of bank regulation. It is not to stuff banks with so much capital that they cannot fail. Instead, it is to create a banking system that has the appropriate level of risk.
Capital is only one input into that risk assessment, and arguably it is a relatively small one. Silicon Valley Bank failed due to mismanagement of interest rate risk. Credit Suisse failed due to its structurally unprofitable business model. Citigroup and Royal Bank of Scotland failed due to weak credit and market risk underwriting. The only thing that their level of capital determined was how quickly they collapsed.
Given the poor history of capital levels as a predictor of bank failure, regulators owe it to both banks and those who use them to actively embrace more innovative measures. One idea — floated several years ago by Andy Haldane (then at the Bank of England) — was to monitor a “market-based” capital ratio, whereby the calculation of capital wasn’t the number shown in the accounts but the stock market value of the bank.
In the case of Credit Suisse, Citigroup and Royal Bank of Scotland, their market-based capital ratios would have been screaming red for more than a year before their collapse. Of course, such an approach might be open to market manipulation, but as an input into regulation it would be a great addition.
Even more proactively, regulators would do well to actively factor in the culture of the bank and make specific demands on those whose “culture ratio” was weak. Calculating such a ratio isn’t easy, but that doesn’t mean it’s not worth doing. The prize could be enormous.
For example, there is evidence that having gender diversity on risk committees improves risk outcomes. Perhaps Harriet Harman, the former deputy leader of the UK Labour party, was right when she claimed that Lehman Brothers might not have gone bust in 2008 if it had been Lehman Sisters. Maybe regulators should penalise or reward banks based on their risk committee gender diversity?
Thought experiments aside, the overarching point is that the traditional capital ratio is too clunky, imprecise and is often misleading as a metric for bank regulators to place so much reliance upon. It has a role to play, but those commentators who claim that ever more capital is a panacea are misguided, while banks that argue they are already safe with their current capital level are foolish.
Regulators owe it to all of us to focus on actively developing much more sophisticated measures for keeping the system safe.