Capital: How much is enough?

Because there was little internal debate within the central banking FSB and BCBS

membership over the need for increased capital minimums, due to the common agreed policy narrative which saw a lack of capital as a root cause of the crisis, the reform debate in 2009- 2010 centred instead on metrics, on the level and type of capital required, and the length of the phase-in period, not on whether higher capital was required. The Basel III Accord resulted from intensive FSB-BCBS negotiations and pitted those arguing for a tough

approach (higher capital, tougher definitions, and a short phase-in) against those in favour of a weaker response (lower base capital levels and a long phase-in). The battle is one of hawks versus doves (Interviews 5 and 7, 2011).

Negotiations and discussions took place in the FSB, in the GHOS, in BCBS formal processes, and in informal discussions at the margins of Bank for International Settlements (BIS)

meetings in 2009 and 2010 (Interview 7, 2011). Just as the conceptualization of the FSB occurred in informal and formal meetings, so too, agreement on the Basel accord was facilitated by a series of informal gatherings supporting the formal process.

On one side of the debate were the hawks, including central bankers from Switzerland, the UK, Spain, the U.S., and emerging markets. Philipp Hildebrand, then Chairman of the Swiss National Bank, pushed for high base capital levels (Interview 7, 2011). UK regulators, including Adair Turner, Paul Tucker, and Mervyn King, were also unambiguous in their support of higher capital standards. Spanish central bankers, who already applied relatively strict prudential oversight and banking regulations domestically on big banks, also pressed for a strong accord, joined by Jaime Caruana, General Manager of the BIS. Canada’s Mark Carney was also supportive of tough core standards (Interview 19, 2012).

Within the U.S., the view was more complicated. Leaders in the U.S. Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC) all strongly supported higher capital standards (Bair, 2011, pp. 257-64; Geithner, 2011; Tarullo, 2011b, pp. 2-3). But the principal bank regulator, the Office of the Comptroller of the Currency, which was led by a Republican (Walsh, 2011), sided with banks and resisted higher standards. Congress,

meanwhile, switched from pro-reform under the Democrats to hostile to regulation under the Republicans in 2010.

On the other side of the debate were the doves, arguing for a weaker accord, including German, French, and Japanese central bankers and supervisors (Bair, 2012, p. 260). Each country had its own reasons. German supervisors worried that too strict a Basel III deal on capital could adversely impact their Landesbanks and other German financial institutions that could need major capital infusions to comply with a new accord. French regulators,

meanwhile, viewed the financial crisis as an America disease transmitted nefariously to Europe, and feared the impact on their large universal banks. They therefore argued in favour of lower capital minimums. Both countries’ banks were in a weak capital condition post- crisis and were heavily exposed to the Eurozone sovereign debt crisis that erupted in 2011. Japan, although its banks weathered the storm well, sided with the doves.

Importantly, emerging market voices were strongly in favour of higher capital. European and North American hawks were backed by tough stances from Singapore, Hong Kong, China, and India (Interview 7, 2011; Bair, 2012, p. 263). Emerging-country FSB members were in agreement with the general aims of the Basel III Accord. In fact, Asian states had been implementing similar policies for years (G30, 2010); China and key Asia G20 emerging countries viewed the new accord as a move towards, not away from, their own policy proscriptions (and national regulatory approaches) of tighter state control over the financial sector. They were content to go along with standards lower than their own domestic position.

In this manner, the new Western paradigm and consensus moved towards the emerging countries’ position on capital and liquidity.

The end result was a multifaceted accord with a significant increase in minimum (risk- weighted) capital levels coupled to a long phase-in period. It was a compromise which gave something to both sides. Influential and persuasive roles were played by Mario Draghi as Chair of the FSB, and Jean-Claude Trichet, President of the European Central Bank, who helped bridge the gap between the hawks and the doves, pushing the latter towards a deal (Interview 15, 2012). The agreement finally unveiled was, according to Geithner, ‘critical to making the financial system more stable and more resilient’ (Geithner, 2011, p. 4). Trichet called it ‘a cornerstone of the new regulatory system’ (Trichet, 2010b, p. 3). Caruana lauded its ‘fundamental strengthening – in some cases, a radical overhaul – of global capital

standards ... [which] deliver on the core of the global financial reform agenda’ (Caruana, 2010, p. 6). The Basel III components are as follows and are summarized in Chart 5.2:

 A qualitatively strengthened definition of risk-based capital and an increase in the minimum level of core equity capital from 2 percent to 4.5 percent.

 A conservation buffer, to absorb losses in periods of stress, of 2.5 percent of risk- based capital, for a total minimum of 7 percent.

 The adoption of a countercyclical buffer of zero to 2.5 percent, to be increased when an economy is booming and drawn down when an economy contracts (based on the Spanish model).

 A capital surcharge (of zero to 2.5 percent) levied against the world’s largest banks (so-called global systemically important financial institutions [GSIFIs]), depending on size, risk, interconnectedness, and other factors which raise these institution’s riskiness to the system as a whole. The capital used would be common equity capital (BIS, 2011), a victory for those seeking real equity rather than other less liquid forms of contingent capital.

 A leverage ratio of 3 percent to capture risk behaviour and to monitor and limit it. Constraining leverage is key. As Turner observes: ‘There is simply no good theoretical argument or empirical evidence that we need to run banking systems with anything like as highly leverage as over recent decades’ (Turner, 2011 p. 6). A leverage ratio seeks to address this.

 A liquidity coverage ratio, to address the need for highly liquid assets in times of credit shortage.

 A net stable funding ratio to provide further strength to the institutions when they face stress.

Note: GSIFI = global systemically important financial institutions. Figure 5.3 Basel III Components

The Basel III Accord resulted in increases in capital over the previous regime—up to a 7 percent base (a 4.5 percent common equity and a 2.5 percent capital conservation buffer) from a 1 percent functional level pre-crisis (Carney, 2011; Caruana, 2010). It was hoped that this sevenfold increase in base capital would strengthen firms and reduce risk taking, and thus also reduce the severity of boom and bust cycles in the future.

The accord included further capital requirements such as the countercyclical buffer, to be built up during periods of excess credit growth associated with increases in system-wide risk and drawn down in periods of stress. It includes a ‘GSIFI surcharge’, which was very

contentious (Interview 7, 2011), requiring the largest firms to hold more core equity capital, up to 2.5 percent extra normally, with an additional 1.0 percent for firms that grow

GSIFI surcharge, but failed to halt the drive for higher capital for the largest firms. Total risk- based and common equity capital will amount to more than 10.5 percent by January 1, 2019.

Taken together, the provisions are a declaration by regulators that the very largest financial interconnected and complex institutions pose inherently more systemic risk to the global economy (Drehmann and Tarashev, 2011; Haldane, 2010a; Haldane and May, 2011). This view amongst politicians and regulators has solidified since 2010 (Bair, Brown and

Huntsman, 2012; Federal Reserve Bank of Dallas, 2012; Haldane, 2012b).

Other mechanisms to provide further stability and resilience against firm-level risk-taking behaviour include a leverage ratio, a liquidity coverage ratio, and a net stable funding ratio. These tools are designed to complement the effect of higher capital. Limits on leverage will add a brake on risk taking. Liquidity and funding ratios are designed to ensure that when a credit crunch occurs, banks have resources available to continue to operate and fund themselves (they did not possess sufficient liquid assets in 2007-2008). When and if these firms take excessive risk, the new tools and mechanisms should aid in raising supervisory red flags in advance of systemic problems.