Further to Narrow Banking Theory, an alternative concept is to impose Capital and Liquidity requirements on financial institutions that are systemically important. A banks balance sheet is characterised by three features, Low cash to assets, Low capital to assets and a maturity mismatch. As a result of this at any one point a bank will never hold sufficient cash reserves to honour the convertibility guarantee.119 Capital requirements have become the principal regulatory response to
resolve the problem of the bank’s balance sheet structure.120
Capital requirements are restrictions put in place by financial regulators for banks and other depository institutions, which determines how much liquidity is required to be held for a certain level of assets. These requirements imposed to ensure that these institutions are not participating or holding investments that increase the risk of default, and that they have enough capital to sustain operating losses, while still honouring withdrawals. The minimum capital is specified as a percentage of the risk-weighted assets of the bank.
Prior to the financial crisis no national regulator sought to monitor the capital liquidity levels of banks deemed systemically important differently from those that were not. Although no legislative impositions had been placed upon systemically important institutions, a general capital requirement had been introduced into the UK financial sector by the Bank for International Settlements in
Basel.121 The rules implemented an amended document known as Basel I; this originally set a ratio of
capital to assets of 8%. Further amendments to the 1988 Accord were first published in 2004, known as Basel II122 the provisions eventually superseded Basel I in 2006. The intention of the amendments
were not to raise or lower the overall level of regulatory capital held by banks, but instead to ensure the provisions were more risk sensitive by the encouraging the use of internal systems for measuring risks and allocating capital. It did this by offering more complex models for calculating regulatory capital. In essence it stated that banks holding riskier assets should be required to have more capital on hand than those maintaining safer portfolios.
119 Lastra (n 1) 226.
120 ibid.
121 Enacted in the EU under Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investment firms and credit institutions [1993] OJ L 141/1.
42 | P a g e The three essential requirements of Basel II were:
1. Mandating that capital allocations by institutional managers are more risk sensitive. 2. Separating credit risks from operational risks and quantifying both.
3. Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.
So although it is clear that there are already some capital and liquidity requirements in place the real question is whether increasing capital and/or liquidity requirements would reduce or solve
completely the problems of systemically important institutions that are too big to fail. Following the crisis there has been a clear belief in the benefits of increasing both capital and liquidity requirements.123 The arguments focus on the belief that if a bank is highly capitalised and
with greater levels of liquidity, then the likelihood of them failing, or coming close to failure is greatly reduced.124Turner in particular was clearly in favour of increasing capital ratios as he saw the
benefits greatly outstrip the costs.
Turner considered that when banks held greater capital levels then they were much less likely, in the face of economic downturn, to have to reduce lending to conserve capital.125Further to this he
believed that with an increase in liquidity standard it may counteract the boom-bust cycles of markets as Banks facing tougher liquidity standards are less able to grow rapidly in boom years and less likely to have to contract lending to conserve liquidity in the face of collapsing
confidence.126Turner went as far as demanding such increases in standards:
‘The direction of travel is clear: the overall level of capital require in the banking system must be significantly increased over time, while liquidity standards must be significantly tightened. These changes are required to create a more stable financial system for the long-term: the challenge now is to determine the precise long-term objective and the appropriate transition path.’127
123 See for example BCBC, An assessment of long-term economic impact of stronger capital and liquidity
requirements (BCBC, August 2010).
124 Turner Review, The Turner Review: A regulatory response to the global banking crisis (FSA, March 2009) 4.8. 125 FSA, Turner Review Conference Discussion Paper: A regulatory response to the global banking crisis:
systemically important banks and assessing the cumulative impact (FSA, DP 09/4 October 2009) 18. 126 ibid 32, 4.8.
43 | P a g e It is the belief in the increase in stability that drove Lord Turner to these remarks; his beliefs were supported by other important bodies. The BCBC also found that increasing capital and liquidity requirements reduced both the likelihood and severity of crises.128
Although it would appear there are significant benefits to increasing capital liquidity levels, which have been supported by preeminent legal and economic theorists, it is not without some drawbacks. Even prior to the financial crisis there had been much criticism of Basel II with some believing it to have been too costly to implement, complex to understand and prescriptive in its numerous
recommendations.129 Further to this capital is extremely costly and holding more capital means less
of a return on equity for banks. Capital that is held in reserve offers a direct detriment to economic output as it may constrain investments which may be required to achieve a sustainable growth rate in line with technical change and population growth.130 Consequently in both the short and long run
this will increase the cost of bank credit.131 So much so one calculation claims that ‘for a large bank
with risk weighted assets of Euro 500 Bn, cutting the amount of capital by just 0.5 per cent would save Euro 2.5Bn.’132
There have been some studies to assess the severity of the impact of increases in capital adequacy regulations on overall output.133 Studies have shown that in reality there will only be a small increase
in costings, for a 1% increase in capital liquidity ratios overall costs would rise as little as 0.13%. Work in the US has produced similar results; Elliot studied the long-run effect of tightening capital requirements on banks’ lending spreads. His work suggests that there will only be a small effect on companies costs.134 Kashyap, Stein and Hanson also conclude that the long-run costs of increasing
capital requirements are likely to be small.135
These values are all well and good, but alone they are relatively meaningless. It is difficult to tell whether a cost of 0.13% alone would be a justifiable cost to the financial institution to ensure
128 BCBC, (n 123) 8.
129 Lastra (n 1).
130 FSA, Turner Review Conference Discussion Paper: A regulatory response to the global banking crisis:
systemically important banks and assessing the cumulative impact (n 125) para 4.14.
131 BCBC, an assessment of long-term economic impact of stronger capital and liquidity requirements, August 2010 at 4.
132 Suiter, J. ‘Overhaul of banking rules could cost up to Euro 200m’ (2003) Financial times 11th May. 133 BCBC, An assessment of long-term economic impact of stronger capital and liquidity requirements (BCBC, August 2010) 20.
134 Elliot, ‘A further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type.’ (2010) The Brookings Institution.
135 Kashyap et al. ‘An analysis of the impact of substantially heightened capital requirements on large financial institutions.’ (2010) Working Paper, University of Chicago Booth School of Business and Harvard University.
44 | P a g e greater systemic stabilisation. A better indication of the viability would be a discussion of the overall net benefit that would occur from increasing both capital and/or liquidity values.
Studies have shown that there are clear net benefits of increasing capital ratio requirements over the original 8% capital ratio that was suggested by Basel I and II.136 It must be noted however that
this will not continue exponentially and the incremental net benefits will gradually decline to become negative beyond a certain range.
Although it would appear that increasing capital and/or liquidity levels from their current values would offer some very clear benefits to a financial system this area of research has not been without its critics. Several leading academic figures within financial regulation have voiced some concerns over relying too heavily on capital adequacy changes. Professor Kay in particular was adamant that this type of reform would not be suitable:
‘[F]rankly, in saying we need better rules from Basel is just the familiar story, that when the snake oil does not work, people tell you what you need is more snake oil and there ought to come a point at which we say, ‘Well, I think we’ll try something else instead.’’137
The House of Commons Treasury Select Committee, although in support of the use of capital liquidity ratios, have been slightly reserved in pointing out that it will never create a zero failure system and that ‘capital and liquidity reform will at best ensure a lower probability of default, and a lower loss given the default, for financial firms...However the financial crisis occurred despite repeated attempts to reform capital and liquidity regimes.138
In theory the optimal level of capital and liquidity in the banking system should reflect an optimising trade-off between the benefits of reduced financial instability and the costs which may arise from a higher price or reduced volume of credit extension and maturity transformation.139 Following the
information given above we can clearly see that this trend would lead to an increase in overall capital and possibly liquidity ratios for financial institutions.
136 BCBC, An assessment of long-term economic impact of stronger capital and liquidity requirements (BCBC, August 2010) 30.
137 Treasury Committee, Too important to fail- too important to ignore (HC 2009-10 261-1) 29. 138 ibid 30.
139 FSA, Turner Review Conference Discussion Paper: A regulatory response to the global banking crisis:
45 | P a g e
Systemically Important Institutions
There is a strong case for increasing the levels of capital and/or liquidity ratios within financial institutions as a means to reducing the probability of banks that are ‘too big to fail’ from doing just that. One idea that is being purported along-side a general increase in ratios is the application of the capital(and perhaps liquidity) surcharge to be applied to only systemically important banks, this would of course reduce the probability of them failing but just as importantly would internalise the externality costs which their systemic importance produces. 140
There was a fairly explicit regulatory philosophy embedded in the Basel II capital adequacy regime, which argued that large-scale financial institutions meant diversification and sophistication, and that both could justify lighter capital requirements. Basel II encouraged banks to invest in risk
management and new technologies which in turn under Basel II allowed them to reduce the overall amount of regulatory capital. Using the Advanced Internal Ratings Board (IRB) suggested by Basel II allowed the larger banks to hold capital up to a third lower than standalone standardised
approaches.
There is new evidence that suggests that although diversification may protect a large firm against idiosyncratic risk, similar patterns of diversification by many large firms across the world may make the whole system more fragile.141 It is argued that a large, globally diverse firm may be less likely to
fail than a smaller, national firm concentrated on specific customer and products, but its failure is more likely to occur when the whole global system is in crisis and that consequences of its failure may be more serious. The BBA unsurprisingly do not agree with this theory as they do not consider it to be ‘borne out by the evidence of the recent financial crisis.’142
One idea that has been suggested that may be a form of trade-off between completely restructuring financial institutions and allowing massive institutions to continue to operate in the same way as they currently are is the establishment of a capital surcharge for systemically important banks, this surcharge would be lower for those groups which go further in the direction of clear legal separation of different activities.143 It would then give the institutions themselves the option as to whether they
wished to either restructure or fund a surcharge that could aid in if the institution entered financial difficulties. The FSA purported that this surcharge could be staggered as a continuous and increasing function of measures of systemic importance, avoiding the dangers created by the definition of a
140 ibid 32, 3.54. 141 ibid.
142 BBA, Response to the Turner Review conference paper (BBA, 5th Feb 2010) 9.
46 | P a g e specific threshold of systemic importance. Its result would mean that financial institutions had the opportunity to reduce their systemic importance (possibly by following the narrow banking model) as an alternative to incurring the capital liquidity ratio penalty. There is already evidence of
something similar in effect. In the environmental sector when large scale risks that are taken they often involve substantial externalities, the environmental sector resolve this by imposing a polluter pay principle. By that what is mean is that those that benefit from the risks bear the full cost of their actions including the externalities.144 If we apply that to the too big to fail argument the substantial
externalities that are imposed by large systemically important institutions can be internalised by a capital surcharge.
Basel III
So there are clear benefits to introducing capital liquidity requirements, and it would appear in the immediate aftermath of the GFC governments have attempted to impose tougher capital standards. Internationally the Basel Committee on Banking Supervision felt it necessary to amend the Basel II framework and to replace it with what is now known as Basel III.145Under Basel III further more
stringent capital and liquidity rules have been imposed with the intention of strengthening the banking sector against potential failings. Basel III was implemented into the UK by the Capital Requirements Directive.146It is not the intention of the piece to scrutinise the specific details of Basel
III this has already been commented on by a number of other academics.147 Some consider the new
regulation to be a significant improvement on the current measures, which will lead to a
strengthening of the financial sector,148whilst others are more highly critical of the real impact of
these counter measures.149 There has been some evidence to also suggest that using complex capital
requirements ratios may not necessarily benefit the market.150The commentary on Basel III is
144Hood (n 83) 138.
145 Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for More Resilient Banks
and Banking Systems (Basel: Basel Committee on Banking Supervision, 2010).
146 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC Text with EEA relevance [2013] OJ L 176.
147 See for example Thieffry (n 6), Richard Barfield, Sonja Du Plessis and Patrick Fell, ‘Basel III – implications for risk management and supervision’ (2011) COB 1, or Bart Joosen, ‘Further changes to the Capital Requirements Directive: CRD IV - major overhaul of the current European CRD legislation to adopt the Basel III Accord: (Part 1)’ (2012) JIBLR 45.
148 Barfield ibid 9.
149 Thieffry (n 6) 459 or Orkun Akseli, ‘Securitisation, the financial crisis and the need for effective risk retention’ (2013) EBOR 1.
150 Andy Haldane and Vasileious Madouros, ‘The Dog and the Frisbee’, Paper presented to the Federal Reserve Bank of Kansas 36th Economic Policy Symposium, The Changing Policy Landscape, Jackson Hole, Wyoming (2012).
47 | P a g e extensive and as such the author does not consider there a need to reiterate that which has gone before. However what is imperative for the current chapter going forward is the acknowledgement by the regulators that capital requirements are in the forefront of their mindset whilst regulating the financial system. A point affirmed by the Independent Commission on Banking in 2011. The Vickers report151 once again affirmed the belief in capital requirements with recommendations aiming to
reduce the probability and impact of systemic financial crises in the future, by calling for both structural reform (including a retail ring-fence) and enhanced loss-absorbing capacity for UK banks.152