Improving capital adequacy and liquidity

The widelt cited Turner review has proposed seven key measures with respect to capital and adequacy, accounting and liquidity policies.

Increasing the quantity and quality of bank capital.
The required capital ratios for banks should be expressed entirely in terms of high quality capital, i.e., Core Tier 1 and Tier 1 definitions – and should not count dated subordinated debt. The current international rules effectively result in an absolute minimum of 2% Core Tier 1 relative to Weighted Risk Assets (WRAs), 4% Tier 1 and 8% total capital (including dated subordinated debt). The Turner review calls for a future regime in which the minimum Core Tier 1 ratio throughout the cycle is 4% and the Tier 1 ratio 8%. This will ensure the generation of an additional buffer equivalent to 2-3% of Core Tier 1 capital at the top of the cycle. Supervisors can insist on a further discretionary buffer above this.

Significant increases in trading book capital:
The current capital regime, requires only very light levels of capital against trading books. The risks are considered low because of the assumption that assets can be rapidly sold and positions rapidly unwound. Major changes to trading book capital, and a fundamental review of the whole methodology of assessing trading book risk are the need of the hour.

Avoiding procyclicality in Basel 2 implementation.
The way in which capital requirements and the actual level of capital vary through-the-cycle is as important as the absolute minimum level. Counter-cyclicality must be injected into the capital regime.

Creating counter-cyclical capital buffers.
Capital must increase in good years when loan losses are below long run averages, creating buffers which can be drawn down in recession years as losses increase. This would slow down the growth of bank lending in the upswing, and in the downswing reduce the extent to which banks need to cut back on lending.

Offsetting procyclicality in published accounts.
This countercyclical element of capital anticipating future losses should be reflected in published account figures as well as in calculations of required or actual capital.

A gross leverage ratio backstop.
A gross leverage ratio must back risk weighted capital as a control measure.

Containing liquidity risks in individual banks and at the systemic level.
Regulation relating to liquidity risk management should reflect three considerations:
• Liquidity risk has inherently systemic characteristics. The reaction of one bank to a liquidity crisis can cause major liquidity strains for others.
• Liquidity management has become increasingly complex over time, with an increased reliance on ‘liquidity through marketability’. So liquidity regulation cannot be based on one or a few standard ratios comparable to the capital adequacy ratio used to regulate solvency.
• At the macroeconomic and macro-prudential level, there is a tradeoff involved. Increased maturity transformation delivers benefits to the non bank sectors of the economy and produces term structures of interest rates more favourable to long-term investment. But the greater the aggregate degree of maturity transformation, the more the systemic risks.