Economic Letter—Insights from the Federal Reserve Bank of Dallas
Vol. 4, No. 3
Federal Reserve Bank of Dallas
Seeking Stability: What’s Next for Banking Regulation?
by Simona E. Cociuba
Rules on bank capital have been a key element of banking regulation for many years. The Basel Capital Accord of 1988, known as Basel I, established a common framework to measure capital and set minimum standards for international banks. One of the main goals was to ensure the soundness and stability of the international banking system.
Currently, many countries are adopting a revised framework, known as Basel II. The new accord refines Basel I's crude measure of bank capital and adds rules on bank supervision and transparency.
Despite improvements over the years, capital regulation failed to ensure stability of the financial system in the crisis that flared in the summer of 2007. The billions of dollars of write-downs on assets related to subprime mortgages raised fears of insolvency and led to lending freezes and liquidity problems at many institutions.
Some banks heavily reliant on short-term funding, such as Britain's Northern Rock, experienced runs. Others found themselves with a need to replenish rapidly deteriorating capital positions. All in all, the recent events underscore the need for further revisions in banking regulation.
The Two Basel Accords
The regulation of bank capital aims to ensure bank solvency and reduce costs associated with bank defaults. Bank failures have systemic costs that lead to financial system disruptions and losses not fully borne by failing institutions. Forcing banks to hold adequate capital reduces these losses. Of course, there's a tradeoff: Very high levels of regulatory capital diminish bank lending. Thus, capital regulation's goal is to protect the system against default costs while promoting healthy bank lending.
In practice, calculations of minimum regulatory capital are based on the credit risk of bank assets. The guidelines formulated by the Basel Committee on Banking Supervision call for a bank to hold capital of at least 8 percent of the total value of assets adjusted for individual risk.
One of Basel I's shortcomings was that assets were grouped in very coarse risk categories, so banks' regulatory measure of risk could differ substantially from their actual risk. For example, all business loans received the same weight, despite large differences in risk among borrowers. As a result, the Basel committee revised the accord in June 2004. The major change, introduced by Basel II, was a more risk-sensitive measure of capital (see box, "Calculating Capital Requirements").
While Basel II improves on some aspects of Basel I, it still raises some of the same concerns.
First, the potential to mismeasure risk remains. The new rules for credit risk work well only insofar as the estimates produced by banks' internal models accurately reflect underlying risks. Problems may appear, for example, in evaluating new assets for which little reliable historical data exist.
A second concern is that capital requirements exacerbate macroeconomic fluctuations. In a downturn, a bank's capital is likely to deteriorate due to loan losses. At the same time, the bank's nondefaulting borrowers are likely to be downgraded, forcing the bank to hold more capital against its now riskier loan portfolio. If the bank is unable to raise more equity—as is often the case in a downturn—it will have to limit lending, worsening already adverse economic conditions.
Third and most important, risk-based capital regulation may be inadequate for protecting the financial system. Capital requirements may promote stability of individual institutions. However, ensuring each bank's stability doesn't necessarily guarantee the stability of the system as a whole.
A simple example shows how prudent action by one financial institution may undermine another. Suppose Bank 1 borrows from Bank 2. Bank 2 has other loans on its books and suffers losses on them. Its capital reduced, Bank 2 decides to curtail its lending to Bank 1, even though Bank 1 is a creditworthy borrower.
Bank 2's reduction in lending represents a prudent move that strengthens its capital position. From Bank 1's point of view, however, Bank 2's action amounts to a withdrawal of lending. Bank 1 will need to find an alternative source of funding or reduce its asset holdings. If Bank 1 holds illiquid assets and doesn't obtain new lending, Bank 2's reduction in lending will feel like a run for Bank 1 (see box, "Capital Regulation: A System Perspective").
This example illustrates that routine links between institutions create risks that aren't addressed by capital regulations. In the current financial crisis, the fate of a British bank made this quite clear.
The Run on Northern Rock
U.K. mortgage lender Northern Rock, the first bank to fail in the current crisis, faced a run similar to that of Bank 1 in the example. As the short-term and interbank lending markets froze in mid-2007, Northern Rock ran into funding problems, even though it had virtually no subprime lending.
On July 25, 2007, Northern Rock published its interim report for the year. The chief executive acknowledged that annual profits would be affected by recent sharp increases in money market borrowing rates but concluded that "the medium term outlook for the Company is very positive." On Sept. 14, the Bank of England granted emergency liquidity support to Northern Rock. This was the first run on a U.K. bank since 1866. Northern Rock was taken into public ownership in February 2008.
What went wrong during those two months in 2007, and why did it lead to Northern Rock's fall? In short, troubles with U.S. subprime mortgages led to sharp increases in spreads on asset-backed securities that summer, causing a worldwide liquidity freeze in short-term markets.
Entities that had relied on these markets for funding, such as structured investment vehicles, ended up tapping their bank lines of credit. In turn, banks began to hoard liquidity due to uncertainty about future liquidity needs, causing a freeze in the wholesale markets. Northern Rock was vulnerable because it had relied heavily on wholesale funds.
Northern Rock engaged primarily in residential lending in the U.K. From 1998 until June 2007, the bank expanded its balance sheet aggressively and became Britain's fifth-largest mortgage lender. Total assets increased from £17.4 billion to £113.5 billion. This growth was accompanied by a reduction in retail deposits from 60 percent of total liabilities to 21 percent.
By June 2007, most of Northern Rock's funding came from securitized notes, wholesale markets and other sources (Chart 1). Accounting rules dictated that the securitized notes appear on Northern Rock's balance sheet. Unlike the short-term asset-backed commercial paper at the heart of the subprime crisis in the U.S., these notes had relatively long maturities, averaging about three and a half years.
The Northern Rock run started with a nonrenewal of its short- and medium-term wholesale borrowing. When the Bank of England announced it would rescue Northern Rock, retail customers started withdrawing deposits as well. Some queued at branches to demand their deposits, while others struggled to access the bank's website to withdraw funds.
Snapshots of Northern Rock's liabilities before and after the run show one striking change—the loan from the Bank of England (Chart 2). The loan amounted to about a quarter of total liabilities in December 2007. Moreover, both wholesale and retail funding declined to less than half of what they were before the run.
In the first half of 2008, the composition of Northern Rock's liabilities saw little change. Retail deposits recovered a bit after the government guaranteed deposits, and the bank repaid part of the Bank of England loan.
Capital and Leverage at Northern Rock. On the eve of the crisis, Northern Rock was complying with its capital requirements. In fact, it had excess capital. On June 29, 2007, the mortgage lender received approval from its regulator, the Financial Services Authority, to switch to the Basel II advanced approach and calculate risk weights for its assets using the bank's internal models. This resulted in a 45 percent decline in total risk-weighted assets. According to the 2007 interim report, Northern Rock's risk weights for residential mortgages were reduced to the mid-teens.
Northern Rock suddenly found itself with excess capital. In December 2006, the capital ratio was 11.6 percent under Basel I calculations, but it jumped to 17.5 percent under Basel II (Chart 3). By June 2007, the Basel II capital ratio had risen to 18.2 percent, well above the bank's regulatory and internal requirements.
Not foreseeing the storms on the horizon, Northern Rock announced a 30 percent increase in its interim dividend, scheduled to be paid in October 2007. However, losses incurred after June 2007 led to a deterioration of the bank's equity, and its capital ratio declined to a record low of 10.2 percent in mid-2008. The dividend was canceled.
One problem with Northern Rock was its high leverage: It relied heavily on debt to finance its assets.
Leverage is procyclical—high in booms and low in downturns. In good times, investors are willing to lend more per dollar of bank equity, allowing banks to increase their leverage.
When economic and financial conditions turn sour, however, investors demand a larger equity cushion to protect themselves from losses. Banks find themselves needing to deleverage—that is, cut their debt. Some institutions adjust their balance sheets by raising new equity or selling assets to repay some debt. Northern Rock wasn't one of them.
Leverage, the ratio of total assets to equity, can be calculated using alternative equity measures. Common equity is held by bank owners with voting power. Shareholder equity is common equity plus preferred shares. For Northern Rock, leverage on both common and shareholder equity were already high when they spiked after mid-2007 (Chart 4).
Financial experts favor common equity when computing banks' leverage. By this measure, Northern Rock's leverage was 58.2 as of June 2007. It jumped to 86.5 by the end of the year in response to equity losses, and it was even higher in mid-2008. These figures are large by U.S standards: Leverage of U.S. investment banks, for example, is around 25 or 30.
Securitized notes are part of the Northern Rock balance sheet, and this leads to higher measures of leverage. Even if the securitized notes were off the balance sheet, leverage on common equity would still have been high: about 35 in June 2007, 52 at the end of that year and about 100 in June 2008. The high leverage made Northern Rock vulnerable to reductions in funding—an unsettling position for a bank that complied with its capital requirements.
Strengthening Bank Regulation
The run on Northern Rock raises important questions about how to revise banking regulation. As it stands, the international standard embodied in Basel II has a few shortcomings. Among them is that capital regulation exacerbates economic downturns because banks choose to curtail lending when capital is scarce.
Ideally, bank regulation seeks to balance two opposing objectives: reducing the cost of bank defaults and ensuring efficient lending. As a result, in a downturn, when banks are capital-constrained, it is desirable to adjust both. However, Basel standards require that the probability of bank defaults be fixed over time. When economic conditions turn sour, lending bears the brunt.
A proposed solution involves allowing slightly higher bank default probabilities in a downturn. This would mean that as the risk of an asset goes up, the capital the bank is required to hold against that asset won't rise as sharply as it does now.
Recent events show that risk-based capital measures may be inadequate for promoting stability of the financial system. Proposals to mitigate this problem include complementing the rules on bank capital with rules on liquidity and leverage. The rationale for liquidity regulations is that banks with more liquid assets or stable, illiquid liabilities are less vulnerable in the face of a run. A leverage constraint would limit the amount of debt a bank can take on during booms and thus reduce the need to deleverage in bad times.
Under a different regulatory scheme, Northern Rock might not have experienced the run that led to its collapse. If future regulations limit spillover effects among banks, they could reduce the chances for financial crises and the resulting damage to economies.
Economic Letter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.
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