How to Regulate Bank Capital

Charles Calomiris considers the challenges and social costs of bank capital requirements. He proposes that contingent convertible bonds (CoCos) and cash requirements supplement traditional capital requirements to produce stronger, market-based incentives for banks to monitor their risks properly and thereby reduce the likelihood of future crises.

One of the central lessons of the 2008 financial crisis was that more effective capital requirements on large financial institutions are needed. But precisely what kinds of requirements, and just how to structure them, have been subjects of heated debate ever since — and with good reason.

For banks, as for other companies, capital may be best understood as a loss absorber in bad times. As an “unprotected” source of financing, capital allows the bank to continue honoring withdrawals and other obligations when the value of a bank’s assets falls unexpectedly, providing security against a default.
Before banks’ debts were protected by government deposit insurance and bailouts, markets ensured that banks maintained adequate amounts of capital and cash assets, and rewarded bankers who engaged in better risk management with lower costs for raising funds. In today’s world, however, government protection has removed the incentives for market participants to play that role. Prudential regulators, therefore, have had to devise rules for capital and cash adequacy to ensure that bank owners, rather than taxpayers, absorb losses related to the risks banks take.

However, existing regimes for regulating capital — and the reforms of those regimes that have been enacted thus far by the Basel III system and the Dodd-Frank bill in the United States — not only require too little capital, but also fail to provide bank officials with incentives to manage their risks and to act in advance of a bank failure, mainly because of two important pitfalls to which they are susceptible: the familiar problem of discretionary bailouts by government, and discretionary loss recognition by both banks and regulators.

Discretionary loss recognition involves the use of accounting practices that distort the meaning of capital. Rather than using market-based concepts (like the price of bank stock) to measure risk and establish the need for capital, regulators rely on accounting concepts: They look at a bank’s books, not at the market’s assessment of the value of what the firm holds. Thus, the rules provide both banks and regulators with a great deal of discretion, particularly with regard to timing, allowing them to choose when to report losses and therefore allowing them to delay acknowledging problems and acting to address them.

Beyond explicit (and often mutual) decisions by banks and regulators to understate losses, bankers can also be very creative in their use of complex transactions to disguise losses on securities. The bankruptcy of Lehman Brothers revealed another device for circumventing capital-adequacy measures — the so-called “Repo 105” or “Repo 108” transactions that disguised repurchase agreements (a kind of loan in which the borrower sells the lender a security with an agreement to buy it back at a later time for a higher price) as removals of assets.

In addition, effectively designed capital requirements must not only overcome the inadequacies of existing rules but also take account of the social costs involved in raising such requirements. The cost of higher capital requirements comes primarily in the form of reduced banking activity— especially reduced lending (in other words, a “credit crunch”). After all, a capital requirement is a ratio of capital to assets, which means that a higher ratio can be achieved both by increasing the amount of capital in the numerator of the ratio and by reducing the quantity of assets in the denominator — that is, by reducing lending.

There is ample empirical evidence that shows how a rise in capital requirements may lead to a contraction in lending. For example, in a 2011 paper, using a sample of banks from 1998-2007, Shekhar Aiyar, Tomasz Wieladek, and I examined British banks’ reactions to capital-requirement changes, taking into account variation in loan demand and other influences that could affect credit-supply contraction. We found that increases in bank-specific capital-ratio requirements resulted in large contractions in credit supply: A 10% increase in the capital ratio requirement (say, from a 10% requirement to an 11% requirement) resulted in a 9% contraction in bank credit supply.

The key, then, is to properly understand the nature of the credit supply costs of increasing capital requirements, so that policy decisions about the structure and timing of capital-requirement increases can take those costs into account.

To significantly increase the capital available in a crisis while minimizing the increase in cost — and therefore the likelihood of a credit crunch — regulators should seek to combine equity capital with a less expensive, but still reliable, form of capital. Requiring contingent convertible bonds, often known as CoCos, is an obvious candidate: Sold as debt, CoCos are cheaper for banks than raising equity capital in normal times; since they convert into equity in times of financial distress, however, they provide for capital if trouble hits. Using a combination of equity and CoCos in capital requirements — if that combination is properly designed — can provide a large and credible buffer against loss, while reducing the costs of raising capital.

The key to the use of CoCos as part of such a capital requirement is not simply that they would convert to equity when the risk of insolvency looms and thus play the same role as additional equity capital. Rather, CoCos could be used to create a powerful financial incentive for the bank to issue more equity capital long before a financial failure. The threat of triggering the conversion of a large volume of CoCos into equity — and thereby severely diluting the value of the common stock held by shareholders, often including bank officials themselves — would provide institutions with a powerful motive to strengthen risk management and take remedial measures to raise equity well in advance.

To achieve this goal, the size of the CoCo requirement should be large and the conversion ratio (that is, the amount of value in new equity that the holders of CoCos received for the bonds they surrendered) should be sufficiently dilutive of existing common shareholders. As a result, the CoCo conversion, if realized, would be painful enough that it makes the prospective dilution from issuing pre-emptive equity into the market appear very desirable by comparison. (In a 2011 paper, Richard Herring and I provide the details of a CoCos requirement that would achieve this objective.)

At the same time, to avoid regulatory failures resulting from discretion, the trigger for conversion of CoCos to equity should be based on the market’s valuation of a bank’s debt-to-equity ratio — which is a more reliable measure of the bank’s financial condition than the accounting measures now used by regulators. For example, the trigger could be set so that CoCos would convert from debt to equity if the ratio of the market value of the bank’s equity relative to the sum of the market value of its equity plus its debt fell to an average of, say, 9% over a 90-day period. (The ratio should be measured as a 90-day average to avoid the risk of investors forcing a CoCos conversion through a coordinated bear run on the bank’s stock.)

As an added benefit, CoCos designed to result in substantial dilution upon conversion would also have an enormous practical advantage as debt instruments: The strong incentives for management to avoid conversion would mean that CoCos would be likely to almost never convert, and thus to trade more like fixed-income instruments than like ordinary convertible securities. They could be sold more like relatively stable debt (bonds) than like comparatively volatile equity (stocks). Thus, CoCos would likely hold greater appeal to institutional investors, such as pension funds, which tend to prefer low-risk debt instruments.

Under these circumstances, CoCos conversion would be a bank CEO’s nightmare: Not only would existing stockholders who were diluted by the conversion be calling for his head, but he would also face an onslaught of sophisticated new holders of stock (such as the institutional investors who were formerly CoCo holders) who would likely be eager to sack senior management for its demonstrated incompetence. Such powerful financial incentives would be much more effective than a set of rules that banks can circumvent with clever financial instruments, let alone requirements that both regulators and financial institutions can easily put on hold when the rules prove inconvenient.

While this new capital requirement would overcome many of the problems that have bedeviled such attempts at regulation in the past, it should be backed up with further reinforcing policies. The most obvious and historically important of additional prudential tools is the cash reserve requirement, under which banks must maintain actual cash reserves at the nation’s central bank, earning interest.
Cash deposited in a central bank is continuously observable, and therefore not subject to the danger of so-called “window dressing”: the use of accounting practices to create the appearance of cash assets at particular dates — like just before public quarterly reports are due to regulators — without having actually invested in cash (as happened in the recent MF Global collapse). Furthermore, as Florian Heider, Marie Hoerova, and I show in a new study, because cash is essentially riskless and not subject to manipulation, requiring a significant amount of cash to be held as a fraction of assets improves bank executives’ incentives to better manage the risks that banks take on, particularly in the wake of losses on risky assets, as during a recession.

Although there are no “magic numbers” for just the right ratios to require, based on a review of successfully regulated banking systems of the present and the past, I believe a “20-20” combination of minimum requirements — requiring at least 20% of risk-weighted assets to be financed by capital (half in equity and half in CoCos), and requiring at least 20% of risk-weighted assets to be held in interest-bearing cash reserves — would be an excellent starting point for enabling an effective, prudential regulatory system.

Such requirements would have to be gradually phased in, to avoid cost shocks that might set off a credit crunch. Because banks already hold substantial Treasury securities and reserves, the cash requirement would affect the composition of those assets more than the amount. CoCos would be priced and treated much like debt, limiting the costs of compliance with this new requirement. But raising substantial new equity would be costly, particularly in today’s highly uncertain environment. For that reason, this approach would have to be implemented through a pre-announced phase-in — one that is not too sudden, and that ensures predictability, so that banks can plan their affairs accordingly.

Although moving to such a system would not be entirely without costs, especially since the supply of bank credit today is already meager, we have learned all too painfully that allowing banks to expand credit on an inadequate base of capital delivers short-term credit growth at the expense of medium-term credit collapse and economic disaster. It is time to recognize at last that rules that fail to account for financial incentives are bound to fail, and that harnessing the disciplining power of markets — rather than replacing it with the supposed cleverness of regulators — is the only way to prudently keep our banks in check while also enabling economic growth.

Charles W. Calomiris is the Henry Kaufman Professor of Financial Institutions at Columbia Business School. This article is adapted from his piece “How to Regulate Bank Capital” that appeared in the Winter 2012 edition of National Affairs.

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