13 June 2013

BoE/Tucker: Banking reform and macro-prudential regulation - Implications for banks' capital structure and credit conditions

Speaking at the SUERF/BoF conference in Helsinki, Tucker tried to dispel some commonly-held misconceptions of how macro-prudential variations of capital requirements would affect credit conditions. He outlined some thoughts on how the reforms might influence the shape of the financial system.

Tucker looked first at changes in the micro-regulatory regime and banks’ capital structure. The micro-level reforms have two important components, he said: a step change in regulatory requirements on capital, leverage and liquidity; and the establishment of credible and effective resolution regimes. “Separately and in combination, they will change how the risks in banks’ portfolios are distributed across shareholders, bondholders, depositors and, perhaps most important, taxpayers”. 

Tucker made the case for a “richer regulatory Capital Accord for the future – one that distinguishes more carefully between the different phases of a bank's life and death”.  He said the core purpose of the existing Basel III Accord, to set a minimum level of equity to provide sufficient going-concern loss absorbency, was not enough. “We also need to regulate for a minimum level of term bonded debt to provide gone-concern loss absorbency”, mandating bond issuance of a mimimum quantity from prescribed parts of banking groups in order to make resolution feasible. While “that might be enough”, a richer Accord might go further still, in providing for the stages prior to resolution, “mandating so-called ‘high-trigger’ CoCos, so as to encode recovery measures into a bank’s capital structure. And it might even include low-trigger instruments to aid resurrection when a bank had seriously impaired equity but was not on the brink of bankruptcy.”

Yet even a more complete Accord along such lines is, Tucker said, not sufficient, as revealed by the authorities’ creation of macro-prudential regimes. In the UK, he noted, the primary objective of the new FPC is to protect and enhance the resilience of the financial system, with a subordinate objective of supporting growth and employment. He underlined that the authorities need to be able to respond to the system’s evolving structure, or temporarily tighten capital requirements in especially threatening circumstances.

Tucker reasoned that the primary objective of macro-prudential regulation – improving financial system resilience - can be advanced even if a credit boom itself is not always tempered. Whether macro-prudential interventions could quell a credit boom turns largely on the effects of the cost of finance, he said. But he expressed concern that too much of the analysis in this area is oversimplified. “A required substitution to more expensive equity finance will, indeed, tend to push up banks’ funding costs, but the effect on overall funding costs will depend on whether, and by how much, debt financing costs fall due to a lower probability of bankruptcy … Where there are question marks over the system’s capital adequacy, the reverse [i.e. a fall, rather than a rise, in overall funding costs] can sometimes be true. More generally, the effects on credit conditions will depend on whether the policymaker’s actions revealed  information about the state of the system and its approach to policy, and on whether the market regarded the actions as warranted, insufficient or too much. Overall, this underlines the importance of transparency – from banks and from the macro-prudential policymaker.”

Tucker said that it would be surprising if the crisis and regulatory response did not induce structural changes in the system; “the shape of some can perhaps be discerned”. Actions to remove the subsidy from banking will he said, amongst other things, create conditions in which the relative role of unlevered capital market investors, probably crowded out in the past, can grow. “Some of that might come through securitisation, although a mature and resilient market in ABS of loans to SMEs might well require initiatives to produce rich data sets on credit histories. The time may have come to evaluate the utility of the central credit registers that have long existed in some continental European and Asian countries.”  He said that, as deposit takers, banks will always be levered and they will always have somewhat risky asset portfolios. But “only sound banks can make a credible promise to repay or lend money on demand”. And he highlighted that there may be greater value in longer-term bonds, which can absorb losses, helping to recapitalise the firm in resolution, and can thus be a source of market discipline through price and rationing, than in short-term debt, often seen as a disciplining mechanism on the basis that it can run.  "Not all forms of leverage are the same."

Full speech

© Bank of England