06 November 2012

FSA/Bailey: The challenges in assessing capital requirements for banks

Bailey began by talking about  the framework by which supervisors assess capital needs, a subject that is attracting a great deal of attention. "I am not a believer that supervisors should rely on any single data point when assessing a given firm’s stability. We need to assess measures of capital, liquidity and leverage. The art of supervision is to look at a situation from several angles and seek thereby to identify weaknesses. Good supervision is about judgement. The psychologist and behavioural economist Daniel Kahneman has described good judgement as ‘the product of a solid grasp of intuition coupled with empirical validation where possible’. 

In terms of how supervision is done, my preference is to start with a risk-based approach to assessing capital needs and then back that up with other risk-based approaches and a simple non-risk based approach, like a leverage ratio. The general approach is also the one that we are developing for insurers by designing early warning indicators to act as a check on the modelled risk-based approach."

He went on to talk about Basel I and Basel II, listing four actions that supervisors have taken to correct the respective failings. He then discussed the leverage ratio and the cost of equity.

Turning to the current situation, Bailey said: "The first consideration to note is that we face a situation where there is uncertainty around our judgements on the quality of a number of asset classes and their valuation. This is a reflection of the unusual and difficult economic conjuncture that we have been going through, combined with the challenge of determining the scale and nature of, for instance, loan forbearance. This is particularly evident in areas like commercial property lending where there is a hump of loan refinancing to come and a quite sharp tiering of performance among assets.

Second, the euro area, and the possible impact of disorderly break-up, should that happen (and in saying this, I offer no view on whether it will happen), could have a sizeable impact on many banks. But here the FPC faces another very difficult judgement, namely what scale of so-called tail risk – the losses from low probability but high impact events – do we wish to see covered in the capital held now by banks? In other words, how much insurance should come from capital providers? The broad answer is a lot, but that does not tell us how much, and in the limit there are utterly catastrophic risks for which it is not sensible to hold capital as the answer.

Third, when we look at the low market value of some banks relative to their book value, how much of this should we attribute to lending margins being considerably lower than they were expected to be? Net interest margins are squeezed in the current environment. This is important because, to the extent this argument holds true, the action taken to deal with it, if any, could be different. 

Another relevant consideration is to what extent it reflects different market valuations of banks’ tangible assets or of their intangible assets, such as goodwill, that are to some extent already and will to a greater extent under Basel III be accorded no value for regulatory capital purposes.

Fourth, to what extent are low market values caused by uncertainty among investors about the future regulatory and operating environment for banks? This could be caused by a number of factors, including ringfencing and capital policy as supervisors adjust risk weights. Fifth, by how much further should we adjust risk weights to reflect past inadequacies.

And, finally, how rapidly should we make any adjustments, and how should such adjustments fit with both the Basel III implementation timetable and the changes that firms themselves are making? " 

In conclusion, Bailey agreed with the need for simplicity. "The proliferation of rules is unhelpful and particularly when it extends into making rules on how to supervise, a feature that we see in the EU processes. To return to Kahneman’s point, solid intuition is a part of supervision. But simplicity is not about one-club golf, and it is not about abandoning risk-based regulation.  A simple timeline would suggest that Basel I did more to cause the crisis than Basel II. 

But the latter would surely have made it even worse had it be in place for longer. Looking forwards, we do need strong judgemental supervision, and we do need the powers to separate trading activities into separate legal entities as the ICB has proposed. As Paul Volcker recently pointed out, customer banking involves a fiduciary duty, whereas trading with counterparties does not. My only caveat here, and it is a very important one, is that the fiduciary duty of customer banking was sadly lost in the wave of mis-selling. 

Judgemental supervision has already been applied to correct the excesses of pre-crisis activities. Investment banks have been forced to lower leverage and raise capital, and we are seeing the consequences. The monoline mortgage bank model – in the commercial not mutual-sector - has been restructured heavily already. No demutualised building society survives as an independent entity today. The high return on equity with low cost of equity business model is dead. Of course, there is more to be done, and I have set out the framework within which I think about the capital needs of the banking system. Above all, simplicity is about clear focus and a firm resolve."

Full speech

© FSA - Financial Services Authority