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Let us first take a step back: capital is the most universal buffer that banks have. The more capital a bank holds, the more losses it can take before it fails. That’s why capital is a key ingredient for safe and sound banks that are trusted by markets and customers.
But at the same time, capital is costly. Holding too much of it can force banks to raise their lending costs. This, in turn, would raise borrowing costs for companies and may act as a brake on investment and economic growth. Consequently, there must be an optimal amount of capital that banks should hold.
So how can we calculate how much capital a bank should hold? The answer lies in the risks it takes. The more risks a bank takes, the more likely it is to face losses. Consequently, higher risks require more capital. Measuring risks is therefore key to calculating capital.
But this is easier said than done. Risks are mere probabilities. They indicate the likelihood of things happening in the future. Dealing with risks therefore involves predicting the future – and that is not easy, to put it mildly.
Banks provide vital services to the economy by channelling funds from savers to borrowers and investors. In Europe in particular, they play a major role in financing the economy. That’s why there is need to have them safe and sound.
Capital buffers are crucial to achieving that goal. They should be calculated on the basis of the actual risks of the banks. This includes the standardised approaches as well as the internal models.
The leverage ratio will serve as a sensible backstop to such a risk-sensitive approach. The same could be true for the output floor that is currently being discussed by the Basel Committee on Banking Supervision. These backstops would go hand in hand with the ECB’s efforts to make internal models more reliable and comparable. Mrs. Nouy is convinced that all these measures will make banks more resilient and increase trust in their capital buffers.
And looking at the current level of these buffers, there is good news. Since 2012, the amount of capital held by large banks in the euro area has risen, on average, from 9% to over 13%. ECB welcomes this, as banks now hold larger buffers against potential losses.
Mrs. Nouy says: „Coming back to measuring risks, we should be ambitious but realistic. We must not succumb to the illusion that all risks can be measured and modelled. The approach should rather be to avoid excessive risk taking. And that does not always require complex models or rules. More often than not, common sense and a bit of prudence provide all the guidance that is needed.”