Capital, Politics and Bank Weaknesses

A debate is raging on capital adequacy requirements for banks. The UK wants to be allowed to “top up” the agreed levels, i.e. to impose stricter capital standards than the EU minimum. This column argues the UK is right, and that the German and French opposition might be motivated by weaknesses in their banking systems.

Bank capital has emerged as a key element in the post-crisis financial regulatory reforms. Basel III is now likely to include a 7% equity-to-risk-weighted-assets capital requirement.

7% was a compromise. Some countries wanting more capital now intend to implement stricter standards unilaterally. This is making some of the others unhappy, and a bitter debate has erupted within the EU on whether individual EU member countries should be allowed to require more capital than the Basel III, and hence EU, minimums.

Capital and bank size in the EU

Measured by total assets of domestic banks, the three largest banking nations in the EU in June 2010 were Germany, the UK and France, in that order. The banking statistics come from the ECB. If we divide by GDP, the UK is largest amongst those three at 464%, followed by Germany at 337% and France at 336%. Judging by these numbers, the UK does not seem to be the outsized banking nation it often is made out to be. By including foreign banks, the numbers for France and Germany increase slightly, but the UK goes to 658%.

The ECB provides several different ways to look at bank capital. By taking the measure most relevant to the financial markets during the crisis, tangible equity/tangible total assets, the UK has the best capitalised domestic banks at 4.2% amongst the three countries, followed by France at 3.8%, with Germany having the least capitalised banks at 3.1%.

Minimum capital and Basel III

In the ongoing debate on Basel III, one of the most contentious issues has been the level of bank capital. One might think that the countries making the biggest public noises about problems of excessive risk-taking and speculation would be exactly those demanding higher capital. After all, higher capital directly reduces leverage and risk taking, increasing safety.

Surprisingly, it is the opposite.

  • The main champions for more capital are the US, UK and Switzerland,
  • The opposition is led by Germany and France.

Their public reasoning seems to be based on the public’s belief that their banks weathered the crisis better than the Anglo-Saxon banking nations. However, there is a lingering suspicion that something less straightforward is behind their stance.

Germany and France may be opposing higher capital requirements because of hidden vulnerabilities in their banks’ assets. This would both make their capital ratios worse than reported above and the banks more fragile. By contrast, countries wanting more capital already might have stronger banks, partly because they have been more forthcoming in forcing their banks to recognise dodgy assets.

Some countries view the 7% as insufficient

The Basel III minimum equity capital levels have been set at 7% of risk weighted assets. The EU is likely to follow. Some countries have indicated they want higher minimum capital levels, such as the US, where an additional 3% may be imposed (Wall Street Journal 2011).

Within Europe, the UK has similarly signalled its willingness to do the same (BBC News 2011). That would need to be allowed by EU regulations. This is strongly opposed by some member states, especially France and Germany, who would like the minimum 7% also to be the maximum, following the so-called “maximum harmonization” principle.

The maximum harmonisation principle for capital is misguided

The maximum harmonisation principle for capital would be sensible if the EU were a single financial market, homogeneous in national attributes such as bankruptcy laws and having a single European supervisory agency. In such a world, variable capital standards undermine the principle of a single financial market.

This, however, is based on a utopian view of European financial markets. After all, the EU does not have a political union, enabling a single EU supervisory agency, nor common bankruptcy laws. Consequently, the composition of assets, and treatment of assets in bankruptcy will be different across borders.

Furthermore, with each state having independent budgets, government policies and development levels, the nature and importance of banking will vary significantly across member states.

Looking at total banking assets over GDP, the relatively smallest banking state is Romania at 64% and the largest is Luxembourg at 1,964%, followed by Ireland at 929% and Cyprus at 928%. For the largest banking states, the financial sector is a significant generator of systemic risk and contributor to the business cycle. Those forces are not as strong in countries with smaller banking sectors, especially where the banks are mostly foreign.

A country with a large banking system needs different approaches to supervision than a small banking state. It needs more protection from financial turmoil and hence it would be prudent for it to require higher capital levels.

Indeed, it is sensible to vary capital levels with the relative size of the banking sector. For these reasons, the maximum harmonisation principle for bank capital is not advisable.

Those wanting low capital may have weak banking systems

The same countries that led the opposition to higher capital standards in the Basel III negotiations now oppose variable capital requirements in the EU, Germany and France.

I suspect they fear that allowing countries to impose more stringent capital standards would expose the weaknesses of their own banking systems. If an important banking nation successfully implements relatively higher capital standards, it directly signals that country’s relative banking strength and a desire not to support the banks in a crisis.

Perhaps, the real reason for the French and German opposition to variable capital standards can both be found in weaknesses in those countries’ bank assets and their willingness to use taxpayers’ money to bail out the banks.

Conclusion

The financial crisis demonstrated the need for improving capital standards, with Basel III a step in the right direction. Countries with large financial systems need to have the freedom to impose stricter controls on risk taking than is the norm. For these reasons, an EU maximum harmonisation for bank capital would be the wrong step.

About Jon Danielsson 5 Articles

Affiliation: London School of Economics

Jon Danielsson has a Ph.D. in the economics of financial markets, from Duke University, and is currently a reader in finance at the London School of Economics.

His research interest include financial risk modelling, regulation of financial markets, models of extreme market movements, market liquidity, and financial crisis.

He has published extensively in both academic and practitioner journals, and has presented his work in a number of universities, public institutions, and private firms.

Visit: LSE

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