Regulatory capital: Why is it different?

Abstract

The global financial crisis has highlighted that deviations between the accounting and regulatory concepts of equity capital have gone too far. Accounting standards have been going too far in the application of fair value accounting. If there are no markets during times of crises, it does not make sense to mark-to-market. These exceptions have now been included in the accounting standards. At the same time, regulatory capital has gone astray by allowing debt elements, such as subordinated debt, to be incorporated, which did not absorb losses during the crisis. The new Basel III capital framework is rightfully reinforcing the central role of equity capital. While the special liquidity function of banks may justify lower levels of capital than those of industrial firms, the social cost of bank failures (externalities) requires higher levels than the extremely low levels of bank capital before the crisis. The level of regulatory capital has been increased, with a systemic surcharge for the large banks, to reduce the too-big-to-fail subsidy for these banks.

Keywords:

• capital requirements
• financial stability
• crisis management
• fair value accounting

Acknowledgements

This paper was prepared for the Information for the ICAEW's Information for Better Markets Conference, held in December 2014 in London. I thank an anonymous reviewer, Elena Carletti, Christiaan van Laecke, Paul Sharma, and Arnoud Vossen for useful comments. The views in this paper are those of the author.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. Another objective is to mitigate risk-taking incentives. Higher levels of equity capital reduce the put option value of equity and thus reduce the incentive to take risks for managers, who are assumed to work on behalf of the shareholders.

2. For the technical reader, the series are log transformed, normalised by the 1985 value, first differenced, and then filtered (using the bandpass filter). The medium-horizon cycles in growth rates are then aggregated starting arbitrarily from zero at the beginning of the sample period. At the end the three are averaged to produce the composite indicator. The unit, therefore, is not particularly meaningful. One should therefore only focus on the relative amplitude of the cycle measures over time.

3. The same argument holds for income tax purposes. Deductibility of mortgage interest payments, which still exists in some countries, can explain the high levels of mortgage debt to GDP in these countries. To reduce the incentive for households to take too much debt, this interest deductibility should be removed.

4. It should be noted that the majority of bank assets are loans, which are typically valued at amortised cost (Laux and Leuz 2010).

5. A good example is ING: doubt arose about the interest payment on the subordinated debt of ING at the height of the financial crisis in Autumn 2008. Some investors questioned publicly whether ING would meet the upcoming interest payments on its subordinated debt. Although ING meant to meet the next interest payment, the supervisor did not permit ING to say so as payments on subordinated debt are conditional on meeting certain capital ratios at the time of payment. After a sharp drop in the share price, the supervisor gave special permission to ING to announce that it was planning to meet its upcoming interest payments (Avgouleas et al. 2013).