A simplified guide to regulation of bank capital

Banks and the scale of their lending are currently controlled by regulation. The regulators place on them capital requirements. Clearly the Regulator has confidence in our banks and believes all our main UK banks have sufficient capital to trade – as his permission is needed for a bank to enter and stay in business.

Because there is such an intense de-leveraging underway – stemming from a wish by the authorities to cut overall lending and borrowing – many now think banks should have more capital than the minimum required by the Regulator, and more than some of them currently have above that minimum. Fear within the banking sector is also forcing banks to raise more capital than the Regulator requires, and more than they have been used to employing in recent years for a given level of lending.

The principal requirement is to have sufficient Tier One capital. This is basically funds provided by shareholders to their bank when the shares are first issued, and the accumulated profits left in the bank after all payments of bonuses to staff, dividends to shareholders and other payments. Typically a bank will have at least £5 or £6 of Tier One capital for every £100 of advances made to customers. The idea is that if the bank proved a bad judge of these loans, then the shareholders funds can pay the losses. It would usually be unheard of for a bank to lose more than 5-6% on all the advances it made, owing to failure of customers to repay, or failure to raise enough money to repay the loan from the security lodged when a customer does give up the payments. Bad debts on most quality lending would normally run at less than 1% overall, after taking into account money released from security where payments are not met.

The back up requirement is to have some Tier 2 capital as well. This is money held as provisions against losses, surpluses on the banks assets like its directly owned property, and long term money borrowed from others. In the unlikely event of the bank having to go into Administration this money could also be drawn down or released by asset sales to pay off the depositors and other creditors. Tier One and Tier Two capital together might amount to say £10 for every £100 of loans.
A bank does not have to provide the same shareholder cover for assets held like Treasury bills and government bonds, as the Regulator assumes these can easily be turned into cash. It is just the “risk assets” – the mortgages and company overdrafts – that need the full shareholder cover.

This means a bank may be 10x geared – it can lend 10 times its combined Tier One and Tier Two capital. It raises the money to make these extra loans by taking in deposits from the public and companies, and borrowing in the markets. Those banks that have relied heavily on shorter term borrowing in money markets are the ones who have faced the most difficulties – Northern Rock was the worst example. When the money markets dried up the Rock was left short of borrowing to finance its substantial mortgage lending.

The authorities have to decide how much extra capital cover they think banks should now be required to hold. The more they request, the less lending will continue to British individuals and businesses. The banks themselves may decide to hold more capital, to reassure fellow banks that they are safe to do business with in current conditions. Banks also have to raise more capital if they make substantial losses, as the shareholders have to make good the funds their managers have lost.



  1. Brian Tomkinson
    October 9, 2008

    Thanks for this simplified guide. Would you now please explain where the £500billion comes from? From whom does the government borrow it and under what terms?

    Reply: From the markets on its current government borrowing terms.

  2. Mark Wadsworth
    October 9, 2008

    Excellent summary.

    But I think you are missing one key element from all this:

    1) Let's assume the assets side is a fixed amount, and that we don't want total lending to households and businesses to shrink unduly. OK, the balance sheet value might have to come down by a couple or per cent for provisions against bad debts, but taking UK banks as a whole, even if house prices dropped by a third and million homes were repossessed, the total losses would only be 3% or so of total lending.

    2) Then there's the liabllities side. As you point out, for a given amount of equity/Tier One capital (call it what you will), an increase in the required Tier One ratio would reduce the total amount that the bank can lend out. But it appears that an increase in the Ratio is necessary (i.e. at current low levels, nobody will lend to UK banks, they won't even lend to each other).

    3) Further, banks are finding it difficult raising capital (and this whole taxpayer funded bailout worries me greatly!!).

    4) So here's the clever bit – all banks have to do is to cancel some of their long term debt and replace it with share capital (or replace bonds with Tier 2, or replace Tier 2 with Tier 1, that's just details).

    5) In the case of (A Bank – ed) even assuming a nightmare worst case write down of 10% of all mortgage advances, to reinstate a superbly healthy Tier 1 ratio of 13%, all it would require is for every £1 of debt (other than ordinary customer deposits) to be cancelled and replace with 61.5p of new debt and new shares worth 23p.

    6) I did the worked example here.

    7) Problem solved. The precise maths of course would have to be rejigged to ensure fairness between bondholders (whose bonds must have been trading at much less than par anyway) and shareholders (who will be diluted down, but on the other hand, they will subsequently own shares in a much healthier bank), but again, that's just details. Anything must be better than being nationalised.

  3. Promise of Avalon
    October 9, 2008

    Informative piece, but I have a simple question that has been puzzling me for a while.

    My understanding is that retail banks, operating under the fractional reserve system have to keep about 20% of their deposits in cash to cover deposit withdrawals, the rest being available for subsequent lending. Why is it that the investment banks, which are now pretty much blurred with retail banks, do not have to hold a similar amount of reserve?

    If I have got it right – and I accept that I possibly have not – then this seems like a stupid imbalance in the system. After all, there is not really any difference between an investment bank and a retail bank. They take deposits and make loans and investments on those deposits. Retail banks usually make loans to companies for capital investment and investment banks usually invest in 'other mysterious things' whilst building societies make loans called mortgages.

    And I also thought the reserve requirement was a critical mechanism to control the amount of money – and hence inflation – the banks could produce. It seems that the retail system has a decent break on this expansion but the other banks do not. Is it any wonder that money has been chasing assets, especially housing, with the inevitable result of a bubble?

    Reply: Clearly a bank which has taken lots of retail deposits from the public should keep more cash in its tills in case they walk in from the street and want to withdraw their cash. Investment banks don't usually have that problem.

    1. Promise of Avalon
      October 10, 2008

      Agreed, investment banks don't usually have the problem of people walking in off the street to withdraw their cash, but we have just seen that the IB equivalent of retail bank depositors – wholesale lenders – can be just as jittery as joe public.

      I admit that treating investment banks more like the retail bit of banks would only reduce the availability of credit, which is probably not what we want right now, but it is certainly what we want in the future. It is patently obvious that the capital ratios these banks have been keeping available up until now has been wholly inadequate, and it is what permitted the Icelandic debacle.

      There is of course the problem that this constitutes more regulation but there needs to be a few basic rules of the game, as there already are, so would there be a problem in mandating higher reserves to be held in all banks?

  4. Patrick
    October 9, 2008

    John, maybe more capital is not the only answer – or even a necessary one.

    The fundamental weakness of the business model is the mismatch of the maturity between assets and liabilities. If banks with inadequate retail deposits were forced to do their wholesale borrowing on much, much longer terms (maybe even equal to the term of the mortgage book) then the problem would largely go away. Having to keep rolling over short term debt is nuts when your in a long term lending game. (OK it can be profitable – but it is horribly risky and as soon as confidence goes and you can't borrow today to repay your debts of only days or weeks previously then you're straight into Northern Rock territory). Ina world of matched maturities the profits would be lower but the bank would still earn the difference the terms it could borrow at vs the terms it could lend out mortgages at – a simple leveraging of its credit rating vs that of individuals. Systemic risk would be all but eliminated.

  5. Rob
    October 10, 2008

    The back up requirement is to have some Tier 2 capital as well. This is money held as provisions against losses, surpluses on the banks assets like its directly owned property, and long term money borrowed from others. In the unlikely event of the bank having to go into Administration this money could also be drawn down or released by asset sales to pay off the depositors and other creditors.

    1. Mark Wadsworth
      October 10, 2008

      Rob, what you are outlining is debt for equity swap, with conversion to kick in once bank was in real trouble. Why not do it right now, the sooner the better (I explained what it entails in the comments above).

  6. Freeborn John
    October 10, 2008

    Thanks for the concise tutorial piece, which I am sure those of us not in the financial sector find useful background to the various plans for re-capitalization and mopping up of bad debt.

  7. mikestallard
    October 10, 2008

    One of the major reasons for the crash seems to be that nobody understood the gobbledegook the bankers were speaking.
    Thank you for explaining so clearly, in jargon free English, what the ratio of capital assets to lending is and ought to be.
    Now for Basel II……

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