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Capital levels are a poor predictor of bank failure

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The writer is a founding partner of Veritum Partners

What do Silicon Valley Bank, Credit Suisse, Citigroup and Royal Bank of Scotland have in common? If you guessed the answer like “they failed and had to be rescued by their competitors or their governments,” then you would be right. But there was another thing they had in common; strong capital ratios at the time of its bankruptcy, well above the level required by its regulators. This is a useful reminder that, for all the talk about how much capital banks need, much of the discussion simply misses the point.

The argument has come to life again in recent months, spurred by proposed changes to the rules governing bank capital that look set to hit U.S. banks especially hard. There has been extensive debate about how much capital banks need. American banks have lobbied furiously in Washington and in the media, arguing not only that more capital is unnecessary but that lending to “working families and small businesses” will simply dry up if the rules are implemented as written.

Others claim the opposite, citing research indicating that the more capital banks have, the more they will lend. Some question the banks’ true agenda, claiming that the real problem is that more capital means lower returns on capital, which therefore means lower executive salaries.

This debate misses the point of banking regulation. It is not about filling banks with so much capital that they cannot fail. Rather, it is about creating a banking system that has the right level of risk.

Capital is only one input in that risk assessment, and arguably it is relatively small. Silicon Valley Bank failed due to poor interest rate risk management. Credit Suisse failed due to its structurally unprofitable business model. Citigroup and Royal Bank of Scotland went bankrupt due to weak underwriting of credit and market risks. The only thing that determined their level of capital was how quickly they collapsed.

Given the poor history of capital levels as predictors of bank failures, regulators owe it to banks and those who use them to actively adopt more innovative measures. One idea, put forward several years ago by Andy Haldane (then at the Bank of England), was to monitor a “market-based” capital ratio, whereby the calculation of capital was not the number that appears in the accounts but the market value of the shares. from The Bank.

In the case of Credit Suisse, Citigroup and Royal Bank of Scotland, their market-based capital ratios would have been in the red for more than a year before their collapse. Of course, such an approach could be open to market manipulation, but as an input to regulation it would be a great addition.

Even more proactively, regulators would do well to actively take into account the bank’s culture and make specific demands on those whose “cultural ratio” was weak. Calculating that ratio isn’t easy, but that doesn’t mean it’s not worth doing. The prize could be huge.

For example, there is evidence that having gender diversity on risk committees improves risk outcomes. Perhaps Harriet Harman, former deputy leader of the UK Labor Party, was right when she claimed that Lehman Brothers might not have gone bankrupt in 2008 if it had been Lehman Sisters. Perhaps regulators should penalize or reward banks based on the gender diversity of their risk committee?

Thought experiments aside, the general point is that the traditional capital ratio is too clunky, imprecise and often misleading as a metric that banking regulators can rely so heavily on. It has a role to play, but those commentators who claim that more capital is a panacea are wrong, while banks who argue that they are already safe with their current level of capital are foolish.

Regulators owe it to us all to focus on actively developing much more sophisticated measures to keep the system secure.