Capital Management: getting back to best-practice

During a presentation on asset-liability management (ALM) – given at a well-known bank – the issue of capital buffers and available capital came up. Just how much capital is available to absorb losses on a going-concern basis?

Is it the entire capital base, only part of it, or none at all (although if the latter was the case it would certainly raise problematic questions)? The answer, of course, depends on how much surplus over and above the regulatory minimum one has. In other words, the answer most definitely isn’t ‘all of it’; not if we are considering the issue from a going-concern perspective.

Exhibit 1 shows the Capital Requirements Directive IV (CRDIV) capital buffers for a bank in the European Union when first presented. At any time, a bank that intends to remain a going concern will need to maintain this minimum level of capital. So in practice how can any of it absorb losses?

This is an important point because it’s often misunderstood, by investors as well as bankers. In banking, confidence and the public display of that confidence is everything. Lose that and we are sunk. If a bank suffers losses that take its capital base to one dollar below the regulatory minimum, then at that point confidence suffers. One must always maintain the regulatory minimum, otherwise one moves from going-concern to gone-concern territory. It is the buffer amount over and above the CRDIV minimum that can absorb losses. This amount has to be one able to absorb losses over the cycle, and needs to be set realistically.

Exhibit 1: CRDIV capital buffers 2013

Source: PRA

Capital strategy and a going-concern

Is there anything controversial about the foregoing? In theory ‘no’, indeed it has been a central tenet of banking ever since regulation was first introduced (before banks were regulated and needed licences to operate, this buffer would have been set by the bank managers’ common sense). Yet in practice it can move into controversial territory, because of what it implies about where capital – which is, of course, part of the bank’s liabilities, not assets – must be invested.

Here is a further question from the same presentation referred to earlier: where should the bank’s capital be invested? Or as the question was posited, can capital be committed to funding risk-bearing assets? Again, it depends on which part of the capital base one refers to. If it is part of the regulatory minimum – and we are still talking about assessment on a going-concern basis – how can it be placed anywhere other than in genuine risk-free assets? Directed anywhere else, it risks being unavailable to absorb unexpected losses. Yet to assume that all banks place their capital base in sovereign T-bills would be to expose oneself as a trifle naïve. Often the funds are “invested in the business”, or used to back the purchase of risky assets.

Does the answer change for the capital amount over and above the regulatory minimum? Theoretically, after all, this is simply surplus capital and so can be used to fund risk-bearing assets. Yet the amount available must still be sufficient to absorb expected and unexpected losses: otherwise the institution risks eroding its regulatory buffers and this is when external perception of the bank’s soundness will suffer. The end-result of such a loss of confidence is invariably alarming.

Maintaining best practice

Module 5 of the Bank Treasury Risk Management (BTRM) programme syllabus deals exclusively with capital strategy, planning and management. While much of the course content is concerned with the technical process behind the internal capital adequacy assessment process (ICAAP), at the core of the teaching is an emphasis on always managing a bank on a going-concern basis.

This may appear to be stating the obvious, but it is worth repeating. The surplus over and above the regulatory requirement is what is available to absorb losses. In other words the capital buffer is sacrosanct and cannot be used to fund risky assets. Yet this interpretation of bank capital opens up something of a paradox. If the minimum amount required under legislative fiat was, say, 10%, but banks maintained at least 20% for sound business reasons, the capital base in practice would be sufficient to cover for just about every eventuality. And 10% of the total base would be available to absorb losses. Yet if the regulatory minimum was, say, 20%, then the surplus buffer may well take the capital base to 25% or higher. From a balance sheet optimisation viewpoint, this may be counterproductive.

However, this is not a major issue, particularly since some large systemic banks around the world showed themselves to be incapable of holding a sufficiently large buffer in the lead-up to the 2008 crash. For now, it’s important to remember these truisms about bank capital and ensure our balance sheet management discipline reflects best practice.

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