We could argue about the merits of small changes in the capital standard, but that is not in my view a worthwhile exercise. What is more notable is the divide between this view of strengthening banks’ loss absorbency and the alternative view that the answer lies in a radical restructuring of the banking system to require banks to have loss absorbency which would be a substantial part (say 20% to 30%) of their total balance sheet2. It is wrong in my view to conflate an argument about small differences in capital buffers with one that is all about a different financial system.
I want to spend a few minutes on this alternative view, on what it would mean, and why it is advocated. To be clear, I am not commenting as a supporter, but rather to try to cast light on this big issue. The essence of the argument as I see it is that it is asserted by supporters of, let’s call it the “big equity” school, that we cannot value large banks adequately because they are too complex and opaque, cannot supervise them effectively and cannot resolve them, we must resort to an approach which requires a sizeable shift in the balance of their funding away from value certain deposits contracts towards loss absorbing equity type contracts. This is on the basis that there is then a large buffer to absorb the losses that will flow from inadequate valuation and supervision, and without recourse to resolution. For me, this begs the question of the appeal of a proposition which states to the public: “will you please provide equity funding to something we can’t value or properly oversee”. Put like that, the idea does not seem appealing. I cannot see why there would be a desire to provide equity funding for banks on such terms rather than invest in other companies either directly or through a collective asset scheme. I recognise that it has been proposed that the equity funding should be built up by retaining dividends, but to accumulate say 20% of a bank’s balance sheet by this means requires I think an implausibly long transition period. In fact, based on the current position of the major UK banks, including the average dividend payment rate, the transition period to 20% equity would be around 90 years. That’s a little bit longer than the 17 year transition period for Solvency II. I do not therefore see “big equity” as a sustainable solution because this sort of proposal is just not practical.
The full speech is available at http://www.bankofengland.co.uk/publications/Pages/speeches/2016/889.aspx