Banks' Capital in the Era of Re-Intermediation

Charles Goodhart says in the FT today that there's loads of money sloshing around the banking system; what's missing is not liquidity, but capital. He explains:

Just as the central bank is lender of last resort to banks, so banks are lenders of last resort to capital markets, especially to their own clients in such markets. When those markets seize up, whether private equity deals or asset-backed commercial paper (ABCP), contingent claims on banks become transformed into huge loan obligations. Such sudden extensions of credit can cause banks to reach prudent lending limits quickly.

This is the process dubbed "re-intermediation" by Nigel Myer of Dresdner Kleinwort, and it's not necessarily a bad thing in the long term. Regulators, for one, will be happy that they can go back to worrying about banks – which they know and understand – rather than a vast and shadowy world of hedge funds and structured products where huge amounts of money change hands without ever going anywhere near a bank.

In the short term, however, banks are going to run into capital constraints: they might not have enough in the way of shareholders' equity to be able to lend money to everyone who wants it, no matter how creditworthy they are. Says Myer:

As banks balance sheets are forced to take on more assets, there is a real potential for capital stretch. Nothing to breach regulatory ratios, we think, but enough to be noticeable.

Goodhart adds to this worry the fact that the new Basel II regulatory regime for banks comes into effect in 2008. Up until now, banks' capital adequacy has been judged on the basis of how many loans they have outstanding – which means that if banks suddenly start bringing a lot of new loans onto their balance sheets, they might have to start worrying about how much capital they have. As of next year, however, it's worse than that, since Basel II capital adequacy requirements are based not only on the sheer quantity of loans outstanding, but also on the basis of how risky those loans are.

Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis.
Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.

In other words, just as banks start lending more to their clients, the amount of capital they have to allocate per dollar lent out will be rising – bringing the banks rapidly towards their capital limits.

My take is that this is a problem, but probably not a huge one. The big, liquid banks are solvent and profitable, which means they should be able to raise capital in the form of either equity or subordinated debt without too much difficulty. What's more, if that funding source dries up my feeling is that global central banks will have a certain amount of regulatory forbearance in the early days of Basel II. If banks stay within Basel I standards, and are clearly providing an important source of liquidity during turbulent times in the capital markets, then I think Europe's central banks might downplay the importance of the new Basel II regime.

(HT: Alea)