Bank Capital Question Must be Resolved- WSJ

Although I talk a lot about commodity and other hard-asset investing, way back in the day I also covered the financial and banking companies. One important thing I learned, among others was that capital levels and access to capital was paramount above nearly all else. The following article from the WSJ highlights this. Although the article is UK centric, I think this will be a growing conversation amongst regulators, investors, bankers, and other interested parties as the debt crisis continues and evolves.
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How much capital should a bank hold in the post-crisis world? Five years after the financial crisis broke, this question is still not resolved—particularly in the U.K. where it is reaching new levels of intensity. Senior policy makers have been queuing up in recent weeks to make speeches proclaiming their belief that the U.K. banking system is undercapitalized, with the governor of the Bank of England prominent among them. The current window of opportunity provided by recent central bank actions needs to be used to restore the capital position of the U.K. banking system, Mervyn King said last month. "I am not sure Western countries in general will be able to escape their current predicament without significant recapitalization of their banking systems...In the 1930s, the pretence that debts could be repaid was maintained for far too long. We must not repeat that mistake."

Bloomberg News

Bank of England Governor Mervyn King, right, last month called for recapitalizations and warned against repeating the mistake of the 1930s.

The reason for all this speechifying is that the U.K. debate is due to come to a head at this month's meeting of the BOE's interim Financial Policy Committee, which oversees the overall safety of the U.K. banking system. The FPC has urged banks to raise capital at every quarterly meeting since its creation, but it has never spelled out how much capital it wants raised or why it is needed and so the banks have ignored it.
Everybody agrees the debate must now be resolved. Yet as things stand, there is no consensus. For Mr. King, for example, the capital is needed to cover unrecognized losses; for Deputy Governor Paul Tucker, it is to provide a buffer against a euro collapse; for external member Robert Jenkins, only large amounts of common equity will do; for Andrew Bailey, the head of the Financial Services Authority, contingent convertible bonds may suffice. The only thing everyone accepts is that the uncertainty is itself deeply damaging.

Needless to say, banks and their investors regard this debate with incredulity. U.K. banks are among the best capitalized and most liquid in Europe. Since the crisis started, their stock of regulatory capital has doubled to £336 billion ($533.9 billion), £150 billion above the current legal minimum. At the same time, they continue to generate sufficient preprovision profits to absorb the costs of past bad lending without dipping into these buffers. Royal Bank of Scotland RBS.LN +1.63% has generated roughly £25 billion of profits in the past five years to cover the £23 billion cost of running down its noncore book. Lloyds generated substantial capital last quarter. By the end of 2013, both Lloyds and RBS will have reduced noncore assets to below 5% of their total balance sheets. Meanwhile the cost of insuring U.K. bank debt against default has fallen sharply since the summer thanks to central bank action in the euro zone and the U.K. The banks say the weak U.K. credit growth reflects a lack of demand, not supply.

To some FPC members, this misses the point. They see them-selves as the inheritors of a 50-year policy error that allowed banks to operate with far too little capital. Many believe that not only did the original 2009 U.K. bank recapitalization plan not go far enough but that even the new Basel capital rules are inadequate. When the full Basel III rules come into force in 2018, the world's biggest banks—the so-called G-SIFIs—will be required to hold a minimum 9.5% core Tier 1 equity ratio. But many U.K. policy makers now believe the amount of primary loss-absorbing capital should be as high as 17%-20% of risk-weighted assets and 4% of total assets. Banks historically operated with far higher capital than today without hurting economic growth. Indeed, theory says it should make no difference if a bank holds more equity; since it will be less risky, investors will accept lower returns.

But how to get to this brave new world? Policy makers have had to acknowledge that the world doesn't always work as textbooks say it should. Regulators under-estimated the economic impact of bank deleveraging, FSA Chairman Adair Turner admitted in a recent speech. Rather than issue shares valued well below book value, banks responded to new regulatory rules by shrinking their balance sheets and pushing up borrowing costs. That contributed to a U.K. double-dip recession which, along with the euro crisis, led to higher bad-debt charges and higher funding costs, making it harder for banks to generate capital organically. Now banks are being hit with huge bills for past misconduct that are also eating into earnings: the bill for payment protection insurance mis-selling could hit £10 billion. Fines and compensation for rigging the London Interbank Offered Rate may end up even higher. Changes to bank business models as a result of the Vickers reforms and new financial conduct rules may also take their toll on future earnings capacity. Regulators are right to worry about the risk that the U.K. banking system "turns Japanese," with zombie banks unable to generate enough capital to support a recovery.

But what can and should the FPC do about this? Essentially, it's choice is binary: either it must demand a one-off, substantial recapitalization to get banks rapidly to the new levels it thinks necessary for the system to operate safely without public support; or it needs to back down, allow banks time to meet the Basel rules in the hope they will generate new capital organically and use this to support new lending. But in making this decision, the FPC will be bound by two constraints: first, it is only allowed to make system-wide recommendations and can't set capital rules for individual institutions. That means if it believes banks should raise capital, it will likely need to express this view in the form of a stress test, spelling out exactly what stress it wishes to test. Second, any decision to order a recapitalization requires the cooperation of the government since the Treasury will need to provide a fiscal backstop, not least to Lloyds and RBS where it is majority shareholder. But it is far from clear the Treasury has the appetite for a major clash with investors and the inevitable political fallout from a new round of bank equity injections: "It is what you might do if you were a benevolent dictator," says one senior official.

The BOE is sometimes compared to a benign dictatorship. But fortunately for banks, the U.K. itself is not. The true answer to how much capital a bank should hold is that it depends on how much risk politicians and investors are prepared to take. That makes it a debate that can never be finally resolved.