Bank Capital Post 2008 Financial Crisis

What is bank solvency and why are low solvency levels a problem?

A bank’s solvency is a measure of its capital; put simply: assets minus liabilities. At the time of the global financial crisis, minimum capital requirements for banks were woefully inadequate. Many systemically-important banks operated very low solvency levels i.e. were woefully under-capitalised.

They had very slim capital buffers to absorb potential future losses from hundreds of billions in assets, and capital ratios were easy to manipulate using a variety of preference shares and structured hybrid securities. Old-style hybrid long-term securities (which had characteristics of both debt and equity) included now-defunct Upper Tier II bonds as well as a class of subordinated debt known as Lower Tier II bonds. The primary problem with these instruments was that they could only absorb losses in the event of a liquidation or when the bank had become a gone-concern.

What improvements have been made to capital standards in recent years?

Over the past decade governments, regulators and financial institutions themselves have made a number of game-changing strides to strengthen bank solvency levels: increasing minimum capital requirements and introducing stricter rules on what constitutes bank capital. Improvements include:

• The Basel III global capital standard, which outlined stricter regulations on capital and risk-weighted asset calculations
• An alphabet soup of new capital regulations, including Total Loss-Absorbing Capacity (TLAC) at a global level and its European iteration: the Minimum Requirement for Own Funds and Eligible Liabilities (MREL)
• Myriad government-led stress tests.

Bank capital structures today are much simpler. They ensure that institutions are adequately equipped to continue critical functions without threatening financial market stability. And there is a clear hierarchy of loss absorption and capital subordination that ensures the burden of losses in any financial crisis situation is transferred from taxpayers to stakeholders. This is referred to as a bail-in regime.

Define a bank’s basic capital structure today

• Going-concern capital
  • Common Equity Tier 1: the bedrock layer of loss-absorbing capacity that includes shareholders’ equity and retained earnings (less goodwill, other intangibles and dividend distributions)
  • Additional Tier 1 (AT1) a.k.a. contingent convertibles (CoCos): perpetual debt securities that absorb losses when a predetermined regulatory capital level is breached. Embedded contractual provisions impose either principal write-downs or conversion into equity
• Gone-concern capital
  • Supplementary capital (Tier 2 capital): consists of revaluation reserves (i.e. the surplus created by the upward revaluation of an asset e.g. real estate owned), general loan loss provisions and subordinated Tier 2 bonds. Supplementary capital is senior to CET1 and AT1 but subordinate to other senior unsecured bondholders, senior preferred bondholders and deposits.