Regulators agree 7% capital ratio for banks
Central bank governors and senior regulators are set to ordain that banks must have a minimum core tier one capital ratio, including a new so-called "buffer" to protect against extreme economic conditions, of 7%, I can reveal.
This is considerably lower than was wanted by the "hawks", the US, UK and Switzerland. They wanted a core tier one capital ratio of 8 to 9% including buffer, which is what British banks currently have to maintain. In fact most British banks currently have a core tier one ratio of around 10%.
But the new 7% minimum has been agreed in the face of stiff resistance from a number of countries, led by Germany, many of whose banks typically have much lower stocks of core capital in the form of equity and retained earnings - and will have great difficulty meeting the new standard.
The 7% minimum represents a dramatic increase on the current minimum of 2%. That 2% minimum is widely seen as far too low: banks' low levels of capital relative to their assets was a major contributor to the severity of the 2008 banking crisis, as investors lost confidence in their ability to survive losses.
As they approached collapse, the capital ratios of Northern Rock and Royal Bank of Scotland fell to dangerously low levels - which is why Northern Rock was nationalised and RBS was semi-nationalised.
The point of capital is to absorb losses when loans and investments turn bad.
Although this new 7% minimum ratio of core capital (in the form of equity and retained earnings) to assets (loans and investments) as measured on a risk-weighted basis represents a significant increase, some will argue that the ratio is still too low.
One reason for this is that the absolute minimum capital ratio, without buffer, will be around 4%, or double the previous minimum.
Under the new system, if a bank's capital ratio falls below 7% or would fall below 7% when the bank is tested for financial stresses, the bank will be forced by regulators to raise new capital. And if the ratio falls below 4%, the bank will be put into "resolution" - which means that it will be taken over by regulators and wound up.
It means that banks' core capital ratios must always be above 7% in normal economic and financial conditions. But regulators would tolerate those ratios falling below 7% for short periods during economic downturns.
A senior regulator has told me that many of the biggest banks - those "too-big-to-fail" banks whose collapse would cause ruptures to the financial system - will in practice be forced to hold more than the 7% minimum.
"There will be some kind of add-on for systemically important banks," he said. So the likes of Barclays, JP Morgan, Royal Bank of Scotland, UBS and so on will in practice have to maintain core capital ratios greater than 7%.
The major concern of banks about the imposition of the higher capital ratios is that it will constrain their ability to lend in the transition period, as they build up stocks of capital - and that could undermine the global economic recovery.
The point is that there are two ways for banks to raise capital ratios: they can persuade investors to buy new shares; or they can shrink their balance sheets relative to their existing stock of capital by lending and investing less.
Because of the threat to economic growth of rapid implementation of the new capital ratios, the regulators and central bank governors are expected to give banks several years to meet the new standards.