How much is enough for safer banks?

Sir John Vickers in 2011 Image copyright Getty Images

Why is it that Sir John Vickers, the man who led the UK's post-crisis review of banking regulation, takes issue with the idea that banks now have enough capital?

Mark Carney, Governor of the Bank of England, has indicated that he sees the job of bolstering banks' capital buffers as largely complete. Sir John thinks banks should be forced to hold roughly double the level they've reached so far.

That is an alarming thought for a sector that has already spent a decade rebuilding, after the crisis exposed the inadequacy of the amount of capital then held by banks as a defence against huge credit losses.

The amount of capital that banks are required to hold is a balancing act. Higher capital standards effectively force banks to set more money aside for each loan they make, reducing their overall lending capacity.

So the benefits of higher capital levels, in terms of the reduced risk of crises, must be set against the costs, in reduced lending and potentially slower economic growth.

Assumptions

Sir John doesn't take issue with the regulator's methodology or numbers per se. Instead, he has a problem with its assumptions.

He told Newsnight: "If you take the analytical model that the Bank itself has published on this question which is an attempt to weigh the costs and the benefits of higher capital standards, the answer they get out of the model unsurprisingly is the policy position that they're sticking to. But they feed some very strange assumptions into that model in my view.

Sir John added: "One is that these new and completely untried, untested so-called resolution regimes are going to work in a very seamless way." That means that the Bank of England is assuming that if there were to be a bank failure, it would be possible to wind that institution down without causing too many problems for other banks.

He continued: "Another is that they've calculated the right capital level for normal risk conditions, average conditions. To me, that's a bit like working out the nation's flood defences on the basis of average weather…. So if I took their own model and I fed in I think much more realistic assumptions, I would get to about double the capital levels the Bank of England is proposing."

Image copyright Getty Images

Since 2008, regulators have created a range of tools designed to help them wind down failing banks in a way that doesn't require the use of public funds and that insulates the rest of the financial system and economy from harm.

But the fact that such tools remain largely untested, including ways to force losses onto private investors, is one source of concern for those contemplating the safety of the system a decade after the financial crisis.

Defences

Sir John believes that higher capital standards could be achieved with little economic cost. "Our defences could be a lot better," he said. "If phased in over time, it would be perfectly doable. We could at minimal, if any, cost to the economy - almost free insurance - get ourselves into a much stronger place than we currently are."

It's a view that has some support elsewhere. A study by the US Federal Reserve found that the Tier 1 capital requirement - one measure of bank capital - that best achieves this balance is in the range of 13% to 26%.

Average capital ratios for both US and UK banks are towards the lower end of that range.