Global authorities continue to strengthen banks' capital adequacy, risk management and supervision to make the financial system more resilient.
The current financial crisis has shown that a strong capital base is critical to bank resilience, and ultimately to broader financial stability. In the last article, we looked at some of the improvements to the risk coverage of the Basel II framework which have already been proposed by the Basel Committee on Banking Supervision (BCBS) as part of its efforts to enhance global regulation of banks' capital adequacy and risk management.
In this article, we'll look at some of the work the BCBS is doing for the longer-term development of the capital framework. A natural starting point is the work of the BCBS Definition of Capital Subgroup (of which the HKMA is a member) to strengthen the quality, consistency and transparency of regulatory capital, particularly the highest forms of "Tier 1 capital". Tier 1 capital refers to those elements of a bank's capital base which are designed, and have the greatest capacity, to allow a bank to absorb losses while continuing its operations as a going concern. While share capital and reserves are at its core, Tier 1 capital may also include (within specified limits) innovative financial instruments, often called "hybrid" instruments, incorporating elements of both debt and equity. When the Basel II capital framework was developed in the earlier part of this decade, substantial changes were made to the way banks' exposures, and the degree of risk attached to those exposures (risk-weighted assets), are calculated. However, the other side of the equation, the calculation of the banks' capital base, remained largely as it had been since 1998, when the BCBS made an announcement outlining "Instruments eligible for inclusion in Tier 1 capital". In the intervening years, there has been substantial innovation and growth in the hybrid capital market leading to some divergence in the treatment of hybrid capital instruments in various jurisdictions' capital-adequacy regimes. This, coupled with the need to consider the impact of changes in the capital treatment of banks' loan-loss provisions under Basel II, prompted the BCBS to fundamentally review the definition of capital for regulatory purposes. Obviously, international convergence is important in achieving a level playing-field. The BCBS's work in this area began before the current crisis, but it has been given added impetus by the crisis and in particular by the increasing market focus on common-equity share capital as a measure of capital strength.
During the crisis, the market has demanded more and better-quality capital when assessing bank resilience. Some banks' capital cushions (in particular their "core" Tier 1 capital) were too low to support their risk exposures going into the crisis, resulting in strenuous recapitalisation efforts in various jurisdictions, often involving government funds. Continued reservations about the ability of banks' capital to absorb further losses, expected to arise in the deteriorating economic situation, have prompted specially tailored stress tests in the US and elsewhere to assess capital resilience. The lessons from this fundamental credit-cycle part of the crisis, associated with large write-downs in some banks' corporate and retail lending books, are clear. The BCBS aims to ensure a stronger base of high-quality core capital to increase banks' resilience to losses, coupled with strong buffers above the minimum prescribed levels of capital to enable banks to continue providing credit to the economy even in severe downturns. This suggests that we should expect to see increases in both the level and quality of capital to promote the stability of the banking sector over the longer term. However, there is a clear message from the BCBS, endorsed by the G20, that it will not raise minimum capital requirements during the crisis. The work underway now is to provide a clear road map of where the Committee is heading.
