[For the previous blog posting in this series, see here.]
Consider the following question: according to the Bank of England’s own guidance documentation, what should be the absolute minimum pass standard in its headline stress test, the test based on the ratio of Common Equity Tier 1 (CET1) to Risk-Weighted Assets (RWAs)?
The Bank of England used a 4.5% pass standard in the test, but I assert that it should have used a pass standard of at least 7% instead.
Why does this matter? Well, if you use 4.5% as the pass standard, the UK banking system performs fairly well under the stress test, but if you use 7% as the pass standard, it doesn’t. [See End Note 1]
This is a big deal because it undermines the Bank of England’s narrative that all is well with the UK banking system.
So what do the Bank’s own guidelines indicate that it should use as the absolute minimum pass standard?
We can break this question down as follows.
First, what is the relevant Bank of England guidance document?
Answer: the guidance document is the Bank’s October 2013 Discussion Paper “A framework for stress testing the UK banking system”.
Then there are two further questions. According to this guidance document:
- What is the connection between the pass standard in the stress test and the minimum capital requirement(s) imposed on banks?
- What exactly is/are these minimum capital requirement(s)?
Page 28 of the Bank’s October 2013 Discussion Paper contains the following statement:
Interpreting these [stress test] results, and reaching a judgement about bank capital adequacy, requires a view on the level of capital that regulators want banks to maintain in the stress scenario. This is often referred to as the ‘hurdle rate’.
This ‘hurdle rate’ is the same as my ‘pass standard’. To continue:
Ultimately, this is a policy decision by the FPC [Financial Policy Committee] and the PRA [Prudential Regulation Authority] Board. But there are a number of considerations the FPC and the PRA Board might take into account in considering the level of capital banks should maintain in a stress.
A key consideration will the minimum level of capital required by internationally agreed standards. Banks need to maintain sufficient capital resources to be able to absorb losses in the stress scenario and remain above these minimum requirements.
My interpretation: leaving aside the judgmental override caveat in the second paragraph, the pass standard should be at least as high as the minimum capital requirements.
This takes us to the second question: what is/are the minimum capital requirement(s)?
The Discussion Paper continues further:
Minimum capital standards have been set internationally by the Basel Committee on Banking Supervision and transposed into European legislation under the Capital Requirements Regulation and Directive (CRD IV).
For example, under the PRA’s proposed implementation of CRD IV, the minimum Pillar I common equity Tier 1 capital requirement will be set at 4.5% from 1 January 2015 onwards.
If you didn’t read any further, you might conclude that the pass standard should be 4.5% because the Bank’s Discussion Paper claims that the minimum Pillar 1 CET1 requirement [note the singular] is 4.5%.
But this is to presuppose that there are no other CET1 minimum capital requirements and this is not so.
In fact, the 4.5% minimum is only one component of a set of CET1 minimum capital requirements [See End Note 2] [note the plural] and the overall minimum capital requirement is the sum of each of the components in this set.
The second component of this overall minimum capital requirement is explained in footnote 2 on the same page:
Consistent with the Basel III Capital Accord, CRD IV [also] requires banks to have at least a 2.5 percentage point buffer of capital [the Capital Conservation Buffer or CCB] above the 4.5% minimum.
Thus, the CCB is an additional minimum requirement on top of the 4.5% minimum capital requirement.
Therefore, the overall minimum capital requirement is the sum of these two minimum capital requirements and 4.5% + 2.5% = 7%.
And since the pass standard in the stress test must be at least as high as the sum of these minimum capital requirements, i.e., the overall minimum capital requirement, the pass standard should also be at least as high as 7%.
The Bank’s position seems to be that they can ignore the CCB in setting the pass standard because the CCB is a different type of minimum requirement and because the failure-to-comply sanctions associated with the two minimum requirements are different: failure to meet the bare minimum 4.5% requirement could lead to the bank being put into resolution, whereas failure to comply with the CCB minimum requirement would merely lead to the bank being required to file a capital plan with its supervisor who may limit payments of dividends and bonuses.
Such thinking would fail any logic test.
The Bank’s point about the CCB being a different type of requirement is correct but irrelevant; what matters is that the CCB is a requirement nonetheless.
Nice try, but the blind-them-with-an-irrelevant-difference-defence doesn’t work.
Conclusion: according to the Bank’s own guidance document, the absolute minimum pass standard for the CET1/RWA stress test should be 7%.
I also consulted a number of experts for independent opinions. Not a single one was willing to defend the Bank’s interpretation of its own rules.
Consider for example this response from my friend, the Canadian economist Basil Zafiriou:
I read the standard the same as you, Kevin. The CCB is a mandatory buffer, so it has to be added to the CET1 minimum for an overall capital requirement threshold. Suppose a fire safety code requires commercial establishments to have a front and back exit plus a sprinkler system: having a front and back exit meets the exits requirement, but an establishment would not meet the fire code standard unless it also had a sprinkler system.
Still, I doubt you can win this argument with the BoE. You’re relying on logic and they rely on argument by assertion. And since they make the rules, like Humpty Dumpty they can make any rule to mean “just what [they] choose it to mean.” [See End Note 3]
Basil’s analogy with a fire safety code is spot on, ditto the Humpty Dumpty – and we all know what happened to him. The Bank’s interpretation of its own document is like Humpty himself, scrambled.
To give another view on the matter, on p. 24 of his authoritative book on the Basel III system, Safe to Fail: How Resolution will Revolutionise Banking (Palgrave Macmillan, 2014) Thomas F. Huertas states that
Strictly speaking, the capital conservation buffer does not constitute a minimum capital requirement.
At first sight, this statement might seem to support the Bank’s position, if read alone and out of context. But now consider the sentence that follows:
Instead, it represents the level at which the bank has to conserve capital by limiting dividends and distributions and by liming bonus payments in cash to management and employees – ample reason in the eyes of many to regard 7 percent as the effective minimum requirement.
Put another way, his view seems to be that “strictly speaking”, the minimum is 4.5%, but “effectively” it is 7%.
Furthermore, after the end of his first sentence there is a flag to a footnote in which it becomes clear that he is not citing the Bank’s ‘framework’ document at all. Instead, he is citing the Basel Committee on Banking Supervision (BCBS) in its original Basel III framework document, “Basel III: A global regulatory framework for more resilient banks and banking systems.” This footnote refers to pp. 54-57 of the Basel III framework document and an example of what it says is the following, which appears on p. 55 of that document:
129. A capital conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the regulatory minimum capital requirement.
This language and the use of the term “minimum capital requirement” in the singular suggest that the BCBS might have seen the CCB as something apart from the minimum capital requirement [sic]. This is a one reasonable interpretation of the BCBS document but the underlying ambiguity in that document (e.g., over whether there is one or more minimum capital requirement(s) etc.) is regrettable.
Be this as it may, Huertas’s statements cannot be cited in defence of the Bank of England’s ‘framework’ document as he was referring explicitly to the BCBS ‘framework’ document and he made no reference at all to the Bank of England’s ‘framework’ document. Nor can there be any ambiguity here: Dr. Huertas was crystal clear what he referred to.
So when is a minimum capital requirement not a minimum capital requirement?
The Bank’s answer: a minimum capital requirement is not a minimum capital requirement when the Bank doesn’t use it as the pass standard in its stress tests, even though it promised it would.
I am tempted to say that this is truly Clintonesque hair splitting, but it is not: it is simply wrong.
The credibility of the Bank’s stress tests should be out there unchallengeable and shining bright for all to see, not dependent on a misreading of its own guidance documentation – and a misreading that just happens to underpin the Bank’s preferred narrative that everything is fine with the UK banking system.
If the UK banking system is as strong as the Bank of England maintains, surely the Bank can build a stronger case that this?
February 29 2016
End Note 1:
To be precise, with a 7% pass standard, the average surplus over the pass standard is less than 100 basis points, 2 banks fail the test, 2 scrape through by very narrow margins over the pass standard, 2 banks get small margins over the pass standard, and only 1 performs well.
End Note 2:
To clarify, the other components are the Capital Conservation Buffer (CCB), the Counter-Cyclical Capital Buffer (CCyB) and the Globally Systemically Important Banks (G-SIB) Buffer. I believe that to be convincing, these should be set at the maximum plausible levels they might take under fully phased-in (‘fully loaded’) Basel III. (And I am ignoring the new Systemic Risk Buffer announced in December 2015.) However, for present purposes I focus on the CCB as I am only concerned here to make the point that the Bank should never have used 4.5% as the pass standard in its stress tests.
End Note 3:
For those of you who forgot your Lewis Carroll, "When I use a word," Humpty Dumpty said, in rather a scornful tone, "it means just what I choose it to mean—neither more nor less."