Highlights from the Bank of England financial stability report

The Bank of England recently published its bi-annual financial stability report for November 2012. As usual it contains some very interesting stuff. Let me highlight a few things.  The first thing I want to highlight is the graph below on bank capital requirements. It shows an interesting comparison, namely what the shortfall in bank capital looks like when capital is calculated in different  ways. It shows that the risk weights that result from banks’ internal rating-based models are significantly lower compared to those resulting from alternative measures for required capital. According to the BoE this could indicate that capital levels in the UK are currently overstated. Regulators in other EU countries should follow this lead (and publish their results).

Alternative measures of capital increases required

The second thing I want to highlight is the BoE view on equity issuance. I quote ‘Since the early stages of the financial crisis, large amounts of equity have been issued by banks. (…) This suggests low bank valuations are not of themselves an obstacle to issuing equity.’ The graph below substantiates this view. It contrasts with the line I’ve heard from other central banks, who regularly argue that banks can only recapitalize by withholding dividend or shedding assets. Of course, banks do not like issuing equity and would rather spare their stockholders. But from a social perspective issuing capital is the preferred way of recapitalizing.

equity issuance banks since 2008

The third thing I want to highlight is the graph below on Greece. It shows the projection of development of Greek GDP at different stages in the eurocrisis. Note that these projections are consistently over-optimistic.  Based on this graph, you may guess what the answer will be to the question: ‘Will we need further debt reductions for Greece?’.

Greek_GDP_forecasts

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Why worry about the optimal level of bank capital ratio if 20 percent is good enough?

The most relevant economic studies do not necessarily coincide with those published in top economic journals. It is easy to miss a great study. This paper by the Sverigse Riksbank is a point in case. It was released in december 2011 and I only saw it yesterday. It tries to answer a crucial question I’ve discussed on this blog here and here (in Dutch) – how much bank capital is optimal from a welfare point of view. The answer:  somewhere between 10 and 17 percent. This is in line with previous studies that try to tackle this nasty question, as shown in the table below.

But what is really interesting is the following graph. It shows the effect on gdp of an increase in capital ratios for the various studies, starting from an initial level of 6 percent.  Clearly, when capital ratios are too low the benefits of increasing them is very large: the curve increases steeply for low capital ratios. Remarkably,  however, it flattens out when capital ratios reach the optimal level. This implies that the costs of setting the capital ratio too high (i.e. at 20 percent if 15 percent is optimal)  are much smaller than the costs of setting the capital ratios too low (i.e. at 10 percent instead of 15 percent).

Let me put this differently. In all studies considered here, bluntly setting the capital ratio at 20 percent results in only a very minor loss relative too choosing the optimal level, wheras it results in a significant benefit when compared to the initial level of 6 percent. So why worry about the optimal level of bank capital if you can just set it at 20 percent?