Ratio controls need reconsideration

Bank equity capital can play several roles; for example as a buffer against (unexpected) loss, as protection for other creditors in bankruptcy, and as ‘skin in the game’. There was never sufficient discussion of which role(s) the BCBS capital adequacy requirements (CARs) were meant to play, and whether they did so satisfactorily. In practice they did not. I discuss what principles should lie behind CARs if we could design these from scratch. I argue that there should be a minimum intervention point triggering official action to depose management and shareholders, and then move to resolution, with an increasingly penal ladder of sanctions as equity capital falls towards this point. A similar approach should also be applied to liquidity requirements.

► Basel capital ratios were not calibrated to meet the multiple functions of equity. ► A lower minimum level for intervening a failing bank is needed. ► Above that, a ladder of toughening sanctions is required. ► Such sanctions can be of different form and need careful design.