At its meeting on 19 March, the Financial Policy Committee (FPC) discussed work by the Financial Services Authority (FSA) in response to its November 2012 recommendation that “the FSA takes action to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets, a realistic assessment of future conduct costs and prudent calculation of risk weights”. The FPC had also recommended that “where such action reveals that capital buffers need to be strengthened to absorb losses and sustain credit availability in the event of stress, the FSA should ensure that firms either raise capital or take steps to restructure their business and balance sheets in ways that do not hinder lending to the real economy”.
The FSA had examined each of these areas for the major UK banks and building societies. It had advised that expected losses which might arise over a three year period on specific high-risk loan portfolios, including exposures to UK commercial real estate and vulnerable euro-area economies, could exceed existing provisions by around £30 billion; that identified future conduct costs arising over a three year period could exceed provisions by around £10 billion; and that a more prudent approach to risk weights in the banking book would raise risk-weighted assets by some £170 billion (equivalent to roughly £12 billion of capital at a 7% equity capital ratio). Taken together, the effect of these three adjustments would be equivalent to around a £50 billion reduction in the regulatory capital of the major UK banks and building societies.
The actions that banks need to take depend on whether, and if so how far, their adjusted capital falls short of the level that the FPC judges banks need to ensure sufficient capacity to absorb losses and sustain lending in the current conjuncture. The FPC judged that the immediate objective should be to achieve a common equity tier 1 capital ratio, based on Basel III definitions and after the required adjustments, of at least 7% of risk-weighted assets by end 2013. Some banks, even after the adjustments described above, have capital ratios in excess of 7%; for those that do not, the aggregate capital shortfall at end 2012 was around £25 billion.
The FPC noted that after 2013 further increases in capital ratios will be required. In particular, banks will need to transition to full Basel III compliance and meet the surcharge on systemically important banks and the new trading book capital regime. In parallel, they will need to meet the requirements imposed by the Government’s implementation of the Independent Commission on Banking (ICB) recommendations.
In light of this exercise, the FPC recommends that:
- The Prudential Regulation Authority (PRA) should assess current capital adequacy using the Basel III definition of equity capital but after: (i) making deductions from currently-stated capital to reflect an assessment of expected future losses and a realistic assessment of future costs of conduct redress; and (ii) adjusting for a more prudent calculation of risk weights.
- The PRA should take steps to ensure that, by the end of 2013, major UK banks and building societies hold capital resources equivalent to at least 7% of their risk-weighted assets, as assessed on the basis described in Recommendation 1. Relative to that benchmark, major UK banks and building societies in aggregate currently have a shortfall in capital of around £25 billion.
- The PRA should consider applying higher capital requirements to any major UK bank or building society with concentrated exposures to vulnerable assets, where there are uncertainties about assets not covered in the FSA's assessment of future expected losses or risk weights analysis, or where banks are highly leveraged relating to trading activities.
- The PRA should ensure that major UK banks and building societies meet the requirements in Recommendations 2 and 3 by issuing new capital or restructuring balance sheets in a way that does not hinder lending to the economy. Any newly-issued capital, including contingent capital, would need to be clearly capable of absorbing losses in a going concern to enable firms to continue lending.
- The PRA should ensure that major UK banks and building societies have credible plans to transition to meet the significantly higher targets for capital and the leverage ratio that will come into effect in 2019 after full implementation of Basel III, the trading book review and surcharge for systemically important banks, and after HM Government's implementation of the ICB proposals, in ways consistent with sustainable expansion of the UK economy.
- Looking to 2014 and beyond, the Bank and PRA should develop proposals for regular stress testing of the UK banking system. The purpose of those tests would be to assess the system’s capital adequacy. The framework should be able to accommodate any judgements by the Committee on emerging threats to financial stability.
The FPC will monitor implementation of these recommendations, but does not intend to issue further recommendations on bank capital ahead of a future stress testing exercise.