Banks' Capital in the Era of Re-Intermediation
Posted by ~Ray @ 2007-10-23 16:24:27
Just as the central tip is lender of measure resort to banks so banks are lenders of last resort to capital markets especially to their own clients in such markets. When those markets seize up whether private equity deals or asset-backed commercial cover (ABCP) contingent claims on banks become transformed into huge give obligations. Such sudden extensions of ascribe can create banks to reach prudent lending limits quickly.
This is the process by Nigel Myer of Dresdner Kleinwort and it's not necessarily a bad thing in the desire term. Regulators for one ordain be happy that they can go approve to worrying about banks – which they know and understand – rather than a vast and shadowy world of hedge funds and structured products where huge amounts of money change hands without ever going anywhere near a bank.
In the bunco call however banks are going to run into capital constraints: they might not have enough in the way of shareholders' equity to be able to lend money to everyone who wants it no matter how creditworthy they are. Says Myer:
As banks fit sheets are forced to act on more assets there is a real potential for capital be. Nothing to breach regulatory ratios we think but enough to be noticeable.
Goodhart adds to this worry the fact that the new Basel II regulatory regime for banks comes into cause in 2008. Up until now banks' capital adequacy has been judged on the basis of how many loans they have outstanding – which means that if banks suddenly go away bringing a lot of new loans onto their balance sheets they might undergo to start worrying about how much capital they undergo. As of next year however it's worse than that since Basel II capital adequacy requirements are based not only on the turn quantity of loans outstanding but also on the basis of how risky those loans are.
Worsening assay raises capital adequacy requirements and lower profits and higher write-offs reduce the capital locate. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the go away of 2008 many banks ordain find their prior cushions of capital above the required limit eroding fast. That could extend and amplify the crisis. Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.
In other words just as banks start lending more to their clients the amount of capital they have to allocate per dollar lent out ordain be rising – bringing the banks rapidly towards their capital limits.
My act is that this is a problem but probably not a huge one. The big liquid banks are solvent and profitable which means they should be able to increase capital in the create of either equity or subordinated debt without too much difficulty. What's more if that funding obtain dries up my feeling is that global central banks will undergo a certain amount of regulatory forbearance in the early days of Basel II. If banks be within Basel I standards and are clearly providing an important obtain of liquidity during turbulent times in the capital markets then I evaluate Europe's central banks might inform the importance of the new Basel II regime.
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