Last Saturday, Professors Benink (Tilburg), Sanders (Utrecht), and Kool (Utrecht) of the Sustainable Finance Lab (a research outfit initiated by former Rabobank board of directors chair Herman Wijffels) presented a proposal for strengthening capital for banks in the Netherlands. The professors respond to the 4% leverage ratio proposal of the Dutch government. Instead of 4%, they argue for a 10% Tier 1 Leverage ratio, with at least 5% common equity. The remainder shall be filled with convertible debt (CoCo hybrids).

It is an odd proposal, mainly because it weakens the quality of capital. Moreover, I find it hard to figure out how the proposal challenges the current state of capital affairs in the Netherlands, or how it contributes to the safety and soundness of the financial system. To me the proposal suits banks that cannot issue shares and banks that suffer from the introduction of the leverage ratio, the ratio that complements risk-based ratios.

Here is my explanation.

The proposal on the structure of regulatory capital, with 50/50 Equity to Hybrids is already part of the 2009 EBA guidelines on hybrid instruments. Paragraph 23 of the guidelines reads: “Hybrid instruments can be included in the highest bucket (up to 50% of original own funds) if they have to be converted into items referred to in Article 57(a) [=Equity] either during an emergency situation or, at any time, at the initiative of the competent authority.” The Netherlands adopted these guidelines in 2011, see Article 94 paragraph 9 of the Decree on Prudential Rules WFT. Therefore, the proposal is hardly new.

Furthermore, I am not sure what in practice a leverage ratio of 5% Common Equity Tier 1 and 5 % hybrids means. This is because hybrids currently contribute at max 200 bp to the Tier 1 ratio, where Tier 1 in Europe is around 12.5% of risk-weighted assets (see the recently published EBA monitoring report on capital in Europe). The very low proportion of hybrids in total Tier 1 capital makes Common Equity Tier 1 (CET1) the dominant part of Tier 1 capital. As a result, I wonder how strict a proposal for 5 % CET1 over Total Assets is in light of what banks currently show: about 3-6 %. Therefore, the proposed 5% may not bite banks with high ratios of risk weighted assets to total assets, but may hurt banks with a high proportion of very safe assets. In other words, the proposed low leverage ratio of 5% CET ‘helps’ all banks, in particular the low risk banks. And even then, risk is defined in RWA terms, not in terms of real risk.

The proposal also ignores the limitations of hybrids with a conversion feature. See my earlier post on the problems of CoCo’s. More importantly, hybrid instruments failed during the crisis, as the Squam Lake report shows. It is for this reason that Basel III has become much stricter on hybrids, see the Basel III rules text: “… the predominant form of Tier 1 capital must be common shares and retained earnings.” Therefore, I am inclined to see Tier 1 hybrids as capital of last resort, perhaps suitable for banks that cannot issue shares, e.g. cooperatives.

Finally, the government  does not have much room to maneuver when it comes to bank capital rules. Basel III will be implemented soon via CRR IV. Instead of a directive, European banks will now face a regulation with direct effect. Under CRR IV, solvency requirements originate from Brussels – no longer from EU member states. Perhaps that is desirable.