The language of Capital and Equity

Frances Coppola this week posted on her blog an explanation of Capital, liquidity and the countercyclical buffer, in plain English. Frances posted because of Caroline Binham’s use of language in a Financial Times article.

Caroline, according to Frances, is wrong. So wrong even that she takes it out on Caroline, blaming her for not being impartial. A long post follows that looks over the top to me, given the brief nine paragraphs of the FT article. Initially, Frances takes aim at the use of expressions like “setting aside capital”, “holding capital”, and the use of the word “reserves”. She then redefines the role of capital, after which she posts some out of character comments. I mean, accusing the FT and its readers of ignorance is no small thing:

lost it

Dude! What’s your problem?

Caroline’s writing is neither confusing nor wrong. She writes that the Bank of England readies banks for the deployment of the counter-cyclical buffer. Banks then respond by complaining. How wrong can Caroline be?

The culprit here is language and the sloppy use of jargon, specifically the language of bank accounting. Bank accounting terms differ from corporate accounting terms, most notably on the use of the term “leverage”, which in banking is generally the inverse of gearing.

Like American English and English English, it takes time to learn the differences between them (as a non-native speaker, I still struggle). In addition, the jargon is dynamic, it also differs from country to country.

“If you think you understand the standard, you have not read it properly”, Sir David Tweedie, former Chairman of the IASB once said about IAS 39, the standard for banks financial instruments. The quote applies to many things banking.

The text below demonstrates some differences in bank accounting speak and corporate accounting speak. I hope you then understand that it is unfair to accuse someone of being “wrong.”

Holding capital? Banks cannot hold capital: capital appears on the right hand side of the balance sheet. In some languages, entries on the right hand side of the balance sheet are called “passiva”, which kind of rules out an activity such as “holding”.

However, it is a nasty one: using “holding capital” for writing purposes is just very convenient. There aren’t many alternative word pairs that convey the same meaning.

That may explain why the EU relies on these words when explaining the CRD IV/CRR Capital Requirements: eu holdsThe CRD IV legal text also mentions the words:hold_crr

It is clear what “holding” in this context means: capital should absorb losses, a bank needs a minimum amount of capital. I don’t think banks are slow in satisfying higher capital requirements because of a confusing CRD IV/CRR legal text.

To avoid confusion (as you may have noticed) I use the ugly, but accurate: “to satisfy [higher | lower] capital requirements.”

Reserves? The use of the terms “reserves” in the context of bank capital is perfectly legitimate. Given that banks are very aware of the legal context in which they operate, it helps to refer to the legal texts that support their choice of words.

For the use of “reserves”, banks may rely on the bank accounting directive (BAD), which defines reserves as part of liabilities (Articles 4 and 23).

The things you can do with reserves. Even though reserves appear on the passive side of the balance sheet, the use of terms that imply an activity is perfectly fine. Even the Basel III rules text does it. See for example:

built capital

There’s two fish in a tank. One turns to the other and says “How do you drive this thing?”

Like the word “tank”, Equity and Capital  are context-sensitive words, which can lead to confusion. Best is to refer to the underlying legal texts, especially today. They are well-defined now.

Equity is the difference between assets and liabilities (see this IFRS text). However, defining what precisely constitutes equity is a daunting task.

Roughly, equity is the sum of shares, share premium, retained earnings, accumulated other comprehensive income, and reserves. Consolidated accounts may add minority interest to equity.

Roughly.

Each of the elements of equity may be subject to misunderstandings. For example, is it “shares”, “stock” or “common equity”, and if it is shares, can holders vote? What if they cannot vote, are they then still shares, or are they certificates instead? What about the infamous German silent partnerships? Does equity include interim profits? What about cooperative shares, are they deemed fully equivalent to common shares?

Given the role of equity in determining the solvency position of a bank, it very, very, very, important to define this element of the balance sheet precisely (not even accurately).

The Basel III rules text, for example uses two pages to define equity. The EU implementation of Basel III (CRR) uses six long articles (Articles 26-31) and a technical standard to define it.

Capital is defined by prudential rules. It is the sum of Tier 1 (going concern)  and Tier 2 (gone concern) instruments, net of regulatory adjustments.

Banks shall satisfy capital requirements to retain their banking licence: a bank can be insolvent, but if it meets the capital requirements, it still can operate as a bank.

Before the financial crisis, the definition of capital was sloppy. EU rules called it “own funds”, a term that covered anything from shares, certificates, innovative hybrids, the dodgy “funds for general banking risks” to subordinated debt. The previous CRD did not even define a core element of Tier 1. Tier 1 was capital of the highest quality, even if it included hybird instruments that could not really absorb losses.

The definition of capital is now very tight, precise and well-specified. The Basel III definition of capital spans 18 pages, an addendum and a FAQ. The CRR devotes a whopping 66 articles, technical standards and Q&As to define capital.

Few people know that the Basel committee started tightening the definition of capital around the beginning of 2008, which explains why the first draft of Basel III appeared so soon, in 2009.

There are important differences between Capital and Equity. The Basel committee spent a lot of time discussing the elements that drive a wedge between them. Many meetings were spent on controversial deductions such as mortgage servicing rights, deferred tax assets, and bank holdings in insurance companies (see para 87 of Basel III rules text and Articles 48-49 of the CRR.)

The irony about the deduction is that they are so complicated that they drive supervisors nuts. It is no surprise to see the ECB now trying to iron them out.

Banks should complain about raising capital requirements, that is the whole idea. Adding to the irony is my paper on regulatory adjustments. It demonstrates that banks that rely on items that increase Tier 1 over equity are generally less solvent than firms that report low Tier 1 compared to equity. It just goes to show that Common Equity Tier 1 is the element of capital you should watch – the other elements are largely irrelevant.

In other words, banks do not complain about raising Tier 1 capital if it can be done through issuing Additional Tier 1 capital. But if it is CET1 that banks should raise, they should.

The purpose of capital is to absorb losses, not to limit lending. Tier 1 capital shall absorb losses in going concern, i.e. when the bank is viable. It should protect the bank from defaulting and thus lower the probability of default. Tier 2 capital shall absorb losses in gone concern. It should help clean up the mess after default.

Frances, however, in explaining the counter-cyclical buffer, incorrectly ends her post with an objective that focuses on the denominator of the solvency ratio: higher capital requirements makes “them less willing to lend. That, Caroline, is its purpose.”

I’m sorry, but this objective was ruled out by the EBA a couple of times. See for example  EBA’s Recommendation on the preservation of capital, and the press release that accompanied the EBA capital exercise in 2011.

Moreover, if you go back to the original Basel III document, then the rationale for the counter-cyclical buffer is not to limit lending, but to mitigate the risks of excessive credit growth: ccbi.e. consistent with the idea that Tier 1 capital is meant to absorb losses in going concern.

The EU spin on the counter-cyclical buffer – that it should limit lending in good times – is not helpful, but can be explained by the fact that the rules for the counter-cyclical buffer were written by a working group that consisted of mainly economists that were not part of the Basel III Definition of Capital (DOC) working group.

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