The UK's bank capital fudge

The Bank of England's Financial Policy Committee highlighted why bank capital regulations without banks being required to provide ultra transparency are completely meaningless.  Without disclosure by the banks of their current global asset, liability and off-balance sheet exposure details, it is impossible to measure a bank's capital adequacy.

I give the FPC a tremendous amount of credit for simply stating that UK banks don't have enough capital.

Now the question is given the losses and risks that are hidden on and off the banks' balance sheets is $75 billion of new capital enough and which banks need to raise the capital?  Without the banks being required to provide ultra transparency, market participants don't know the answer.

Given its mandate to protect the financial system from systemic risks, I wish the FPC had also called for the banks to provide ultra transparency.  Not only would the FPC have solved the measurement problem with bank capital, but it would also have addressed a systemic risk.  Specifically, our current financial crisis shows that opacity in the banking system is a systemic risk.

From a Simon Nixon Wall Street Journal Heard on the Street column,

So that's clear then. The U.K. banking system has a capital hole of around £50 billion ($75.8 billion), according to the Bank of England's Financial Policy Committee. Well, actually, that hole shrinks to around £25 billion relative to a new BOE benchmark of a 7% minimum core Tier 1 capital ratio on a Basel III basis after making various regulatory adjustments. 

OK, the true capital hole may be only half this size once one takes account of anticipated retained earnings and other capital-enhancing actions under way at U.K. banks. 

But the final size of the capital hole and the identity of the guilty banks must remain a state secret, only the regulators and the banks themselves to know. 

This is, of course, nonsense.

Actually, it is worse than nonsense that the size of the capital hole is a state secret known only to the regulators and banks.

It puts the financial system at risk.  Effectively, the regulators are gambling with taxpayer money.  I say this because experience shows that banks that need to raise capital would rather try to "earn" the capital by taking on risk than sell shares.

A classic example of this were the US Savings and Loans.  Everyone knew they needed more capital, but rather than try to sell stock at low prices, bank management preferred to gamble on redemption on risky exposures.  The end result was bigger losses for the taxpayers.

This state secret also distorts the financial system as those banks that need additional capital benefit from investors providing them with funds at too low a rate of return.  Recall that investors don't know how big each bank's capital shortfall is as it is a state secret.

With its latest pronouncement on the capital adequacy of the banking sector, the FPC has effectively introduced a new regulatory capital standard for U.K. banks. Yet it has failed to spell out key details of how this regime works in practice. 

At best, this creates an opportunity for fudge, with key decisions relating to the safety and soundness of the financial sector taken behind closed doors on the basis of a negotiation between regulators and banks.

Excuse me, but how much capital a bank should hold should not be limited to a negotiation between regulators and bankers.

Ideally, unsecured bank creditors should have a say as they should be exposed to the risk of loss on their investment.  The only way these investors can have a say is if there is ultra transparency and they can assess the risk of loss for themselves.

At worst, it risks creating a false market, with investors in U.K. bank shares—particularly Royal Bank of Scotland RBS.LN -2.83%and Lloyds Banking Group, LLOY.LN +2.42% believed to be the FPC's primary target—denied information vital to making informed decisions.

Please re-read Mr. Nixon's comments about the false market because investors are denied information vital to making informed decisions.

Your humble blogger has been making this point since the beginning of the financial crisis.