Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Loss absorbency of regulatory capital

The Basel committee on banking supervision has put out a proposal to ensure the loss absorbency of regulatory capital at the point of non-viability.

The proposal points out that all regulatory capital instruments are loss absorbent in insolvency and liquidation – “they will only receive any repayment in liquidation if all depositors and senior creditors are first repaid in full.” However, the financial crisis has revealed that many regulatory capital instruments do not always absorb losses in situations in which the public sector provides support to distressed banks that would otherwise have failed.

The solution that is proposed is as follows:

All non-common Tier 1 instruments and Tier 2 instruments at internationally active banks must have a clause in their terms and conditions that requires them to be written-off on the occurrence of … the earlier of: (1) the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority; and (2) a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority.

I am unable to understand how such tweaking of contractual terms will get around the fundamental problem that governments are unwilling to impose losses on banks and their stakeholders. In the United States when the government injected TARP capital into the banks, it forced the healthy banks also to take the capital to eliminate any stigma associated with TARP capital. Even if the proposed clause were present in the regulatory capital instruments issued by the insolvent banks of that time, clearly the clause would not have been triggered by the injection of TARP capital in this gentle form.

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