Since the financial crisis intensified in 2008, the fans of bank book capital have made numerous positive claims about its magical capabilities. Examples of these mythical claims include bank capital instills confidence and bank capital is there to absorb losses.
Please note, bank capital is an accounting construct. As a result, bank capital is easy to manipulate. For example, if regulators allow banks to engage in “extend and pretend” with bad debt, bank capital is overstated by the amount of the loss on the bad debt the bank should have incurred.
But couldn’t an easily manipulated accounting construct instill confidence in depositors?
In theory, yes. In reality, no.
Retail depositors don’t look at a bank’s balance sheet to decide whether to open an account or not. Retail depositors look to see if the government is insuring deposits at the bank.
The champions of bank capital like to say it is there to absorb losses.
In theory, this is true. In reality, global financial regulators will step up to prevent this from happening.
Why do regulators prevent declines in bank book capital? Fear. Fear a sharp decline might trigger a run on an individual bank and/or fear a sharp decline might trigger contagion and a run across all the banks.
For proof global financial regulators won’t let bank capital levels decline, we can look to the EU.
It is widely known the EU banks are sitting on a significant amount of bad debt (some of which regulators have allowed to be classified as non-performing assets and some of which is still classified as performing loans because regulators are willing to allow banks to engage in “extend and pretend”).
The regulators would like to see the banks clean up their balance sheets. One way to do so would be for the banks to recognize the losses on their bad debts. However, this would result in bank capital declining.
Since regulators refuse to allow this to occur, regulators are looking at two other approaches.
First, regulators are looking at what they call a precautionary recapitalization. This involves having the banks raise capital before the banks recognize their losses. As the Italian banks have shown, this is a tough sale because investors are being asked to trust the banks that all the capital they put in will more than cover any losses the bank faces.
Second, regulators are looking at recapitalizing the banks with taxpayer funds or engaging in a Cypress-style recapitalization by seizing depositor funds. Again, the money goes in before the losses are taken.
Preventing regulators from using taxpayer funds or seizing depositor funds is simple. Require the banks to provide transparency.
When market participants can see the exposure details, they can exert discipline on the banks to recognize their losses. More importantly, market participants can also assess which banks are still viable after recognizing their losses and should remain open and which banks are not viable and should be closed.