WhyBanksFail:TheDefinitiveGuidetoSolvency,LiquidityandRatios

As BaselIII changestobank capital levels are being announced and implemented theresbeen asurgeinarticles
on bank capital levels. How much capital is required, what type of capital isrequired and howminimum capital
levels should bemeasuredandset areall hottopics. Bankscomplain that havingtoholdmoreequitywillreduce
their returnsandthus meanstheyhave tochargecustomersmore.Governmentswantstrongbanks,sothatthey
and their votingtaxpayersdonthavetopaythebillwheneverabankstrikestrouble.Everyproposalcomeswitha
cost,butwhichgivethemostbangforbuck?

WhyBanksFail
In trying to figure out how to stopbanks failing ithelps to startwithanunderstanding ofwhy they fail.Theres
twobasicrisksthatbanksneedtowatchoutfor,solvencyandliquidity.

Solvency ishaving meaningfulpositiveequity on the balancesheet, that is assetsexceed liabilities.Solvency can

be improved by raising more equity (stock offerings or dividend reinvestment plans) or by retaining profits.
Solvency is reduced by bad loans and investments, which become bad debt expenses on the profit and loss
statement and writedownsin the value of assetsonthebalancesheet.Forbanks,negative equityalmostalways
comes about from lending to borrowers who cant repay their loans and thus the bank incurs losses onthose
loans. It is typically the corporate and institutional departments that do themost damage with personal lending
lowerrisk.

In Spain and Ireland in the lead up to the financial crisis lending for property development skyrocketed.
Developers often contributed limited equity and when property marketscrashed thedevelopers were leftwith
property they couldnt sell and thus defaulted on their loans. Banks were caught with large amounts of failed
loans, and formany banks the losses onthese loansoverwhelmedtheirequity.Thisexperienceisfairlycommon,
SwedenandAustraliabothexperiencedapropertyandbankingcrashintheearly1990s.

Another practical example of solvency issues was the US subprimelendingcrisis.Whilstthis involved residential
loans, it was mostly lossesin the corporateand institutional departments onsecuritisationstructurescontaining
subprimeloansthatcausedsomelargeUSandEuropeanbankstofailortorequirebailouts.

The second key risk for banks is liquidity. Liquidity issues arise as a result of banks undertaking maturity
transformation, whichistakingshorttermdepositsandlendingoutthemoutforlongerterms.Customerswantto
deposits funds with banks and earn a positive interest rate whilst being able to withdraw the funds at short
notice. Borrowersneed longtermloans topurchasepropertyandequipmentfortheirpersonalorcorporateuses.
Banksprovideaservicetotheeconomybybridgingthegapbetweenthetwo.

Experience has shown that maturity transformation is adangerous business. Rumours of a bank having solvency
issues are enough to startarushfor theexits bydepositors,whichcansnowballonce picturesofpeoplelinedup
outside bank branches hits the news. The financialcrisisshowedpanicscanquicklyspreadglobally,withallbanks
being considered suspect once a few failed. Once one government offered deposit guarantees, others were
obligedtodothesameorriskseeingarushfortheexitsonthebanksintheircountry.

Whatarethemaincapitalratiosandhowdotheywork?
The complexities of bank capital requirements can quickly overwhelm even seasoned investors, analysts and
commentators. As a result, much of what is written about capitalratios iswrongormisleading and thedebate

about capital levels becomes a convoluted mess. It doesnt helpthattheres little evidence based modellingon
the costs and benefits of higher capital ratios. Banks often fill the void with alarmiststatementsthatthe cost of
lendingwillsoarandeconomicgrowthwillcollapseiftheyarerequiredtoholdevenalittlemoreequity.

However,out of this quagmire came a recent article byMikeKonczalthatsummariseswhatthecapitalratiosare

trying to fix.He explains that there arethreeareastofocuson;leverage,riskweightedassetsandliquidity.These
align with the balancesheet componentsof equity, assetsandliabilitiesrespectively.His neat summarychart is
below. In the following paragraphs theres an explanation on what each capital ratio is and what potential
problemitistryingsolve.

Source:RooseveltInstitute

Leverage Ratio: The leverageratioisthesimplestandmosttransparentofthethreekeyratios.Itistheamountof

equityrelative tototalassets,expressedasapercentage.Forinstance, abankwith$5ofequityand$100ofassets
wouldhave a leverage ratio of5%.The standardleverageratioincludesjusttheordinaryequitycapitalofabank,
ignoring preference shares (additional tier 1 or AT1) and subordinateddebt (tier2).An extendedversion ofthe
leverageratioincludestheseitemsandisusedforcalculatingtotallossabsorbingcapital(TLAC)ratios.

Theleverageratio istrying to solvethe problemof banks nothaving enough capitalto cover potential losseson
their loans and investments. Prior to the financial crisis, some banks had leverageratios of only 23%. With so
little equity, it wasnt going to take much of a financial storm to wash away a banks solvency. In the case of
Lehman Brothers, it combined a very low leverage ratio with high levels of risk taking in its lending and
investments, includingleveragedloans,mezzaninedebtandequityinvestmentsinpropertyandLehman Brothers
funds.

Risk Weighted Assets Ratio:The risk weightedassets ratio is similartothe leverage ratio inthatitmeasuresthe
percentage of nonsenior capitalrelativetoassets.However,thedenominator(thebanksassets)areadjustedfor
the perceived risk. Government debt is often (wrongly) considered to berisk freeandusually attracts a 0%risk
weight. Home loans are consideredlowrisk and can adjusted downto 1550% oftheiractualexposure.Business
loans are seenas medium risk andtypicallymarkedat100%oftheirexposure.Equityinvestmentsareconsidered
very high risk and usually attract a 3001250% risk weighting, which atthe high end implies that they are to be

fully fundedby bank equity. Riskweightedassets also includescalculationsformarketriskandoperationalriskin

thedenominator.

Risk weighting is trying to solve theproblem of comparing banksthataretaking varying levelsof riskwiththeir
lending and investment activities. Lets consider a hypothetical comparison of Boring Bank andRisky Bank.
BoringBanklends its$100 in homeloans andtocompanieswithinvestmentgrade creditratings. Asa result,its
exposures are adjusted down to $50 by risk weighting. Risky Bank lends its $100 to subinvestment grade
companies and alsoinvestsinequity.Itsexposuresareadjustedupto$200byriskweighting.Ifboth wanttohave
a risk weighted assets ratio of 16%, Boring Banks needs $8 of equity and subordinated capital and Risky Bank
needs $32. The leverage ratio would ignore the different risk profiles and treat them the same, but the risk
weightedassetratiosadjustforthedifferentriskprofiles.

Thetablebelow shows thebreakdown ofa banks capitalstructureinto the different capital types.Theseratios
have been created by using the average of the fourmajor Australian banks as at their annualreportingdate in
2015. Note that theratios for risk weighted assetsaremuchhigherthanthe leverageratios,whichislargelydue
tothesebankshavingsignificantexposurestoresidentialhomeloans,whichattractriskweightsofaround25%.

Liquidity Coverage Ratio:This ratio measures the amount ofhighly liquid assets relative toliabilitiescomingdue
over the next 30 days. There are adjustments to both the numerator and the denominator for the perceived
qualityof the assets(cash, centralbankdeposits,bonds)andliabilities(at calldeposits,wholesalefunding).Banks
need to maintain the ratio above 100%, which theoretically implies that they are able to meet their maturity
liabilities. Bankscan increase theirliquiditycoverageratio byincreasingtheproportionofhighlyliquidassetsthey
hold (less loans and more cash) or by increasing the length of the funding they receive from retail depositors
(termdepositsinsteadofatcallaccounts)andwholesaleproviders(mediumtermbondsinsteadofbankbills).

Whilst the leverage and risk weighted assets ratios are dealing with the solvency of the bank, the liquidity
coverage ratio is dealing with the liquidityrisk.In theory, if abank runbeginsthebankisabletosell highlyliquid
assets tomeetthe withdrawalsbydepositorsandmaturingwholesalefunding.DuringthefinancialcrisisNorthern
RockandDexiabothsufferedsubstantialrunsontheirwholesalefundingandrequiredliquiditysupportfromtheir
governments. The liquidity coverageratio triestoaddressthisriskbyassumingthatshorttermwholesalefunding
is unreliable and thus banks need to fundtheiractivitieswithstickier retaildeposits and long term wholesale
funding.

Limitationsofeachratio
The simplicity of the leverage ratio is also its greatest limitation. By assuming that all lending and investment
activities are equally risky itencouragesbanks toundertakehigherriskand potentiallyhigherreturnactivities.On
its own the leverage ratio would see banks increase risk taking, thus offsetting the required increases in their
equitylevels.

Thecomplexityoftheadjustmentsintheriskweightedassetsratioisitsgreatestlimitation. Whilst therearesome

floors onrisk weighting and a levelof regulatory oversight, the Basel IIIframeworkoftenallows for banksto set
their risk weights artificially low insomesegments.Italsotreatssomeassetswithinsegmentsasequal,whichlike
theleverageratiocanskewlendingtowardstheriskierborrowerswithinthosesegments.

Theliquidity ratiorelieson heroicassumptions aroundwhatpercentageofliabilitieswillberedeemedinthenext

30 days. At call retail and small business deposits are assumed to see a 310% redemption rate. If a bank run
begins,thisredemptionratecouldbehitwithindays,whichwouldseeabankquicklyexhaustitsliquidassets.

Thelimitations ofeachratio on itsown meanthatallthree ratios havea role to play. Some recentproposalson
reforming banks fail to recognise this. The Hensarling plan, named after USHouse ofRepresentativesFinancial
ServicesCommitteeChairmanJebHensarling,suggeststhatbanksbeexemptfrommostregulationsiftheyholdat
least 10% equity relative to their total assets. Areport by Kroll BondRating Agencysuggested that liquiditynot
capital isthe major issuefor largebanks. Each of these proposalsis flawedbyfailingtounderstandtheproblems
thattheotherratiosareseekingtosolve.

Thedifferenttypesofcapitalthatareincludedintheratios
Within bankcapital structures there are fourmain types ofcapital: equity, preferenceshares,subordinateddebt
and senior debt. In a small number of countries, the regulators have allowed for a fifth layer sitting between
senior and subordinated debt, which is commonly called bailin senior debt. Most regulators havent approved
bailin senior, as it is essentiallyaweakerformofsubordinateddebt.Itadds additionalcomplexityto bankcapital
structureswithoutadding material value. Thetablebelowshowsthenamesand featuresofthedifferenttypesof
capital.

RegulatoryName
Payment
Minimum
Approximate
CapitalType
PaymentType
Optionality
Maturity
Cost*
Compulsoryif
SeniorDebt
N/A
Interest
Any
2.50%
solvent
Compulsoryif
BailinSenior
Tier3
2years
3.00%
Interest
solvent
Debt

Subordinated
Tier2
Debt
PreferenceShares Additionaltier1
Tier1
Equity

Interest
Dividend
Dividend

Compulsoryif
solvent
Discretionary
Discretionary

5years

5.00%

Perpetual
Perpetual

7.00%
11.00%

*BasedoncurrentbaserateandmarginsinAustralia,withinternationalcomparisonsusedfortier3

Thetwo arguments betweenbanks and regulatorsare (i) howmuchtotal subordinatedcapital(everythingother

than seniordebt)is required and (ii) howmuchofeachtypeofcapitalisrequired.Bankswillobviouslypreferless
capital and more of the cheap types of capital, bailin senior and subordinated debt. Regulators prefer more
capital and more of the longer tenorcapitalitems,equityandpreferenceshares. Thenextsectionexploresthese
argumentsfurther.

Thecostsandbenefitsofliftingratios
Everybody agrees that increasing theamount of subordinated capital and liquid assets will come at a cost. How
much that cost is and what benefit is obtained fromdoing that is hotly debated. Themajorbenefit from banks
holding more capitalis a reduced likelihood oftaxpayerseverneedingtobailoutaninsolventbank.Thisisnotan
insignificant risk, many banks both large and small were bankrupted or bailed out following the onset of the
financialcrisis.Asecondarybenefitisareductionindebtfuelledboomandbustcycles.

Priorto the financial crisis, Ireland andSpainbothhadlowlevelsofgovernmentdebtandaboveaveragelevelsof

economic growth. However, the growth was not sustainable as it was driven by excessive credit growth. The
banksinbothcountriesweremakinghighriskloanswithoutholdingadequatecapital.Attheonsetofthefinancial
crisis, the economies of Ireland and Spain suffered substantialrecessions. Government debt to GDPratios have
skyrocketedfollowing governmentrecapitalisations of failing banks. Both countries are nowleftwithamountain
of debt that will take decades to repay (in an optimistic scenario) and will be a substantial burden on future
generations.Thisextraordinarycostiswellworthtakingoutsomeinsuranceagainst.

The gold standard in lifting capitalratios isSwitzerland.Its experience duringthe financial crisis, whichincluded
having to use taxpayermoneytorecapitaliseUBS and establish abadbankforitstoxicassets,meanstheSwiss
are keenlyaware of the risksbanks cancreate for taxpayers. Thetablebelow shows theminimum capitallevels
thatSwissbanksarerequiredtohaveinplacebytheendof2019.

CapitalType

LeverageRatio

RiskWeighted
Assets

SeniorDebt
SubordinatedDebt
PreferenceShares
Equity

<90.0%
5.0%
1.5%
3.5%

<71.4%
14.3%
4.3%
10.0%

Total

100.0%

100.0%

What the Swiss have done is substantially increase the amount of subordinated capital required but have done
this primarily with subordinated debt. On the leverage ratio, Swiss banks arent far away from being at these
levels already. Based on current estimates, the leverage ratio is slightly higher than what the international
benchmarks are expected to be. For risk weighted assets, the Swiss ratio is well above where international

benchmarks are expected to beset. Swissbanks do have a decentgapbetweentheircurrentcapitals levels and

the2019minimumsforriskweightedassets.However,itistherelativelycheapersubordinateddebtthatneedsto
increasemostwithsmallerincreasesrequiredforpreferencesharesandequity.

Belowis an estimate of the cost of increasingbankcapitaltotheSwisslevelsforthefourmajorAustralianbanks.

The leverage ratio is shown first. Note that as the major banks already meet the equity and preference share
requirementstheselevelsarenotadjusted.
CurrentWeighted
Alternative
CurrentMarket AverageMajor AverageCostof SwissCapital
Weighted
CapitalType
CostofCapital
BankCapital
Capital
Level
AverageCostof
Capital
2.50%
2.35%
89.79%
2.24%
SeniorDebt
94.00%
Subordinated
Debt
PreferenceShares
Equity

5.00%

0.79%

0.04%

5.00%

0.25%

7.00%
11.00%

0.86%
4.35%

0.06%
0.48%

0.86%
4.35%

0.06%
0.48%

Total

N/A

100.00%

2.93%

100.00%

3.03%

Next are the calculations for the risk weighted capital levels. Here the Australianmajorbanks do notmeetthe
capitallevelsrequiredforanyofthethreelevelsofsubordinatedcapital.

CurrentWeighted
Alternative
CurrentMarket AverageMajor AverageCostof SwissCapital
Weighted
CapitalType
CostofCapital
BankCapital
Capital*
Level
AverageCostof
Capital*
2.50%
2.16%
71.40%
1.79%
SeniorDebt
86.49%
Subordinated
Debt
PreferenceShares
Equity

5.00%

1.77%

0.09%

14.30%

0.72%

7.00%
11.00%

1.95%
9.79%

0.14%
1.08%

4.30%
10.00%

0.30%
1.10%

Total

N/A

100.00%

3.46%

100.00%

3.90%

*FormajorAustralian banksriskweightedassets average44.47%oftotalassets, sothegapbetweencurrentandalternativecapital

costsmustbemultipliedbythispercentagetocalculatetheactualcost

Basedon adoptingtheSwissleverageratio,Australianmajorbankswouldseeanincreaseof0.10%intheircostof
capital. For riskweightedassets,the increase of 0.44%is multiplied by 44.47% (the riskweightedassets to total
assets proportion) fora cost ofcapital increase of 0.19%.Assuming this was completely passed onto borrowers,
this would have minimal impact on the demand for credit. These higher capital levels will not make banks
bulletprooffromsolvencyrisks,butitwillsubstantiallyreducethelikelihoodofataxpayerbailout.

Unlike increasing leverage and risk weighted asset ratios, increasing liquidity ratios is of limited benefit. The
liquidity lesson from the financial crisis was that bank runscan quicklybecome a global phenomenon and only
governmentguarantees and central bank fundingcan stabilisethe situation.In 2008interbank lendingcollapsed
as bankswereunsurewhether any oftheirpeerswouldbe capableofrepayingtheirdebts.Excessdepositswere

parked with central banks, as banks were unwilling to take the risk of lending to other banks. Increasing the
amount ofliquidassetsmightcoverabankforadditionaldaysor weeks,butinafullscale bankrunonlylongterm
capitalisreliable.

To meaningfully addressbank liquidityrisk wouldrequire banks to cease their maturity transformation function.
Banks wouldneed to matchlong termloanswithlongtermfunding. Thiswouldbeacombinationofdepositsand
wholesale funding of atleast3yearsfor onbalancesheetactivitiesandasubstantialincreaseinoffbalancesheet
securitisation.Itnot simplyan issue of how much it mightcost,itisalsoanissueofwhetherbankswillturnaway
short term deposits and whether there is enough long term capital available to fund such a dramatic shift in
capitalmarkets.
Retaining the statusquo on liquidity comeswithanacknowledgementthatthismeansrelyingoncentralbanksto
provide liquidity in times of crisis. Providing a bank is appropriately capitalised, central banks should provide
liquidity at a cost higher than markets would charge in normal times but less than themarket costin timesof
crisis.Centralbanksshouldrequirecollateralwithappropriatediscountsappliedinordertoprotecttheirposition.

Theroleofregulators
There are two main roles for regulators in bank solvency, liquidity and ratios. Firstly, regulators need to set
appropriate ratio levels and police compliance with those levels. Thus far this paper has concentrated on this
aspect. Secondly, regulators need to monitor credit conditions within the wider economy as well as within the
bankstheyregulate.Thissectionexploresthissecondrolefurther.

Hyman Minskyhighlightedthatifcreditiseasilyavailablewithinaneconomy,thepotentialforasset pricebubbles

to emergeiselevated.Evenifabankislendingconservatively,theactions ofother lenderswithinaneconomycan
increasetheriskofabankbecominginsolvent.Thiscanhappenbothdirectlyandindirectly.

The direct lending risk is when banks lend to other banks,nonbanksor structuresthatarefacilitatinghigh risk
lending. As was seenin the US in thefinancial crisis, many banks werent making material amounts ofsubprime
residential loans directly. However, they were caught up in the collapse by their warehousing facilities with
subprime originators, mortgage backed securities and CDOs.Banksalso had tradinglimits with otherbanks and
mayhavesufferedlossesasLehmanBrothersandotherfinancialinstitutionsfailed.

The indirect risks mean what would otherwise be reasonablelevels of gearing become aggressive levelsdue to
inflated asset prices. For instance, a 50% gearing ratio on prime commercial property might be considered
reasonable, but this can quickly become a 75% gearing ratio if asset prices fall by onethird. This indirect risk
increasesboththeprobabilityofdefaultandtheseverityofloss.Asspeculativeassetprices fall,gearingcovenants
are sprungwhich creates acycle ofdistressedsellers. Whilst a banksborrowers may not be distressed, the fact
that the borrowers peers are distressed will see whole investment sectors repriced. It may also reduce a
borrowers income levels as excess supply increases competition and reduces the margins earned by all
participantswithinanindustry.

Whilst it obvious that regulators should beconcerned about the directriskstobanks,theymustalsomonitorthe

indirectrisks.This meansbeing aware ofassetpricesandcreditavailabilityacrossthewholeeconomy,notjustat
the regulated banks. It may requirethe use ofmacroprudentialmeasures,suchascappingthemaximumloan to
valuation ratio as New Zealand has done, or capping leveraged lending to corporate borrowers as the UShas.
Regulators should regularly visit banks and review a sample of theirloan books to ensure that lending standard

are notslipping. In crisis aftercrisis,banks haveproventhey cannot be trustedtomaintainconservativelending

standardsontheirown.

Thebest exampleofaregulatorreviewingloanqualityistheUSSharedNationalCreditprogram,runbytheOffice
of the Comptroller of the Currency (OCC). This programfocusseson corporateand institutionallending,thearea
that most frequently causes bankstofail. Each year the OCCinspectorsreviewthese largeloansandassignarisk
grade. For higher risk and defaulted credits, the regulator specifies the amount of capital the bank must hold
againstthe loan. By reviewingthesame loansandlendersyearafteryear, theOCCgainsanenormousinsightinto
whether lending standards are improving or deteriorating. When they are deteriorating, the regulatorcan take
actioninclude increasing the amount ofcapitalheldagainsthighriskloansorstoppingbanksfromlendingtohigh
riskborrowersaltogether.

When put together, the two roles of a banking regulator form a very strong barrier to banks ever needing a
taxpayer bailout. By setting and policing capital ratios, and reviewing credit quality across the economy bank
regulators candramaticallylowerthe risk ofbankfailure.Regulatorsneed tobeexpertsin bothrolestoproperly
setcountercyclicalcapitalbuffersandtounderstandwhenandhowtoimplementmacroprudentialmeasures.

Conclusion
Banks arecomplex,butunderstandingwhybanksfailandwhatcanbedoneaboutitdoesnthavetobe.Banksfail
because they have suffered losses onlendingandinvestments that outweigh their equity or cause concern that
their equity might be inadequate to cover future losses. This solvency problem is typically due to losses inthe
corporate and institutional lending segments. Solvency concerns fuel liquidity problems, rather than the other
wayaround.

Theleverageandrisk weighted capital ratios measure theamount of subordinated capital a bank has relativeto
its assets. The liquidity coverageratio measures theamountof short termassetsrelativetoshorttermliabilities.
Increasing subordinatedcapital greatly decreases the likelihood that a taxpayerbailout willeverberequired,but
increasinglong termfunding does not.Governmentsandregulatorsshouldprioritisethebuildingofsubordinated
capital over long term funding. Using the gold standard Swiss model, increasing subordinated capital for the
Australia four major banks wouldincreasefundingcostsby0.19%.Thisisarelativelysmallcostforanenormously
valuableinsurancepolicythatwillgreatlyreducethelikelihoodandcostofbankbailouts.

As wellassetting and monitoring capitallevels,regulatorsshouldalsoconductsamplingexercisestomeasurethe

risk of banks lending activities. If donewell, thesetwoactionsformavery strongbarriertobankseverneedinga
taxpayer bailout. If there is onelesson that governments andregulators must learn fromthe financial crisisit is
thattaxpayersshouldnotbeabackstopforbankshareholdersinaheadsIwin,tailsyoulosegame.

Written by Jonathan Rochford for Narrow Road Capital on August 16, 2016. Comments and criticisms are
welcomedandcanbesenttoinfo@narrowroadcapital.com

Disclosure
This articlehasbeen preparedforeducationalpurposesandisinnowaymeanttobeasubstituteforprofessional
and tailored financial advice. It contains informationderivedandsourced from a broad list of third parties,and
has beenpreparedonthebasisthatthisthirdpartyinformationisaccurate.Thisarticleexpressestheviewsofthe

author at a pointin time,andsuch viewsmaychangein the futurewithnoobligationonNarrowRoadCapitalor

the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of
securities,includingsecuritieslinkedtotheperformanceofvariouscompaniesandfinancialinstitutions.