FSA Easing of Banks’ Capital and Liquidity Rules Gets Mixed Response from Industry

A move by the UK’s Financial Services Authority (FSA) to relax the capital and liquidity rules applied to Britain’s main banks has met with a mixed response from analysts.

In a bid to stimulate lending to business and boost the economy, the FSA confirmed that banks will no longer need to have a 10% core capital ratio but can instead hold a fixed amount of capital. It added that the Bank of England’s (BoE) Financial Policy Committee (FPC) had set out the shift in policy last month and banks were already aware of the change.

The regulator will also not require banks to hold extra capital against new lending that qualifies for a Funding for Lending Scheme targeted at loans to corporate borrowers.

Welcoming the move Zahir Bokhari, lead UK banking partner at Deloitte, said: “Regulators’ efforts to boost bank stability in the wake of what was the biggest financial crisis for 50 years are understandable.

“Deloitte’s latest research reveals that higher regulatory capital and liquidity requirements are the chief driver of European bank deleveraging. However, banks are finding it difficult to increase capital in the current market and say that run-off is the most common way of deleveraging. By encouraging banks to lend, the FSA is helping to strengthen the banking sector and economy as a whole.”

However, Dr Enrique Schroth of Cass Business School said that while the decision was a response to “legitimate concerns” that banks may be holding too much capital and, as a consequence, harming economic activity by lending too little, the FSA was taking a risk.

“This unprecedented move confirms that banking regulators see the urge to undo the pro-cyclical effects of Basel II risk-based capital requirements,” he said. “The key to understanding the effects of this policy is in trying to anticipate what the FSA will do after the recession.

“If the FSA is expected to continue with its countercyclical interventions as a rule, and tighten the capital requirements during the next boom, then lending may not increase much today: expecting tighter requirements tomorrow, banks would remain cautious today as future defaults could be relatively more costly. Therefore, this policy could reduce the volatility caused by the credit cycle, but not kick start lending today as much as expected.

“On the other hand, the incentives of banks to screen loan quality could decrease significantly if banks expect the FSA to relax capital requirements during recessions but leave them intact during booms. Lending may increase, but at the expense of higher default probabilities, and more severe recessions in the future.

“In summary, with its recent intervention, the FSA has opened the possibility of intervening via temporary changes to capital requirements to smoothen the pro-cyclical feedback effects of credit on the business cycle. But the real problem is not so much the use of risk-based capital targets per se, as opposed to the way default probabilities and credit ratings are measured. Basel III prescribes conservation buffers that address that issue, but they will only come in full force in 2019.

“Until then, banks will naturally start making forecasts of the FSA’s reactions, and the FSA will have to develop a reputation of sticking to rules set in stone or acting discretionally. Is the FSA ready to play that game?”

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