A Letter to Governor Carney from Professor Kevin Dowd

Dear Governor Carney,


I thank your colleagues and yourself for taking the time to meet me on my visit to the Bank earlier in the year to discuss the Bank’s stress tests.


I have a number of concerns about the tests and about capital standards more generally.


Market versus book values


I agree with Sir John Vickers that it would be prudent to use market values in the stress tests especially when they are lower than book values. We should not, I believe, discount the possibility that market values are signalling problems that the book values do not pick up.


Now the Bank might be right that low price to book ratios merely reflect low future profitability as opposed to, say, unrecognised losses on banks’ books, but no-one can know for sure and it would be prudent to consider this latter possibility.


I would go further, however, and suggest that whatever the cause, low price to book should be a concern for financial stability because it signals problems of some sort with the banks. Even if the BoE view is correct, then “good assets” are still impaired by virtue of their being used in an impaired business model that offers low future profitability, i.e., the assets are impaired on a going concern or value in use basis.


This concern is reinforced by the fire sale problem, highlighted by Sir John, that one cannot prudently assume that any bank can sell assets at a good price in a systemic crisis


These considerations point to the conclusion that we should regard market values that are below book values as a major financial stability issue.


I would therefore endorse the Vickers proposal that the Bank publish parallel sets of stress tests based on both market values and book values.


Now I acknowledge your concern that adopting this proposal might compromise the Bank’s communication around the stress tests. However, I would make two points in response:

  • the stress test is first and foremost a resilience test of the banks;
  • communication is a secondary concern and the Bank has shown itself well able to communicate its message.


By market values, I do not mean that the Bank should base stress tests on the market value of shareholder equity. Instead, I am suggesting that it should make appropriate market-value-based adjustments to banks’ book-value core capital. This core capital measure should subtract all intangible and unreliable capital instruments: the only items that belong in such a measure are the loss-absorbing capital instruments known to be reliably available to support a bank in a solvency crisis.


To quote Andrew Bailey from a speech in 2014: “The big lesson [from the history of innovative capital instruments being included in regulatory measures of core capital] is that a going concern capital instrument must unambiguously be able to absorb losses when the bank is a going concern.” [1] (My italics)


CoCos are unreliable as core capital


This point takes me to my second suggestion: that the Bank use only the narrowest regulatory measure of core capital, CET1. The alternative – the one used in the Bank’s leverage ratio stress tests – is Tier 1, but Tier1 includes CoCo capital instruments that ought not to be regarded as on any par with CET1.


CoCos are unsuitable for a number of reasons:

  • the actual or anticipated bailing-in of CoCo investors can aggravate or even trigger a crisis, and can create destabilising market dynamics;
  • CoCo triggers are too low to be of much use as going concern capital, especially given the unreliability of the regulatory and accounting measures on which they are predicated; and
  • a considerable number of experts have expressed serious doubts about their reliability.


Further doubts about their reliability arise from recent experience. In Italy, the adverse public reaction to regulators bailing-in CoCo investors in late 2015 has made Italian authorities reluctant to do the same again, e.g., with MPS. In February last year, falls in the prices of Deutsche Bank’s CoCos triggered concerns that Deutsche might fail and cast doubt on the ability of CoCos to support a major systemic bank in a crisis. Even the recent bailing-in of CoCo investors in Banco Popular in Spain suggests that CoCos only worked as gone-concern loss-absorbency for a non-systemic bank.


I would add that CoCos have not been tested for a systemic bank let alone in a major market crisis. One also has doubts that CoCos will work as intended in the next major crisis when their hybrid capital antecedents failed to do so in the last.


Therefore, I would suggest that the Bank replace Tier 1 with CET1 in both its regulatory leverage ratios and in its stress tests.


Higher pass standards in the stress tests and higher capital requirements


Finally, I would suggest that the pass standards (if I may use that term) used in the stress tests should be higher and be reflective of higher minimum regulatory standards. Lord King has recently suggested that a minimum ratio of equity to total assets equal to 10 percent would be “a good start”[2] and other experts – most notably Professor Anat Admati – have suggested even higher minimum requirements.[3]


In each case, I believe that the guiding principle should be that of prudence. Prudence would suggest that the Bank emphasise market values when they are lower than book values, that it not put questionable CoCo instruments on a par with equity capital, that the Bank apply higher pass standards in its stress tests, and that the Bank substantially raise its minimum capital requirements.


Yours Sincerely


[1] Andrew Bailey, “The capital adequacy of banks: today’s issues and what we have learned from the past,” speech to Bloomberg London, July 10th 2014, p. 4.

[2] M. King, The End of Alchemy: Money, Banking and the Future of the Global Economy, London: Little Brown, 2016, p. 280.

[3] See A. Admati et alia, “Healthy bank system is the goal, not profitable banks.” Financial Times November 8th 2010.

1 Comment

  • I don’t attach a huge amount of importance to what Sir John Vickers has to say. In sections 3.20 – 3.22 of his “Independent Commission” report on banking, he claims that a big increase in capital ratios (of the sort required by narrow or limited purpose banking) would involve “very high economic costs”

    He (and his committee) do not fully explain what they mean by “very high economic costs”, but if they mean a general deflationary effect, that is easily dealt with via bog standard stimulus. And that costs nothing in real terms as Milton Friedman explained. So on that basis, the net costs are zero.

    Sir John then came out with this bizarre passage:

    “However, limited purpose banking would severely constrain two key functions of the financial system. First, it would constrain banks’ ability to produce liquidity through the creation of liabilities (deposits) with shorter maturities than their assets. The existence of such deposits allows households and firms to settle payments easily.”

    Well of course narrow banking “constrains banks’ ability to produce liquidity”! Milton Friedman (and some of the other Nobel laureate economists who advocated narrow banking) were quite explicit about the fact that narrow banking stops private banks creating or “printing” money. I.e. only the state has the right to create money / liquidity under narrow banking.

    As for the idea that under narrow banking, households and employers would not have a method of “settling payments easily”, that is sheer nonsense. Amazing as it might seem, the sundry Nobel laureate economists who advocated narrow banking (and who Sir John does not seem to have heard of since they don’t feature in his report) are aware of the fact that households and firms need bank accounts with which to make day to day payments! And equally unamazing is the fact that that’s catered for under narrow banking.

    A final and fundamental point which Sir John and his committee failed to consider is this. On the assumption that much higher capital requirements (100% in the case of narrow banking) does raise lending costs, the all important question is whether that constitutes a rise TOWARDS or a AWAY FROM the free market rate of interest.

    It’s widely accepted in economics that GDP is maximised where prices are set at free market prices. So if narrow banking raises interest rates, and that constitutes a move towards a genuine free market, that would actually RAISE GDP (counter-intuitive as that might be). Certainly there are problems associated with the ultra low rates that have prevailed in recent years.

    And there’s a very good reason for thinking that narrow banking amounts to a free market: it’s that under the EXISTING bank system, private banks are allowed to print money (as a recent Bank of England article explained). Allowing a particular set of corporations to do that is clearly a subsidy of those corporations, and subsidies reduce GDP (unless there is a very good social reason for the subsidy, as there is for example in the case of kid’s education.

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