Capital adequacy approach to bank soundness is fundamentally flawed

Inconsistent and poorly informed guidelines undermine the financial system

There is a fatal flaw at the heart of approaches to bank soundness which seek to insure against insolvency by requiring banks to hold capital sufficient to provide cover for any risk that the regulator considers possible.

Bank capital is the difference between the value of assets and the value of liabilities, both determined in the market. In times of financial crisis, markets often fail and prices fall precipitately. It will not usually be the case that price changes affect both sides of any bank’s balance sheet equally. If the fall in the price of assets reduces their overall value sufficiently relative to its liabilities, the bank faces insolvency, no matter how large its stock of capital might be.

This is the phenomenon we have seen in the sensational financial failures of FTX, Silicon Valley Bank and Credit Suisse. Whatever the source of concern, it is the loss of asset value which triggers the failure of the institution.

Prompt and unconditional support from the regulator is the best response to the failure of any financial institution whose national and international interlinkages may set off widespread apprehension about banking soundness. Anything less and the regulatory authorities risk loss of credibility, as shown by recent circumstances. Naturally, such support should take place simultaneously with assumption of the bank’s management and the start of a resolution process.

In my new book, ‘Development and Stabilization in Small Open Economies: Theories and Evidence from Caribbean Experience’, I make some key observations in this area.

First, the impact of financial instability on national wellbeing, reflected in the human development index, is not of lasting significance provided measures are taken for resolution.

There is a widespread – but false – narrative that says the 2008 financial crisis was the result of inattention by global supervisors. On the contrary, the crisis was triggered by a set of interlocking relationships, incomplete information and poorly coordinated decisions in unprecedented circumstances. This event could not have been anticipated, no matter how intrusive financial oversight might have been.

Stress tests and similar assessments of financial soundness are often misused. Instead, the recommended approach involves a set of interdependent tests which together give an exhaustive picture of the health of the financial sector. These include a macroeconomic forecast, a forecast of the main aggregates of the financial sector derived from the macroeconomic forecast and progressive stress tests of financial institutions, using the financial forecast as reference. For completeness, the analysis should be extended to evaluate risks of interbank contagion and secondary effects from changes in household and corporate balance sheets.

There is an over-reliance on elaborate lists of judgmental standards and codes for banking supervision, anti-money laundering, tax compliance and financial conduct, evaluated by complicated and largely defective methodologies. These guidelines are administered by different bodies at different times, using widely different criteria. The resources of skills, finance and time devoted to reviews of standards and codes, peer reviews of tax regimes and evaluations of measures to combat money laundering and human trafficking are enormous, both on the part of national and international regulators and financial institution respondents.

Finally, modern communications have undermined due process in ways that preclude the possibility of equity and the rule of law in international finance.

This chaos of inconsistent, poorly informed and largely politically driven guidelines, assessments and sanctions gives rise to an international financial system that is arguably more fragile and less able to detect and react swiftly to crises than it was in 2007-08. It is a system that is noticeably less efficient, less equitable and less inclusive.

The International Monetary Fund should be at the centre of the arrangements for international financial surveillance. Its board is fully representative – even if in need of reform – to reflect the economic and financial weight of members, and it has a large and talented staff devoted to the analysis and surveillance of the international monetary, financial and exchange system. That would not perfect the system of international financial surveillance, but it is a small step in the right direction.

DeLisle Worrell was formerly Governor of the Central Bank of Barbados. He is a member of the Bermuda Financial Policy Council, the Bretton Woods Committee and the College of Central Bankers.

This article was based on arguments made in Worrell’s new book ‘Development and Stabilization in Small Open Economies: Theories and Evidence from Caribbean Experience’ (2023).

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