Turkey will put capital rules to the test

TURKEY’S economic and political conniptions have driven a significant sell-off in European bank stocks. This meltdown may illuminate a deeper question about regulation: whether more capital makes banks or the financial system resistant to periodic crises.

Additional capital requirements were the primary regulatory response to the financial crisis of 2008. Global systemically important banks now must increase their total lossabsorbing capacity over time to at least 18% of risk-weighted assets and 6.75% of unweighted exposure.

While useful, these requirements don’t eliminate financial risks. They may even create new ones. Turkey — which is suffering from a collapsing currency, rising bond yields, and soaring debt loads — should offer an important test case.

First, bank failures are triggered by funding problems; typically, a run on the bank and an inability to cover deposit outflows. More capital can’t protect against this risk. Banks are also highly leveraged by design. Unless they’re willing to return to 19th-century standards of 50% equity, the effectiveness of capital requirements will depend on the magnitude of exposure and loss in question.

As Turkey’s problems mount, these measures could be put to the test. Institutions such as Banco Bilbao Vizcaya Argentaria SA, UniCredit SpA, and BNP Paribas SA all have substantial exposure to Turkey. BBVA’s exposure is more than 15% of total risk-weighted assets. If major losses occur, then it would materially affect the capital position of these banks, with unpredictable consequences.

A second concern is that banks’ resilience to losses will depend on the type of capital instruments they rely on. At least a third of minimum capital requirements can be met with what are known as hybrid-capital instruments, such as contingent capital bonds or subordinated debt. These instruments present significant risks of their own.

Contingent capital notes can’t be repaid without a regulator’s consent. In bankruptcy, investors are repaid only after depositors, senior bondholders, and holders of subordinated debt. Crucially, the notes convert to ordinary shares when the issuer’s capital falls below a specified level. Subordinated debt presents similar problems: Repayment of principal will rank behind depositors and senior bondholders, and the debt may be “bailed-in”; that is, the liability can be written down partially or fully where the issuer suffers losses. (In practice, regulators may hesitate to do this for fear of exacerbating financial pressure on the affected institution.)

Investors have purchased these instruments for yield, and issuers have frequently sold them as a substitute for deposits. But ordinary investors may not understand that these are deeply subordinated investments with uncertain income, complex conversion or bail-in provisions, and substantial capital risk. Facing losses, panicked sellers may cause a collapse in prices and accelerate an affected bank’s failure.

As Europe has recently learned, this can be politically perilous.

In November 2015, retail investors in four Italian banks lost their savings after subordinated debt was bailed in. The suicide of a pensioner who had lost 100,000 euros led to an angry backlash against the sale of these instruments to ordinary investors. The write-down of subordinated debt after Spain’s Banco Popular Espanol SA failed in 2017 was similarly divisive and is currently the subject of legal action. If bank investors are forced to take losses once again due to the Turkish crisis, governments should expect to face rising public anger.

And this suggests the biggest problem of all: These instruments don’t eliminate underlying risks from bad lending. They transfer them from banks to investors. If the strict terms of a contract are enforced, then the losses suffered will affect the ability of pension funds, insurance companies, and other asset managers to meet their liabilities. Losses suffered by investors may affect consumption and reduce savings, which in turn might necessitate government intervention to bail out the bank or investors directly, undermining the entire rationale of increasing capital levels to strengthen the financial system and prevent the need for public support.

The Turkish crisis may provide a useful real-world stress test of the complex new regime of regulations and additional capital. Recent experience suggests some skepticism is in order.

Several instruments don’t eliminate underlying risks from bad lending. They transfer them from banks to investors.

BLOOMBERG

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