I've been enjoying an email exchange today with someone who spotted my write-up in the Parliamentary Brief promoting the idea of a bank shareholder guarantee scheme.
This reader picked up on my definition of Tier 1 Capital, which is a critical aspect of bank solvency under Basel II.
He asked about the definition of Tier 1 capital, stating that: "as I recall its basically shareholders' capital and reserves, but your article suggests it includes cash holdings. How can that be? One is a non-deposit liability and the other is an asset."
Through various exchanges, here was my response:
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view composed of cash reserves for paying dividends and other liabilities, along with equity capital.
The Government defines this as: "the highest form of capital of the bank and is regarded by the Financial Services Authority as broadly equivalent to equity. This means it must be capable of absorbing losses so that the bank can continue trading even if it makes losses up to the value of that capital. The majority of this capital is made up of: fully paid-up ordinary shares, perpetual non-cumulative preference shares, and retained earnings (profits taken to reserves after payment of dividends and tax)."
This means that cash and cash holdings are an asset, and not part of Tier 1 Capital unless it is moved into reserves as retained earnings or to cover dividend payments. I am speculating that, due to share prices being reduced, some banks are doing just that – moving cash holdings to reserves as retained earnings to improve Tier 1 Capital.
This is due to their concern regarding Tier 1 Capital requirements and general solvency, as well as withholding cash due to nervousness about the economy and to cover contingencies or 'shock' premiums on credit derivatives or lack of access to wholesale funding or all of this.
It is this nervousness that means cash holdings are not being used for lending.
The point of this exchange is that Tier 1 Capital definitions may be the same, but attitudes and perspectives regarding the use of cash as part of capital are not the same. For example, I believe cash holdings influence Tier 1 Capital, whilst my interrogator is saying this is an asset and does not.
Either way, banks are hoarding cash to cover contingencies, and the result is that any money the government puts into the banks to lend
is meaningless because it is not being lent.
That's why we need a bank shareholder guarantee scheme to bring back confidence in the banks themselves. The only alternative is to nationalise the system which, as mentioned earlier, has its own challenges.