Right level of capital stirs debate

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Many central bankers and investors have argued recently that the solution to the credit crisis is to inject fresh capital into the banking system. What is less clear, however, is how much capital is enough.

On Tuesday night, the government was holding urgent talks about a state-sponsored recapitalisation of Britain’s banks.

If approved, the package is likely to involve the government in injecting capital directly into the country’s largest lenders.

Policymakers hope that boosting the banks’ capital reserves will restore confidence to the industry at a time when investors and other financial institutions are wary of extending credit to banks for anything other than a few days.

This concern, which was triggered by the collapse of Lehman Brothers, the Wall Street investment bank, has made it difficult for even large financial institutions to fund themselves in the money markets.

Some central bankers argue that a perceived shortage of capital is at the heart of the problem. Banks with relatively thin capital buffers are less able to absorb unexpected losses, making it more likely that bondholders will suffer losses in future. In this analysis, recapitalisation is the first step to restoring confidence.

However, nobody seems to know for sure what level of capital a bank needs to regain the market’s confidence. When the crisis started in summer 2007, the Royal Bank of Scotland’s core Tier One capital – reserves that a regulator considers to be permanent –- was about 4 per cent of total risk-weighted assets. Even at the time that ratio, which had been stretched by RBS’s role in the break-up bid for ABN Amro, the Dutch lender, was considered the lowest acceptable level for a large bank.

When RBS launched its £12bn rights issue in April, the bank set out plans to maintain a core Tier One ratio of at least 6 per cent. Other European banks quickly followed suit.

But now the government appears to be contemplating a recapitalisation that would lift the core Tier One ratios of RBS and other UK banks much higher. On Tuesday some observers suggested the new target might be a core Tier One ratio of as much as 9 per cent. That would require RBS, Barclays and Lloyds TSB, the country’s largest lenders, to raise tens of billions of pounds in additional capital.

Such a move would make Britain’s banks among the best-capitalised in the world. Assuming the fresh capital came from the government in the form of preference shares, it could also reassure creditors and depositors by providing an effective guarantee that nobody would be allowed to lose money, although ordinary investors would be likely to suffer.

However, analysts argue that capital is just one part of the puzzle. They point out that, until the money markets markets thaw, banks will face questions about their ability to fund themselves. “Until investors return to that market, and allow risk transfer to work again, the demand for funding will outstrip the supply, and banks will not be able to return to their normal lending activities,” said John Varley, chief executive of Barclays, at an investor conference on Tuesday.

Another question is the willingness of central banks in the UK and the rest of Europe to cut interest rates in order to minimise the risk of a serious recession, which could lead to further losses for the banks.

“If the government and the banks think they can fix confidence in the system just by injecting capital then they are being overly optimistic,” says Michael Helsby, UK banks analyst at Morgan Stanley. “They also need to solve the funding issue and the perception of the macroeconomic situation in terms of interest rates.”

Bankers point out that the appropriate level of capital for a bank also depends on the geographic spread of its businesses, and what share of its revenues come from relatively risky activities, such as investment banking.

Another question is whether a recapitalisation of Britain’s banks would merely shift the focus on to other, less well-capitalised institutions in other countries, and risk creating a race between countries to create the best-capitalised banking system.

All in all, it is far from clear that a wholesale recapitalisation of the banks is going to end the credit crisis. That is a risk the government appears willing to take.

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