The Regulator
Why this chapter
To understand why banking rules exist and how to see from them, in advance, that a bank is about to fall.
An analogy
Picture the rules for someone who carries passengers. Nobody forbids them to carry people, but three things are demanded: that the bus has brakes, that the tank holds enough to reach a filling station, and that the driver does not carry relatives for free, past the till. Brakes are a margin of safety in case of an accident. The tank is a store of fuel in case the filling station is shut. And the rule about relatives sounds petty, but it is exactly the one that ruins the operator most often. The twelfth chapter is about the same thing, except that instead of a bus there is a bank, and instead of passengers other people's money.
How it works
The regulator looks at three things. Capital (CET1): whose money pays for the mistakes — the Basel minimum is 4.5% plus buffers, while our supervisor asks for ~10% of assets weighted by risk (government bonds in the national currency — 0%, mortgages ~35–50% (in the final Basel III — by LTV), business 100%). Liquidity (LCR): will the bank live through 30 days of a run without help — a stock of HQLA ≥ one month of outflow. Conduct: AML/KYC, loans to related parties, the currency position.
The licenses of the world of money are a ladder: payment agent (Russia) → PI/EMI (the EU, PSD2: you may hold and move other people's money, you may not lend) → MTL state by state (the US) → a bank (the full engine: money creation + an account at the central bank + supervision forever).
The investor's view: the requirements are the language for screening banks: CET1 and its cushion above the minimum, NPL coverage by provisions, the share of related-party lending, the funding structure. A bank dies either of capital (slowly) or of liquidity (in 48 hours, like SVB).
The words of this chapter
A license
Permission to take other people's money and create new money. It requires capital paid in — the shareholders' money — before the first customer, and supervision forever.
The order cannot be reversed: the cushion has to exist before anything that could burn. Otherwise the very first loss is paid for by the depositors.
CET1
The capital adequacy requirement: the ratio of the owners' money to property weighted by risk. The Basel minimum is 4.5% plus buffers, and local supervisors demand more.
It was invented to tie the size of the cushion not to the size of the bank but to how risky its investments are.
LCR
The liquidity requirement: the store of easily sold property has to cover the outflow expected over 30 days of siege.
It was invented because a bank dies not from a loss but from having nothing to pay with on one particular day.
Provisions by stage
A requirement to recognize the expected loss on a schedule, without waiting for arrears: first a small percentage across the whole portfolio, then more on loans that have deteriorated.
It was invented because pain that is not recognized piles up and explodes all at once.
Related-party lending
Loans to a bank's owners and their companies. They are limited harshly, because the bank quietly turns into the shareholder's pocket.
The ban protects not the depositor from greed but the bank itself from a coincidence of risks: the owner and their bank go bust on one and the same day.
AML and compliance
A system for checking customers and watching their operations. The supervisor punishes not the fact that a customer turned out to be a criminal but the absence of a system.
It was invented because checking every operation from outside is impossible, while making an institution build a process is not.
What happens to the balance sheet
The rules look at a balance sheet from two sides at once. On the right, how much of the owners' money there is relative to the risk taken on: that is the store against losses, and it is spent slowly. On the left, how much property can be turned into money within a month: that is the store against outflows, and it is spent instantly. A bank can die from either side. From a thin cushion it dies slowly and visibly; from a shortage of fast money in two days and without warning. The third view is not on the figures but on the people: who exactly the largest loans went to.
Where the money comes from here
Rules cost money, and the bank pays for them: capital that cannot be put to work, a store of fast securities with a low yield, a staff of checkers. In exchange it gets the right to collect other people's money and to create new money — the most valuable product in finance. The one who wins is whoever builds the system in advance: it gives access to customers competitors cannot serve. The one who loses is whoever skimps on recognizing bad news: understated losses turn into a share issue at the worst price at the worst moment. This matters to you as a customer too: the published accounts show that a bank will soon be asking its shareholders for money, and they show it earlier than the news does.
What people usually get wrong
The common belief. Requirements are bureaucracy that stops banks from working.
What is actually true. The capital adequacy requirement is counted not from the size of the bank but from the risk of its investments. That is exactly why a bank hits the ceiling on its very first large business loan and never notices it when buying government bonds.
The common belief. If the liquidity requirement is met, there is no need to fear a run.
What is actually true. The requirement is designed for a month of siege. One bank received withdrawal requests of 42 billion dollars in a single day: an app on a phone and a group chat make a run faster than any requirement.
The common belief. A bank's main risk is bad borrowers from outside.
What is actually true. In emerging markets what most often kills banks is lending to their own owners. Such a borrower's refusal to pay and the bank's collapse happen on the same day.
After this chapter you will be able to
- read the queue of losses in the structure of liabilities: whose capital stands in front of whose money
- judge a deal by the capital it ties up through its risk weight, rather than by its size
- predict which liabilities will run first in a thirty-day stress, and lengthen exactly those
- tell the recognition of a loss apart from paying for it: a provision changes the value of an asset, not the cash flow
- tell a loan apart from asset stripping by who approves the deal and what secures it
Check yourself
The bank made a large loan to a business and bought government bonds for the same amount. Which tied up more of its owners' cushion?
The business loan.
The requirement counts not the size of an investment but its risk. Government securities in your own currency weigh zero and tie up no cushion at all, while a business loan weighs in full. Hence the banks' demand for government debt that is built into regulation.
Why is lending to companies owned by the bank's owner limited more harshly than any other lending?
Because the risks coincide completely.
When things go badly for the owner, they go badly for their companies and for their bank at the same time. An ordinary portfolio is saved by the fact that the borrowers are different. Here there is no difference, and the owners' cushion disappears exactly when it is needed most.
A bank has just been through a tough supervisory inspection, recognized losses and topped up its capital. Is that a bad sign?
More likely a good one.
The unpleasant surprises are already on the table, and the pain that was recognized has been paid for. Far worse is a bank with not a single finding in a jurisdiction where the supervisor is asleep: there nothing is known, and that is not an absence of problems but an absence of information.
In short
A bank is allowed to collect other people's money on three conditions. The first: it must have a store of its own money against losses, and that store is counted not from the size of the bank but from how risky its investments are. The second: it must have a store big enough to keep paying for a month, even if customers start pulling their money out en masse. The third: it must not lend to its own owners, because then it and its owner go bust on the same day. All of this is visible in the published accounts in advance — earlier than the problems are written about in the news.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.