Maintaining Adequate Bank Capital

Abstract

The Basel framework has produced complex definitions of “adequate” capital, expressed in terms of book (accounting) ratios. However, solvency actually depends not on accounting ratios but on private investors’ valuation of the firm’s assets’ and liabilities’ market values. At large banking firms, short-term liability-holders key off the firm’s economic solvency when deciding whether to renew their claims. Runs can cause a large bank’s failure regardless of its book capital ratio. Yet supervisors have been largely unable to maintain minimum risk-bearing capacity at large institutions. Actual default probabilities have often exceeded the 0.1% annual rate to which Basel II was calibrated. Over the past 25 years, the median probability of failure (PD) was 0.55%, with some large banks substantially higher. The value of conjectural guarantees has averaged 11.41% of the largest 25 U.S. BHCs’ equity value. I conclude by discussing the extent to which orderly resolution or contingent capital bonds might improve supervisory oversight.

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